A recession will test the buy now, pay later model. What it will take for these fintechs to survive

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Buy now, pay later services grew up during a time of economic stability, with demand ballooning in the early days of the pandemic as bored consumers shopped to break the doomscrolling cycle. The services — Affirm , Afterpay, Klarna and more — allowed shoppers to purchase new patio furniture, comfy clothing and other goods they needed to pass the time at home, and pay for these items in small increments, spread out over time. These fintech newbies now face their first major test: Slowing consumer spending, a potential upturn in delinquencies should a recession hit, dwindling profits and growing regulatory pressure. All this at a time when competition is rising. Tech giants like Apple are entering the space. The pressure of these forces is apparent in the companies stock prices, which have plummeted more than 75% from their highs. “These companies still trade like they’re going to have significant levels of growth and I don’t think that’s going to be the case,” said Vincent Caintic, an analyst at Stephens. “It underappreciates the fact that these companies have balance sheet risks and are going to have to deal with that if we go into a recession.” The fear is that these companies cater to consumers with lower credit scores, which could put firms in danger of rising default rates, or at the very least, a pullback in demand, if a recession comes. The companies counter that they have tools to adequately assess credit risk. Key investor takeaways Buy now, pay later services are facing their first major test: Slowing consumer spending, a potential upturn in delinquencies, dwindling profits and growing regulatory pressure. Competition is also rising, with tech giants like Apple entering the space. Analysts say more diversified players could outperform their rivals, and their could be consolidation ahead in the sector. “It’s very difficult to invest in this sector because on the one hand the companies may be doing fine today and may not ever experience significant credit or funding issues … but the stocks don’t really care,” said Chris Brendler, an analyst at DA Davidson. And there’s an argument that more consumers will want to use these services to buy the things they need as their budgets tighten. Remember, paying in installments isn’t an entirely new concept. It is the latest iteration of layaway, which was created during the Great Depression to help cash-strapped consumers make ends meet. Installment payment plans, in various forms, are older still. Just 2.9% of global e-commerce sales in 2021 were completed using BNPL — a fraction of purchasing globally — according to recent data from Worldpay. Sales are expected to nearly double by 2025 as the service grows in popularity, said the company, owned by the payment processing firm FIS. An April report from Experian said that 18% of consumers have used BNPL in the last six months and 80% of U.S. consumers use the service to avoid credit card debt. Forrester data indicates that BNPL use is largest among millennials, with 18% of them using the service. The market is expanding across age groups and income levels. It is particularly attractive to consumers with lower credit scores as many services only require soft credit checks or don’t conduct one as part of the application process. Some names in the space have already shown signs of trouble. Swedish buy now, pay later platform Klarna, said in May that it would lay off 10% of its global workforce . A year ago, the Softbank-backed firm was valued at $46 billion , but a recent funding attempt could knock its value down to around $15 billion, according to a report in the Wall Street Journal on the preliminary talks that cited people familiar with the discussions. How it works Many buy now, pay later services allow customers to pay back a loan in four, generally interest-free, payments. Some companies also offer monthly options, allowing customers to pick a desired timeframe to pay back loans. At Affirm, which is among the largest standalone companies in BNPL, customers can opt for four payments every two weeks or pick a monthly installment plan. The latter typically requires interest payments. The company also offers loans through merchants without interest, which generally translates to higher fees for the retailer. Some companies charge interest on the principle of the loan. At Affirm, that’s based on a variety of factors including the merchant, the value of the loan, how the payments are broken up, and the underwriting process. Affirm’s weighted average loan term stands at 5 months. “That means that in the event of a downturn, much of our outstanding back book (the loans we held or sold) will have been paid off, and it’s that newly-tuned ‘front book’ that will have the greater impact on our financial results,” wrote CEO Max Levchin in a blog post earlier this month . Users of PayPal ‘s “Pay in 4” option typically divide purchases into four payments due every two weeks. The company announced a new monthly BNPL option this week called “Pay Monthly,” which charges interest on the principal of the loan but allows customers to pay over a six- to 24-month period on bigger ticket items. Many companies make the lion’s share of their profits by charging fees to merchants, but some companies do make money off of late fees as well. Klarna, charges late fees up to $7 to the