Affirm Holdings, Inc. (NASDAQ:AFRM) Credit Suisse 26th Annual Technology Conference November 29, 2022 5:05 PM ET
Company Participants
Michael Linford – CFO
Conference Call Participants
Tim Chiodo – Crédit Suisse
Moshe Orenbuch – Credit Suisse
Tim Chiodo
All right. Great. Welcome, everyone, to the afternoon session here of the 26th Annual Credit Suisse Technology Conference. We’ve got a great packed room here, and we’re very happy to have with us today Michael Linford, the CFO of Affirm. My name is Tim Chiodo. I’m the lead payments processors and fintech analyst here at Credit Suisse. And I’m alongside my colleague, Moshe Orenbuch, the specialty finance analyst here at Credit Suisse. All right. Excellent. So as many of you know, Moshe and I co-cover Affirm, and we’ll both be working through some of the questions here together and then we’ll make sure that we save some time at the end for the audience to jump in with a few questions as well.
I’m going to start with Shopify. So we recently learned that the Shop Pay button is now the most popular or has the most share or the most volume of any accelerated checkout button on Shopify, and that would include PayPal as well. Clearly, that is the channel that Shop Pay Installments is working through. Maybe you could just talk a little bit about your relationship with Shopify, how that ramp started, how it’s progressed, where we’re at and what the future looks like in terms of that relationship. And if I could just put a finer point on it, I believe the relationship is mostly in the US now. Maybe you could talk about the potential to expand to new geographies.
Michael Linford
Yes. So at the highest level, we have a very good relationship with our partners in Shopify. We talk a lot about the depth of integration that we have on the technical side. We talked about this deal way back in 2020 before we went public. We shared a lot about the shared and common approach to the problem that the two companies had, and it’s really borne out exactly like we thought. So we spent the first year or so that partnership building the product, we launched it to general availability in the summer of 2021 and then late in the summer, early fall, we really got pushed out to merchants on a more broad based. And so as we hit our second quarter this year, we’re lapping the first year of what we would really consider to be the full rollout of Shop Pay Installments. And since that rollout, which essentially we launched with just the Pay in 4 product, which is the short-term installment product, we’ve added monthly installments to the Shop Pay Installments program through our Adaptive Checkout product that we rolled out this summer.
And we’re just really pleased with the traction that we’ve had. We’re pleased with what we’re able to do for the merchants on Shopify site. We’re pleased with the economics of the program. We’re pleased with our ability to do the right things from a credit perspective and we’re really happy about the future here. The growth is not just in expanding geographies, which obviously remains an opportunity for us together in the future, but also in gaining share in the existing merchant base. The penetration that we see today is still below what we think we can get to as competitive as buy now, pay later is and has been and will continue to be, we will have plenty of opportunities to continue to take share and win all the business that we can there.
Tim Chiodo
Okay. Great. What about the presentment of Affirm within that checkout flow? Have you experimented with different places to put it and seeing different results in terms of uptick and maybe usage of the product? Maybe just talk a little bit about the ongoing learning that you have there.
Michael Linford
Yes, it’s a great question. We talk a lot about how long it takes us to get to full scale with a lot of these partnerships. I think that some folks in the investment community like to think of it as, “well, you win the business, you launch a product, it ramps 100% and then it’s there forever. And that’s just not really how the product works because of things like you’re alluding to. We have a lot of work that goes into what offers are displayed, where they’re displayed and how they’re displayed. And the problem with Shopify is unique. So that’s the same problem we have at other merchant sites and other integrations. But with the Shopify product, the Shop Pay Installments product, it’s not about building a solution for a merchant partner. It’s about building a solution that’s distributed to hundreds of thousands of merchants, which means it has to be scalable and automated and it can’t be a bunch of manual configuration. To answer your question, yes, we’ve done a lot of experimentation and trial around different product display pages, as we call our PDPs, presentation of offers. And I would say that we’re still very early in having that be fully optimized.
