Cold November rain, a sea of red… various phrases could be applied to the recent performance of Australia’s listed BNPL sector – particularly over the past month.

That accelerated downturn is partly a by-product of the sector’s transition, professional investors told Stockhead; from the post-COVID boom to market maturity, which means more competitors and pending consolidation.

For BNPL investors, it’s a trickier path to navigate. And discussing the outlook, Shaw & Partners investment advisor Adam Dawes said the tone of caution is justified.

ASX BNPL returns:

CODE COMPANY PRICE ($) 1 WEEK RETURN % 1 MONTH RETURN % 6 MONTH RETURN % 1 YEAR % RETURN MARKET CAP
LBY Laybuy Group Holding 0.29 -31.0% -41.4% -47.7% -79.0% $75,066,349
ZBT Zebit Inc 0.37 -6.3% -29.5% -66.7% -64.3% $36,424,351
SPT Splitit 0.28 -6.7% -29.1% -56.6% -78.5% $131,424,847
SZL Sezzle Inc. 4.11 -15.1% -28.6% -43.7% -33.0% $824,345,808
IOU IOUpay Limited 0.185 -9.8% -27.5% -40.3% 2.8% $90,982,991
OPY Openpay Group 1.015 -10.6% -26.7% -43.3% -61.8% $106,458,697
Z1P Zip Co Ltd 5.24 -8.1% -22.9% -26.2% -13.7% $3,044,276,350
PYR Payright Limited 0.275 10.0% -21.4% -43.3% 0.0% $16,747,112
HUM Humm Group Limited 0.765 -6.7% -17.3% -27.5% -38.6% $381,356,605
APT Afterpay Limited 110.55 -5.0% -12.7% 18.2% 15.4% $31,665,352,811
CI1 Credit Intelligence 0.014 0.0% -6.7% -36.4% -44.0% $22,438,129
LFS Latitude Group 2.05 0.5% -4.2% -14.9% 0.0% $2,076,923,076

Top-down view: When the tide turns

“I think it’s partly due to the fact the sector is quite saturated now – it’s not just Afterpay (ASX:APT) and Zip Co (ASX:Z1P) anymore,” Dawes told Stockhead.

The continuation of post-COVID growth rates is also a key question for investors.

“Comparatively, Australia’s considered more of a mature (BNPL) market. Obviously the US is a major addressable market, but can these companies keep their 2020 growth rates going? Probably not,” Dawes said.

“They’re definitely still growing, but whether they can sustain those growth rates – I don’t know. And I think that’s what the market’s getting a bit cautious on.”

Ron Shamgar, head of Australian equities at TAMIM Asset Management, offered a similar view.

“They’re cycling huge growth numbers from the previous period. Also in this space, no one makes money yet – they trade on revenue multiples,” Shamgar said.

“In that environment, valuation multiples are often benchmarked to the market leaders so when they fall back, the whole sector contracts.”

“What I think we’ll see is a period of consolidation in the next 12-18 months because there’s too many competitors. So that’s the next obvious stage in the growth cycle.”

What next?

Is it time to run for the BNPL exit? Dawes and Shamgar stopped short of that. Instead investors should position in line with the sector’s maturity.

“As an advisor my view is to always invest in the top two players for a given sector,” Dawes said.

“Obviously APT caught the market’s attention and they’ve been the leader, but Zip Co has established itself as the number two player and we’re more comfortable with their model.”

Shaw currently has a Buy rating on Zip Co, but is less bullish on the broader sector.

“I heard the Splitit (ASX:SPT) CEO the other day saying their messaging is getting lost, and they’re not communicating to clients the benefits of what they do and how they do it,” Dawes said.

“Well it’s not that hard, it’s four payments in instalments. So again when I look at all the competitors I lean towards the top one or two players.”

In that context, he likes Zip Co’s efforts to have a go in new markets where BNPL is less established.

“They’re doing something different in the sense they’re going for a land grab right now,” Dawes said.

“They’ve gone into India, South Africa and parts of Europe and they’re trying to get a foot on the ground in those markets before everyone else does.”

“Entering new markets obviously costs money from a per-unit economics perspective, but I think it’s the right strategy.”

