The Afterpay Juggernaut

WHAT IF I TOLD YOU…?

...that a company that makes no profit and has risen 600% plus from its lows in March, is raising $800m and the two company founders were selling $250m worth of shares and potentially more to come in November. Of the $800m in fresh equity, $650m will be sold through a placement while $150m will be offered to existing retail shareholders in lots of up to $20,000.

What if I told you that this company had a market cap of around $18bn? What if I told you it was expecting EBITDA of $20m-$25m this FY?

That company is Afterpay (APT) of course. The little Aussie company that can and just keeps on doing. Seems it is Teflon as far as its business goes.

Part of the reason that APT is so successful at what it does, is it does it very well. It is a really simple product. No bells or whistles. No complications. Easy to use. Easy to understand. It does what it says on the box.

The business model is a little like Selleys No More Gaps. It just keeps expanding and moving into new markets. Canada is next up it seems.

Yesterday the company released its business update. A massive amount of big numbers. Big numbers are what APT does best. Everything about it is big.

• 116% increase in active customers.
• 72% rise in active merchants.
• Underlying sales up 112% 4Q sales up 127%.
• US users up 219%
• 1m users in the UK in just a year.
• Underlying sales of $3.8bn for 4Q.
• Adding 20,500 new customers a day.
• Australian users grew only 18%.

Remember that sales are not really sales but the transactions that APT funds through its platform. It charges the merchants a fee for use of around 4%. The company has a 2% margin on those sales through its platform. The key to profits one day is keeping the bad debts down and the marketing costs of customer acquisition under control.

It costs money to expand into new countries. Does have plenty of that now.

Also, it is worth noting that the media talks of it raising an extra $250m from the founder’s shares, well no, that money does not go to APT but to the founders, Anthony Eisen and Nicholas Molnar.

The big kicker in the APT share price was the vote of confidence from Tencent when it bought 5% in the market. Its price around 2260c. It is now bidding aggressively for more stock and prepared to pay 6600c according to the leaky sources inside the brokers. The SPP will be another disappointment for retail shareholders. Expect a large scale back and that old pro-rata allocation.

It was interesting to read the article in The Australian about the coincidence of analyst upgrades to target prices and then the capital raise from the same brokers. UBS still has a target price of only 2500c, and this is after raising it from 1400c. It also has a sell recommendation. Citi, which is broker to the deal recently, raised its Price Target from 2710c to 6425c. RBC Capital Markets, one of the other brokers involved, raised its target to 6000c from 2900c.

Clearly both brokers were playing catch up to the reality of the stock prices. It probably helped them win the mandate too. Call me cynical. Maybe a good indicator of a placement coming is a large price target upgrade?

That is part of the problem with broker research. Marcus has talked about this extensively. You have to remember that research costs a lot of money. Analysts that are any good are expensive. Brokerage rates are a shadow of their former self, so producing an in-depth research product on a sector or company is a large and expensive undertaking with the return on capital (brokerage) not guaranteed. The kicker for brokers, and the reason why they do it, is to win business from the company itself. Every research piece from a major broker will be run by the company for comment before publication too.

It is similar to real estate agents. When they come round to value your house you go with the one that says he will get you the highest price. Same with brokers. You are not going to give your capital raising mandate to UBS which has a price target of 2500c on the stock. Pretty hard to get clients interested in a placement at 60 bucks plus when your analyst has a valuation half of that. So, research and PTs are inherently corrupted by an agenda.

I once ‘famously’ compared analysts to nuclear weapons during my time running the trading business at Macquarie. As with nukes, analysts are expensive, dangerous to use, we only have them because everyone else has them, and the world would be a better place without them. Safe to say, it didn’t win me many friends in the research department. Don’t get me wrong, I love research and analysts, I just do not always believe either their recommendations or their price targets as they frequently have an agenda that I am not privy to and it clouds their judgement. Nothing I like better than an in-depth sector report.

So back to APT.

Investors in APT fall into the believers and the non-believers. Some think this is the best thing since sliced bread (Tencent clearly does). Others think that it is a bubble that will burst and that bad debts will rise or regulations will impair the business model. The bigger you get the more attraction of the authorities. So far APT has had a few regulatory scares. I remember writing an article on the company when the regulator attacked them, and the stock collapsed. I said at the time not to worry and that APT would be fine. I think they were around $12 that day.

Given the strong support in the market from Tencent and given that APT is banging to get into the ASX 20 there are many institutions that will be underweight and need to top up. If retail investors are torn on valuations and recommendations, index funds are even more torn. They may think the stock is vastly overvalued but have to buy it anyway. The higher it goes too, the more they are dragged kicking and screaming into the stock. The placement may be the chance they are looking for to get in. I would imagine that the demand is strong and residual demand will see the stock do well post-placement.

What is APT doing with the funds?

Takes away some of its reliance on the wholesale funding market. It is also talking acquisitions. Likely to be new country acquisitions to gain a bridgehead in a new market. Both of these are a positive.

This is an interesting way to look at the relative valuations of some of the sector. How much the market values its customers.

The SPP timetable.

The price will be either the same as institutions get it at or a 2% discount to the VWAP up to $20,000. The price has been set this morning at 6600c. A very positive sign of strong demand. a very small discount to the closing price and given the founders selling is a huge tick in the box.

Given the now strong balance sheet and the support of Tencent the juggernaut will continue.

The debate about valuation will also continue. Better minds than me will be looking at that.

It is a phenomenon. It is a HOLD at these prices only on the momentum that is now in the business. Balance sheet strength, business model and strong execution. Hard to argue with that.

If I had a big long position it would be great to buy some long-dated, out of the money puts and relax a little. APT has never been a stock that you can relax with though. But then again if you believe, you are used to that. That will not change. Keep the faith the story is getting better in some respects and the management continue to deliver. Maybe one day they will make a profit too. Didn't hurt Amazon for years whilst they built scale. 

The two biggest risks are the bad debts and regulatory clampdown - but both seem to be manageable. There is also a slim risk that the Wirecard scandal forces regulators in other countries to look at the sector in more detail. That one is a long bow but it is there.

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