Much more growth ahead for Afterpay

The key information in today's result from Afterpay is the remarkable growth numbers. The velocity of this growth is evident when you compare the numbers in this result to just 12 months ago. 

• Integrated Retail Merchants: Grown from 2,000 to 11,500
• Underlying merchant sales (6 month period): Grown from $144m to $918m
• Afterpay end-customers: Grown from 0.4m to 1.5m, and 90% of transactions are now returning customers
• Merchant fees (6 month period): Grown from $6m to $37m.

These are real numbers. The company is generating real revenue and increasingly translating into real profit.

The market has become accustomed to Afterpay delivering exceptional growth in its key metrics of integrated retail merchants, end-customers, sales, and fees so the expectation is understandably high – but that doesn’t mean it should be taken for granted. 

Very likely to get a lot bigger... or get acquired

As original investors in the Afterpay IPO around 18 months ago, we have been lucky enough to witness its progress from very close quarters. The valuation of the business is now more demanding, so we consider the outlook with a degree of caution, but on balance we remain supporters for the following reasons:

1. Continued growth in domestic online: With an estimated 25% of Australian online fashion retail and 8% of online physical retail sales, and with end-user and repeat customers numbers continuing to climb, we believe the domestic business is far from mature. We see further expansion into new verticals.
2. Expansion of domestic in-store: Afterpay is now available in over 5,000 bricks and mortar retail stores with the rollout expected to accelerate over the balance of 2018 and beyond.
3. Expansion offshore, predominantly in the US: Only recently announced, but the deal is well structured and the opportunity is huge. There doesn’t appear to be a direct competitor in the US that has gained any real traction with a similar offering. The risk is obviously in the execution but we have confidence in the APT management team and the appointed US partner is reputable, so if it works it will not only prove to be lucrative but will put the company on the global investment map (think offshore buyer).
4. Risk management: Net transaction losses (bad debts) remained stable at 0.7% of underlying sales, illustrating how prudently the team manages risk, particularly in light of the growth that has been delivered.

Obviously, risks can never be ignored, particularly with a sharply priced growth stock. We have comfort that the management team is strong and prudently mitigates risks within the business (such as management of default rates and capital allocation), but there are always a number of factors beyond their control.

The following factors are amongst those that must be considered: 

• Consumer confidence and retail spending 
• Legislation around new innovative payment providers 
• Strong competitive response from industry incumbents 
• New entrants (eg. traditional banks, credit card providers or like services)

However, if you look at where this company is now and where it is likely to be in, say, two years time, it is very likely to be a lot bigger or in someone else’s hands, especially if the US expansion works.

What is the market missing about Afterpay?

The key thing the market is missing here is the leverage in the business and how effectively capital can be used to drive profits.  

Afterpay has a relatively low fixed cost base and is not a capital-intensive business in the traditional sense (it’s a technology company and doesn’t need to invest in tangible assets or even a sales force).

It does require capital to fund the strong sales growth, but given the average credit cycle length is 28 days, each dollar of capital can effectively be recycled more than 12 times a year.

This working capital requirement was initially funded using equity capital but APT now has the support of a major bank in NAB with a $350m facility. This can be  “recycled” 12 times a year, equating to current capacity of more than $4bn in annual sales, which in turn generates significantly higher profits with limited further investment.

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