Thursday, 6 February 2020

Afterpay Touch: a more expensive solution to an existing, solved problem

Afterpay Touch (APT AU) is a stock that has acquired a cult following in recent years. The shares have risen spectacularly, and catapulted the company's market capitalisation to an astonishing A$10bn - almost 40 times trailing revenues (there are no earnings - the company lost about A$40m last year on revenue of $260m).*

To the uninitiated, APT is an ASX-listed fintech 'buy now pay later' (BNPL) payment system/platform, that styles itself as a replacement to traditional credit cards. The value proposition from the customer side is that consumers can use APT to purchase goods/services and pay back the amount in subsequent fortnightly installments, and unlike credit cards, do so interest free and without any pesky credit card fees. They have been adding a lot of merchants to their network, as well as consumers with APT accounts, and this has created a putative two-sided network flywheel effect that has caused investors to salivate about the possibilities - particularly as they begin to pursue international expansion.

The company's presentation materials are replete with stories of multi-trillion dollar addressable markets (indeed, in the company's FY19 results presentation, you have to get about 30 slides in before you get to any meaningful financial information, whereupon you learn that they lost money in FY19). The company seems to envisage itself disrupting the traditional credit card industry, and becoming a conduit through which trillions of dollars of consumer payments are made the world over.

Going by the company's share price, a lot of investors evidently believe them, and have bought into the story hook line and sinker. There is only one problem with the bullish narrative, though: the company's core product is actually a more expensive solution to an existing, solved problem, that actually makes the world a worse rather than better place. Long time readers of this blog will know that I'm a skeptic of many putatively disruptive 'Valley' businesses, but I will acknowledge that at least most of them are attempting to make the world a better place, and offer better products/services at lower prices, even if most of them are losing money trying to do it. APT is different, and I find it very difficult to think of any 'disruptive' business models that have succeeded where their product is a more costly and inferior solution to existing alternatives, for obvious reasons.

Furthermore, the very factors which caused the company to enjoy some initial success in building out its network do not scale, and are also exposed (as I will discuss) to considerable regulatory risk. Indeed, as the company gets larger, rather than becoming more valuable and entrenched as network-effect businesses typically do (and APT's share price anticipates), it will actually increasingly undermine its merchant value proposition, and make the fundamental structural weaknesses of its business model impossible to ignore - potentially bringing the whole house of cards tumbling down.

I will acknowledge one thing, however: from the consumer's point of view, APT is clearly a great product and in many respects better than a traditional credit card, for a very simple reason: there are no fees, and it allows you to borrow to pay for purchases without incurring any interest (although the rewards programs associated with many credit cards need to be forgone). APT and the bulls belabour this point ad nauseam. The problem though is that this is not the end of the story, as the issue is not the consumer-side experience, but the fact that APT charges merchants 4%+ to accept APT payment. Indeed, the AFR has reported that APT charges merchants a fixed 30c transaction fee, plus a 3-7% sales commission (while APT's accounts indicate it averages to a bit over 4%), which is significantly more than merchants typically pay to accept credit cards (which ranges from about 0.6% for large merchants to 1.5% for small merchants, in Australia according to the AFR), or cash (0%).

APT might at first appear to be saving consumers money (and be perceived that way by consumers), but somebody has to pay for this 4%, and that somebody will ultimately be the end consumer, because merchants will have no choice but to raise prices to recoup this 'APT tax'. The bulls attempt to deny this fact, but denials make no economic sense (at scale). Most retailers earn in the vicinity of 5-10% operating margins, and the industry is not going to settle for seeing more than half of its profitability stripped away and passed on to APT. And it makes no sense that a product as simple as APT's would, in competitive free markets, allow it to capture more than half of the entire retail industry profit pool.

In the long term, equilibrium industry margins are determined by the complex interaction of a number of forces, including demand and supply, competition, industry cost structures, and the cost of capital. If 5-10% is the economic level of margins for the industry, that is where it will stay, and just like if labour and rental costs were to rise and need to get passed on to end prices to preserve industry margins, so it will be if merchants have to pay a 4% APT tax on turnover. The mechanism might be implicit rather than explicit ("our margins are under pressure - let's bump prices up slightly and see if they stick"; rather than "let's put prices up specifically to compensate for the APT tax"), but the outcome will be the same either way: consumers will ultimately end up paying.

It is staggering that the APT bulls actually believe it is feasible the world will move to a situation where merchants the world over will be paying a 4% transaction tax to the likes of APT; retailers won't put prices up to compensate; and that this is somehow innovative or disruptive, and will represent an improvement to the world as compared to the status quot ex ante. The reality is that this is a much worse world - a world where everyone pays much more for goods and services than they otherwise would, so companies like APT can pocket a massive, parasitical middleman fee.

