Pratyush Rastogi of Farrer Wealth Advisors based out of Singapore provides a great bull case, as well as what he believes the market is missing, for Afterpay and why he isn't worried about competitors such as Paypal entering the market. I'm posting this to Twitter so please excuse the formatting.

https://www.farrerwealth.com/research

https://player.fm/series/capital-employed-fm/investing-in-fast-growth-industries

January 2021 APT Thesis

BNPL company

4 instalments

0 interest

Nominal late payment fee

No debt spiral as you'd see with credit cards

Merchant charged 4-6% of sale value

Merchant value proposition

30-50% growth in basket sizes

Increase in average order value

More repeat customers

Bank of America Research

BNPL market by 2025 up to $1 trillion

Still a long runway for growth 7-8x

Aren’t all BNPL the same?

What the market misses

$APT shop directory

Through their app you can explore every merchant on APTs platform

Becomes discovery

Friends wife was using APT as entertainment during lockdown

Trying to discover new shops/things to buy

$APT sends >14M leads to merchants every month

Why is that so powerful for merchant?

Merchant unit economics

Example

Customer spends $10

COGS 50% = $5

Sales & marketing $2

Delivery etc $1

Operating profit = $2

Generic BNPL acquiring customer at end of check out

Customer spends 30% more = $13

COGS 50% = $6.50

Sales & marketing $2

Delivery $1

Operating profit = $3.50 has increased 75%

$APT

Same as generic but because APT sends you the lead for free

Marketing goes to $0

Operating profit = $5.50

Vs

$3.50 generic BNPL

Vs

$2 no BNPL

By having the active shop directory & the app as a point of discovery

APT becomes super powerful

And this is why they weren’t worried when Paypal entered the market

No one uses Paypal as a point of discovery

In BNPL the best strategy is to win the customer way before checkout

^This is what the market gets wrong about APT & why they’re different

Still believes there is lots of growth ahead of it

SQ announced the issuance of Square Class A common stock (including the shares underlying CHESS Depositary Interests) (New Square Shares) to Afterpay shareholders as contemplated by the Scheme Implementation Deed.

Afterpay expects the transaction will close in the first quarter of 2022.

As our Strawman said on the Motley Fool Money podcast a few weeks back, if you are looking at APT then you really have to have an opinion of Square, because the APT business will only be around 20% of what you own once they merge.

A recent article in the AFR talks to what APT (soon to be SQ) has done to the banks.

Essentially, despite it losing money, fintechs like APT have forced the banks to modernise not just their offerings, but also their tech stacks.

I think APT (and SQ when it lists) will be a fintech force to be reckoned with and the big4 performance will continue to erode.

Disc: APT held in RL.

Alan Kholer and Scott Pape (of Barefoot Investor fame) briefly talked about Afterpay in the 24/06/21 podcast episode Talking Money, Debt and Crypto with the Barefoot Investor (around the 24:00 mark).

"As a financial counselor...I have clients that won't pay their rent in order to keep their Afterpay going"

What crazy brand loyalty. I myself have not used Afterpay but given the upcoming Square listing I am certainly taking a closer look.

I dont hold, having sold out waaaaaay too early, but here's something to help those that do hold, work through the issues.

Afterpay-Square: What's next for shareholders?

On a day in the not-too-distant future, Australian tech darling Afterpay will vanish from the ASX and be replaced by American payments giant Square.

Under the terms of the deal, Afterpay (ASX: APT) shareholders will be given the option of taking shares in Square (SQ) listed on the New York Stock Exchange or taking locally listed Square CHESS Depository Interests (CDI).

But what is a CDI? How will Afterpay shares be exchanged for Square shares? And what happens to investors who hold Afterpay through a big ETF like Vanguard Australian Shares (ASX: VAS)?

Morningstar has spoken to experts and pored through documents to answer these questions and more. And for those who aren’t sure whether to stay or go, see here for Morningstar’s valuation of Square.

CDIs: Middlemen of the investing world

CDIs exist because countries have different rules for trading shares. Australia uses an electronic system called CHESS, where shares are registered in the investor’s name. In the US, where Square is incorporated, shares are registered to a third-party custodian.

Arcane distinctions like this means shares exchanged via Australia’s CHESS aren’t recognised in some countries, including the US.

Chess Depositary Interests (CDIs) solve this issue by acting as middlemen between Australian investors and foreign companies. Through a CDI, Square’s shares can be traded on the ASX in a way recognised by US authorities in three simple steps.

First, Square will transfer shares to the imaginatively named CHESS Depositary Nominees (CDN), an ASX subsidiary. The CDN then creates CDIs corresponding to those Square shares, usually on a one-to-one basis, but other ratios are possible. Finally, Square CDIs join the ASX and are traded normally.

Square isn’t the first to use this arrangement. Companies such as Resmed (ASX: RMD), Janus Henderson (ASX:JHG) and Unibail-Rodamco-Westfield (ASX: URW) all trade with this structure.

Almost like real shares

Investors holding a CDI get “beneficial ownership”, which covers all the economic benefits of holding shares such as dividends.

CDN keeps legal title, but this has limited impact practically. Square will still contact CDI holders directly for the purposes of dividends and corporate actions. Shareholders can buy and sell Square CDIs through their broker as they would a normal stock.

