BNPL bubble? Two pro investors help us value the red-hot sector

Buy now, pay later (BNPL) stocks have risen anywhere from 145% to 1,688% since March 23
The gains have raised talked in some sectors of a BNPL bubble
Pro investors Dean Fergie and Martin Pretty both struck a cautious tone with valuations at these levels

Are BNPL stocks in a bubble? Ask pro investors how the sector should be valued, and you’re almost guaranteed to get a broad array of answers.

So this week we caught up with two small cap investors to get their thoughts on the road ahead, after what’s been a torrid 2020 rally.

To start with, a quick scoreboard recap.

We’ve collated BNPL stock returns since the market lows on March 23, alongside monthly performance for October:

Code	Company	Price	% Mth	% since March 23	Market Cap
SZL	Sezzle Inc.	6.62	-7%	1688%	$649.4M
APT	Afterpay Limited	101.24	27%	1037%	$28.0B
OPY	Openpay Group	2.7	-3%	750%	$211.9M
SPT	Splitit	1.27	-8%	475%	$429.4M
Z1P	Zip Co Ltd.	5.89	-9%	377%	$2.9B
FXL	FlexiGroup Limited	0.96	-5%	145%	$455.6M
LBY	Laybuy Group Holding	1.49	5%	6%	$249.5M
ZBT	Zebit Inc.	1.23	-20%	-20%	$113.4M

Two >10x returns and (among stocks that were listed at March 23), every company has at least doubled.

And what also stands out in that chart is that the ASX-listed BNPL cohort is now eight companies strong.

To Dean Fergie from Cyan Investments (an early investor in Afterpay (ASX:APT)), that rush to market is a relevant factor in assessing the BNPL bubble.

“It’s economics 101 that when you’ve got one big competitor in a market with low barriers to entry, you’re going to have other players enter to get a piece of that lucrative pie,” he said.

“Obviously there’s investors out there willing to fund these businesses to try and achieve that but not all of them are going to be successful.

“And as you get more competitive, it does get harder to maintain margins.”

Buy now pay later — a rising tide?

One argument behind the rush of new entrants is that the BNPL market is a rising tide that can still lift all boats.

In Australia for example, BNPL services are still only applied at less than 20 per cent of domestic retailers.

And most of the BNPL stocks listed on the ASX are looking to execute on a global expansion strategy.

Martin Pretty is a now director at fund manager Equitable Investors.

But his previous firm was involved with Afterpay’s IPO, which gives him a unique perspective on how the sector has changed.

“It comes back to that thing about ‘what’s the total addressable market’?” he says.

“So originally investors were talking about the online market, and doing their calculations based on whether APT could grab a percentage of that.”

“Then you say, hang on they’re also executing in bricks and mortar retail, which is a bigger opportunity. Then they’re moving into markets like airline tickets, and it starts snowballing out.”

Looking ahead, Pretty does hold the view that BNPL will continue to become a more widespread option in the years ahead.

However, that will be accompanied by a higher level of commoditisation.

For example, Zip Co’s (ASX:Z1P) new distribution partnership with Visa is based on a low-margin strategy.

Conversely, Afterpay’s recent collaboration with Australian Fashion Week is a relationship marketing effort targeted at its core Millennial customer base.

“So it’ll be a question of how you win that game. Are you the biggest and most efficient, and/or do you have the most loyal following?” Pretty said.

Valuation game

A hot topic in the valuation debate is that BNPL stocks aren’t yet making profits.

Market leader Afterpay booked a statutory net loss of $22.86m in the 2020 financial year (although it did flag positive core earnings of $24.37m).

But as with other tech sectors such as B2B SaaS plays, Pretty highlighted that the valuation focus has moved to the top line (revenue).

“For a long time after the dot.com boom no one looked at price-to-sales as a valuation metric, but now it’s quite common,” he said.

At the same time, markets also have more familiarity with scalable top line growth.

“I think Amazon were probably the company that proved this out – a tech model where you can have high operating leverage,” Pretty said.

The model is based around marginal operating costs, where the cost of acquiring each new customer is less than the revenues they generate.

“The faster you go the better and that means your accounting profits aren’t there, but it’s all about what the value is at some distant point – whether it’s three, five or 10 years down the track,” Pretty says.

“So you can take something on 50x revenue, and if your growth rates and future margin assumptions add up you can take bring it back to a present value using traditional valuation techniques.”

And for Fergie, the assumptions built into current valuations are veering into BNPL bubble territory.

“If you look at Afterpay’s valuation, it’s indicating fairly extreme long-term sales growth,” he said. “Pretty constant margins, no blowouts in bad debt, not much in terms of significant competitor behaviour.

“So it’s really optimistic but I see that not just with Afterpay, I see that across the board.”

In particular, he cited the post-Covid ecommerce boom which has resulted in a dramatic acceleration of online sales.

“Right now investors appear to be extrapolating these growth numbers indefinitely into the future, and for me that’s not realistic,” Fergie said.

(Resident market bear UBS agrees, although in the bank’s latest research note on Afterpay it did up its valuation slightly – from $28.25 to $30).

Like Fergie, Pretty is also a “market watcher” at these levels.

Applying the Amazon model to BNPL, he said investors will adopt a “winner take all mentality” over the medium term.

“A key part of that will be what drops out the bottom line in the future,” he said.

“So top line growth still has to come back to at some point in future to the net profits it generates for shareholders.”

“If I could build a confident base case I’d invest. But I find I don’t have enough confidence in the case you’d have to make that you’re going to make money at these prices.”