Affirm Holdings: A New Model for Lending

Affirm Holdings (AFRM) has recently filed its S-1 for IPO. AFRM acts as a matchmaker in a two-sided market, bringing together borrowers looking for a way to make payments by installments, without incurring interest, or simple-interest loans; and merchants who provide credit and are charged a fee by AFRM for successful transactions on AFRM’s platform. The bulk of loan origination derives from Cross River Bank. A “0% APR” model is as old as religious prohibitions against usury and is the norm in many countries that employ Islamic banking practices.  Merchants are attracted to this market because of AFRM’s ability to model risk and use its data and relationships with customers to help merchants raise conversion rates from online browsing. The 0% APR business provides over half of revenues, with the remainder, 37%, largely emanating from fixed interest payments from simple interest loans to consumers. The company also earns revenue from gains on sales of loans, loan servicing, and its virtual card network. 

An Impressive Business Model

Self-evidently, there are network effects which accrue to both consumers and merchants and this is the most important competitive advantage the company cites. As more consumers enter the ecosystem, the ability of the company to price risk and help merchants optimize their pricing and products, improves. As more merchants enter the ecosystem, the more funds are available to consumers and the more products AFRM can offer its consumers. As the volume of consumers and merchants increase, the insights from data will improve and AFRM can improve customer experience for a prosthodontist. In a word, down the road we get flywheel effects. 

This business model is part of a broader, “Buy now, pay later” trend that is becoming increasingly important across the world. AFRM’s role in the lending value chain allows it to act at the most profitable part of the value chain. In an environment of low interest rates, it is very difficult to make money earning interest. There are exceptions, of course, for example, with unsecured consumer loans that have premiums on interest rates such as 30-year fixed rate mortgages.  

Consumer lending is an important source of revenue for businesses that earn interest income, largely because of the higher risk of default as well as the loss-given-default is higher. By loss-given-default we mean that when a loan is unsecured, there is no collateral backing it up, whereas with a secured loan, for, say, a home, the bank can always repossess the house and may not make an actual loss. Even if AFRM were to try and repossess the property bought, the cost of doing so would exceed the value of the loan, because many of the products financed are small products, such as home-fitness equipment. The risk of the loan is the reason the interest rates can be high enough to make the consumer finance space fertile ground. 

AFRM’s ability to provide its services to customers rests on its aggregation of data to build granular risk models that can determine the risk at “transaction level”. Using this competitive advantage, it can approve 20% more clients than its rivals, while pricing risk with what it claims is “a high degree of accuracy”. This has the knock-on effect of increasing the number of purchases for which merchants will be called upon to provide loans. 

The company has over 6,500 merchants, though Peloton Interactive Inc. is a very important merchant within the ecosystem, accounting for 28% of AFRM’s revenue. To give a sense of just how important Peloton is, AFRM’s top 10 merchants account for about 35% of revenues. The relationship with Peloton seems driven by the rise in expenditure on home-fitness products as a result of more people spending time at home due to Covid-19. AT present, it is not clear if this will continue to drive Peloton’s growth and therefore AFRM’s results. 

WIth both loan origination and in terms of merchants, the company is exposed to a dramatic change of fortune if either Cross RIver Bank or Peloton decided to partner with another firm. 

The firm is, of course, aware of this risk and has attempted to grow its merchant base. Indeed, it struck an agreement with Shopify in which AFRM will be listed as a payment option, allowing AFRM to work with Shopify’s vast merchant base. The company will be Shopify’s exclusive partner for transactions of the kind AFRM offers credit for, with the initial agreement lasting three years, renewed on a yearly basis. 

AFRM’s revenue grew 98% year-over-year, as of June 2020, generating $509.5 million compared to $264.4 million in the prior fiscal year. 

In that time, losses have marginally declined, from $120.5 million to $112.6 million.

Conclusion

Valuations are stretched at present. Let us take land investments as a simple example of how to think of AFRM. Some land is priced expensively but will never be worth buying. AFRM is good land that at present is priced richly. Given the growing importance of IPOs, the price will certainly appreciate in the near-term. The market has a huge appetite for tech IPOs. For example, the Renaissance U.S. IPO Index is up 88% from last year, compared to 12% for the S&P 500. This has rewarded firms coming into market in this climate, but, the investor may find that buying at these valuations will leave very little room for alpha.