The main difference is CDI holders will not be able to vote at Square shareholder meetings, although they can instruct CDN to vote on their behalf.

Not that CDI holders will miss out on all the AGM perks—Square’s 2017 and 2019 meetings were held virtually.

Investors also have the security that should they change their mind, they can swap their Square CDIs for the NYSE version at any point.

For those Afterpay shareholders who opt for CDIs, there will be very little administrative work, says John Winter, chief executive at broker Superhero.

In the lead up to the acquisition finalising next year, Afterpay shareholders will hear from their broker or registry asking whether they want Square CDIs or Square NYSE shares, he says.

When the acquisition closes, investors should simply receive Square CDIs or Square shares in their broking account. Winter says there could be delays of a few days.

Afterpay shareholders will receive 0.375 square shares for each Afterpay share they own. It’s expected Afterpay shareholders will own 18.5% of the combined company.

The deal is an all-scrip, stock for stock swap. Afterpay shareholders will receive 0.375 shares, regardless of the price. Since shares prices will fluctuate between now and 2022, the final value of the Square shares investors will receive won’t be known until the date of the deal.

In the case that Square opts for its CDIs to be at a ratio different than 1:1, the number of CDIs investors receive vary accordingly. The details of the listing have yet to be confirmed by Square or Afterpay.

Investors should quality for “roll over relief” says Winter and it’s unlikely there will be any tax liability associated with the change.

As with any US security, Square CDI holders will have 30% of their earnings withheld by the US tax office. Investors can reduce this to 15% by submitting a W8-BEN form.

Square won’t be in all Aussie equity ETFs

Afterpay has gone from ASX minnow to a member of the ASX 50 but Square’s place on the ASX will depend on the appetite for CDIs among investors, says Russel Chesler, head of investments and capital markets at VanEck.

The number of Square CDIs that join the ASX in 2022 will be determined by how many investors opt for them. In a hypothetical world where all Afterpay shareholders opt to take shares on the NYSE, there would be nothing to list on the ASX.

S&P Dow Jones Indices, which constructs the S&P/ASX 200, then includes shares in the index based on to the number of CDIs issued.

“The extent to which Square will be in the ASX 200 will depend on what investors choose,” says Chesler.

“I would guess many will default to the CDI but when it comes to institutional investors it will come down to whether holding Square is the right investment for them.”

He says there will be notice closer to the date clarifying how many CDIs are being taken up. Index providers like S&P will then recalibrate their indexes. The exchange traded funds that track those indexes will be given advance warning so they can adjust in turn.

Not all Australian equity ETFs will include Square because of special restrictions on what companies can be included, says Chesler. VanEck will not be include Square in its Australian Equal Weight ETF (ASX: MVW) because index rules require foreign companies earn at least 50% of revenue locally.

The index tracked by the BetaShares Australia 200 ETF (ASX: A200), the Solactive Australia 200, does not exclude CDIs and foreign domiciled companies, according to documents viewed by Morningstar.

Duncan Burns, head of the equity index group at Vanguard says that in cases of a foreign acquirer establishing a secondary listing via CDIs, shares are usually just replaced at or close to benchmark weight, leaving the index largely intact.

Vanguard does not comment on specific securities.

Once Square joins the ASX, its place on the index will depend on what investors do with their CDIs. If investors are happy holding onto their CDIs, they should trade with lots of liquidity like Resmed. However, if investors start swapping their CDIs for US-listed stock, the number of CDIs would shrink, taking Square’s position on the ASX with it.

It’s not the first time it has happened. The CDIs of Unibail-Rodamco Westfield have steadily shrunk as investors opted for the foreign listed shares. Singtel, the Singaporean telco giant that owns Optus, delisted in 2015 in the face of persistently low investor demand for their CDIs.

More details will be clarified over the next few months and until then Winter recommends Afterpay shareholders rest easy.

“There’s no way anyone will be short-changed through the process,” he says.

“Every Afterpay shareholder will get treated as per the terms of the deal.”

The deal is expected to be completed in the first quarter of 2022.

Andrew Eisen interviewed on Ausbiz.

His explanation of Afterpays mojo and how it fits with SQ is fantastic.

Afterpay's future is a fusion of payments, commerce and finance to serve the next gen on ausbiz

I watched it 3 times, APT is my largest position and I hold SQ. 

The shareprice movements from here are just a mirror of SQ, so the results for APT only have an impact in so far as they may move the SQ results…

It is interesting how hard you have to look in the wealth of materials produced by Afterpay today to uncover how much money they are losing.

Total loss (including currency losses) of $190m, vs $40m last year. Revenue is a totally different story, $924m vs $519m last year. Clearly the company is going all out for global land-grab, and with their soon to be new parent Square I can't see what is going to stop them. Already 10.5m of their 16m customers are in the US, an increase of 88%, with 2.1m customers in the UK, an increase of 104%. The UK should soon outstrip the 3.6m customers in ANZ, and the company has set its sights on four new countries already: Canada, Germany, Spain and Italy.

With global expansion opportunities, product diversification into the Money app and the Afterpay Marketplace, the sky seems to be the limit for this company if you ignore the little matter of profitability. It is claimed that the ANZ market is already profitable (EBITDA $195m), the implication being that the US and UK will inevitably follow suit.

With 100,000 merchants signed up, the attraction for Square is pretty obvious.

