Square Inc. is paying top dollar for Afterpay Ltd. and analysts say it's worth it.
The digital payments player has said it will acquire the Australian buy-now, pay-later, or BNPL, platform for $26.9 billion. The deal values Afterpay at 29.29x next-12-months revenue rather than against trailing revenue or earnings, a multiple that is significantly higher than that of other fintech deals over the past few years. The elevated price is a sign that Square sees a huge market opportunity for BNPL going forward. Investors appear to agree: Square's stock price has risen as much as 16% since the deal was announced Aug. 1.
"It turns out being relatively understandable why they paid up," said Darrin Peller, managing director at Wolfe Research. Peller estimates that Square will be able to leverage Afterpay to boost the payment volume generated from e-commerce transactions from 20% to 28% of its total business.
BNPL has surged in popularity during the coronavirus pandemic, particularly for e-commerce transactions. Major players such as Afterpay, Affirm Holdings Inc. and Klarna Holding AB (publ) give merchants the option of offering installment plans to customers at checkout, typically in four interest-free payments. That encourages larger sales, and retailers pay the BNPL provider a fee, usually 3% to 6% of the merchandise cost, in exchange for full payment of the item or service. Afterpay funded $15.8 billion in transactions in its fiscal 2021, double the previous year. Other large U.S. fintechs are seeing the business expand. PayPal Holdings Inc. posted $1.5 billion in total payment volume in the second quarter from its BNPL product, which increased by 49% from the first quarter, thanks to the scale of its customer base.
“It made much more sense for the company to buy its way into the space rather than trying to build its own capabilities," Mark Palmer, managing director and fintech analyst at BTIG, said in an interview. ”If anything, Square was a bit late to the game.”
Square did not respond to a request for comment on the deal's pricing. The company expects the deal to be accretive to its gross profit growth in the first year after closing, excluding synergies. It plans to bring Afterpay's deferred payment features to the existing 40 million users of Square's Cash App, its consumer-facing digital wallet, and to the thousands of retailers who already use other Square small business solutions, such as its card reader hardware.
Afterpay, like its contemporaries SoFi Technologies Inc. and Marqeta Inc., has not yet had a profitable quarter, making the usual valuation metric of price-to-earnings not meaningful. Even for profitable fintechs, valuations lean high, with the median PE ratio among global fintechs above $10 billion in market capitalization at nearly 48x, according to S&P Global Market Intelligence data. That compares to a PE ratio of about 34x for the S&P 500.
Peller described the 29x future revenue multiple as relatively expensive. But after layering in the strategic opportunities, "it turns out being relatively understandable why they paid up," Peller said.
Stephen Biggar, director of financial institutions research at Argus Research Group, agreed that the projection of accretion in the first year indicates that Square sees a path to getting the full benefit out of the purchase price.
"One of the big helpers for Square in this case is that they’re really getting that global platform, where they were U.S.-focused up till now," Biggar said.
Credit risk in the BNPL model
One concern about Afterpay's growth outlook is that the BNPL model has not been time-tested through a full credit cycle, Biggar said. The space has ramped up aggressively, with companies investing heavily to build their brands and attract customers, but losses do occur when borrowers miss payments. And if losses start to snowball when a credit cycle turns, Square would have to bear the cost of growing the business too fast, Biggar said.
But Square has never hid its ambition in growing into more banking and lending services. It formed Square Financial Services Inc. in March after obtaining approval for an industrial bank charter. In July, it launched Square Banking, providing business savings and checking accounts and aggregating its lending products into Square Loans.
As part of Square, any constraints that Afterpay may have faced in terms of having the funding to pay merchants up front would no longer be of concern, Palmer said. As of Dec. 31, 2020, Afterpay had slightly over $1.4 billion in liquidity through several warehouse facilities funded by Citigroup Inc. and National Australia Bank Ltd. in Australia and U.K. and Goldman Sachs Group Inc. in the U.S.
For the six months ended Dec. 31, 2020, Afterpay's loss ratio, a key lending metric representing the money borrowers failed to pay that Afterpay could not collect on, was 0.5% of total sales, or $46.8 million in net transaction losses, according to the company's latest semiannual report. In comparison, the group average charge-off rate of six major U.S. credit card issuers was 1.35% in June, an 84-basis-point increase from June 2020.
During the pandemic, the BNPL industry did not see the spike in losses that some expected, in part because BNPL lenders only keep borrowers without any overdue payments. Repeat customers that have good repayment history contributed over 90% of the gross merchandise value generated on Afterpay's platform, according to Square and Afterpay's merger presentation. The short duration of the loans is another layer of protection against losses piling up. Afterpay typically allows customers to pay in four installments due every two weeks, according to its terms of service. For credit card borrowers, delinquencies usually rise in a six- to nine-month time frame, said Wolfe Research's Peller.
Consumers do not pay interest but are subject to late fees up to 25% of the order value, if permitted by applicable state law, according to Afterpay's terms in the U.S. That also helps offset the impact of the losses, Palmer said.
May draw regulatory scrutiny in consumer protection
Combining Square and Afterpay may not have obvious anti-competitive issues, with established competitors in payments and e-commerce such as Stripe Inc. or Shopify Inc., said Alex Johnson, director of fintech research at Cornerstone Advisors. In the consumer market, Square today does not have a credit card product, which is typically viewed as a direct competitor to BNPL, and Afterpay's 16 million consumers is impressive but still nowhere near the scale of the largest card issuers, Johnson added.
BNPL accounts for about 2% of the more than $10 trillion in online consumer business, and the space is competitive particularly at a global scale, with specialists like Afterpay, Klarna and Affirm now facing the entry of tech firms like Apple Inc. and payments giants like American Express Co. and PayPal, BTIG's Palmer said.
Even so, regulators are growing more concerned with BNPL as an increasingly popular form of consumer debt, Johnson said.
"I do think this acquisition will get a decent amount of regulatory scrutiny just because of its size and the companies that are involved," Johnson added.
Some U.S. lawmakers have already raised an eyebrow at the deal. Democrats on the Senate Banking Committee urged regulators during an Aug. 3 hearing to evaluate mergers more strictly, and Committee Chairman Sherrod Brown, D-Ohio, called out Square's acquisition of Afterpay as an example of fintech companies potentially posing risks with too much market dominance.
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