customer, while Block -owned Afterpay bills $8 on late payments. Late payments or defaults in many cases are not reported to major credit bureaus although many firms indicate delinquencies can prevent future loans with the service. At Afterpay, for example, customers failing to make a payment are blocked from making additional purchases. Merchant fees are arguably one of the biggest ways BNPL firms typically make a profit. Many companies do not explicitly disclose these rates but offer a range. Analysts often refer to merchant fees as the take rate, which is essentially a fee charged to merchants or money made per transaction. That number is around 6% industry-wide for pay in four options, Caintic said. The take rate is typically calculated by dividing revenue by the total value of goods sold, commonly referred to as gross merchandise volume. Afterpay’s merchant transaction fees range between 3% and 6%. In its most recent quarter, Affirm’s revenue minus transaction costs as a percentage of gross merchandise volume totaled 4.7%. The company’s long-term target is 3% to 4%. At Affirm, fees can vary by the duration of the loan but are over 5% for the company’s traditional BNPL — the pay-in-four model. PayPal offers its BNPL platform to any merchant already using its services, meaning there are no additional fees beyond the already negotiated contract. Regulatory pressure ahead Major credit reporting agencies have said they plan to incorporate BNPL loans into credit reports. However, these loans may not affect a user’s credit score, per se. The move came after the Consumer Financial Protection Bureau opened an inquiry into five major BNPL players to accumulate information on the risks associated with the increasingly popular loans and the potential for debt accumulation. ” It could be a perfect storm of increased defaults and increased financing costs that could really squeeze their margins and make these margins go negative,” said Former FDIC Chair Sheila Bair. “A few of them already have.” Bair said investors should proceed with caution. Default rates could rise further if consumers overextend themselves using BNPL. Anyone considering investing in the sector should examine the companies’ default rates, customer credit profiles and financing costs, among other metrics, she said. Many BNPL firms rely on lines of credit to fund their products, which means financing costs for these companies will rise along with interest rates. Some lenders could offset these costs by charging higher rates especially given the riskier credit environment and margin pressure, said Anisha Kothapa, a senior fintech analyst at CB Insights. Companies will need to attract more customers, place limits on loans to riskier ones or even underwrite shorter-duration loans, she said. That could mean requiring customers to pay in a smaller timeframe, giving companies more time to deal with delinquents. So far in 2022, Affirm’s delinquencies as a percent of active users range between 2% and 3%. Its allowance for credit losses, which is essentially the total amount of losses a company anticipates it will take on existing loans, rose to a little over $159 million for the period ended March 31 from about $118 million at the end of June 2021, but declined for two quarters as a percentage of loans Affirm held on its balance sheet. In Block’s recent quarter, Afterpay’s losses totaled 1.17% of total processed payment dollars. Afterpay did not track quarterly rates prior to the acquisition, but that equaled 0.9% for the full fiscal year ended June 2021, a company spokesperson said. PayPal does not currently break out its BNPL service, which is a part of its total processing business. Kothapa anticipates credit losses may rise at many BNPL companies in the future. Vetting customers for loans can differ from company to company. Affirm, for example, currently incorporates its own models and data to assess risk using several factors, including the time of the consumer’s purchase. “We believe that by making every transaction an explicit borrowing event, we don’t just protect Affirm from excess risk, we protect our borrowers from overextending themselves,” wrote Levchin in his recent blog post, adding that the company only offers credit on loans it anticipates will be repaid. Affirm remains confident in its “ability to deliver strong growth while driving positive credit outcomes,” he said. Combating a recession Major BNPL firms have plummeted from their highs in recent months as investors question the stocks’ long-term growth trajectory, especially with a potential recession ahead. Affirm, for example, is 89% off its all-time high and is trading down about 82% since the start of the year, while shares of Block and PayPal sit more than 79% and 76% off their high, tumbling about 64% and 61%, respectively, year-to-date Traditional credit card names including American Express , Visa and Mastercard have also sold off in recent months, falling about 27%, 24% and 22%, off their highs respectively. Those losses pale in comparison to the massive hit to BNPL names. These names have benefited from an anticipation that there will be uptick in consumer borrowing. This month, Wedbush Securities analyst David Chiaverini initiated coverage of Affirm with an underperform rating, warning in a note to clients that the stock could plummet 40%. He cited heightened competition in the industry, margin pressures and profitability concerns among the reasons for the call. “Affirm’s