Hi all,

I am just wondering if someone could provide a little clarity?

Sorry if i look stupid.

I own afterpay, with the recent news what does this mean moving forward. I have no US companies and have never traded on the Nasdaq, will i need register with my broker regarding this?  If i keep the Square shares will i have to then fill out a tax return  for the US. What does a future square ASX listing mean and how will this work.

I have read and followed a number of you, i know some smart cookie will be able to help.

cheers

APT will merge with Square (SQ on the NASDAQ) sometime Q1 calendar 2022, at 0.375 Square shares for each APT valued at US$29b (A$39b).  APT founders Anthony Eisen and Nick Molnar will join Square running Afterpay business which will be integrated into Squares Seller (merchant focus) and Cash app (Consumer focus) businesses, forming a stronger connection between their two ecosystems.

This expands Afterpays consumer base from 16m to 70m active Cash App customers and expands Afterpays merchant base (98k) with millions of square sellers. 

APT is my largest RL position and I also own SQ and would be happy to own more.  My initial take on the headline of APT being sold for A$39b was it was opportunistic and way undervalued, but on looking at the announcement detail and that it is with SQ, I couldn’t think of a better partner – a bit like when they merged with Touch to become Afterpay Touch.

With the entry of Paypal and Apple Pay, APT was in danger of being trodden on, despite a great lead and strong product value proposition.  By teaming up with SQ it immediately achieves the scale and strength it needs to take Paypal and Apple Pay on.  The game has stepped up to a new level and APT is stepping up to meet the challenge, Anthony and Nick continue to impress!

I am not sure what is happening with a possible ASX listing of SQ shares for what is a large Australian shareholder base, but expect that this will be accommodated - TBA.

FY21 Update (attached):

The exciting news of the merger may leave sensational FY21 figures almost un-noticed, so here are the key points (note they had unfavourable FX impacts, I am interested in the underlying business so will quote variances at constant currency):

·         Underlying Sales: 22.4b +102%, the mature ANZ market was a drag with “only” 44% growth, North America had 177% growth and Clearpay (UK+EU) had 242% growth.  I was looking for 100% growth and they just beat it.

·         Merchant Revenue: 875m, which gives a 3.9% revenue to merchant sales which is consistent with prior year and shows merchant margins are being maintained (despite constant bear cases that they are too high and will fall).

·         Active Customers: 16.2m +63% YoY, North America growth of 88% now makes it about 2/3 of customers.  ANZ only grew 8% due to maturity.  Note that underlying sales growth is much stronger than customer growth which tells us that existing customers are spending more (93% of FY21 underlying sales are from repeat customers).  These will also be the better-quality customers with proven history, so credit quality will have improved.

·         Gross loss is expected below 1% (inline with FY20) but lower contribution from late fees mean net Transaction Losses are expected to be slightly above FY20.

·         Active Merchants: 98.2k +77% YoY, North America growth of 148%, ANZ +47% and Clearpay +501%.  Merchants are still seeing value in having it or can’t operate without it.

I maintain my valuation of A$221.91 based on this update, but it looks like this stand-alone valuation is now irrelevant.  Square is a great business and looks to be a good fit with Afterpay, I plan to hold but may trim given portfolio weightings, but in no rush.  It is a little disappointing to see the Australian hero that APT is being absorbed by a US company, but I think we can continue to be proud of it’s success as part of a bigger Square

Wow -- Square to acquire Afterpay in a deal worth $39b. And Afterpay also announces an 88% lift in FY21 revenue (constant currency)

Very early thoughts:

• roughly $134/share at current exchange rates
• Shares based payment (APT shareholders to get Square shares NYSE:SQ)
• Equates to a 42x sales multiple (!!!)

A mammoth deal. Will take some time to digest all this, but congrats to shareholders.

Announcement today (attached) that ‘Money by Afterpay’ is scheduled for launch in October and some more details on what it will be.  The collaboration with Westpac to offer this product was announced 10 months ago, so what is interesting is the detail:

Good:

·         On brand product that focuses on customer benefit and helping with cash management as well as offer a very good 1% interest payment on deposits (which I assume it can then use to offset higher cost funding for their BNPL product).

·         APT has now got a AFSL which offers more opportunities to promote deposit product and debit cards.

·         Eco-system expansion: the offer is not likely to generate revenue directly but makes customers stickier and per the screen shots offers more opportunities to promote products for their merchant, enhancing the offer.

Not So Good:

·         This is just in Australia, given much of APT’s valuation is predicated on US and EUR market opportunities, this does little to add significant value.  However this may the testing ground before offering this type of feature in the US and EUR.

·         Risk that by offering a “Banking” product that it’s brand attraction as being different to the banks may loose some shine.

A good development, I trust management based on track record maintain brand credibility to consumers and value to merchants.  I expect this will be a test cast for expanding a similar offerings in overseas markets, which is the APT play book, and once that happens it will enhance value. No change to valuation based on this alone.

I hold APT as my largest real world position and expect this to continue (despite Apple and Paypay joining the party)

APT marketplace lead generation and data

Sales Generation

I think the value of sales lead generation for merchants is possibly overlooked, although it is mentioned in the annual report.

