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Affirm: Can it satisfy investors in a fraught environment
Investing in the fintech space has not been good for the performance of a portfolio during the past 14+ months. Supreme understatement, I suppose. Depending on the definition of fintech, most of the group has imploded. In terms of winners, there has been Shift4 Payments (FOUR) and little else. Even the closest analog of Shift4, Adyen (OTCPK:ADYEY) has shed a substantial amount of its prior valuation. One of the worst performing shares in the space has been Affirm (NASDAQ:AFRM). Having called that out, the share price implosion of Affirm is not necessarily a reason to consider the shares at this point.
That said, I do believe that there is a case to be made for recommending the shares of Affirm, even at this point with a recession either here or impending. The case is not about recommending the shares because of expectations of short covering although that is part of the positive case to be made. The case is because of a more measured evaluation of the company’s prospects and risks. I need to mention here that I base my evaluation on non-GAAP measures adjusted for potential dilution. Affirm uses SBC, and Affirm has provided warrants to a couple of its most important partners, Amazon and Shopify. It amortizes the value of the warrants through its income statement as the warrants become vested. Thus GAAP profitability is not on the horizon, but non-GAAP profitability is. But for readers focused on GAAP, this is not an investment that will be suitable.
Recommending Affirm shares or acting on such a recommendation is not an undertaking for the faint of heart. While the shares have most recently bounced noticeably as investors focused on lowering inflation data and the hope for a Fed pivot the past few days, there hasn’t been any relaxation in the plethora of negative recommendations of the shares by brokerage analysts. And bouncing from the recent low of $8.62, while significant in percentage terms is not much more than a drop in the bucket after a fall of more than $150/share. The latest scorecard on brokerage recommendations shows 8 buys, 8 holds and 3 sells. The most recent ratings change was that of the B of A analyst, Jason Kupferberg, who replaced his buy rating on Affirm and some other Fintech companies, with a neutral rating about a month ago. The basis of the downgrade was all too familiar. Retail sales being pressured by macro headwinds. Interest rates being pressured by Fed actions. Affirm borrowers defaulting at increasing rates, the sector crowded with a multitude of competitors.
One fund manager, Trent Masters of Alphinity Investment Management has forecast that Affirm would not survive 2023. That seems to be a rather sensational forecast, not really based on specific insights into Affirm, but it is illustrative of the attitude of many investment managers toward the shares. Alphinity is a large, Australian based fund manager/investment advisor with a mixed track record. Its investment style is not based on investments in any tech space. So, perhaps the attitude of Mr. Masters is not a function of anything more than the predilections of Alphinity in terms of investing. Of course, for those with a contrarian turn of mind, that kind of sentiment is what leads to opportunities.
Once upon a time shares of Affirm were flying high. They made an all-time high above $170 share on 11/1/21 in the wake of an announcement of a partnership with Amazon (AMZN). The share price spike back then brought valuations into the stratosphere. Of course the shares were hardly alone with their elevated valuation based on expectations of continued hyper growth and profitability at some point but there was an existential disconnect between the valuation at the time of the spike and the DCF valuation of the shares.
The shares are now down more than 92%, and that is after a significant rally over the past several days or so. While pendulums in clocks tend to swing in a circumscribed arc, pendulums in stocks have no such limitations. Sometimes, companies whose shares are the most overvalued and have sucked in the most investors, wind up becoming undervalued as the staying power of dip buyers get used up. And no doubt, the environment in which expectations for Affirm thrived is simply no more. Interest rates are high, interest rates spreads are under pressure, defaults on loans to consumers might be rising and retail sales growth is minimal. Further, while Affirm was a pioneer in the buy now/pay later space, at least in the US, there are plenty of competitors now, and many investors are not convinced that this company offers its partners and their customers any significant advantages.
Beyond the deterioration of the environment, although certainly a concomitant, the short interest in Affirm shares has ballooned. As of 12/30/22, the latest data that is available, Affirm’s short interest was 35 million shares, or nearly 18 % of the float. Not as high as Upstart (UPST) often viewed as an analog investment, but certainly high enough. That said, the short interest has started to decline and dropped 4 million shares in the latest reporting period.
My own record in terms of recommending the shares is far from enviable. While I managed to avoid the hype of the spike, I started recommending the shares about a year ago, and most lately in early September, 2022. Needless to say, these have not been my favorite recommendations. But at some level, while the share price has continued its decline, the company has made noticeable progress in terms of a pivot to profitability, and while investors and many analysts were seemingly mortified at the most recent results, my view is that the results showed a glass at least half full.