Why then, you might ask, has the company achieved a degree of success/scale to date? For two reasons: (1) at a small scale, its platform does offer early-adopting merchants some meaningful benefits that offset the high transaction costs; and (2) APT's contracts with merchants have restricted their ability to impose a transactional surcharge when accepting APT payment. The former factor above contributed to merchant's willingness to acquiesce to the latter, but it is very likely that both of these two factors are fundamentally unsustainable.

It doesn't take a particularly deep level of thinking to see that the putative benefits for merchants are a fallacy of composition that don't scale. APT and the bulls are always quick to emphasise that APT allows merchants to boost their sales, but there are only two mechanisms by which this can occur. Firstly, an APT merchant can cannibalise the sales of competitors who do not accept Afterpay. From the consumer point of view, APT is a superior payment option than using a credit card/cash, so if Merchant A accepts APT and competing Merchant B does not, consumers might decide to shop more frequently with Merchant A, allowing Merchant A to pick up market share at Merchant B's expense. However, the benefits of this don't scale. It's only a matter of time before Merchant B decides to accept APT as well, and then the cannibalistic effect disappears, but the 4% transaction fees do not.

The second way APT can boost a merchant's sales is by providing consumers with yet another means by which to outspend their income. If a customer lacks the cash or credit card balance to purchase item X, without APT they will have to go without. With APT, they can now 'afford' to buy it. While in the short term this will indeed boost merchants' sales, the ultimate effect is merely to pull forward consumers' purchases, and so in the long term drives no sustained benefit.

Consequently, what we are left with is simply a more expensive solution to an existing solved problem. What is that solved problem? Fast, convenient, secure, and inexpensive electronic payments, and ready access to unsecured credit lines for customers (credit cards). If you think about it at a high level, the first payment system in modern times was cash. Cash has (and still has) its advantages - for a start, it's free (no transaction fees), and relatively fast and simple. However, it has some disadvantages - particularly in the modern era: you can't use it to buy things online; and you also can't use it to buy big-ticket items that require consumer credit, which you are able to afford by paying back over time, but don't have the cash to pay upfront for today.

Credit cards were the solution to this, as well as other use cases (e.g. for people travelling). In the past, credit cards had several attendant disadvantages, however. They were not only more expensive (requiring the acquiring of merchants; payment terminals; etc), but also importantly, they were slower to process than cash. However, with continued innovation, most of these disadvantages are now disappearing. The emergence of 'tap-pay' credit and debit cards which can process transactions virtually instantaneously has been particularly material, and is both convenient for customers and important for merchants, as it reduces queuing times at checkouts. Lower cost acquiring solutions (e.g. Stripe) are also emerging, and not ending up with a pocket full of coins is also a significant convenience benefit for customers. Credit and debit cards still cost more than cash, but the many advantages and convenience have increasingly outweighed them.

Not surprisingly, this has resulted in credit and debit cards increasingly becoming a superior solution to cash, and is why Visa and Mastercard have thrived in recent years, as the market share of credit/debit card payments have risen, while cash's market share has fallen. Furthermore, V/MA's global 'payment rails' represents infrastructure that other fintech companies can build upon to offer new innovative financial products, and at relatively low cost (V/MA transaction fees are only in the ballpark of 10bp; most of the cost of traditional credit card fees are split between banks and merchant acquirers, as well as funding the cost of rewards programs).

In other words, fast, secure, and affordable digital payments, as well as on-the-spot consumer credit, is already a solved problem. And now along comes APT, and wants to provide a similar solution at triple the cost. It doesn't make any economic sense. The reason there is so much confusion is that (1) from the consumer perspective, they falsely believe they are saving money (as the APT costs are hidden and incorporated into retailer prices); and (2) many merchants testify that they have benefited from APT, but as discussed, this was due to the early-adopter cannibalisation, and consumption pull-forward effects. What this means is there is an incredible lack of clear thinking and prevalent misinformation with respect to APT's business model and its likely ultimate effects.

There are signs, however, that things might be set to change. The AFR has reported that the RBA is looking into measures that would prohibit BNPL providers such as APT from denying merchants the right to impose surcharges. The policy discussion has arisen in response to advocacy from consumer protection groups, as well as merchant associations, who unlike the stock market, understand the situation for what it is, and argue correctly that it results in a lack of transparency and market failure (consumers perceive the product to be free, when in actual fact it is extremely costly, and this is resulting in consumers making suboptimal decisions, and stifling the emergence of lower-cost alternatives). While the bulls have recently been celebrating and back-slapping as APT has surged above $40 - a valuation that requires the company earn and distribute $2bn a year sustainably by 2026 to generate a 10% return - about 10x the company's current revenue - the emergence of an existential risk to the viability of the company's business model has been ignored.