There is a generation of APT users who want a pair of shoes and find a retailer via the APT marketplace/site.  It doesn’t then matter how many payment options are at the end of the sales funnel, if you have found the retailer you want via APT you are probably committed to paying by APT.  (note: rask podcast/summer12 acknowledge marketplace potential)

The question then is does the merchant fees charged negate the advertising costs the retailer would require to get the sale?  As a retailer it is very easy to see the ROI of online advertising via sales conversion, return customers & basket size.  I don’t know the answer but suspect sales acquired via the APT platform are cost effective despite the fees.

The earlier you can get commitment from a customer in the sales funnel the greater your chances of a sale. Further to this retailers report larger basket sizes when payment is via bnpl.

Data

Over 12mths ago, (I think) I heard Nick Molnar talk on a podcast about APT’s data collection.  He wasn’t talking sales of clothes v’s shoes, it sounded like they were able to drill much further down into specific clothing categories.  I’m not sure how/if APT can use this data but this is valuable information.

Ex ragtrader/retailer

Held PA

Competition is a fact of life for almost every company, and in and of itself not a reason to be bearish on a stock.

That being said, when you have two of the world's biggest tech players moving in on your turf, as well as the major banks, it does perhaps warrant some restraint for those forecasting blistering and unfettered growth. 

PayPay has launched an offering and Apple is rumoured to be working on a product too. These guys have deep pockets, awesome development resources, incredible reach, powerful brands and are likely happy to accept lower margins.

I'm the first to admit that Afterpay deserves lots of credit and has the makings of a wonderful company that will endure for a long time. My issue is the valuation which suggests incredible and unbroken growth for a long, long time. This was the thrust of my bear case earlier this year when I chatted with the lads from Equity Mates (see here).

I also have concerns over customer stickiness -- is it really that hard for consumers to switch to another product? Will retailers not offer anything that helps them boost sales? I doubt it.

I wish I bought AfterPay back when it first entered the Strawman Index (hindsight is wonderful!), but at present it's just too rich for me. There's just no margin of safety at the current price.

29-June-2021:  This morning I placed an order with ePharmacy and paid using Paypal, and was offered an option to pay in 4 equal interest-free installments if I wished to, instead of paying the entire cost up front.  This offer was made directly by Paypal, not by another provider such as AfterPay or Zip.  Paypal is now competing head-to-head with all of the other BNPL providers, and they have the largest global customer base already.  

See here:  https://www.itnews.com.au/news/paypal-launches-new-bnpl-service-in-australia-561965

and here:  https://smallcaps.com.au/paypal-enters-australian-buy-now-pay-later-space/

And this is now live.

Also CBA has this:  https://www.commbank.com.au/digital-banking/buy-now-pay-later.html?mch=ps&gclid=EAIaIQobChMIvf6BiLa78QIVTCQrCh3H6AEiEAAYASAAEgJoVPD_BwE

However, I see Paypal as the biggest threat to companies like Afterpay, particularly as they try to expand further in the USA and in other geographies overseas.

Andrew covered the key points announced in today’s Q3 Business Update (20/4/21), but much of the variance announced was YoY not QoQ, which can be more revealing.  I test the assumption in my previous valuation considering QoQ (new detail format attached):

·         Q3 GMV of $5.2b ($5.7b constant currency) is down from Q2 GMV of $5.7b, but this does not indicate growth has stalled. Last year the same thing happened, Q3 was 10% lower than Q2 – it’s seasonal.  Last year Q4 was up 50% on Q3 and I expect a similarly strong Q4 rebound given the quarter growth in customer (14.6m from 13.1m in Q2) and Merchants (85.8k from 74.7k in Q2).

·         My full year GMV target of $22.6b is still achievable based on prior year performance, also note that the US has taken the lead as the largest market for APT and has actually grown Q3 Vs Q2, so we see acceleration in it’s largest market opportunity.

·         Clearpay launched across Spain, France and Italy in March (Germany to follow), so in Q4 we will start seeing ex-UK Europe sales ($494b e-commerce market).

·         Margins and credit losses remain consistent with Merchant revenue margins are in line and so are Gross Losses, so no need to revisit margin or loss assumptions.

·         Product development such as the Afterpay Card in Australia (28 March launch), Squarespace partnership (live) and Afterpay Money (in development) progressing to maintain APT’s lead.

·         Regulatory engagement in ANZ and UK progressing constructively, still a threat but has been managed well to date.

·         The potential US listing is new news but not a surprise – a positive if any influence on price.

I don’t see any material change to growth, margins or credit loss assumption so will leave my valuation as is.  APT seem to be continue to deliver and I remain a very happy shareholder

AfterPay has posted yet another strong update, with underlying sales up 104% in the 3rd quarter ending March 31. Excluding FX impacts, it was a 123% improvement, with a 75% lift in active customers.

All regions saw good growth, but the UK and the US were the real standouts with underlying sales up 277% and 211%, respectively. North America is now the largest segment, recording more than $1b in underlying sales in March alone.

Another interesting point was that the board is considering a US listing. That would certainly provide more access to capital, although whether that would be good for the share price is hard to know -- the ASX tends to grant much higher multiples for tech stocks than the US currently does. Anyway, it may not happen and there's no timeline associated with this.

There's a lot more detail on the ASX announcement, which you can read here.

Overall, it's hard not to be impressed with AfterPay's success. Their growth has been truly spectacular. 

