Afterpay Touch Group Limited (ASX: APT) shares took a tumble last week, falling more than 20% from a high of $37.30 on Tuesday to finish the week at $29.65. Afterpay saw its shares heavily sold off following the release of a blistering report from investment bank UBS on Wednesday, which initiated coverage on the stock with a price target of $17.25, as reported by the Australian Financial Review (AFR).
The buy-now, pay-later (BNPL) provider has been a market darling in 2019, seeing its shares rise from just $12 in January. Since listing in 2016 at $1, Afterpay shares had increased in value by more than 3,700% at their peak. But the WAAAX stock is facing headwinds in the form of increased regulatory scrutiny and doubts over its ability to replicate its Australian success in the United States (US).
Regulatory headwinds blowing
Under Afterpay's business model, merchants are forbidden from passing on the costs of the service to customers. According to UBS, this has the potential to increase regulatory scrutiny by influencing customers' choice of payment method.
Based on Afterpay's merchant charges, UBS estimates the cost to merchants of providing Afterpay is equivalent to an effective annualised interest rate of 19% to 49% on a $150 transaction, far higher than credit card interest rates levied on consumers. Merchants have thus far accepted the fees due to the potential incremental sales uplift associated with offering Afterpay.
Credit and debit card providers, however, cannot prevent retailers from passing on the costs of paying by card. The Reserve Bank of Australia (RBA) on Thursday announced it would investigate whether policy action should be taken to target the "no surcharge" rule enforced on merchants by Afterpay and other BNPL providers.
In the annual report of the Payments System Board, the RBA announced a forthcoming review of card payment regulation, which will consider the impact of BNPL services. The report stated that such services were expensive for merchants to accept and restrain the ability of merchants to pass costs on to the consumers that benefit from them. Therefore, "an issue for the bank is whether policy action in relation to these no-surcharge rules should be considered."
Credit protection lacking
Afterpay and other BNPL providers operate outside consumer credit laws. By avoiding charging customers interest and instead levying late payment or account fees, they avoid rules that prevent credit providers lending to indebted or unsuitable customers. Earlier this year, the Senate Committee on Economics declined to recommend expanding national consumer credit protections to BNPL providers, which would have forced Afterpay to conduct credit checks on end users.
Zip Co Ltd (ASX: Z1P), a competitor BNPL provider, operates on an alternate business model to Afterpay. While neither charge interest, ZIP Co Ltd does conduct credit checks. Afterpay splits payments for goods into four equal parts and deducts repayments bi-weekly, while Zip Co Ltd provides a credit line to customers and conducts credit, bank statement and identity checks.
Afterpay makes the majority of its income in fees levied on retailers with another chunk attributable to late fees charged to customers. Zip Co Ltd, on the other hand, makes more money from customers, charging a $6 monthly service fee as well as late fees, but charges retailers less than Afterpay. Zip Co Ltd was also heavily sold off last week, finishing the week at $4.35, down nearly 25% from a high of $5.79 on Monday.
ASIC's review into the BNPL industry, published late last year, found there were potential risks to consumers using these arrangements. ASIC remarked that it would remain an area of ongoing focus, with the regulator targeting arrangements where consumers were paying more than they need to using a BNPL arrangement.
ASIC has found that 40% of BNPL users had incomes of less than $40,000, and of these users nearly 40% were students or worked part time. Meanwhile, 1 in 6 BNPL users has become overdrawn, delayed bill payments, or had to borrow money to meet their payments.
Afterpay Chief Executive Anthony Eisen has dismissed concerns of regulatory risks, arguing consumers understand BNPL services. Eisen rejects suggestions that BNPL services changed customer-purchasing desires. The real question, however, is whether they change customer-purchasing capabilities – the report released last week by UBS found 26% of users of services such as Afterpay used them because they couldn't otherwise afford something.
Of those surveyed by UBS, 64% thought BNPL services were a form of credit. Another 30% had used a credit card to pay the balance on a BNPL product. As UBS states "this supports our view that the BNPL sector is at significant risk of being regulated as a credit provider." According to Eisen, Afterpay is in "favour" of regulation, provided it is "in line with what we do."
In April, ASIC was granted product intervention powers, allowing it to intervene if a financial product is likely to result in "significant consumer detriment". These powers allow the corporate regulator to intervene in the BNPL space, although ASIC has thus far declined to do so. The product intervention power is a broad and flexible tool that allows ASIC to take a range of actions including banning products or product features, imposing sales restrictions, and amending product information.
A breach of law is not required for ASIC to exercise the product intervention power, rather, the focus is on reducing detriment to consumers. Concerns the corporate regulator will step in and regulate the BNPL sector continue to haunt the industry.
Afterpay is also waiting on the outcome of an AUSTRAC-ordered investigation into potential breaches of anti-money laundering and counter-terrorism financing laws. Afterpay was ordered to appoint an external auditor by AUSTRAC after the agency identified concerns with Afterpay's processes. The report is due on 23 November with potential outcomes including fines, civil proceedings, remedial directions, and enforceable undertakings.
US success in doubt
Afterpay's valuation is at least partially premised on success in the US. UBS has doubts Afterpay can achieve the same levels of growth and market penetration in the States as it has in Australia. Low barriers to entry in the US leave Afterpay open to the threat of competition. Further, higher credit card rewards encourage a culture of credit card use, which Afterpay will need to compete against.
In order to justify its current value, UBS estimates that Afterpay will need 47 million customers spending $3800 each per year by 2030. UBS sees these figures as unrealistic and has used them to justify slapping a sell rating on Afterpay.
Foolish takeaway
Opinions on Afterpay and the BNPL sector differ. Goldman Sachs had a price target on the stock of $42.90 late last month, while Morgan Stanley has pitched Afterpay as being worth as much as $44.
Some commentators believe the use of BNPL services will become as common as credit cards in future. While increased usage has an obvious upside for Afterpay and its ilk, there may also be a regulatory downside. This very scenario may be what forces regulators' hands and initiates the imposition of tighter controls around the business models of BNPL providers.