The thing that irked me most - and prompted me to write this article - was the fact that APT is lobbying hard to oppose this RBA policy measure, and the shameless, self-serving misinformation the company has served up to oppose the policy absolutely needs to be countered (contained in the article previously referenced). It is important to emphasise here that no one is proposing that merchants must impose a surcharge - merely that they have the freedom to do so. Why is APT so rabidly opposed to their merchant customers having such choice? If the product is so great and it delivers so many benefits to merchants, as APT claims, then surely the merchants would choose of their own volition to not impose one for commercial reasons, right? In that respect, APT's protestations speak volumes about the extent to which APT's management recognises that the success of its business model hinges critically on its ability to continue to impose hidden transaction cost on customers.

In the article they make many spurious arguments, including that the merchant costs should be compared more to what Facebook or Google charges for click-through sales leads, rather than alternative payment platforms (a laughable claim); and that the RBA's mooted restrictions would "stifle innovation, compromise consumer choice, and reduce competition". This latter argument is so bad, and so shamefully self-interested, that I think it has crossed the line into outright unethical conduct by APT management, because the the truth is the exact opposite to what APT claims.

It is absolutely vital to the emergence of increased competition (which is a key driver of innovation), and hence enhanced customer choice (and value), that there is price transparency, and that there are avenues for competing payment platforms to proliferate and offer more attractively-price alternatives. Let's be very clear again: it is customers who are ultimately paying the 'APT tax', and customers paying in cash (or with a credit card) are also being forced to pay it. From a consumer protection perspective, it is vitally important that this tax does not become systemic and entrenched, and leave customers with no choice but to pay it - even if they are not an APT customer. By making the cost transparent and explicit, you allow consumers to make a more informed and efficient choice about which payment methods are the most optimal/cost effective. Consumers can ask themselves, ok I like APT, but do I like it enough to pay 4% more? That is the right question to have customers ask.

Indeed, I might even be prepared to go as far as arguing that regulators should insist on merchants imposing a surcharge (although importantly, restricting the magnitude of that surcharge to the actual cost borne from external payment providers). That would allow room for innovative and lower cost payment systems to emerge, because you would give consumers a reason/price incentive to change. Currently, that price signal is lacking, which is one reason why we have emerged with a global duopoly with V/MA. The way things currently work, where fees are hidden/built in to prices that all customers pay - even those paying cash - the system tends towards the creation of monopolies and excessively high fees. I for one really hope regulators address this situation.

But if regulations change, and merchants have the freedom (but not the obligation) to impose a surcharge, will they choose to? The answer, I believe, is quite likely yes; it will likely start slow, but a trickle will eventually turn to a torrent. Why? Because those that impose a surcharge for APT will have an important cost advantage over those that do not, and will therefore be able to offer all customers lower prices. And if surcharges start to appear here and there, it could quickly become an industry-wide trend. This will particularly be the case as the touted 'merchant benefits' start to fade, for the reasons previously discussed.

If surcharges indeed do become a trend, the consequences for APT could be quite catastrophic. Their product will now be revealed to be what it has always been - a more expensive solution to an existing, solved problem. Furthermore, 'adverse selection' could also become a serious issue for the company, as the customers that can afford to pay you back will probably opt to pay cash or via credit card, as they will enjoy lower prices by paying that way (avoiding the surcharge), while only those heavily strapped for cash would agree to pay the surcharge. This could result in APT ending up with a portfolio of low-quality payday loans that suffer very significant defaults.

Time will tell. I am a generalist covering all industries and countries, and have only spent a couple of hours researching APT, so I might be mistaken or have missed something. I am not short the stock, because for reasons discussed in past blog posts, I believe shorting is dangerous in a world of ample liquidity and irrational exuberance, as many Tesla shorts have recently had to once again relearn the hard way. Many sensible people were wiped out shorting worthless stocks too early in 1999.

I would not be at all surprised to see APT eventually fall >90%, however, and it's also not impossible it goes to zero (although much less likely than merely a >90% loss). One suspects that if APT were come to be seen as a payday lender with weak underwriting discipline, rather than a hyped-up conquer the world fintech payments platform/network, which a shift towards APT transactional surcharges could quite easily lead to, it wouldn't trade at 40x sales.


*It is also notable is that about one third of the latter were late fees charged to past due borrowers, which APT book as revenue prior to collection - even though the collectability of late fees from delinquent borrowers ought to be considered questionable. This is very aggressive accounting. 