That being said, I remain of the view that the share price already accounts for ongoing significant and enduring growth, and that the risk/reward proposition isn't great at present.

Add to this the potential for increasing competition and regulation, and over time i expect gross margins to narrow.

Too hot for me.

07-Mar-2020:  I am not invested in APT, however I do note that the IT sector (including FinTechs) is the largest sector within the S&P500 in the US and it's one of the smallest sectors in our ASX200.  Information Technology companies account for just 4% of the ASX200 (the ASX's top 200 companies).  I therefore believe that the few tech companies that we do have to choose from here are more likely to get overbought and highly priced than might otherwise be the case.  This has included all of the WAAAX stocks at various times, of which APT is one.  It is also then not particularly surprising that when the market corrects or when there is a sustained sell-down or bear market, the sectors that have run the hardest are more likely than not to be the ones that fall the most.

The tech-heavy NASDAQ in the US has just fallen -12.54% in 14 days, one of the fastest corrections in history for that index (a "correction" is a 10% fall by definition).  Back home, over the past 18 days (13 trading days), since Tuesday 16-Feb-2021...

• The S&P/ASX200 Index (XJO) has fallen -3%
• The All Ordinaries Index (XAO) has fallen -3.4%
• The S&P/ASX200 Information Technology Sector (XIJ) has fallen -16.5%
• The S&P/ASX All Technology Index (XTX) has fallen -15%
• APT has fallen -24.8% from $153.46/share to $115.40.

Some sectors, like Energy and Financials are actually positive over that same period - Financials were up +3% - which is what's saving our XJO and XAO indices from looking a lot worse, particularly as Financials is the largest sector in the ASX200.  It's why many of us are feeling a lot more pain or staring at a lot more damage than what the headline index numbers are suggesting has occurred.  Unless you've got a market-weight allocation to our big banks, which is a lot (and I don't), or better (even more bank shares), then you are likely to have seen heavier falls in your portfolio(s) than experienced by the ASX200 or the All Ords indices.

 Afterpay Limited (Afterpay) attaches a Clearpay media release to be distributed in the UK regarding the release of the Woolard Review and the report’s proposal to bring the ‘Buy Now Pay Later’ industry under FCA oversight with proportionate regulation

Dodging the darlings and loving the lonely

SIMON MAWHINNEY

Allan Gray

Our lack of exposure to the high-growth technology sector and the stable earnings streams from the healthcare and consumer staples sectors may seem extreme. But so are the prices one pays for companies in those sectors today. 

Consider a hypothetical market darling, whose growth runway extends many years into the future due to its highly sought-after product or service and significant barriers to competition. 

Even if it's clearly attractive, there is a price that is simply too high and exceeds the value of the likely trajectory of future earnings. No company is worth an infinite amount. 

At the other end of the spectrum is a cyclical company with a bleak growth outlook. But a bleak outlook does not necessarily mean the company’s shares are worth zero. Navigating the grey area between these extremes requires a focus on underlying fundamentals.

Knowing when a market darling’s price is too high is no less important than knowing when an underperforming company’s share price is low enough. 

Avoiding the former and building a portfolio of the latter will generate outsized investment returns in the long term, but it’s not easy to do consistently.

We have recently accumulated a stake in South32 Limited, an out-of-favour company that we think is attractively priced. At the other end of the spectrum, an expensive market darling we don’t own, is Afterpay. Sudhir Kissun discusses South32 below, followed by my analysis of Afterpay.

About South32 Limited

In 2015, BHP demerged a diverse portfolio of assets that it considered non-core, creating a new separately listed entity named South32 Limited. The main commodity exposures and assets of South32 are as follows:

• Alumina and aluminium: The Boddington bauxite mine and Worsley alumina refinery in Western Australia, the MRN bauxite mine and Alumar alumina refinery in Brazil, and two aluminium smelters in South Africa and Mozambique that source their alumina requirements from South32’s alumina refineries.
• Manganese: The GEMCO manganese mine in the Northern Territory, two manganese mines in South Africa, and a manganese alloy smelter in South Africa.
• Coal: Metallurgical coal mines at Illawarra in New South Wales, and thermal coal mines in South Africa (the South African operation is in the process of being divested).
• Nickel: The Cerro Matoso nickel mine in Colombia.
• Silver, lead and zinc: The Cannington mine in Queensland.
• Other: An investment in the Hermosa zinc, lead, silver and manganese asset in Arizona in the USA, which is currently in the development phase, and various other exploration and development ventures.

The earnings contributions of each of these assets will vary from year to year depending mainly on commodity price movements, but also on production volumes, operating costs and expenditures on sustaining capital. Through the cycle, we estimate the contributions to earnings before interest and taxes (EBIT) to be as per Graph 1.

Graph 1 - Estimated contributions to EBIT by commodity group

Source: Company financials, Allan Gray.

It is important to point out that the reserve lives of the individual assets differ. The Boddington bauxite mine has many decades of low-cost, high-quality reserves and resources available, whereas for most of South32’s other assets the reserve lives range between 9 and 18 years. Therefore, while alumina (which is produced from bauxite) is a large earnings contributor, it is an even larger component of the company’s overall value.