For a positive recommendation on Affirm shares to work as more than a bounce, a less baleful set of interest rate expectations than has been the case until quite recently will be needed. And that, of course, is in turn predicated on improving inflation data, and ultimately on a Fed pivot. In terms of trading the shares of Affirm, as opposed to investing in the company, the trend of interest rates and interest rate expectations is of paramount importance. I do not want to pose as a seer on interest rate trends. I have my thoughts-frankly I had believed that the evidence at hand might have convinced Fed governors that inflation threats were waning sooner than has proven to be the case. And my recollection and read of the 1970s is at some variance with the pronouncements of some Fed speakers. I actually lived through the period, was subject to wage/price controls, oil price shocks, the Whip Inflation Now idiocy and ultimately double digit inflation with mortgage rates of more than 15%. This period really has little resemblance to those times in terms of macro trends.
This article will NOT focus on expectations for interest rate trends. And while it is impossible to write about this company, or any other Fintech company, or IT company, without expressing a view of some kind about the economy, much of this article will discuss the reasons why I believe that Affirm can achieve differentiated success in spite of macro headwinds. Of course the company would have better results in a less difficult economy. No doubt it would grow faster, and have wider interest rate spreads in a different environment. But at the end of the day, I think it is reasonable not to focus investment judgement of this company based on expectations for results at the nadir of an economic cycle, but based on expectations for its performance during periods in which the economy is growing and when it is not.
Taking a look at Affirm’s last reported quarter
It’s been more than 2 months since Affirm reported its results. At the time of the earnings report, many commentators seemingly felt that the guidance was a disaster. The shares fell by 23% the next day before recovering subsequently and then falling steadily to recent lows at the end of last year. I think in presenting an investment case for the company, it is reasonable to start by reviewing the latest quarterly data even though it is more than 2 months old at this point.
It should be noted that Affirm can be a relatively complex company to analyze. It records revenue in several buckets, and these different buckets have different gross margins and net margins. Specifically, Affirm offers its merchant partners many different options that they can offer their customers. These include a 0% interest rate option in which merchants pay for the cost of credit upfront. It also offers merchants the ability to provide their customers with a 4 payment option, and in some cases such as sales generated through Amazon, consumers can pay over several years with an APR of as much as 30%, in which case revenue is recognized ratably over the life of the loan. When considering revenue growth, it should be noted that the company recognizes the fees merchants pay it for their 0% interest rate offers up front so the change in mix, depending on which channel is seeing growth, has a material impact on reported revenues. In addition, the metric known as RLTC (revenue less transaction costs) is impacted by charge offs. At the time of the pandemic, the company bulked up its loss reserves. Then, when the reserves proved to be excessive, they were released leading to growth in RLTC not related to current period activity. So, some year to year comparisons are skewed by this accounting measure, as opposed to actual trends in the company’s business.
The major revenue related performance indicators were essentially in-line for the quarter. GMV had been projected to be $4.2-$4.4 billion. It was nearly $4.4 billion. Total revenue had been projected to be about $355 million; it was $362 million. RLTC had been projected to be about $175 million; it was actually $182 million. The non-GAAP operating loss margin of 6% was noticeably better than the company’s prior projection of a loss margin of 12%-10%.
The growth in gross merchandise value is probably the most important performance indicator for the company. GMV rose by 62% year over year last quarter, or by 73% excluding Peloton. Sequential growth was nil for the period, somewhat below the trend in the year earlier quarter. Revenue for the quarter rose by 34%, and by 46% excluding Peloton (PTON), an erstwhile leading partner, now a low single digit contributor to revenue. Revenue less transaction costs (RLTC) rose by 63%. Last quarter RLTC actually benefited because of a favorable impact from funding costs because the company was able to switch to lower cost funding sources. This is highly unlikely to be a consistent factor; it almost certainly reversed last quarter. Overall, at least through the end of the last quarter, and through October as well, merchant fee rates have essentially been stable.
Most investors and analysts have been focused on the company’s consistent losses, and its cash burn. Management has spoken frequently and at length of its expectation to reach sustainable non-GAAP profitability from the start of the new fiscal year which begins on 7/1/23.
