Afterpay's rivals set for battle with rates and regulators

-- | 03/03/2022 Text size Decrease

Lewis Jackson: Afterpay left the ASX this January, but its spirit lives on. There's more than 10 buy now, pay later stocks still listed on the Australian Stock Exchange. To talk about the sector and Afterpay, I'm joined by The Australian Financial Review's Jonathan Shapiro, who has recently written a book about Afterpay. Jonathan, thanks for being here. Jonathan Shapiro: My pleasure. Happy to be here. Jackson: Okay. Let's start with Afterpay itself and its legacy. I think everyone is familiar with the story, but what's the takeaway for retail investors looking back over the three or four years of the journey? Shapiro: I think for retail investors, I think, like you said, the legacy lives on. I think for retail investors it absolutely will live on. I mean, every time I'm on the Internet, it's like what is the next Afterpay. So, I think Afterpay showed what the stock market can do. And the incredible thing about Afterpay is its entire journey took place on the ASX. There was only like one small round of raising that they did privately. But unlike a Canva or even Atlassian or even some of the big U.S. venture Uber, all of them, a lot of the kind of incredible growth took place when they were private. But Afterpay, almost its entire journey, 99% of its journey and its wealth creation took place while it was listed on the ASX. So, you and me could have shared the kind of (Sequoia or Horace) and Andreessen Horowitz returns. So, that's the legacy is that Afterpay kind of – there's an incredible growth story, and the entire journey took place on the ASX and that tested – it tested the kind of the commitment of retail investors. A lot of them made a lot of money. But as it passed through the market caps, it also – like, it tested the market cap investors, the small cap investors, the mid-caps and the large caps, and it really kind of ran a gauntlet of the market. So, it gave everyone a lesson. Every investor of every style had to look at it and analyze it and make it kind of just a choice on it. Jackson: What are some of the things that – that growth story was incredible – 158 times, I think, from IPO to its sort of peak. Shapiro: Yes. Jackson: But looking back over it, everyone is looking for the next Afterpay now. But how discerning do people need to be? What are some of the lessons from that crazy journey? Because not everyone becomes an Afterpay obviously. What are some of the things to keep in mind? Shapiro: Look, I think – I mean, I have a lot of sympathy for investors that didn't buy Afterpay because there were a lot of reasons why it might have become hugely popular but not hugely profitable. So, I think there's – especially as it got larger, it was harder and harder to justify its valuation. So, as more people came to hear of it, it's difficult to kind of justify why it should be worth $20 billion-$30 billion when it's a financing company, you know, that requires capital and is a margin business. And the more it grows, the more capital it needs. But it is also a difficult thing to bet against because it was very popular with consumers, and it grew exponentially, and it had this incredible traction with merchants and with customers. And the model kind of worked, at least it – it might not have been – it was profitable, but it could sustain itself because of the way it charged investors and lent a dollar out 12 times a year. So, yeah, there's – it's a real test of – and I guess one of the – maybe the enduring lesson is, what is a growth company and what is a financial company. So, this is where a lot of investors were divided. It was basically lending money. I know they won't – they don't like to call it that for a whole lot of reasons, but it was extending your money in the hope of getting it back and making a fee, whereas a lot of growth companies like a Visa or payment companies, they're platforms, and they charge a fee, and once their costs are battered down every kind of transaction is pure profit. So, Afterpay kind of tested where the lines are of what is a platform, what is a finance company. And yeah, I don't know, there's something we were obviously saying earlier about one of the lessons is regulation. A lot of investors thought that Afterpay might get regulated away. And I think what Afterpay showed a lot of people is that if something works and consumers like it, the regulation will bend – it's just as likely to bend as the actual product. The regulation might have to move if something is popular. The lawmakers and rule makers don't want to be the guy that kills the party for a whole bunch of reasons. So, the laws might change. Jackson: And on that question of laws, if we look to the sector more broadly now, there's a whole series of headwinds – interest rates, competition, but regulation as well – the reserve banks now looking, let's change the tune on the sector, regulators in the U.S. as well. Do you think – or you just talked about how regulators will follow the crowd – but is this a risk for the 10, the 15, the 20 buy now, pay later stocks out there trying to be the next