It is also worth noting that the key end-markets for South32’s commodities are aluminium and steel (with manganese, metallurgical coal and nickel being key inputs into the steelmaking process). Our view is that both these end-markets should exhibit sustainable demand growth over the long term as they have over the last few decades. Steel demand will be dependent on emerging countries continuing to industrialise and develop new infrastructure, while developed countries replace ageing infrastructure. Aluminium uptake will be supported by consumer demand for housing, automobiles, and packaged goods, to name a few.

As contrarian investors, we aim to adopt a countercyclical approach

Our interest in South32 was piqued after a period of significant weakness in the prices of the commodities that make the largest contributions to its earnings (notably alumina, aluminium, manganese and metallurgical coal, as depicted in Graph 2).

The price weakness began in mid-to-late 2018 and was exacerbated by the demand destruction caused by COVID-19. We now have a situation where South32’s commodity prices, and therefore earnings, are low relative to history. As shown in Graph 2, with the exception of aluminium, the prices of South32’s other key commodities have been higher than today’s levels for most of the past 10 years.

Graph 2: Historical prices of South32’s key commodities

Source: Platts, Bloomberg, Metal Bulletin, UBS

Commodity share prices indirectly reflect market expectations of future underlying commodity prices. As contrarian investors, we prefer to adopt a ‘countercyclical’ approach: we buy companies when prices are depressed and the share price of the company reflects an expectation that earnings will remain low for the long term. Our view is that it is overly pessimistic to extrapolate today’s low commodity prices too far into the future, given the supply-demand imbalance that this will likely create. We believe South32’s share price today incorporates a lot of pessimism, creating an attractive buying opportunity for patient long-term investors.

South32 has two other attributes that we find attractive. Firstly, it is a low-cost producer, with most of its operations positioned in the first quartile of the cost curve. It can therefore withstand deep price troughs while mostly still generating positive free cash flow. Secondly, it has a strong balance sheet with a cash balance that exceeds its borrowings, so during periods of weak commodity prices (and therefore weak cash flow) it is not under pressure to service an onerous debt burden. Its strong balance sheet also means it is potentially well-positioned to take advantage of any cheap acquisition opportunities that may arise.

What do we pay for South32?

While it’s impossible to predict which of South32’s operations will outperform or underperform in any given year, we estimate that its portfolio of operations in aggregate should be able to generate pre-tax earnings of US$1.3 billion to US$1.5 billion per annum through the cycle. We estimate that this represents a high single-digit return on the capital that would be required to replicate South32’s portfolio of operating assets today. This does not seem excessive to us. With an enterprise value (EV) of just under US$11 billion, inclusive of the future cost of closing and rehabilitating its mine sites, the company is currently valued by the market at seven to eight times these earnings. 

We can compare the earnings multiple to South32’s weighted-average reserve life, which is approximately 16 years. With a market capitalisation of a little over US$9 billion and our estimate of post-tax earnings of US$900 million to $1 billion, South32 is trading at 9 to 10 times post-tax earnings. We are therefore expecting to receive 16 years’ worth of earnings, but only paying for 9 to 10 years of those earnings. This strikes us as a good deal.

In addition to the attractive earnings multiple, we have identified three additional sources of upside that may or may not materialise.

1. The Hermosa asset in which South32 has invested US$1.6 billion to date. We have not accounted for any EBIT contribution from this asset in our earlier estimate of US$1.3 billion to US$1.5 billion. Even a sub-par return on the investment in Hermosa would represent attractive upside.
2. South32 is in the very early stages of exploring a low-cost option to extend the life of the GEMCO manganese mine. If this extension is successful, it has the potential to meaningfully increase the value of the company.
3. If South32 manages to complete the sale of their South African thermal coal business, US$700 million of rehabilitation liabilities will be released from the balance sheet.

Our investment thesis is not dependent on any of these three events coming to pass, but if they do, the upside in South32 could be compelling.

As with any investment, a lot could go wrong from here. Structural, political, regulatory or other factors could conspire to negatively impact South32’s commodity prices, sales volumes or production costs. While it is difficult to quantify these uncertainties, our view is that the low earnings multiple that investors pay today, alongside the company’s assets (which are low on the cost curve), and a strong balance sheet provide a reasonable margin of safety against adverse future outcomes.

About Afterpay Limited

Afterpay is a buy-now-pay-later facilitator that allows its users to split the cost of retail purchases into four equal two-weekly instalments over six weeks (with the first instalment paid at the time of purchase). It does not charge its users interest and generates its revenue by charging retailers a percentage of the merchant sales it facilitates as well as by charging its users late fees.

Afterpay’s business is best understood with reference to its unit economics. Table 1 shows its 2020 annual results with reference to its underlying merchant sales.

For the year ended 30 June 2020, retailers were charged 4.1% of merchant sales on average. The company made a further 0.6% of merchant sales in late fees and incurred non-scalable processing costs totalling 1.2% of merchant sales. It incurred bad debts of 0.9% with the net of all these amounts, its net transaction margin (NTM) being 2.6% of merchant sales. It targets an NTM of greater than 2%. Below this NTM are almost $300 million in scalable costs dedicated to customer acquisition, business development, head office costs, IT development and so on.

How successful might Afterpay be?

In order to determine what a mature and successful Afterpay might look like, we first need to determine how big its addressable market is. In Australia, retail sales excluding food retailing, cafés, restaurants and takeaway food services amounted to $104billion for the 12 months to September 2020. This represents approximately 5% of Australia’s gross domestic product.

