Things went from hot to cold quickly at Affirm (NASDAQ:AFRM). After hitting a $139 peak in February, AFRM stock has dropped over 50%. The stock has been essentially in free fall since that peak.
Part of this plummet is due to investor sentiment. Tech names that thrived during last year’s lockdowns are taking a backseat to stocks that stand to gain from reopening. But looking closer, there are fundamental concerns that continue to spell trouble for this stock.
Specifically, Affirm’s high operating losses and loan defaults, coupled with increasing competition, signal more trouble ahead. Then there’s the stock’s valuation, which, despite a massive haircut — still trades at a pricey 25x forward sales — a premium to payment giant Paypal (NASDAQ:PYPL).
While Affirm is the best name in the space, I’d wait for a better entry point in the stock. Here’s why.
AFRM Stock: The New Digital Wallet
Launched by Paypal co-founder and former CTO Max Levchin in 2012, AFRM is now one of the top three players globally in the buy now, pay later (BNPL) sub-sector of payments. The company has attracted attention for its popularity among young shoppers, who spend an increasing amount of money online. Young people in particular are slower to spend with credit cards, but have been early BNPL adopters, seeing it as a more budget-conscious and transparent spending method.
Affirm’s value proposition is simple: the company offers a more flexible alternative to traditional credit cards. Affirm’s lending product integrates with e-commerce sites and allows shoppers to pay for goods over time in fixed installments. Depending on the total spend and loan duration (usually 3, 6 or 12 months), customers pay between a 0% and 15% average annual interest rate. Other perks: Customers can see how much a loan will cost in dollar terms.
The company doesn’t charge late fees or compound interest typical of traditional credit card lenders (although missed payments can affect credit scores).
As a BNPL player, Affirm makes money in two ways: it collects transaction fees from merchants (estimated at 2-3%) and interest on financing from purchasers. Merchants pay Affirm’s fees because installment plans entice customers to make bigger ticket purchases, boost order volumes and drive repeat purchases. AFRM customer Peloton (NASDAQ:PTON), for example, offers a near-$1,900 exercise bike for $49 a month, with 0% interest.
The Dark Side: Debt Defaults
BNPL, which comprised only 2% of global e-commerce sales in 2019, is a massive untapped market, expected to top $680 billion globally in 2025. But while the future looks bright for AFRM stock, there are some dark sides to the story.
The first dark side? Default risk.
Affirm is essentially a lender, so its underwriting standards are important to the company’s profitability. Affirm only generates 1 to 3 cents of gross margin per $1 of lending, leaving very little margin for error.
Affirm hasn’t been operating through a full credit cycle and if the company writes loans to the wrong people, it could continue to suffer big losses. BNPL users aren’t those with the best credit.
In fact, Reuters reports that “[n]early 40% of U.S. consumers who used ‘buy now, pay later’ have missed more than one payment, and 72% of those saw their credit score decline.” There’s also evidence to suggest that 40% of BNPL users are turning to these alternatives “because they couldn’t get access to traditional credit — either because they’ve maxed out their credit limit or because of a poor or non-existent credit history.”
These losses are apparent in the numbers, which are going in the wrong direction. Affirm’s Allowance for Credit Losses increased from $85.9 million to $131 million during the company’s most recent quarter.
Affirm faces a second challenge: competition.
Right now, the company is the leader in the high AOV (Average Order Value) segment of the BNPL market, bolstered by its long-standing relationship with Peloton for bikes and treadmills. But, to reach its long-term goals, Affirm must tap into a very crowded market for low AOV transactions.
Not only do giants like Paypal, American Express (NYSE:AXP) and Alliance Data Systems (NYSE:ADS) play in this space, but so do other BNPL companies like Afterpay (OTCMKTS:AFTPY), Zip Co (OTCMKTS:ZIZTF) and Splitit Payments (OTCMKTS:STTTF), as well as a handful of privately held companies like Quadpay and Klarna.
Not only is competition intense, but it’s hard to see that Affirm has any sustainable advantage. Competitors are already building strategic partnerships to grab market share. Zip, for example, partnered with Visa (NYSE:V) to give customers a digital BNPL card. It’s effectively a credit card with a low maximum limit of $1,500 plus all the BNPL benefits like low (or zero) interest charges.
And while Affirm isn’t standing still (the company plans to roll out an Affirm Card later in 2021), neither is the competition. Major Australian banks have begun to roll out low-interest credit cards with much higher credit limits. PayPal is rolling out a “Pay in 4” BNPL service next month to 9 million Australian customers.
For Affirm, increased competition means profitability metrics could get worse. Paypal, for example, charges a very competitive 2.9% fee for merchants, although it doesn’t offer longer-term installment plans and limits shopping carts to $600. Afterpay charges the merchant a percentage fee based on the transaction value, and the consumer only pays fees if they’re late on their payments. With margins already razor-thin, the timing to profitability is very uncertain.
Affirm Has More Distance to Fall
AFRM stock is the best publicly traded pure-play on BNPL, in my opinion. And there’s no doubt that the BNPL market has the potential to capture an increasing piece of the payments space.
But while Affirm has enough working capital to cover its losses, the company’s path to profitability isn’t clear. Intensifying competition will complicate timing. The valuation for Affirm stock is another issue.
Today, AFRM trades around $60, which is still around 22% above its $49 IPO price. Even at AFRM’s dramatically reduced $16 billion market capitalization, that’s a multiple of 25x forward sales — a massive premium to Paypal, at 11x sales. You can also compare that to Social Capital Hedosophia Holdings (NYSE:IPOE), whose fintech merger target, SoFi, is expected to trade at around 20x revenue.
Longer term, I think this company has potential. But with the company reporting earnings results on May 10, there’s no need to rush in. Wait for a better entry point in AFRM stock.
On the date of publication, Joanna Makris did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Joanna Makris is a Market Analyst at InvestorPlace.com. A strategic thinker and fundamental public equity investor, Joanna leverages over 20 years of experience on Wall Street covering various segments of the Technology, Media, and Telecom sectors at several global investment banks, including Mizuho Securities and Canaccord Genuity.