Risks ahead for Afterpay, Zip, warns UBS

Shares in hotshots Afterpay and Zip hit after UBS warned regulators may spoil the party and slashed target prices.

An Afterpay sign in a Sydney store. Picture: AAP

Shares in buy now, pay later (BNPL) hotshots Afterpay and Zip have been hit after UBS analysts warned regulators may spoil the party, as the investment bank hit the companies with sell rating and slashed target prices.

According to a UBS Evidence Lab Australian BNPL survey, investor exuberance in the sector has failed to take into account a raft of commercial, regulatory and technological risks.

UBS has set Afterpay’s target price at $17.25, significantly lower than its current trading price of $34.6, with analyst Tom Beadle warning the market leader was particularly susceptible to regulatory backlash.

“In our view, somewhat paradoxically, the more successful BNPL services are, the more likely they are to attract regulatory scrutiny,” he warned in a client note on Wednesday.

“Afterpay is most exposed to regulatory risks, while Zip is less exposed with about 40 per cent of its portfolio income generated from BNPL today.”

Read more | Riding the Afterpay rocket

Shares in Afterpay fell by as much as 8 per cent on Wednesday, dropping as low as $33.50 at lucnhtime before recovering to be trading at around $34.46 mid-afternoon.

UBS is also unconvinced that Afterpay can make swift inroads into the US market, despite it adding former US Treasury secretary Lawrence “Larry” Summers to its US advisory board.

According to Mr Beadle, the US market may be 10 times the size of the Australian one but greater competition, more challenging economics and higher reliance on credit cards will cap Afterpay’s aspirations.

“We estimate Afterpay’s share price infers a long-term US customer base of around 12 per cent of the population, which appears optimistic.

“We also believe consensus may not be factoring margin dilution from US growth,” he said.

Meanwhile, Zip’s recent acquisition of the Australian and New Zealand businesses of global SME lending provider Spotcap, according to Mr Beadle, affords it a level of protection if the BNPL momentum starts to fade.

UBS has cut Zip’s target price to $4.80, compared to the $5.38 the company was trading at at the open on Wednesday.

Zip followed Afterpay down on Wednesday falling as much as 6 per cent to $5.09 before regaining some ground to trade at around $5.24 during the afternoon.

One major regulatory flashpoint for both Afterpay and Zip is whether buy now pay later will be considered a provider of credit in the future.

According to UBS’s survey, over 60 per cent of BNPL users see it as a credit service, with another 26 per cent unsure about how the services are classified.

“We think this is significant: if such a high proportion of BNPL’s users believe it is credit, we see substantial risk that it is regulated as such,” the analysts said.

The growth of the BNPL sector has come largely on the back of retailers signing up to the service and UBS’s survey shows that consumers want access to the service when shopping.

That means retailers are increasingly compelled to offer BNPL or risk missing out on sales. However UBS analysts said Afterpay and Zip can’t take that trend for granted.

“A significant portion of BNPL users agree that they spend more money and pay full price when BNPL is available, and return items less, which is clearly positive for retailers.

“However 62 per cent of BNPL users have also used BNPL even when they have sufficient money to pay outright. We see risk that retailers encourage such customers to use other payment methods given BNPL is significantly more expensive to process than other means of payment.”

UBS’s survey also highlights that consumers are not aware of the fees paid by retailers to Afterpay and Zip.

“Once made aware of fees charged by each of the BNPL providers, while over half of consumers surveyed were still comfortable with the level of fees charged by BNPL services and would continue to use them, a not-insignificant minority for each of the services stated they would not continue to use them now that they were made aware.

“The fact that the majority of BNPL customers think they are not paying higher prices potentially implies that while this subset is comfortable using BNPL for ‘free’, it could be difficult for BNPL services to grow volumes by allowing merchants to surcharge,” UBS said.

Any potential change in consumer and retailer behaviour opens the doors for traditional players to counter BNPL disrupters, with UBS expecting the likes of MasterCard and American Express to start to flexing their muscles.

The response from the traditional players is a persistent source of concern in the buy now pay later sector, with tech pundit Scott Galloway recently pointing out that Afterpay remained exposed to competition.

According to Professor Galloway, BNPL disrupters have a distinct lack of economic “moats” that allow them to keep competitors at bay for an extended period of time.

“These (BNPL) disrupters have puddles rather than moats that credit card companies can likely breach and step over.”

UBS is little more generous in its assessment, saying that Afterpay’s moat may be a bit more substantial, albeit in the local market. But it’s far from bulletproof.

“Low barriers to entry, the relative ease of replicating Afterpay’s product offering and competition from other payment methods leave it vulnerable to competition, though we acknowledge that Afterpay’s first-mover advantage in ANZ has potentially created a moat in its home market.

“Afterpay’s success is likely to attract the attention of competitors and new entrants. Regulatory and execution (particularly the US) risks are also significant,” Mr Beadle said.