We can use Australia’s addressable market to infer Afterpay’s total addressable market from the geographies in which it is seeking to grow. The combined GDP of the United States, Australia, the United Kingdom, Canada, Spain, France, Italy and Portugal (Afterpay’s chosen target markets) was US$33.7 trillion in 2019 (and likely lower in 2020). Assuming the same 5% addressable market share as in Australia, Afterpay’s addressable market would be US$1.7 trillion or about A$2.3 trillion in merchant sales.

Table 1: Afterpay’s unit economics

Source: Afterpay Annual Report 2020.

Mastercard’s share of global consumer-to-business purchases is 14%. Let’s assume the successful and mature Afterpay has a market share that matches that of Mastercard’s. This would imply merchant sales of $322 billion (14% of $2.3 trillion). 

How profitable might a successful Afterpay be?

Using this level of merchant sales and the unit economics detailed above, it is possible to calculate how much profit Afterpay will generate. First we need to make two important assumptions:

1. The current NTM of approximately 2.5% is sustainable.
2. Afterpay’s scalable cost base will only grow by half of the dollar transaction margin growth.

Using the above, we can calculate that Afterpay’s earnings before interest and taxes would be $3.7 billion. 

How much does an investor pay for Afterpay?

Afterpay currently has a market capitalisation of over $30 billion. It is largely debt free today, but would require a further $18 billion in capital were merchant sales to grow by over $300 billion. Its enterprise value then (assuming the share price doesn’t change between now and then) would be close to $50 billion. Investors are paying over 13 times those future preinterest and pre-tax earnings today.

This mature Afterpay should be as cyclical as any other shortterm money-lender. Its fortunes will rise and fall with the economic cycle that already sees retail spending (upon which it relies heavily) and bad and doubtful debts fluctuate. Banks, which are similarly exposed but have both a more secured loan book (Afterpay’s loan book is unsecured) and longer-dated lending profile (Afterpay’s loans are repaid over six weeks) trade at much lower multiples than this today.

There are a few obvious pitfalls in the analysis above. For example, Afterpay could expand beyond the chosen geographies in our analysis. The bigger Visa might be a better benchmark to judge success than its smaller rival Mastercard. Its customer database might have considerable value across a number of adjacencies that Afterpay is not currently targeting. Or its costs might scale far better than the 50% we have assumed (though doing so would place them among the very best technology companies). But there are also significant risks that we’ve not mentioned (e.g. regulatory risk and competition) that will go a long way towards offsetting any upside and an almost certain near-term future of no or very low profits (as distinct from an established lender like a bank). 

At today’s price, the risks in owning Afterpay seem heavily skewed to the downside.

Thanks for the update on APT Dazbo  

 A few years ago I did a head to head comparison of signing up and then buying stuff with Zip (which I held) and APT ( which I didn't). I have never used Zip. I sold my holding. And bought APT. 

I agree it is a great product. I use it regularly now. 
foolishly I sold my APT shares at ~$27. 
one of my many regrets!

As you point out, valuing it now is a huge challenge. However in your thesis you state it is the incumbent BTC to other products alt-coins ie is going to benefit from ever increasing network effects.  That may be true in ANZ but may not true in other geographies. Klarna is huge in Europe and giving them a run for their money in the US. And CBA are betting heavily on them in ANZ  

Affirm has more regular monthly users. (Not registered users)

and there are now a whole bunch of competitors likely to compress margins. 

Happy to keep using there product and im certainly not betting against them, but at these prices I'm not betting on them either! 

Afterpay's CFO Luke Bortoli is stepping down after about three years in the job.

He will be replaced by Rebecca Lowde, who was formerly the CEO of Salmat and the CFO of Bravura. The handover will formerly commence on October 6.

Based on the announcement, it appears an amicable decision and there's probably not much to read into here (although would appreciate any scuttlebut if anyone has any).

You can read the ASX announcement here

01-Sep-2020:  From Marcus Padley's ("MarcusToday") EOD (end-of-day) email:

BNPL stocks woke up to a brave new world, one where a big gorilla is flexing its muscles, as Paypal announced it was entering the market sending the sector into a tail-spin. SZL dropped 14.7%, OPY down 7.2% and Z1P down 12.8%. The behemoth APT dropped 8.0%, leaving the All Tech Index down 2.2%.

A brain dump on AfterPay:

https://twitter.com/tickertvau/status/1282538917267337217

I think there's a lot to like about the business, but find the price very difficult to take. 

At the current price, it's a bet on whether bnpl legitimately becomes a lasting global phenomenon, and that AfterPay can hold a major share of it. 

AfterPay is taking advantage of its, er, "robust" share price to raise up to $800m.

Shareholders can subscribe for an additional $20k of new shares at $61.75 each, a ~9% discount to the last traded price (but a 100% premium to where they were at the start of the year).

Frankly, i think it's a smart move and a cheap way to access extra capital that can (hopefully) accelerate growth.

At the same time, founders Anthony Eisen and Nicholas Molnar will be selling ~2m shares each, or around 10% of their holdings. Again, hard to fault them given the current price (but perhaps somewhat telling of their estimation of value).

Further details can be found here

01-May-2020 (7:23pm):  Afterpay welcomes Tencent as a substantial holder

Media Release, 1 May 2020.

