Home / Leaders / Why optionality matters for the future of Zip Co

Buy-now-pay-later (BNPL) Zip Co Ltd (ASX: Z1P) shares have been the most traded on the ASX in recent weeks (again) according to Commsec data.

After reaching highs of close to $15, the current Zip share price represents a discount of nearly 50 per cent.

Could now be a good time to pick some Zip shares?

Why optionality will matter

While it’s indeed true that global BNPL adoption would still be fairly low compared to traditional payment methods, it’s no secret that this space has become increasingly heated in recent years.

Most BNPL’s have an interest-free instalment product as their core offering. Due to low switching costs between different BNPL’s, some have suggested these companies may lack a sustainable competitive advantage.

Some market research from the US suggests that over 70 per cent of customers would choose an alternative BNPL provider rather than finding a store that accepts their current provider.

My colleague, Raymond Jang hit the nail on the head in his recent article. Companies like Zip and Afterpay Ltd (ASX: APT) will need to look for other sources of revenue to stand out and retain customers over a long time period.

Afterpay seems to be headed in this direction through its recent partnership with Westpac Banking Corp (ASX: WBC).

What about Zip though?

Expansion plans

For the moment, Zip seems to be sticking to its core offering of BNPL and business loans as it focuses on attracting new customers.

The large growth story is in the US under its Quadpay brand, but it’s recently announced multiple acquisitions that will establish the company in Europe and in the Middle East.

While no solid plans have been made, Zip has flagged the possibility of cryptocurrency trading, share trading and high-return savings accounts.

Is the current valuation fair?

Here’s just one way I consider the valuations for companies like Zip and Afterpay.

I view most BNPL’s the same beneath the surface. They’re effectively unsecured lenders that free up working capital for merchants. For a detailed explanation of the BNPL business model, I’d suggest reading my previous article here.

While BNPLs such as Zip, Afterpay and US-based Affirm Holdings Inc (NASDAQ: AFRM) have traded on eye-watering tech multiples similar to that of high growth software companies, I don’t think unsecured lenders dressed up as tech companies are worthy of such valuations.

For context, the average Price/Earnings (P/E explained) ratio of companies in the financials sector is typically between 10-15.

There are many reasons why companies in the financials sector trade on much lower valuations compared to other higher growth sectors, but here are just a few.

Financial companies like banks and other lenders are cyclical and are leveraged to the state of the underlying economy. Investors are usually willing to pay a higher multiple for the predictability. Given that financials don’t have this quality a lot of the time, it makes sense investors are willing to hand over less for the company’s earnings (profits).

Interest rate risk is another reason, which could explain typically low valuations.

Companies like Zip borrow money by issuing receivable-backed bonds, which is used to fund growth and pay merchants at the point of sale.

The model could work well in a low interest rate environment, but it may be worth considering the implications of higher borrowing costs and the effect this has on already slim net transaction margins (NTM).

Banks and traditional lenders can actually benefit from rising interest rates due to being able to generate a larger spread between their borrowing costs and income-generating assets such as loans and mortgages.

The key difference between traditional lenders and BNPLs is that the latter will not earn more in a rising interest rate environment, due to offering an interest-free service.

So, in a rising interest rate environment, borrowing costs could increase, but there’d be no additional margin expansion due to not having interest-bearing receivables.

Summary

As previously mentioned, Zip will likely need to find other avenues for revenue in order to retain customers and rely less on significant levels of marketing spend.

The potential interest rate risk coupled with increasing customer acquisition costs (CAC) leads me to believe that there isn’t a clear path towards profitability, which is why many of these companies aren’t investable for me at this stage.

That being said, if companies like Zip could expand their offering to make it more sticky – and/or even better, outside of the typical financials space, I think they could be worthy of much higher valuations.

Information warning: The information in this article was published by The Rask Group Pty Ltd (ABN: 36 622 810 995) and is limited to factual information or (at most) general financial advice only. That means, the information and advice does not take into account your objectives, financial situation or needs. It is not specific to you, your needs, goals or objectives. Because of that, you should consider if the advice is appropriate to you and your needs, before acting on the information. If you don’t know what your needs are, you should consult a trusted and licensed financial adviser who can provide you with personal financial product advice. In addition, you should obtain and read the product disclosure statement (PDS) before making a decision to acquire a financial product. Please read our Terms and Conditions and Financial Services Guide before using this website. The Rask Group Pty Ltd is a Corporate Authorised Representative (#1280930) of AFSL #383169.