Question-and-Answer Session
Q – Moshe Orenbuch
Got it. Shifting to some of the commentary from the fiscal first quarter earnings call. You talked a little bit about that some of the loan sales — that loan sales might be somewhat lower in the second quarter than in others, than in other periods. It’s both probably partly a result of the mix of business that you’ve got in the quarter as well as the state of the markets. Just talk a little bit about that impact and what that means for revenue in Q2 and the balance of the year.
Michael Linford
Yes. So first, a pretty important clarification. When we talk about the mix of funding in the quarter, we think about it on a proportional basis. So when we think about less forward flow, we mean that as a percentage of the total. Our forward flow program is one of our three funding channels, all of which are very important, and I can walk through each in a second. But we don’t anticipate that to be declining sequentially. We think that’s flat. The lack of growth though at Affirm means that you’re declining on a proportional basis just given the rapid growth in the GMV and the total platform portfolio. So it’s not — we don’t believe it will decline sequentially. We believe it will just be less of the total and that shape, the percentage and mix across finding channels does impact the P&L. So as we use less off balance sheet forward flow and off balance sheet securitization, you’d expect more of what we generate to be on the balance sheet, which has two effects. One is obviously the cost side where we have the provision for credit losses that will be taken upfront, as we always do, for any movements on our balance sheet. So you’ll have more of that as a percentage of GMV. And the revenue is earned over the life of the loan as opposed to forward flow arrangements where we earn the revenue at the time that we sell it.
And so there’s more revenue on loans that are on our balance sheet and more cost, and it’s spread out over time. And when you have a quarter like the quarter we’re in right now with Black Friday, Cyber Monday, we just finished the period, you have a lot of originations happening late in the quarter, which means that you’re kind of ending more fresh and green than you would be in a normal quarter. And on top of that, you have more on-balance sheet warehouse financed loans. As a result, the P&L it’s going to see a little bit less revenue and a little bit more cost in the period. But as we play out the rest of the year, as we talked about, that begins to normalize and you begin to have the benefit of all that origination volume on the balance sheet.
Moshe Orenbuch
Maybe just to follow up on that. Could you talk a little bit about how the spread widening impact kind of influenced your decisions about funding in the short term? How much would it have to retrace in order to get back to the more historic levels that you had, and maybe what does it look like as we sit here today?
Michael Linford
Yes. So I think, again, I think it’s really important to think about our kind of approach in funding the business. We have three different funding channels. And really, in any macroeconomic environment, we’re going to use all three. A year ago, we got the question a lot, how come you even still have your warehouse lines, what’s the point of them? The securitization market is so robust, why don’t you just fund your entire program there? And the answer then is the same answer now, which is we really need all of our funding channels to work because it’s how you build a durable funding model through these kind of environments. And in the environment we’re in right now, we cannot be reliant upon execution in the securitization market and the forward — and net new forward flow capacity. I’ll note that the existing forward flow capacity and the existing partners we feel like are very engaged and very supportive. We were very pleased to announce the upsize in renewal with — or upsides with CPPIB last quarter, which is a very notable from our perspective, piece of execution in the environment that we’re in. So that’s a general context.
To answer your question specifically about where we have to be in order to get to that, I think the market is ultimately going to decide the market clearing yields that are required. And we can and should execute better than the market were large. But at the end of the day, the market needs a certain clearing yield because of where rates are at. I think our focus is on making sure that we’re doing everything we can to put as much economic content into the unit to make our assets that we generate have the yield that’s needed to clear the market price. And when we get there, we can continue executing normally. There’s capital out there, it’s just becoming more and more expensive, and it’s our job to fund the business in the best way for the shareholder and to get us through this moment of pretty extreme dislocation.
Tim Chiodo
Okay. Moshe, should we move to the pricing levers?
Moshe Orenbuch
Please do.