pay-in-four product, which was 20% of GMV in the most recent quarter and is the fastest growing segment, is becoming especially commoditized with margins getting squeezed and bigger merchants pushing a hard bargain on economics,” he wrote. During a June interview with CNBC’s “TechCheck,” Affirm CEO Levchin addressed the stock’s fall and the company’s outlook for profitability, which the BNPL firm previously said it plans to reach by 2023. “We are very confident of our strategy — of growing responsibly, underwriting every transaction, making sure that our unit economics are extraordinarily strong — is the right path,” he said. “We are quite certain that we do not need to start breaking glass or hitting red buttons or anything of the sort. Perhaps my competition does but that’s what downturns are all about.” Some companies anticipate they can charge larger fees to merchants to offset higher losses and analysts agree this is one way to recoup revenue. But in a competitive sector, companies run the risk of losing pricing power if merchants opt for cheaper competitors offering lower rates, Stephens’ Caintic said. “Without the ability to price, Affirm is going to have to give up on volume or accept higher losses,” he said. “And it’s not just Affirm, you can say the same with what Afterpay’s doing, what PayPal’s doing.” Affirm’s merchant fees have remained consistent, said Michael Linford, its chief financial officer, during a recent earnings call. “We view that as a real mark of success that in the face of pretty heavy competition we were able to maintain and even grow, in some cases, the merchant fee side,” he said. BNPL as ‘a loss leader’ Companies offering a range of financial services along with BNPL may be better positioned to weather a downturn, said MoffettNathanson analyst Lisa Ellis. As examples, she pointed to Paypal and Block, which purchased Afterpay for $29 billion last year. These companies can recoup losses in the market through other revenue streams, she said. PayPal first launched its buy now, pay later offering in August 2020. During the first quarter of 2022, the company processed $3.6 billion in volume on the service, said CEO Dan Schulman on the company’s first-quarter earnings call in April. More than 18 million consumers have used BNPL and it continues to gain traction, he said. “And that plays, by the way, right into our advantages as well because we have 10 years of credit experience, we think we have the lowest loss rates of the buy now, pay later industry, probably the highest approval rates because we know so many of the customers and a really powerful value proposition to merchants,” Schulman said. Some analysts aren’t so optimistic that BNPL can survive on its own. “It’s a loss leader,” Caintic said. “It’s just one offering that brings a customer or a merchant into the ecosystem and then they can sell other products with better margins. As a standalone business, it seems really tough that buy now, pay later can continue.” PayPal makes the majority of its revenue through its payment services to merchants and operates the digital wallet platform Venmo. Block’s major business segments include Square and Cash App. Its Square product allows businesses to process payments while CashApp enables customers to send and receive money, along with other services. Apple set to shake up BNPL Many credit card companies and banks have also begun offering their own iterations of buy now, pay later to clients and that’s likely to continue putting pressure on the market, CB Insights’ Kothapa said. She also anticipates more tech companies will follow Apple by building out platforms or acquiring smaller players. Some analysts see Apple’s entry as a threat. Apple Pay is already accepted at 85% of U.S. retailers, giving it access to a substantial share of the market. And its demographic is typically higher-income consumers with other credit alternatives, wrote Morgan Stanley analyst James Faucette in a recent note. “As such, in our minds the long-term trajectory of BNPL providers remains unchanged: attract consumers that may have more limited access to traditional consumer credit options, and then mature them into more fully established customers, ultimately with a full suite of banking services,” he said. Amid the competition, Affirm’s brand presence may help it gain market share over the long-term, said Chiaverini in his recent note. But the sector could be ripe for consolidation. Aside from Block’s Afterpay acquisition, Paypal announced plans in September to buy Japan’s Paidy for $2.7 billion . Affirm bought Canadian provider PayBright in December 2020 . Meanwhile, Mizuho analyst Dan Dolev said fears of an implosion in the fintech sector are “way overblown” and the ability to underwrite loans is another competitive advantage for many larger firms. Many of these companies may not experience the credit risks or funding issues markets are anticipating but their stocks are nonetheless taking a hit, making it a tricky area for investors to straddle, said Chris Brendler, an analyst at DA Davidson. “It’s very difficult to invest in this sector because on the one hand the companies may be doing fine today and may not ever experience significant credit or funding issues as they did back in 2008, but the stocks don’t really care,” he said. “It’s almost like you’re better off just waiting for better times. I think those can come quicker than people realize.”

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