Michael Linford
James, thanks for the question. Yes, we are still very much on time and on pace to achieve the profitability goal that we outlined, which just to recap everybody, we talked about getting to profitability starting in the first day of our fiscal ’24. We said on a sustainable basis, meaning that we’ll intend to do it repeatedly most of the time and looking at adjusted operating income.
And so for us, the challenge is some pretty simple math. We need our revenue less transaction costs to be greater than the adjusted operating expenses that we have below the transaction cost line. The key things for us then are making sure we’re doing everything we can to maximize the unit economics in the business. And if you look at our back half of the year road map, we have a lot of focus on making sure we’re doing all that we can and should do there as Max outlined in the letter. And we’re going to be mindful about controlling our operating expenses. And to that, that means being very careful, in particular, on hiring, but also making sure that we’re not having any pockets of waste in the business.
The last quarter brought some positive signs regarding the moderation of non-GAAP opex growth. Year over year, non-GAAP expenses rose by 28%, while revenues rose by 34%. On a sequential basis, non-GAAP operating expense fell by about 6%.
The performance of Affirm loans was basically stable last quarter despite the concern by investors and analysts regarding the potential for deterioration of credit quality. The latest data suggests that stability continued through to the end of 2022 and into the first part of January. While it is certainly a risk that bears watching, unlike some other lenders using AI technology, thus far Affirm’s credit experience simply hasn’t shown deterioration.
Guidance-Was it really that bad?
Obviously the market thought so, and the market is always right. But really, here are the facts. The company had provided guidance at the start of its fiscal year the prior quarter as follows: Gross Merchandise Value (at the mid-point) of $21.1 billion; Total Reported Revenue (again at the mid-point) of $1.675 billion and Revenue less transaction cost (RLTC) of $785 million. The company projected a non-GAAP operating loss margin of about 5.5% at the mid-point of the range, or about $92 million of operating loss.
The new guidance is for GMV to be about $21 billion; for headline revenues to be about $1.64 billion; for RLTC of $740 million and for a non-GAAP operating loss margin of 6.3% or about $103 million. Quite a bit of this guide down is a function of mix. Specifically, as the partnerships with Amazon (AMZN) and with Shopify (SHOP) produce an increasing proportion of GMV, the immediate revenue contribution of that GMV is less than it would be for 0% loans where the revenue is recognized up front.
Part of this pivot is the result of the substantially reduced volume of loans based on Peloton merchandise. Peloton remains a partner of Affirm, but its scale has gone from a 30% contributor to GMV to less than 2%. Loans for Peloton merchandise are recognized up front, so its decline as a contributor to the business has exacerbated impact of revenue recognition towards products that produce ratable revenue.
I really think that much of the analysis of Affirm ignores this point and how it has produced some results that have been questioned by some. The fact is that the income statement as reported doesn’t completely reflect the economic value of the transactions Affirm has been financing through its partnerships with both Shopify and Amazon. Here is a brief explanations of that phenomenon by the CFO during the last conference call.
So if you take a 12-month loan that’s originated on in December, for example, most of that income happened in the back half of the year.
What’s important, though, is the provision for credit losses for those loans will happen upfront. And so that means as you get less revenue, less transaction costs in the period, even though those loans are very good and profitable for us throughout the year. But then more broadly, I think it’s just really important to remember how early we are with these large partners and with the program overall.
So, despite the 35% growth forecasted for GMV, revenue growth is forecast to be 24% and the growth of RLTC is expected to be 12%. Eventually, the economics of the extended payment offers winds up producing more revenue for Affirm, but initially the revenue contribution is smaller. In turn, this produces a somewhat lower RLTC yield, and with headwinds from increased funding costs, this is what has driven the operating loss margin slightly higher last quarter and is forecast to have a similar impact this quarter, before significantly reversing in the 2nd of half of FY 2023.
In order to maintain the operating loss margin at around the 6% level, with RLTC only increasing by 12%, the company is obviously planning to exercise a substantial level of expense discipline. Part of that is a function of the mix change; as an increasing proportion of GMV comes from Amazon and from Shopify merchants, the requirement for sales and marketing is less than heretofore. This started to show up in Q4 opex ratios and is one factor that is part of the company’s ability to move to non-GAAP profitability starting less than 6 months from now.