Tim Chiodo
Okay. Great. So when we think about ROTC as a percentage of GMV, you do have one offset to help to support that, which is pricing. And there’s really two levers that you have to pull there, one is on the consumer interest bearing side and the other is potentially with the merchant fees. A lot of these fees when they’re originally set were in a different interest rate environment. So many investors would feel you’re well within your right to increase some of those fees. Let’s start on the first one in terms of the consumer interest bearing side. Our understanding is that that’s much more in your control to simply change it. However, it might require a little bit of a heads up to the merchant. So hey, we’re changing some of the consumer pricing on your Web site. But it’s not a fee they are paying, so they’re maybe not as sensitive to it. So maybe let’s just first really drill in on the consumer interest bearing fees, where they are, where they could go and the mechanics to raising those prices.
Michael Linford
Yes. So our business today is three products. We have our interest bearing installment loans, we have our Split Pay products, and we have our long term zero program. And it’s useful to think about consumer pricing there, because consumers really only are revenue source in one of those three business models, even though on the income statement, interest income is earned on the other two. On the interest-bearing products, today, we have two different originating bank partners. We have Cross River Bank in New Jersey, which has a 30% APR cap and we have Celtic Bank in Utah that has a 36% APR cap. And within both of those two cap regimes, we have a lot of room to move between where we’re at and where we would be if we capped those APRs at those particular caps. Furthermore, we’ve done a lot of work in trying to understand consumer elasticity to our APRs. And it’s important to think about what the APR means at Affirm. If you’re a revolving credit card or a mortgage or a long term loan, consumers have a lot more sensitivity to the APRs because it’s an ongoing and permanent commitment. If you think about the Affirm installment loan products that maybe have a six month term, you take a six month term and you move a few points of APR, and could be talking about $0.75 or $1 a month payment difference, which ends up being just noise in the eyes of the consumer. They’re not focused on the carrying cost of the obligation, they’re focused on what the monthly payment amount will be.
And we did some work this summer to really understand that and feel very good about what the consumer reaction is. And that is to say we don’t feel like there’s really any elasticity at all to the kind of rate movement we’re talking about. And that’s especially true today with where credit card APRs have moved. We do believe that we have a right to have APRs in an excess of revolving credit card APRs in large part because of the nature of our product. We don’t charge late fees. We have cap interest. We get prepayment earns back all of the interest, et cetera, et cetera. And so these pro consumer features make it so that the headline APR is probably not the full cost of credit and consumers understand that and they value the control that we give them. And so as credit card rates have come up plus the funding environment generally being where it is, we feel very good about it, and it tested into it and feel like there’s a lot of room to play. And this is a really important lever for us. I mentioned before about our work is making sure that the asset has the yield that it needs to have to clear the capital market’s yields. One of the ways you do that is you put more interest income into the interest bearing loans, and a few points of APR here can make up the entirety of the movement in rates in the market. I feel like that’s well within our control. I feel like it’s very actionable, and you will see us addressing that. I think the things that constrain it are some arcane things around the regulatory environment that we operate in, and there are some partners who do want to be thoughtful about what the consumers see and want to make sure that we’re being good partners to them through that process.
Tim Chiodo
Point well taken on the partners and various restrictions around interest rate caps and whatnot. Okay. That was really well covered on one angle of the pricing. Let’s hit the second, so which is merchant pricing, which might be a little bit more complicated. But maybe just talk about the discussions that could be taking place with merchants, if any of those are happening and what they sound like.
Michael Linford
They are happening and they’re happening evergreen. I think that they’re happening now with an eye towards price changes to the Affirm benefit. I think they were happening a year ago to the other side where people were putting pressure on prices. I think that — we think about pricing not as just the headline MDR, right? So I think a lot of folks in the room probably look at our merchant network revenue, they divide it by GMV and they say that’s the fees that Affirm earns and that’s the price. And they think that number going up or down implies pricing power or competition, competitive pressure. I think that misses a little bit about how it’s actually done. Our product set is very diverse. So we have, again, I mentioned three different products. And even within that, we have different term links and different approval cutoffs, and we have quite literally millions of different permutations that we can offer merchants with respect to the total financing programs. And so when we think about pricing, it’s about what the merchant pays and then what they get. And oftentimes, we’re able to change what they get, which may result in lower credit losses, for example, for the same level of merchant fee. The way these conversations work vary by partner, and I mentioned Shopify before being so important because it addresses the scale of merchants. There, we’re not having bilateral negotiations over price. There, it’s a platform discussion about where the prices need to be.