  1. so, why do marketplaces exist? using your logic, 15% take on a 5-10% operating margin business is clearly negative. you're definitely missing something, don't you think?

    1. Marketplaces exist to match buyers and sellers, and the 15% take rate you mention includes substantial fulfillment/logistics costs. For online e-tailers, instore costs (rent, labour) are lower, but fulfillment costs higher, and this is built into the 15% 'take rate' you mention.

    2. The current Afterpay business is far away from offering the value-add as a marketplace. What it offers now is a business catalogue, like the old yellowpages in an app. Is that worth a 4% take, probably not. Can they evolve to a real marketplace platform? Yes. But will Afterpay be worth more even it becomes a marketplace? Take eBay as an example, GMV is $23.3B, with 183M buyers at US$38B market cap, and a low capital intensity business and low credit risk. Compare these numbers and you can make your own decision on Afterpay valuation.

    3. so, if everyone is on the marketplace, it's a stalemate that becomes negative sum for everyone. marketplaces existed long before fulfillment and logistics, some still don't have them. should they exist? just using your logic again...

      FYI. The Unknown poster at 8:46 is not the same as me, same as the one that asked you the initial question.

  2. Afterpay can becomes two things: either focus on a niche like Amex being a marketing company and brands and high surcharge but can maintain its current take rate, with a very low credit loss. It can be worth a lot if it can grow a very big customer base. Amex valuation is about 2x revenue at the moment. The second way is to become the de-facto payment network like WeChat/Alipay where the take rate is very low but it penetrates most of millennial's daily transactions. This model means they take market share from the banks' credit card business rather than rely on merchant's profit pool. Afterpay is one of the few businesses at the moment that have both the consumers (the app) and merchants (POS integration) so can develop a closed loop payment platform.

    1. To follow up, there is a better way to think about the product. In a marketplace business, the provider makes money uniformly over all customer base. In a credit card business, the provider makes most money from the low income customer, actually lose money from the middle income credit, and make a small amount of money from the high income customers. For Afterpay, its product is inferior to a credit card for middle to high income customers, due to the low credit limit, limited acceptance. The frictionless aspect for online is on par with using Paypal over a credit card as the payment method so there is no incremental benefit.

  3. Great article - Just two questions for you please.

    1) You could write the same arguments when Visa/Master/AMEX cards were launched years ago, what made you think that APT couldn't achieve the same result as other credit card providers did?

    2) Majority of your arguments are related to the high transaction fees that charges the merchants, if APT changes the transaction fees to match the other credit card providers (i.e. 0.6% - 1.5%), would you arguments still valid?

  4. Thanks for your questions; in response:

    For #1, because as discussed in the article, credit cards solved some real problems that previously had no solutions - on the spot access to credit; online payments; and more recently, faster and more convenient digital payments. The reason I don't believe APT can have the same result is that it is trying to provide a solution to a solved problem at much higher cost.

    For #2, if APT matched transaction fees CC companies charge, they would be competitive in the marketplace, but their economics would be woeful and I'm not sure they could make money, as they lack the benefits of scale existing established payment networks have in place. This would make them merely a me too, subscale provider. The might survive, but it definitely wouldn't be worth 40x sales.


  5. Nice article. Not sure regulators are needed just allow merchants to apply surcharges to certain payments will solve this mess. You are right when you get to checkout would you pay a extra 4% for Afterpay? A lot of businesses that offer Afterpay have larger margins and even take AMEX as payment (larger fees than VISA/MC) so merchants might decide to absorb Afterpay costs also. In Australia we have PayID which is like a bank transfer (done with your bank also) but instant to any bank account with no fees up to $1000 so why would anyone use Afterpay unless they want credit (bring forward spending as you mention).

  6. Hello,

    I think your main agreement is around the hidden cost (after pay tax) and merchant were unable to pass them to the end consumer now.

    The 4% is big deal given most retailer net earning margin is in sub 10. Essentially, they sell their account receivable for 4% discount from credit sales. The company is a pure financing company than retail tor tech. The 4% cost essentially subsiding their bad debts.

    Now, the merchants are subsiding after pay revenue. As you mentioned, this might work well at the beginning if the additional sales are outweighing the 4% additional cost. However, this benefit will be reduced as more merchants are coming onboard and everyone offer the same thing.

    I think the trigger point can from one the followings:
    1. Regulators investigate the 4% additional cost and allow merchants to pass them to the end consumer and disclose them to the consumers, this would be really bad for the company. I think After pay do have some strings in the political arena.