“So I think investing in the top two for any sector is wise. But for BNPL when you look at the stocks down the ladder in a saturated market, that again is fraught with danger.”

By the numbers

In a sea of red, leading the BNPL laggards over the past month was NZ-based Laybuy Holdings (ASX:LBY), which closed yesterday at 29c.

It’s a different market to the upward BNPL rerate in September 2020, when LBY raised $40m from investors at $1.41.

The recent selloff in LBY shares accelerated last Tuesday following its half-year trading update.

In that context, Shamgar provided some insights on the key metrics investors should be looking for in BNPL results.

“What you could see is their total transaction volume (TTV) was going up. But even though TTV was growing, they reported a contraction in their net revenue margin,” Shamgar said.

“While LBY’s half-year TTV came in at NZ$391m, its net transaction margin fell to 1.5% (from 1.7%). At the same time, its bad debts as a percentage of TTV were also going up,” Shamgar explained (from 2.5% to 2.6%).

Like other BNPLs, LBY is chasing a global distribution strategy and on that front, it’s had early success in the UK market, Shamgar said.

“But what those numbers suggest is that as they’re growing into that market, it’s coming at the expense of customers quality with higher bad debts. So that’s what you have to look for with these businesses – it’s not just about top line growth.”

Those kind of unit economics result in a cash burn, which is a problem in a market where big bets from sophisticated investors on expansion liquidity is starting to dry up.

“Like other companies in this space they’re probably going to have to raise more money, which is working against them in terms of the share price going lower as well,” Shamgar said.

Shamgar also flagged the model deployed by US BNPL player Sezzle (ASX:SZL) which generates some of its funding costs through its Merchant Interest Program (MIP).

Sezzle doesn’t return the funds directly to retailers; instead, it keeps the sale funds on hand and pays the retailer an interest rate.

“That’s a more creative way of approaching the funding issue but I think in the market’s view they’re still burning cash and losing momentum,” Shamgar said.

In fact, despite the high transaction volumes generated through BNPL, the model is quite capital intensive.

In one of its many bearish research notes on Afterpay, UBS bank noted that the company operated with a negative equity free cash flow (FCF) position — the amount of free cash that could be distributed to investors once all expenses and debts had been paid.

Consolidation?

That bearish thesis got blown out of the water when Square Inc bet on scale and synergies in its marquee August acquisition.

Square’s APT takeover took another step forward when shareholders voted in favour of the deal earlier this month.

In turn, APT shares increasingly trade in line with the fortunes of its soon-to-be parent company on the Nasdaq.

Elsewhere, Zip Co followed up a $120m share placement last December with a $400m convertible note offering in April.

Further down the line, both Dawes and Shamgar said the capital intensity and margin pressure of the sector, combined with increased competition, means more consolidation wouldn’t be a surprise.

“I think Zip Co being in that number-two position could be a target, and there’s been speculation in the past of them joining forces with Klarna,” Shamgar said.

Privately-owned and headquartered in Sweden, Klarna was valued at almost US$50bn earlier this year in a funding round led by SoftBank. (Aussie lender CBA also has a $300m stake in the business, and recently launched its own vertically-integrated StepPay offering.)

“The other one I think could be a takeover candidate is actually Laybuy,” Shamgar added, despite the negative per-unit trend in its recent trading update.

“The reason I’d flag them is because of their size; they’ve got a market cap of around $75m, which is digestible relative to their first-mover position in the UK market,” he said.

Dawes said that once APT is merged into Square, Zip Co will be the biggest fish in the ASX pond which means it may go after a smaller player.

On the global level, he also flagged ~$40bn US player Affirm, which is still trading above US$130 after listing on the Nasdaq in January at US$49.

“A company like that looking to get a foothold in Asia through acquisition sounds more palatable than merger activity at the smaller end of the ASX,” Dawes said.

But as the sector matures, both Dawes and Shamgar said investors will have to tread carefully into 2022.

“I still think companies can succeed in this space but it’s probably get a bit crazier next year with inflation and interest rates taking centre stage,” Dawes said.

“So it’s going to get more difficult to pick a stock and at the very least we’ll be in for a bit more volatility in the cycle.”