AFTERPAY WELCOMES TENCENT AS A SUBSTANTIAL SHAREHOLDER

Afterpay Limited (Afterpay) is pleased to welcome Tencent Holdings Limited (Tencent, 00700.HK) as a substantial shareholder of Afterpay, confirmed by the lodgement of a notice of initial substantial holder on the Australian Securities Exchange on 1 May 2020.  

Tencent is a listed company on the Hong Kong Stock Exchange. The company provides Internet valueadded services, including digital entertainment, online advertising, and FinTech and cloud services to users. Its communications platforms include Weixin, WeChat and QQ. Its Weixin Pay service is the leading mobile payments platform in China, facilitating an average of over 1 billion commercial transactions per day.

Anthony Eisen and Nick Molnar, Co-founders of Afterpay commented:

“We feel very privileged to welcome Tencent as a substantial shareholder in our business.  Being able to attract a strategic investor of this calibre is extremely rewarding and is a testament to our team and the strength of our differentiated business model.

“Tencent’s investment provides us with the opportunity to learn from one of the world’s most successful digital platform businesses.  To be able to tap into Tencent’s vast experience and network is valuable, as is the potential to collaborate in areas such as technology, geographic expansion and future payment options on the Afterpay platform.  

“We remain focused on delivering value for our new and existing shareholders over the long term.”

James Mitchell, Chief Strategy Officer of Tencent, commented:

“We are pleased to become investors in Afterpay. Inside China we operate the leading digital payment service and a rapidly growing FinTech platform, and outside China we have actively invested in pioneering FinTech companies, providing us with unique insights into emerging FinTech services. Afterpay’s approach stands out to us not just for its attractive business model characteristics, but also because its service aligns so well with consumer trends we see developing globally in terms of Afterpay’s customer centric, interest free approach as well as its integrated retail presence and ability to add significant value for its merchant base. We look forward to a deep and long-term business partnership between Tencent and Afterpay.”

--- ends ---

Revenue - $212.2 M up 105% on pcp
Net transaction Margin - $102 M (or 48% of revenue) up 118% on pcp
Impairment expense - 1.0% down from 1.2% on pcp
Net transaction loss - 0.5% down 0.1 % on pcp
Operating loss - $31.5 M or -14% of revenue.
Operating expenses - $80.8M - 317% increase on pcp - Primarily due to a 500% increase in marketing spend ($32M), which is now around 15% of revenue.
Merchant income margin - 3.8% up 0.1% on pcp
operating cashflow - -$33.8 (-15% of revenue)

Revenue growth - regional breakdown

ANZ ($3.1B transactions)- 55% growth on PCP - 23% active customer growth, showing expanding revenue per customer as the platform matures. 98% customer retention for monthly users - this is despite being only able to use Afterpay when the accoutn is fully paid month to month.

US ($1.4B transactions)- 445% growth on PCP!. Customer net losses and revenue per customer is tracking the ANZ experience, demonstrating the model is translating to the US - so far. There are now more US customers than ANZ customers.

UK ($0.2B transactions) - operational for 6 months. At the end of December, $0.65B transaction run rate achieved.

Late fees, as a percentage of underlying sales continues to fall, down to 0.7% of sales. This is important, as APT needs to demonstrate it promotes responsible use.

22900 customers signed up PER DAY in November / December. Thar is more than 1 million customers in 2 months!
Expansion into Canada this year.

Customer outstanding balances are $211 compared to credit cards at $3380.

Current revenue run rate is $480 Million ($11 billion transactions)! However, APT only has sufficient funding capacity for $15 BN in transaction volume. I think APT will need more capital / funding to meet the opportunity.

Currently, existing US & UK merchants and pipeline merchants comprise a $30 BN transaction pipeline TAM - WITHOUT ANY FURTHER MERCHANTS ACQUISITION.

PEOPLE - Afterpay have recruited some executives to boost management capability -

GLOBAL CHIEF PRODUCT OFFICER
DAVID KATZ (EX FANATICS, GROUPON)

GLOBAL CHIEF MARKETING OFFICER
GEOFF SEELEY (EX AIRBNB)

ANZ SALES DIRECTOR
KATRINA KONSTAS (EX AMEX)

VP PRODUCT DESIGN
SCOTT POLCHLEB (EX WEWORK)

US HEAD OF FINANCE
LAURA NADLER (EX VISA)

Partnerships - VISA in the US, and Mastercard in ANZ.

Regulatory Developments:
Australian BNPL code of Practice - APT support code of practice, with it being resolved later this year.
Reserve Bank Issues Paper on surcharging - APT oppose surcharging, but this is a risk to the Australian business.
AUSTRAC considering auditors (positive) report - APT implementing recommendations. Low risk of adverse outcomes.

Targeting to exceed revenue run rate of $800 M by June 2022.
In store transactions is 25% of underlying sales in ANZ, and it is anticipated this will increase over time.
They have achieved their online target in the US of 5% of the millennial market, and are now turning their attention to bricks and mortar retail in the US, using their millenial customers to drive this channel.

Marketing spend - marketing is done in partnership with merchants, with increased spending anticipated with new US, UK, and Canadian merchants.


Presentation link: https://edge.media-server.com/mmc/p/24q3daze