Affirm exists in the economy as it is. While ecommerce revenues have been growing, that growth has slowed substantially. That is going to have some impact on Affirm’s growth, but that affect can easily be exaggerated. Currently the company has about a 2% share of the market for ecommerce purchases, and that has risen quite steadily over several quarters. US ecommerce sales are increasing at just over double digit rates, while Affirm’s GMV growth, based on the revised guidance is for an increase of 35%. The current GMV estimate would take Affirm’s share of the ecommerce market up to 2.5%. When analysts and commentators talk about how the slowing growth of ecommerce produces a headwind for the expansion of Affirm’s GMV, the issues of current penetration and market share are often ignored.
Affirm has announced an earnings date to release the results of the quarter that ended on 12/31/22. It may be that some investors had feared that deteriorating results would have required the company to pre-release results, and thus the announcement of an earnings data has been viewed through a positive lens. The forecast for the quarter to be reported was particularly undemanding so the ability the company had to meet such subdued expectations is not really an indication that there aren’t macro headwinds. The issue for the shares short-term is going to be forward guidance. At this point, simply reaffirming guidance will be enough, and perhaps more than enough to reverse some of the negative sentiment the shares have battled for months.
In addition, the current consensus of interest rate expectations has downshifted noticeably. While there are a variety of opinions on the Fed board, the preponderance of the latest speeches seems to be for a 25 bps increase at the next meeting, and perhaps one or two more increases depending on incoming data, before rates are held steady for some time period. Some bond investors are apparently already expecting a series of interest rate cuts in 2024, and this is obviously having an impact on the shares of Affirm and other fintech shares. There are, of course, strategists and economists who have far more dire forecasts regarding the course for inflation and rates; there are days when these more dire forecasts gain credence. So far as I can tell, however, the course of inflation, while certainly not a straight line, is likely to continue to show steady movement toward the Fed’s desired rate of 2%, while payroll employment, despite its relatively anomalous behavior thus far in this cycle, is likely to start to track downward, even with lower labor participation rates than those that obtained before the pandemic.
The issue of credit quality and charge-offs
A principal component of the short thesis regarding Affirm, particularly, and for many other fintech equities is the belief that as economic headwinds accelerate, defaults on loans made by Affirm will rise, limiting the ability of the company to attract needed resources to fund a higher level of loans to support the growth in GMV. The belief is that Affirm provides credit to borrowers who are less creditworthy/more risky than consumers who use their credit cards as their source of paying for purchases. There really is no objective evidence regarding this assertion-at least at this point in the cycle. One reason is that unemployment hasn’t spiked and that jobs are still available. I think that for the thesis to play out, if it does, will require a significant change in the labor market from its current place.
At the moment, the data that the company has presented simply doesn’t show a rising trend in defaults and charge-offs. the quote below is from the CEO on the last conference call.
We were pleased that our credit quality remained resilient during FQ1’23 with 30+ day delinquencies remaining below pre-pandemic levels (excluding Pay in 4 and Peloton). Despite an increasingly complex macroeconomic environment, this trend also held in October. Similarly, as we describe on the next page, our Pay in 4 loans have shown consistent improvement in recent quarters on the basis of Cumulative Net Charge-off per loan cohort.
Pay in 4 loan performance Our Pay in 4 product has a shorter history, as we only began to meaningfully scale this offering in June of 2021. Recent Pay in 4 loan cohorts have shown substantial sequential improvements in charge-off rates compared to the FQ4’21 and FQ1’22 cohorts. For example, the loss rate for our recent cohorts of Pay in 4 loans is tracking to less than 2%. As our Pay in 4 portfolio has grown, we have continued to optimize our product-specific underwriting and have benefited from an increasing proportion of transactions from repeat customers. When coupled with the pricing stability we have observed since launch, these underwriting improvements and favorable repeat customer dynamics have helped drive better than expected transaction-level profitability across our Pay in 4 portfolio.
Affirm’s securitization data is reported monthly. In December, the data from the securitization trusts showed trends that are better than feared. Delinquencies are not rising and charge-offs have been quite low. There just hasn’t been any signs of credit stress in the current data. Actually, the most significant of the securitization trusts showed delinquencies falling by almost 20 bps from the prior month. The argument about the company’s viability, and even the argument about defaults impacting the company’s growth simply do not pass the test of factual analysis.
