Afterpay ... buy now, merge later

Afterpay (ASX:AFY) is changing the way consumers buy retail goods and, in the process, is revolutionising layby. The outlook for growth in Afterpay isn't slowing but the market appears apprehensive with the recent announcement that AFY will merge with, its once big brother, Touchcorp (ASX:TCH). Is this an opportunity to buy into a flourishing business or an overcomplicated merger that would be wise to avoid?

Since listing in May last year Afterpay’s share price has more than doubled as the company has proven its business model and grown its consumer and merchant numbers at an extraordinary pace. But now investors appear wary about the proposed Afterpay Touch Group, possibly due to the complexity of the deal (which involves related party transactions and cross-shareholdings) or perhaps cynicism around the motivation behind the proposal itself (did Afterpay basically have to acquire Touchcorp to protect both businesses and secure its own future?).

So what does the future hold? Does the addition of Touch into Afterpay completely change the risk profile and impact the stellar growth outlook?

Having tried to cut through the speculation we have examined both operating business and the strategic rationale, and conclude that the growth is only just beginning.

Firstly, let's look at the businesses individually before putting them together.

Afterpay – why we like it

(1) Simple and proven product – The ‘buy now, pay later’ product is simple to use and offers obvious benefits to all involved being merchants, consumers and Afterpay itself.

(2) Incredible growth to date – The attraction and simplicity of the product is evidenced by the growth in all relevant metrics since listing. Over the past 12 months or so the number of merchants signed up to Afterpay has increased from only 100 to more than 3,100 (the most recent additions include businesses such as Myer and Officeworks) and the end-customer numbers have grown from 38,000 to over 500,000. This has resulted in current annual underlying sales of around $500m.

(3) Proof of model – The business model has now been proven to be successful and robust. The traction of the product has not only resulted in more merchants, but importantly an increase in merchant fees (higher margins). Also, the customer data analytics has improved and the net transaction losses have stabilised below 1.0%, comfortably better than prospectus forecasts. Funding options have also broadened from relatively expensive equity to major bank-funded debt. The short credit cycle supports high return on capital and funds the rapidly increasing sales base.

(4) Extraordinarily scalable - The Afterpay business should be viewed as not only targeting online retail sales, but rather online and in-store sales for both retail products and many more product categories such as telco, travel, ticketing and utilities. The scope to expand the offering domestically and offshore is vast.

Touchcorp – the key considerations

After a solid start to listed life in mid-2015, Touchcorp has endured some problems, most notably in the 2016 result. That said, it processes all Afterpay transactions and has long-standing relationships with Optus, 7-Eleven and European-based retailer Valora Group.

1. Weak recent result – The December 2016 result exposed the business to a cost base that appeared too high given the lack of new client signings (eg. the proposed Telstra deal was never completed). Fuller disclosure was given on the previously opaque business model and exposed some flaws in the mix of integration versus transaction revenue.
2. There is still a good proportion of recurring revenue – Long term relationships (some contracted) will continue to generate ongoing transactional revenue, so even if future capital is not deployed into winning new Touchpay clients, the business is still sustainable and should be managed comfortably into a strong net cashflow positive position.
3. Management re-focus and right sizing of the business is required – The cost base of the business needs to be reduced and future spending needs to be directed into high Return on Investment (ROI) initiatives.

The merged group – Afterpay Touch

It’s proposed that the entities will officially merge on 1 July. Here are the reasons we believe the outlook for the new business is outstanding.

1. Management’s ability to execute – Afterpay MD Nick Molnar and Executive Chairman Anthony Eisen will drive the new combined business. Keep in mind Touchcorp is a business that this team, particularly Eisen, already knows very well. Other than the growth focus, they will certainly be looking closely at the cost base and cashflow position of Touchcorp. It’s worth noting that TCH’s strong net cash position can also be utilised more effectively on high ROI priorities. We have faith in this management team.
2. Afterpay will continue to grow strongly – The momentum in Afterpay is not subsiding.
3. Potential for synergies – The existing customer base of Touchcorp may be attracted by the demand-pull from the Afterpay product. This could be the catalyst for Afterpay’s European expansion with customer data analytics already available through the Valora Group relationship.
4. Complete control – The combined group will now have complete control over transaction integrity and data analytics, which will be valuable both operationally and strategically.

Given the market value of TCH prior to the merger proposal equated to only the value of the AFY shares it owned, and AFY paid away an undisclosed proportion of its revenues to TCH, we believe the combined entity offers a compelling investment proposition and the current hesitation by the market presents an attractive entry opportunity.