I think, for our largest enterprise partners, the ability for us to command MDRs are very product specific. So if we’re going to offer 0% and Split Pay offers at the largest enterprise merchants, we can have some room to negotiate there, but our interest bearing program has quite a bit of pressure on the MDR side. We talked about at our largest merchant partners and we don’t really feel like that’s a lever that we can pull in the near term. And then you have the piece in the middle, right? So merchants where we do have bilateral relationships with, we often do, do negotiations. And there, we’re engaged in conversations about where the programs need to be. What’s important from our perspective is that we don’t try to solve the whole problem before we understand the scope of it. And what I mean by that is the rate environment has been volatile, I think it’s fair to say, and I think it continues to be volatile. And we feel like we have a really good sense of where the rates will settle in for some period of time, it has some stability, we can address with the merchant the whole financing program and really build out the right package. So we’re reticent to want to move too quickly and have to touch it twice. And we’re also mindful of the state of many of our emerging partners, which we do think need support here as a lot of them are dealing with their own issues in the macro environment, a lot of inflation for them on the cost of goods side, and we want to be good partners in that. And so it’s a combination of the need to actually negotiate new prices to want to be respectful of those partners and help them through this time and then also not want to have to change it twice.
Moshe Orenbuch
Got it. Maybe kind of putting together a few of the previous questions. Can you just talk a little bit about how much that increase in rates actually was kind of over the last year? And given what you know or expect now, would it might be kind of over the next 12 months? And as a corollary the $11billion-plus that you’ve noted in terms of committed financing, could you just talk a little bit about how much of that will — the costs of that will change in that period?
Michael Linford
Yes. So we gave a framework last February or this February, February of this year and to lay out what we expected to happen with the rising rate environment. And we dedicated a lot of time in it in our earnings call. And I always refer people back to that because we — we were both very thoughtful of that and it’s also still surviving as a really good framework for how to think about the impact of rate movement on our business. So again, if you think about our funding channels, the existing securitization deals have, generally speaking, fixed cost financing. And so those don’t have any rate sensitivity. What does have rate sensitivity on the securitization side of the net new deals. So as we do a new deal, both the spreads are wider and the rates are higher, which means the total cost of financing goes up. Incidentally, also, so does the equity capital required goes up as well as there’s less leverage in those deals. If you think about the warehouse financing that is the portion of our business which is pretty much floating rate. So we have arrangements that take benchmark rates and pay a spread on top of that. And there, you’d expect more or less a full flow through of the change in rates to flow through the funding cost for any of the funding that held against those warehoused loans.
And then you have our forward flow program. And the forward flow program is a bit of a mixed bag. And so while there is obviously not any risk to the loans that we’ve already sold, we sell a loan and the loan is sold, the next loan that we sell to the forward flow partners is subject to any number of repricing events. Sometimes it’s every two years, sometimes it’s as frequently as monthly. And there rates factor heavily along with credit into how the repricing happens with the forward flow partner. Long term, given the duration of our asset, 100 basis point movement in rates gives us about 40 basis points in RLTC headwind before mitigants. I mentioned we talked a lot about rates, it’s one of our mitigants, there’s obviously cost mitigants as well. And in the near term, it’s very, very low. It’s just the floating rate portion of our business, which we’ve given a framework for.