Part of the reason for that is that the employment and layoff data haven’t deteriorated at this point. A substantial rise in unemployment and layoffs might impact credit metrics but that hasn’t yet taken place. A second reason is that Affirm’s borrower pool is not as risky as some have feared. Affirm’s longer-term borrowers are high quality, and not traditionally sub-prime borrowers as some analysts have posited. Further, Affirm’s loans are of very short duration-most recently they averaged 4.6 months. The company began tightening standards 2 quarters ago, so most of the loans made before higher credit standards were imposed have been paid down at this point.
I don’t want to suggest that Affirm will not ultimately see some increase in delinquencies and charge-offs. That will, to some extent, be a function of the severity and longevity of a recession and most particularly a rise in unemployment. But concerns regarding the exposure this company has to massive delinquencies and defaults seem to be substantially exaggerated.
Affirm’s Differentiation-Real, hype or just how much in between
One of the principal investment issues with regards to Affirm is its differentiation. There are many investors and commentators who look at the BN/PL offering as just another means to extend credit to consumers who do not qualify for credit cards or other kinds of credit offerings. There are views that BN/PL is a device to entice the unwary to spend more than is prudent, and to trap consumers into what are in essence high interest loans. And there are loads of BN/PL alternatives.
All BN/PL offerings are not the same. The one that is best known is that of offering a consumer the opportunity to split payment of his/her purchase into 4 equal payments without interest. This form of credit is generally paid for by the merchant as a means of offering a more attractive price. Self-evidently pay in 4 offerings are pretty much all the same. They require the least amount of software to actuate, and merchants will mostly choose between vendors based on the discount that they have to pay to enable the service. Obviously, pay in 4 offerings are not really suitable for many consumers, and particularly for many kinds of products and services.
Affirm offers many additional options that merchants can offer their customers. It has interest bearing products with variable repayment periods up to as much as 3 years. It has 0% products with different repayment periods. It can tweak offers in terms of required down payment percentages. It offers a virtual card product and what it calls a Debit+ card. The company offers a Google (GOOG) Chrome extension. And of course its partnership with Shopify’s Shop Pay has been a major growth driver since it was rolled out a couple of years ago.
A couple of years ago, the company announced a partnership with Amazon. Affirm is the exclusive provider of Amazon’s Buy Now/Pay Later solutions. Last fall, the agreement was extended to Canada. The agreement runs through 1/25 and is automatically extended unless cancelled by either party. As part of the agreement, Amazon wound up with warrants to purchase Affirm shares. One of the warrants has an exercise price of $100 so is essentially not a factor in current financial analysis. The other warrant has an exercise price of $0.01; the net of this is Amazon has an economic interest equal to about 2.5% of the equity value of Affirm. The companies have never revealed the specific terms of their commercial agreement so it is not really possible to determine just how much revenue and margin is coming from the Amazon partnership. The interest rates on purchases can be fairly stiff-on the Amazon site APRs are listed as up to 30%. There has been a significant level of customization required in order to facilitate the partnership. It would not be easy to replace Affirm as Amazon’s BN/PL partner and especially in a period in which Amazon is retrenching, the expense required to either change vendors or produce an internal solution would probably make little sense.
Probably the most innovative and unique offering of Affirm is what it describes as adaptive checkout. In adaptive checkout, the Affirm solution provides the buyer with a multiple set of choices for bi-weekly and monthly payments of various term lengths. The buyer can determine which credit/payment offer makes the most for their specific circumstances. It is not terribly surprising that adaptive checkout increases cart conversion notably. Adaptive checkout has been widely deployed; recent major adopters have included BigCommerce (BIGC) and Stripe.
Of course the single most significant differentiator for this company is its ability to appropriately analyze credit and manage delinquencies and charge-offs. Most of the analysts and traders who disdain the company do so because they believe that Affirm, and other BN/PL companies are essentially vehicles to provide credit to borrowers whose credit worthiness is questionable. They believe that the economic basis of Affirm is deeply flawed and that it is doomed because its borrowers will default at rates that will cause catastrophic results for the company.
Many of these commentators believe that the Consumer Finance Protection Bureau should regulate and circumscribe BN/PL credit offerings. The latest report of the CFPB does propose regulation, but the report, and the proposed regulation would not negatively impact the opportunity Affirm has in this space. In fact, were some of the proposals of the CFPB to be adopted, it would enhance the relative position of Affirm in this space.
