Mainstream financial press finally catches up to why all BNPL companies will go bust
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Feb 15, 2022 – 11.33am
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The interest-free lending business model of buy now, pay later operators faces its fiercest examination yet as a forecast 50 basis point rate hike from the US Federal Reserve in March signals the end of pandemic-era of cheap credit.
Buy now, pay later groups finance their loans to consumers by borrowing at benchmark floating rates like the London interbank offer rate (LIBOR) or bank bill swap rate (BBSW) plus a variable fixed margin, related to the assessed credit quality of the underlying loans and businesses.
As floating borrowing rates rise in line with cash rates, so does the cost for the buy now, pay later players to fund their enormous loan books.
As at June 30, Zip Co’s annual report reveals it had borrowed $1.62 billion to fund its receivables, with the interest payable on the debt subject to a fixed margin above BBSW or LIBOR.
The 3-month LIBOR borrowing rate has risen from 0.2 per cent this time last year to 0.37 per cent today, with 1-year LIBOR up 1.08 per cent from 0.31 per cent 12 months ago to 1.39 per cent today.
Affirm’s warnings
In the US, shares in $US12.2 billion ($17 billion) Nasdaq-listed buy now, pay later giant Affirm have cratered 45 per cent from top to bottom over just the last three trading sessions. On February 10, it lifted revenue guidance for financial 2022 to between $US1.29 billion and $US1.31 billion. It also said second quarter revenue climbed 77 per cent, with active consumers up 150 per cent to 11.2 million.
So, why does a group reporting huge growth have investors running for the hills? Perhaps, because its margins are contracting due to rising fixed costs. In the second quarter gross profit reached 50.8 per cent of revenue. In the third quarter at the mid-point of guidance, gross profit is forecast to fall to 42.8 per cent of revenue.
For Wall Street’s analysts and investors schooled the same way, free-falling margins are a traditional sell signal, as a sign of competitive pressure, or structural problems.
Affirm’s chief financial officer, Michael Linford, told last week’s earnings call its financial outlook already reflects the roughly 180 basis point increase embedded in the 3-month forward LIBOR curve.
Mr Linford also said that beyond financial 2023, for every 100 basis points of rate movements beyond the current forward curve, its gross profit margin could fall 40 basis points as a measure of revenue, less transaction costs, as a percentage of gross merchant value.
These forecasts assume Affirm’s current funding mix remains the same at a time when credit or bond markets are set to tighten for corporate borrowers.
The underlying credit quality of a portfolio of revolving loans over a typical period of three years can change if bad debts on the loans rise.
If the buy now, pay later lenders have to issue more bonds in the future to fund expanding loan books it may need to be done at wider fixed margins above a floating benchmark lending rate like LIBOR.
Less-sophisticated investors with financial memories stretching back less than a year have supported a flood of new IPOs and vertiginous share price rises disconnected from reality.
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In fairness, it’s possible some of the lenders convince the ratings agencies to assign their securitisation issues higher credit ratings, and consequently achieve lower fixed margins. But only if they show their business models are moving to sustainable cashflow profitability.
On the other hand, the subprime mortgage crisis of 2008-09 where credit and lending markets dramatically froze over as counterparties worried over each others' solvency shows that lending against portfolios of bundled-up receivables is a risky business.
The GFC also showed credit ratings tend to go up by the escalator, and down by the elevator.
Recently, the virtual-zero interest rate environment has artificially limited bad debts and eroded risk adversity. This means the price of risk declined, but its level remained and is likely to rise.
Will the credit ratings agencies, still tarnished by the GFC, forecast any worsening of bad debts in terms of frequency and severity? That’s up for debate, but as interest rates rise on student loans, cars, mortgages, and credit cards, cashflow pressure will increase on buy now, pay later users. More responsible ones may use it less often, so that less creditworthy users represent a higher proportion of the total.
This might sound neurotic, but the collapse in valuations reflects the risks. Shares in subprime lenders Zebit and Laybuy are down 95 per cent and 91 per cent from their respective IPOs.
Zip Co and Sezzle are down 77 per cent and 83 per cent over the past year and fell 5.3 per cent and 7.3 per cent respectively on Monday to fresh 52-week lows.
On an FX-adjusted basis Block’s current value means its takeover bid for Afterpay would only be worth $56.74 a share today, versus the $160 a share investors sent Afterpay to at the top of the buy now, pay later bubble this time last year.
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