    2. Nearly all the merchants are on the after-pay platform and the benefits for them are fading away. By using Afterpay, they are not getting more sales and even lower profits for each sale. This is hard to predicate what will happen. If after pay have the upper hand, then merchant must follow it, but I do not think this is the case.

    3. A new competitor come in and lower the overall costs. Given this old problem, it is hard to come up with another sustainable business model at even lower price.
    Another thing to notice is the after pay has substantial revenue from the late payment’s fees. Seems like a sub-premium lending company.

    Only time can tell, and it will very interesting to see what the outcome is.



  7. The 4% and late fees are used to offset their bad debt and all other expenses. When customer are paying, everything goes well, however, the economic go south, they will the first under the water.

    Their existence is very depends on the accessibility to the capital market.

  8. Local restaurants often charge over a 20% premium to dine in price for Uber Eats (eg $14.90 for a Guzman burrito v $11.90 on local website). Two tier pricing is understandable in this environment, however I'm confident local purveyors notice (personally I'm growingly cautious on buying on Uber Eats for this reason).

  9. Broadly agree with your thesis, though came to the same conclusion from a slightly different angle. I've been focusing on (1) merchant basket size reversion to the mean (i.e. destruction of demand pull-forward dynamic) (2) structural headwinds posed by the composition of its customer base (i.e. demographics, do customers graduate to CCs as they age/priorities change), and (3) competition - entry of Klarna/its partnership with CBA which grants it access to CBA's merchant base +  Zip MSFs are already lower than APT's. 

    My feel is that the regulators/ASIC is still tied up with the banking system, and that APT/BNPL players don't constitute a large enough % of payments volume to attract attention in the short term, though there's a clear regulatory risk in the medium-term.

  10. LT have you looked at Japanese stocks lately?

  11. Thanks for spreading a word of knowledge. You are doing great!

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  14. The majority of Millennials use debit cards and not credit cards - negating you entire "it's a solved problem" argument, as they don't use credit cards to solve the problem and there's no credit card that is interest free always that I know of like Afterpay.

    Secondly, what the RBA does is irrelevant, as they don't control what happens in USA and UK, Australia doesn't matter anymore as it's too small. Afterpay is already bigger overseas than in ANZ/NZ. Only tiny shops and idiots pass on credit card fees as most customers won't accept paying them. So even in Oz, it won't matter. Afterpay could also just list the free stores first, making it self regulating to not pass it on.

    Thirdly, you won't pull forward all demand and reach some point that the benefit drops, as Afterpay is a type of credit that people grow out of once their income is high enough to get an interest free credit card that they pay off on time during the interest free period. Girls never seem to grow out of spending the future and there will always be ppl earning in the gig economy who need to smooth all purchases because their income is not certain or is low but they still want to shop.

    Fourthly, the naysayers who think Afterpay has no moat should cogitate on the fact that marks and Spencer and JD Sports UK added clearpay AFTER already having Klarna... Why is that hmmmm Why did Coutue a $17b quant tech hedge fund from USA pump $200m into it and agree to partner on the big data analytics work?

    Fifthly, Afterpay only needs to reach $25b approx transaction value to have about $1b in revenue... 2022 or earlier at this rate.

    Just my opinion but I think you'll be seeing it pass $60 this year and $100 late 2021. $150 in 2022.

    Do your own research and don't rely on me at all.

    Lastly, great blog. I find your posts very interesting and we'll thought out with the exception of this one.

  15. Great article, you do a great job of pointing out the margin issue. I do wonder if there is a middle ground though. For the reasons you outline, I think it is fair to say that retailers will eventually successfully be able to start to recover the APT surcharge. Disallowing this permanently makes no sense at market saturation, because like you say, no retailer group is going to allow a ubiquitous 4% to go to a payment provider without passing this on to the customer and from a retailer point of view, it makes more sense to do this directly (through a surcharge) rather than indirectly (through a universal 4% margin mark up).

    But I wonder if purchasers will still appreciate the choice of a 4% increase on purchase price up front (if they can see it) with no future interest and a clear payment cadence and process, compared with a 1-4% credit card merchant fee with potential future interest on the card. Ultimately, on average, the customer is still going to be looking at it thinking 'well, I can use the APT product and pay 4%, but that's it and my payment plan is clear, or I can save 2.5%(ish) if I just pay on credit card, but that might be risky because I might have a bunch of other stuff on there I haven't tracked very well and will pay interest on it'.

    I think the product will still remain attractive to a lot of users - but will just face more competition from banks who will try and make larger purchase pay off periods clearer and more interest free (they're doing this already). Does dampen the potential growth of the platform somewhat though.

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