January has the reputation of being the most disliked month. In many parts of the world, it’s a long, cold period without any festivities and not much to look forward to. And in the aftermath of Christmas, it’s also a month of financial reckoning. For a lot of people, money stresses are high as the credit card bills from December begin to roll in.

All the exuberant spending on Christmas and New Year’s comes due in January, adding an extra bite to an already frosty month. But not to worry. A brand new business model has emerged to help consumers keep on spending, despite the post-Christmas budget crunch.

We’re talking about a new generation of Buy Now, Pay Later (BNPL) services, which are “helping” consumers push that age-old IOU even further down the road. The tantalizing draw of instant gratification and delayed payment have helped BNPL companies flourish in recent years, but at what cost? While the BNPL industry is indeed growing quickly, high user fees, ballooning consumer debt, and lack of collateral, point to another financial crisis – and an unviable business model for the long term.

What is BNPL?

BNPL is simply a spin on the lay-away plan, wrapped in the latest technology and artificial intelligence to make it sound more appealing to young online shoppers. In a traditional lay-away plan, you have to finish making all the payments before you get the item. With the new BNPL model, consumers get their items right away, and make the payments later. The basic concept is the same: lure and nudge consumers to spend more on things they can’t immediately afford today, with the promise to pay in the future.

The big difference? In the past, lay-away was used to purchase mostly bigger ticket, tangible items, such as washing machines. Nowadays, online shoppers can use BNPL to pay for almost anything, from massages to t-shirts.

Source: Urban Outfitters

Who are the main BNPL players?

Four companies in the BNPL industry have built scale: Afterpay, Klarna, Affirm and Zip. Many other small players are more focused on a geography (e.g. Sezzle in the United States) and/or verticals (Brighte in home improvement).

The business model

In the BNPL world, there are no credit checks on customers. The merchant is paid upfront and the BNPL company collects the installment payments.

Cost can be incurred in three ways when using BNPL products:

1. Interest payments (if all payments are not made by specified deadlines);
2. Late fees; or
3. Account fees.

Costs differ for each provider. For example, Afterpay and Klarna don’t charge account keeping fees, whereas Zip collects a monthly account fee.

The maximum amount of purchases one can make varies depending on the company. On paper, credit loss is mitigated as the book turns anywhere from nine to 15 times a year, depending on the terms and loan balances.

What is driving BNPL industry growth?

Consumer

The massive shift to online shopping has naturally led to a growing increase in online transaction volume. There is also a structural shift away from credit cards to online payment methods, like BNPL. Penetration of BNPL is merely 1% of United States (U.S.) e-commerce and 1-3% in most parts of Europe, compared to 10% in Australia or 25% in Sweden, so there is a strong secular tailwind.

At a combined 140 million, Gen Z and Millennials now comprise the largest portion of the U.S. population. They are the driving force in e-commerce growth, and the primary target customers for BNPL operators. This is because many of them do not have credit cards, with a major concern being the fees and penalties associated with having one. Interest-free instalment payments offer an appealing alternative, and have quickly gained traction among younger consumers. Even older Generation X adults are starting to adopt BNPL products.

Merchant

There is an obvious value proposition for merchants, namely access to a large, engaged, and rapidly expanding online customer base. BNPL provides higher conversion from leads to sales, increased average order value, and improved online and in-store traffic. Many BNPL companies also provide customer insights and benchmarking data to retailers. The average merchant fee can range anywhere from 2-6%, depending on the provider and the services rendered.

The looming risks of the BNPL industry

Historically, recessions are almost always triggered by problems in the credit market. BNPL could very well be that trigger. For now, the consumer balance sheet is in great shape, but the question is for how long? What happens when government handouts stop, and all these installment payments come due? We could be setting ourselves up for the next global financial crisis.

Take credit scores, for example. As BNPL in most cases is not considered conventional credit, it does not show up on credit scores. This in turn paints a distorted picture of the consumer’s true financial health. 

Where is the collateral in case of default? Many consumers are using BNPL to pay for clothes, vacations or other services which do not have any resale value as they are not tangible. How will the lenders recover the unpaid debts?

There is also regulatory risk. The rules differ from country to country. In Australia, the BNPL industry is allowed to self-regulate. In the U.S., regulations are lax and differ by states. For example, the State of California requires BNPL providers to obtain a license from the Department of Business Oversight (DBO). But this is not the case in other parts of the country. In the United Kingdom (UK), the Financial Conduct Authority (UK) is currently reviewing the regulation of unsecured credit, including BNPL arrangements.

At some point, customers will have to come up with the funds to pay their loan, and if they don’t, they will be on the hook for late payment fees and/or high interest payments. Many customers might even default. One thing seems certain: BNPL loans will make the collective debt burden worse.

Portfolio impact

At Global Alpha, we do not invest in BNPL. Our focus is on finding high-quality companies with defensible business models and strong balance sheets that should outperform the small-cap benchmark.