Afterpay? Shapiro: I think it's a good question. I think when they were small, they were the underdog and challenging the incumbent and bringing something new to the table. And regulators were a bit reluctant to kind of stamp out innovations. Certainly, the message they were getting from politicians is like, you know, you don't want us tough on innovation. I don't know if I agree with that or not, but there was certainly the line that – that was certainly kind of the lobbying line, and it seemed to buy them time. And now, they're very big, and now I don't think that line quite works, because now they are entrenched and well understood and big, and they need to be – you could argue they need to be regulated. If they now have so many customers and so many merchants, it's hard to justify that they're small, growing and challenging a new model. They now are very much part of the fabric of Australian payments. Jackson: And do you think that creates a problem then for the other players who are still small and innovative and trying to get into the market that the regulators are now saying actually we do want to look at this? Shapiro: It's a very good question. Yes, I think it does. But the – any new innovators will have to come up with new products. And I think where it will be interesting and where regulators will maybe be tougher is like Afterpay rightly or wrongly – and again, this is kind of controversial and something we explored in our book is, were they harmless? Like, they would say they weren't doing anything. Everybody liked them. They have helped drive sales for customers and they charged late fees, but generally they were better alternative to credit cards. So, Afterpay argued that they were a win-win. Again, that's debatable. Consumer groups might argue that there are like hidden costs associated with Afterpay, and the costs come later. Young people get introduced to debt. Like these are arguments where there's compelling arguments on both sides. But I think for new, kind of, I wouldn't call them buy now, pay laters, but some of them, I guess, are – but new kind of FinTech financing models that are consumer-focused, I think, in order for them to run the gauntlet successfully like Afterpay did and stave off regulation, I think they're going to be able to demonstrate that they aren't doing any harm, and I don't think that's obvious with some of the newer players in the space. I think regulators might take a dimmer view if a product is seemed to be predatory or unfair for the consumer… Jackson: Like a Beforepay, for example. Shapiro: I'll leave that to your viewers' imaginations. Jackson: Maybe quickly on interest rates. So, this whole sector was born at the sort of bottom of maybe a 5,000-year low in interest rates. They're probably going up. We know they're going up in the U.S. They will probably go up here as well. What does that mean? Is that a headwind? How does that factor in…? Shapiro: I'm glad you asked me this question, because there is actually a nuanced and interesting answer to this. So, on the surface, I actually don't think high interest rates matter too much, like, at the kind of – at the unit economics level. So, Anthony Eisen would repeatedly say, we're not scared of rising interest rates, we actually welcome them. And the reason is, they charge the merchant 4%, and let's say, on $100 goods purchase, they will charge the shop 4%. And that $100 will be lent out on an average of 12 times a year. So, if interest rates go from 2% to 3%, like global interest rates go from 2% – that extra percent gets dissipated into 12 transactions on a unit economics basis. So, it doesn't really make that much difference. It's really kind of a marginal expense absorbing a higher base interest rates. But where interest rates absolutely matter, and this is something that he can't just deny away is, long-term interest rates and interest rate uncertainty has a huge bearing on these business' terminal value or how much are they worth into the future, because none of them make profits. All their profit is kind of assumed to happen 10 years into the future and you have to present discount a huge amount of market value and profit out into the future, and 2% to 3% interest rate can halve their terminal value which feeds right back into their cost of equity capital, and we all know that these businesses are hungry for equity capital and debt capital. So, it makes their cost of funding more difficult, makes it harder to attract investors when they're growing all the time, and the way their models are that they constantly need equity capital to grow. So, on a kind of unit economics basis, low interest rates don't matter. But on on a cost of equity capital, it makes a huge difference, and I think it actually is hurting these buy now, pay later businesses and will continue to hurt them if – and interest rates don't even have to go up. There just has to be interest rate uncertainty that you can't ascribe with as much conviction a terminal value to an Afterpay or some of these high-growth businesses. Jackson: Okay. Fantastic. Jonathan, thank you again for joining us. Shapiro: My pleasure. Thank you.