On several occasions the CEO and the CFO have spoken about how Affirm manages its risks and has been able to keep defaults at levels far below feared. Here are a few quotes that illustrate the strategy and tactics of the endeavor.
I’ll start and I think Michael can probably help quantify second half of the question. So just to set the stage, the most important thing to take away from us, we are not just managing credit outcomes, we set them. The whole point of these ultra short-term 4.6 months weighted average life of every loan, every transaction is underwritten. We have full control of transactions requiring down payment, or not, we control the amount of down payment, et cetera, cetera.
So we have lots of levers we use to control risk. We’ve said about talked about this many, many times, but never gets old. And that gives us a lot of very nimble controls over the actual credit outcomes. So we set a number we want to hit. Obviously, every week, we get a stack full of new formation going back all the cohorts that are still active, and we adjust credit that we have been now managing it quite actively to make sure that we get to the numbers that we require. Because the back book runs off very quickly, we have a lot of control. This compares pretty favorably with the rest of the industry that does things like credit card consolidation loans or personal loans that go back years and there’s nothing you can do about it.
So that’s just a really important thing to understand. And again, I apologize for — to those who from this sounds like just an old repeat, but this really is how this business works.
Now to move on to my second topic, consumer credit performance. We believe we managed this to a great outcome despite the environment. As we have shared in the past, we are, first and foremost, focused on managing risk. We constantly monitor the credit performance of our portfolio as well as the broader environment. Given inflationary pressures, we began to see the signs of stress during the quarter within certain low credit segment consumers. This stress without mitigation would flow through to charge-offs.
However, the inherent advantages of our underwriting every application at the transaction level and the high turnover nature of our book provides natural agility. Accordingly, we ever so subtly turned our dials and gave up a couple of points of growth this past quarter through small optimizations, and we still grew GMV by 77%. When we say we have the ability to manage credit outcomes, this is exactly what we mean. Our delinquency levels are healthy for our business, and we have demonstrated our ability to grow while controlling them.
We’ve said it before and we’ll say it again. We are different from our competitors who had to dramatically slow their growth rates because this is the only lever they have for managing risk. We are confident that these differences will only become more apparent over time
Many times on conference calls, CEOs and CFOs present views of their business and strategy that might reflect a positive bias. Not everything in a conference call transcript can be taken at face value. But in considering Affirm as an investment, I have to look at what the CEO and the CFO have said over several quarters, and compare it to what has actually happened. The record on delinquencies as presented, and as was noted in the latest monthly delinquency report simply do not show the kind of deterioration that has been feared. And while statistics on market share in a market that is still in its nascent stages are perhaps less than completely reliable, the company’s flexible offerings and partnerships have apparently allowed Affirm to gain an increasing share in a large market.
Competition
I am not going to try to evaluate all of the competitors in this space. They are numerous. I have tried to present the ways in which Affirm is different from its competitors. Probably the best known competitors to Affirm are Square’s (SQ) Afterpay and PayPal (PYPL). At this point, both offerings are quite limited when compared to the choices that Affirm is able to provide its partners and consumers.
Perhaps the most significant current competitive development is the partnership Walmart has with Ribbit Capital that has invested in fintech start-up ONE. Walmart has been an Affirm partner for some time now, but that partnership has never been exclusive. Both Klarna and Zip offer BN/PL loans through Walmart, and Zip’s loans don’t require a credit check. It isn’t known just what percentage of Affirm’s business is related to its Walmart partnership, or the profitability of loans through that channel.
ONE offers a variety of financial services offerings, most of which are in beta at this time. There has been no discussion of Walmart ending its partnership with Affirm and Affirm’s BN/PL offering is far more extensive than what appears to be ONE’s current capability. It is, however, a risk and one that bears watching.
Wrapping Up: Affirm’s Valuation and its investment outlook
Affirm shares have rebounded significantly in the last couple of weeks as investors believe that the Fed’s interest increase program is nearing an end. That said, despite an 80% bounce from the low point set near the end of last year to the high point a couple of days ago, the shares are still down more than 90% from their high set in 2021. Even by the standards of the tech valuation implosion, that is a notable outlier.
Affirm’s valuation spiked in the fall of 2021 when its partnership with Amazon was announced, and it reached an exceptionally rich valuation. Since that time, investors have become far more focused on the issues that Fed policies and macro headwinds. Investors and commentators speculate how the macro environment might impact the performance of the company. Many hedge funds have used Affirm, and other fintech equities as vehicles for their bets on Fed tightening and negative macro trends in the consumer economy. This has pushed the short interest ratio to high levels, and part of the recent move may have related to short covering.