However, one of our holdings, ACI Worldwide (ACIW), is benefitting from increased transactions online. Every time a customer uses a credit or debit card, a number of systems are involved, including the merchant processor: Visa, Mastercard, or the ATM and the card issuer systems. ACIW software essentially provides the “electronic handshake” that connects these systems.

Every second a purchase is made using BNPL, we can rest assured in some way or another that ACIW is benefiting from it without the inherent risk of the “buy now, pay later” industry. As the saying goes, ACIW is enjoying both the cake and the cherry.

Have a nice day.

The Global Alpha team

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2022 is already upon us and the New Year often brings up some resolutions, usually based on some form of self-improvement such as living a healthier lifestyle or picking up a new hobby. It is believed that the first resolutions were made about 4,000 years ago by the ancient Babylonians. The Babylonian New Year was actually in March, when crops were planted, and the festivities lasted for 12 days. Part of the festivities were making promises to the gods to repay debts and return any borrowed objects.

More recently, the link between the New Year and debt comes from consumers assessing their spending habits for the holiday season. A survey of 2,000 Americans by LendingTree showed that 36% of those surveyed spent more than they could afford during the holiday season, and went into debt with an average sum owed of just over $1,200. Putting debt onto a credit card remains the most popular option, and with the shift to online shopping, we saw an increase of almost 40% of “buy now, pay later” financing to spread out expenses. Whether this encourages consumers to spend more than they can afford is a different question. Credit cards remain an expensive way to borrow, and over 80% of holiday borrowers will be unable to clear their debt within a month.

During the early stages of the pandemic, credit card balances were paid down at record levels. During 2020, when American consumers were receiving more stimulus checks but had fewer ways to spend discretionary income, $83 billion was paid off in credit card debt.

However, as many predicted, there was a surge in consumer spending once vaccination campaigns progressed, COVID-19-related restrictions eased and the economy reopened, which meant people slipped back into old habits and credit card use increased during 2021. The latest data from the Federal Reserve Bank of New York saw a $17 billion increase in credit card balances.

The trend continued into the fourth quarter, fuelled by the holiday season. It was estimated that Americans were on pace to add $70 billion in credit card debt throughout the year. The expectation is that this number will continue to rise in 2022. TransUnion is expecting a further 10% increase in debt based on more applications for credit and increased spending.

By the end of this year, the balance is forecasted to reach over $800 billion, attaining its highest level since the start of the pandemic.

On a larger scale, a recent blog by the International Monetary Fund (IMF) observed that global debt was at $226 trillion at the end of 2020, which represents 235% of GDP. Debt was already high going into the pandemic, but actions were taken to protect lives and jobs and avoid significant bankruptcies.

There was a distinct difference between developed and emerging markets. Developed markets (and China) were responsible for over 90% of the $28 trillion debt that was added in 2020, primarily due to low interest rates and central bank actions. Emerging markets, faced with higher interest rates and more limited access to funding, added significantly less debt.

The problem going forward is finding the correct balance of fiscal and monetary policies in the current high debt, inflationary environment. The two combined well during the pandemic, with lower interest rates facilitating government borrowing. However, central banks are now signalling a rise in interest rates to combat inflation but this, combined with high debt, puts a brake on how governments can support the recovery and the private sector’s future investment prospects. Central banks are also reducing asset purchase programs. Fiscal responses have historically been less effective in times of rising interest rates. The greater risk is interest rates rising faster than expected, hurting economic growth. This would place heightened pressures on the most highly leveraged governments, households, and firms. If everyone has to deliver at the same time, growth will stumble.

Global Alpha has some exposure to the debt industry via two companies.

PRA Group (PRAA US)

PRA is one of the largest acquirers of non-performing loans in the world. PRA returns capital to banks and other creditors to help expand financial services for consumers. The main business consists of the purchase, collection, and management of portfolios of non-performing loans. These are typically unpaid obligations of individuals owed to credit originators: e.g., banks and other types of financing companies. The portfolios of non-performing loans are bought at a discount in two broad categories being core and insolvency operations

Core operations specialize in the purchase and collection of non-performing loans, which PRA is able to buy as the credit originator and/or other third-party collection agencies have not succeeded in collecting the full balance owed. Insolvency operations differ slightly as they seek to purchase and collect on non-performing loan accounts where the customer is bankrupt.

doValue (DOV IM)

doValue is a manager of loans and real estate assets for banks and investors. It is the market leader in Italy, Spain, Portugal, Greece, and Cyprus, which are attractive markets with significant growth opportunities because of high levels of non-performing loans and the strong interest from international investors. doValue is an independent servicer with an asset-light business model. It differs from PRA in that it does not make direct investments in loan portfolios or real estate assets. Revenues are earned from fixed and variable fees. doValue operates in high-value-added activities including the management of medium to large corporate loans secured by real estate assets (the non-performing loans), helping banks in the early stages of the loan management cycle (Early Arrears and Unable to Pay) and also in the optimization of real estate portfolios from credit recovery actions.

Have a nice day,

The Global Alpha team

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