Moshe Orenbuch
Got it. One of the questions that we get very often from investors has to do with your establishment of loan loss reserve. And it’s a bit complicated because you originate different types of products and sell different types of products. So in each period, there’s differing amounts kind of both originated and on the balance sheet. But I guess what has happened is consistently over the last several quarters the rate has actually declined. And I know that there’s a very strong mix effect. But I mean, could you talk a little bit about how much is that? Are there effects of your lending standards and others that have impacted that, and how you kind of see that developing going forward?
Michael Linford
Yes. So I really think that investors who are more used to how a traditional financial institution thinks about allowance for loan losses, when they try to apply those models to Affirm, they kind of look at us kind of sideways because they don’t really understand what’s going on. So maybe a couple of things to level set. We don’t have people in a room deciding with the allowance is. We have machines that tell us what it is. And our asset turns over so fast. For example, when you’re finished Q1, I think roughly half of the Q4 originations had already been repaid. And so you’re in a situation where it isn’t about what our judgment is of the macro economy 12 months from now. It’s a reflection of what do we currently own and what does the repayment data look like on what we own. On the front book side, it’s very much model driven around where our credit scores are. And on the back lot side, it’s a function of how those loans are performing. And so we, at the time we originate, will take an allowance for losses round numbers here, call it, 3% of a given loan. And then as that loan pays back or not, that number goes up and down. And you do it on a full basis, and we update that every month. So the numbers that you see kind of shaking out in the balance sheet and the allowance for loan losses is math. It’s a math based upon the credit scoring that we do forward looking and the actual loan performance, it’s how those loans are performing, not a statement about the future macro uncertainty or conditions that may arise.
What’s so important is if we were trying to speculate about where the world was going to be in 12 months, it wouldn’t matter anyway. All the loans that are on our balance sheet are going to be paid off by then. What matters for us much more is how are the loans that we own performing today. And we get that signal every day. We understand exactly how those loans are transitioning from one stage to another and how they’re being paid back. And it makes it so that we don’t really like to apply a lot of judgment. Where we do apply some judgment, because we’d like to ensure that there is some level of conservatism in the modeling that we do for allowances and we apply that same conservatism in the estimates when we make underwriting decisions where we’re assuming some level of stress at time we make an under decision. So if you take a level of stress at the time of the underwriting decision and then you further take some conservatism at the beginning point when you build the allowance, by the time those cohort of loans had hit the second, third and fourth months of repayment, their performance will exceed the level that you’d estimated at the beginning. And as a result, you have seen the allowance come down. I think that’s a reflection of those things I mentioned and a more conservative credit posture that we started taking into our fourth quarter last year.
Tim Chiodo
Okay. Excellent. We don’t have a ton of time left here. I want to hit one on Amazon briefly, and then I want to make sure we get time for the audience. So for those of you in the audience, please be prepared. We’ll have a microphone coming around pretty shortly. All right. So Amazon, I think what investors really want to get at is how much runway remains. Clearly, there’s more geographies that you can move into, but let’s put that aside now and let’s just talk about the US Amazon business. How often is Affirm being shown, whether it’s in terms of frequency within verticals, whether it’s across verticals? How much more runway is there for the Affirm button to be presented across the mix of US transactions on Amazon?
Michael Linford
We feel like there’s a lot of runway there. I feel like, again, not to pick at — sometimes, I think full ticket is easier than it is, but we do is really hard. And it takes a lot of effort to scale these programs. Last year, we were so thrilled to be able to sign the agreement with Amazon and get live for Black Friday, and that was like literally sliding at the last minute to get live. And over the course of the year, we’ve been working on the first wave of optimizations and testing and iteration, growing the product set away from just interest bearing, but it’s super early. And it’s super early for both the products that are offered, how they’re displayed and working Amazon to fine tune the algorithms that decide when and how offers are shown to users. It’s still extremely early and we have a lot of runway. We’d anticipate that Amazon continues to be a really important part of our business with lots of growth into the future.