Affirm, in some ways, has a rather complicated business model. Not all of the transactions done on its platform have the same impact on reported revenues and the company’s RLTC metric. The revenues coming from its most recent partnerships are recognized ratably across their term, but loan loss reserves are established up front. This has the impact of reducing RLTC currently, while increasing its growth in future periods.
The company’s revenue forecast for its current fiscal year is about $1.65 billion. That would be growth of 21.5%, which is constrained because of the revenue recognition factors described above. Revenue growth, based on the consensus is expected to rebound to 28% in the next fiscal year when the specific factors constraining revenue growth will be of lesser significance, and when the implosion of Peloton will not weigh on results. The company’s forecast for RLTC for its current fiscal year is about $750 million. That number reflects increasing interest costs and a significant headwind as the contribution from Peloton has almost disappeared. RLTC growth for the full year is forecast to be 13%. The company has projected a non-GAAP loss margin for the year of about 6%. The forecast impact of Peloton’s decline as a major Affirm partner is apparently about 600-700 basis points for the full year. I have forecast revenues for the next 12 months of $1.775 billion. That would bring the EV/S ratio to less than 2.5X, far below average for the company’s growth cohort. Given all the uncertainties and skepticism swirling about the space and the company, that kind of valuation is not terribly surprising; for these shares to work, there will have to be a massive pivot in terms of investor sentiment, built, in whole or in part, on the recognition of the company’s differentiation from other companies in the fintech spaced as well as a belief that the Fed’s tightening cycle is coming to an end.
Perhaps the most important financial metric for this company will be its ability to fulfill its pledge to investors and other stakeholders to become consistently non-GAAP profitable starting in July 2023. Last quarter, the company reported RLTC of $182 million, and non-GAAP operating expenses of $200 million (non-GAAP operating expenses exclude the recognized costs of warrants and other share based expenses which were about $240 million last quarter). Non-GAAP operating expense declined $15 million sequentially.
Affirm’s operating cash flow has been positive. This is a function of the ebbs and flows of its funding resources’. While I prefer to look at free cash flow in valuing companies, in this case, and given the stage of the company’s evolution to positive non-GAAP operating margins, it seems best to just look at EV/S ratios.
While unlike many other companies in the tech space Affirm is not laying off employees, it has slowed hiring. So, it does seem reasonable that the company can achieve its objectives of non-GAAP profitability starting in Q1 of FY 2023.
Will that be enough for the shares to continue to recover from their oversold condition? I think that despite the uncertain state of the economy, and a potentially tapped out consumer, Affirm is in a position to grow its revenues through the kind of economic slowdown that currently seems to be the most likely scenario. The headwind of Peloton is behind the company. The tailwind of increasing revenues from key partnerships continues to unfold. The company continues to acquire additional merchants and commerce providers, although, of course, none are larger than Shopify and Amazon. Of course, if there is a deep recession, with substantial increases in unemployment, all companies in the consumer finance space are going to suffer. And contrariwise, if inflation doesn’t continue to show favorable trends, and the Fed raises rates beyond what has recently become consensus, this too will hurt the performance of Affirm.
I think investors, generally underestimate the differentiation of the company’s solutions which provide consumers more choices and provide merchants tools to enhance cart conversion and run highly targeted promotions. Adaptive checkout is a substantial differentiator that is still in its early stages. While the economic slowdown is going to reduce the company’s growth rate, and its revenue recognition model has impacted its reported revenue growth this year, its ability to achieve long-term growth of 30% or higher hasn’t been compromised. While Walmart’s investment in ONE may, at some point, impact that partnership, there are plenty of other channels available for this company to extend credit.
Anytime I see shares spike by 70% or more in a few weeks, I generally choose to wait a bit before making a large new investment commitment. There have been times in the recent past when the Fed’s level of accommodation was substantial, and in that period shares of growth companies could appreciate for weeks without a check. These aren’t those times. While I think the shares of Affirm should be part of a high growth portfolio, I advise patience in the tactics of establishing a significant position. In other words, some now, and more later. But this is basically a long term call that suggests that from this point, Affirm shares over the next year will produce positive alpha and do so in spite of potential macro headwinds.
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