BUY HOLD SELL – Afterpay (ASX: APT)

Afterpay (ASX: APT) traded as low as 801c in March and now trades back towards 4000c, the question on everyone’s lips is, ‘is it too late for me to buy APT?’ Tied up in the answer is how macro headwinds and COVID-19 will influence the BNPL sector. Commentary surrounding the BNPL sector and the influence of the pandemic has created some intriguing headlines. Critics have been quick to point out that the real test for the business is still yet to come. As we’ve said before however, sitting on the sidelines, wagging your finger, and waiting for the bubble to pop doesn’t make you any money. An increase in hardship claims would be an obvious area for concern, although APT recently pointed out that while there was an increase in mid-March, levels have now moderated and are trending down. Furthermore, overall levels remain within manageable parameters. Pre-emptive adjustments to risk settings had a positive impact on performance in the second half of March and early April. The business skewed underlying sales contribution towards lower risk and higher performing, returning-customer cohorts. Tightening approval parameters and spending limits on high-risk products are other pro-active measures. Modelling of potential downside scenarios suggested that APT is adequately capitalised to support operations for multiple years based on its current cash flow, balance sheet and liquidity position. No need to raise capital another positive sign. The Q3 update pleased the market, March was the Group’s third-largest underlying sales month on record, behind the seasonally higher months of November and December. Underlying sales increased by 97% on Q3 FY19. APT remains on track to achieve its previously stated objective of 9.5m customers by 30 June. The major tailwind at the moment, however, is Tencent’s 5% interest in the company. While not a commercial partnership (at this stage) it has helped reaffirm APT’s global relevance and has left investors salivating at the prospect. Tencent is one of the biggest companies in the world and processes 1 billion transactions a day. Validation by a global heavyweight is not something that should be taken lightly, and the overwhelmingly positive market response has been evidence of that. China is renowned to be a difficult market to break into, but with Tencent by APT’s side, the scope of possibility and the addressable market is enhanced dramatically. This could be a game-changing future catalyst. Main Observations:

• ROE unimpressive at -4.7%. It is important to remember companies that aren’t yet in a mature stage of life often lose money in their early days. If we valued a company based negative ROE no one would every buy into a new(ish) business.
• At this stage in the business life cycle looking at EPS and PE metrics do not help us in valuing the company. What is encouraging, however, is that in futures years EPS growth in FY3 turns positive and outpaces revenue growth.
• Outstanding revenue growth at 90% in FY1 and 54% in FY2 is one of the major focus points for the stock. The story for APT is about expanding into other geographies and winning market share particularly in the US and UK. This is what attracts investors.
• Of the 12 brokers surveyed by Thomson Reuters half have a buy or strong buy recommendation.

WHAT SORT OF INVESTMENT IS APT? APT is a growth play. The expansion narrative and adoption by new merchants and consumers around the globe is what drives interest and has made it one of the most widely discussed companies on the ASX. Commentary about a potential entry into Asia through Tencent the latest chapter in its tale. Although it is difficult to know when/if investors have overvalued aspects of the business and become too fixated on the story at the expense of reality. With fundamental analysis proving to be almost irrelevant in valuing the stock, it is important to look at other drivers. What are investors focused on and what expectations do they have? An obvious metric that stands out is active customer numbers, which have continued strongly since the end of H1 FY20, with the US and UK in particular, increasing 24% and 30% respectively. This increase followed the record number of new customers acquired in November and December 2019. 9.5m active customers still in reach for the company by June. A number over 9.5m would likely be a very supportive result. Total income and sales other measures that may garner slightly more attention. Possibly better reflecting progress from investment in marketing, employment and operations than traditional ROE calculations. They are also the first things management commented on its half year and quarterly statements. Total income for the half year end in December lifted 96%. Underlying sales at $7.3byear to date (YTD). Regulatory issues appear to have been put on the back burner. The RBA has deferred its review on surcharging until 2021. AUSTRAC still considering an auditor repot on AML and compliance. Most of their attention focused on WBC at the moment. The company also seemed little phased by the UK’s decision defer payments to credit providers by three-months on the back of COVID-19. BROKER STUFF While the Tencent interest in the company does not involve any commercial or strategic arrangement. It does, however, indicate a robust level of confidence in the business. Morgan Stanley expects the relationship will evolve into a business partnership that could assist APT diversify from its initial focus on fashion and beauty retailing. Citi sees potential for an entry onto the Chinese market and even suggests the low probability of a takeover in the near term. Morgans considered Q3 sales as reasonably solid. Assessed the company could weather most negative scenarios for the near-term. Macquarie mirrored that sentiment, pleased with how management responded to the virus and macro headwinds. No material impact from the virus and a strong balance sheet key highlights. Customer numbers remain robust and, while guidance for targets has been withdrawn officially, the business remains on track to reach 9.5m customers. Currently APT is trading at a 25% premium to the average broker target. That might be a bit alarming although, if we believed every piece of fundamental analysis on the stock the last few years, we would’ve gone heavily short and be broke by now. SHORTING Short interest in the company increased significantly since COVID-19 outbreak fears hit march, understandably. Interest peaked early April and has since contracted, likely a result of the well-received business update. A short interest of 4.7% cannot be ignored and is slightly concerning. At the current level, it does indicate a degree of bearishness towards the company. However, this does present an opportunity for the bulls. The higher the short interest, the greater the risk that short covering may occur in a disorderly fashion. What happened in April following the business update was a ‘short squeeze’, a jump in a share price that forced a number of short sellers to close their positions, which pushed the share price even higher as they were forced to buy back the shares sold short. SHORT TERM TECHNICAL VIEW APT is now only down 6% from its high in February before the sell-off. The stock fell 78% from its high and has since rebounded 227% from March 23. On an RSI of 72 is it overbought, momentum has also found a bottom and is rising again. The market update on April 14 and the Tencent announcement on May 1 have been significant tailwinds for the share price. TOP INVESTORS No real pattern after sorting by most recent filings. Morgan Stanly and Lone Pine Capital mid-March just before the market bottom both picked up significant parcels of stock. CONCLUSION Improving consumer confidence, validation from a global heavyweight (Tencent), the reopening of global economies and underlying market resilience are all positive signs that bode well for the company. Brokers are behind the eight ball with this one. Target prices failing to account for optimistic market sentiment. A strong balance sheet and the decision by management to not raise capital more positives for the company. Sales strength in the face of macro headwinds another. The Q3 update essentially de-risked the stock for the near-term and the tide is clearly running in its favor. Price is the tricky part. It is showing as overbought and our preference would be to buy back towards the 3500c region. The problem is, you might not get an opportunity to do so.