Tim Chiodo
Okay. I have a follow-up on Amazon. But why don’t we go to the audience because we only have about five minutes here. If you would like to ask a question of Michael Linford, just raise your hand. We’ll bring you a mic. Okay then, we’ll keep it rolling here then, but we’ll circle back one more time to the audience. So Amazon, can you just walk through the mindset of Amazon as they present Affirm, right? When they’re thinking about their total payments acceptance costs, clearly, this is largely not exclusively a core IB type of offering, right? So there’s — the consumer is paying not Amazon, to some extent. Maybe just talk about what it means for them in terms of their goals of maintaining/increasing conversion, but also reducing total payments acceptance costs.
Michael Linford
So first, you will have to ask Amazon what their mindset is. I can’t possibly do a good job at representing that. That Being said, I think the things that are important here are the consumer orientation of the product, the shared mindset of Affirm and Amazon, the reason why this relationship is what it is at all, is because we both put the consumer first in everything that we do. And that’s so important to Amazon, how they talk. It’s so important to us and how we treat our consumers. And that’s the most important thing. They want to delight consumers and they want to grow their business with them, and that means it shows up as conversion, it shows up as satisfaction. It shows up as engagement. I think that, from a cost standpoint, that’s probably a secondary item. The first and most important thing is are they getting, are they lobbying consumers and are they driving the kind of outcomes that they want from a conversion standpoint. And yet, they are very focused on making sure that they’re managing their costs, they’ve made some very bold and visible statements in their payment space. And I think that it’s important not to ignore the fact that we are also an economic benefit to them even for the same level of conversion.
Moshe Orenbuch
One of the goals that you’ve expressed is starting your fiscal 2024 at being profitable. Could you talk a little bit about what it’s going to take to get there, is it a combination of both on the top line scaling as well as on expenses? And maybe if you can kind of squeeze it in on the three minutes, one of the questions that I think has been important to investors about stock based compensation and how you look at it and how it’s going to develop.
Michael Linford
So first question. The most important thing for us is to scale the human capital consistent with the revenue less transaction costs or the margin in the business. If you look at the past several years, Affirm has been very aggressively investing in our human capital. And while that continues to be a priority, we have attenuated the pace of human capital addition and I think that’s how you get it. The operating leverage in this business is mostly through the hiring plan in the business and delivering on the top line plan that we’ve signed up for. And really, it’s that simple. I mean, I give a cheeky answer sometimes or folks like how are you going to do it, and I say the higher or less quickly, and they’re like, but there has to be more to it. And it’s really not — the math isn’t more than that. The trick is to figure out a way to continue to deliver our growth and network building aspirations with less human capital addition. And that’s the thing we’re working pretty hard to get right.
In terms of stock based compensation, we do not manage the business to a GAAP stock based compensation expense number. That number is excluded from our adjusted operating income number and we believe for good reason. We do manage the business to a dilution number. We’re very mindful at the rate at which we’re diluting the shareholder. The sources of dilution at Affirm historically have been across four different items. They’ve been the Shopify warrants, they’ve been the Amazon warrants, they’ve been Max’s value creation award that we gave at the time of the IPO, and it’s been the rest of the awards for new hires. Those are the four main sources of share issues of Affirm over the past several years. The first three aren’t going to repeat. Max isn’t going anywhere, we’re not signing Shopify and Amazon. Again, we have them already, and that level, we think, is behind us. And the fourth comes back to the point I was making around property. The level of human capital investment, the net new additions and headcount is what will drive a big portion of the share grants required for new employees, and we feel like that will allow us to continue to moderate the level of dilution. And I’ll just note that if you look at us historically, we’ve done a pretty good job in the level of total dilution to the shareholder.
Tim Chiodo
Great. Excellent. Well, on behalf of everyone at Credit Suisse, I want to thank Mike, also Rob and Zane, who also joined us here from Affirm and made the trip in. I want to thank you all for coming here and being a part of our 26th Annual Tech Conference.
Michael Linford
Thank you very much.
Moshe Orenbuch
Thanks very much.
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