The previous year (ending 22 February 2019) has been by far
the best year for the fund. Pleasingly, the fund returned +86.6% for the year
taking the annualised return since inception to +39.3%.
The funds large position in Afterpay (ASX: APT) has surged
substantially, rising from $7.53 from the beginning of the year to $17.20, or a
rise of +128.4% over the year and has largely driven the returns of the fund. Although
the below might read like a partial investment thesis, that’s not the
intention. It’s just some thoughts of mine that I wanted to put forward.
Late last calendar year, I made the decision and sold the
vast majority of my holdings and progressively accumulated more stock in
Afterpay. After the stock more than halved from the peak to the trough on the
back of regulatory risk, a global sell off in tech stocks, and some adverse
journalism, I saw an opportunity and took a big swing and progressively accumulated
stock between $10.80 and $14.00. I’ve been following the company religiously
for over 1 year now, and I am convinced Afterpay will be a global success and the
stock in my opinion offers impressive risk-adjusted returns. This company is on
track to be amongst one the fastest companies in the world to reach annual
revenue of $1bn ever. To put that into context, it took Dropbox just a little
bit over 8 years to reach an annualised revenue run-rate of $1bn, and they claim
they were the fastest SaaS business to reach that milestone. Although Afterpay is
not a Saas business, they are on track for similar success based on actual revenue and not the run-rate. A visual
representation of some fast-growing SaaS businesses is below.
Using SimilarWeb, I’ve been tracking website traffic to Afterpay
and also website traffic from Afterpay’s platform to various large retailers in
the US to get insight into the early momentum in the US. The indicators are
extremely positive with Afterpay showing early success in terms of website
traffic and customer referrals. For example, in January 2019, the website with
the highest referral rate was to Urbanoutfitters in the US, outstripping any
other site in Australia. This is an important early indicator given the US
business is less than a year old but has been in Australia for ~5 years. Other measures
such as Google Trends and app reviews also confirm this strong early momentum and
what appears to be growing by the month despite retail seasonality. For
example, February 2019 in my opinion is shaping up to be the biggest month in
the US in terms of customer additions, outstripping the typically stronger
months of November and December. In fact, as the shares halved before my eyes,
watching the popularity of the product in the US surge using these 3 measures
is what kept me sane.
While Afterpay’s value proposition to most retailers is clear, a major competitive advantage is how Afterpay’s platform is leading to
strong customer referrals to businesses on the platform. Afterpay is now the
second largest referrer of business to retailers in Australia after Google.
This isn’t a point many people harp on about, but I see this as a major advantage.
Afterpay’s strengthening moat will largely depend on their ability to unlock
the true potential of these referrals and harness the true power of their
platform in the long-term. The uplift in average basket values are nice, but
long-term, the value isn’t just in that. It goes much further than just a
transaction.
Afterpay’s product in my opinion is self-regulating. This is
by design of the product. You can only continue to use the product if you are
not currently late on a payment or are under the limit of $2,000. The fact that
you cannot use the product if you are late (and need to make up for lost
payments until you can begin using it again) weeds out lower quality customers.
This is important as Afterpay continues to expand geographically because when
you enter a new market which has no incumbents, this process takes time to play
out and ideally, you want to be the first one to start so that the later
entrants are left with the lower quality customers. In buoyant times the
importance of this is masked, but when shit hits the fan, you should see the power
of having a higher quality customer base in lower bad debts relative to
competitors. As the customer base matures, you end up with a more profitable and
less risky customer base. Moreover, as the number of customers and merchants
grow, it creates a self-fulfilling cycle as the marginal customer will look for
the provider with the largest (and/or most suited) retail network, and while
merchant fees are important, the marginal retailer will look for the provider
with the largest (and/or most suited) customer base.
Putting aside where we sit in the current economic cycle, the
short repayment cycle helps determine the credit riskiness of the customer base
relatively quickly. As the average customer is paying back within ~30 days, Afterpay
get a pretty good grasp of their customer base within a matter of months. I’ve
spoken to someone who models credit risk for a bank who also confirmed this. It
takes banks much longer to figure out how risky a new and first-time credit
user really is as the repayment cycles tend to be much longer and loan sizes
are typically larger.
Afterpay is unique because it has a very low Customer
Acquisition Cost (CAC). At a basic level,
in FY18, the company added 1.5m customers but only spent $5.8m in marketing,
equating to a CAC of only $3.9. Bear in mind that when comparing this to other
companies, the CAC cannot be viewed in isolation, as it needs to be viewed alongside
other metrics such as Average Revenue Per User (ARPU) and EBITDA per customer.
Afterpay are pricing their product lower in the US to gain faster
and more effective traction. I don’t have an issue with this as many of the
brands who are paying a lower rate in the US are paying a higher rate in
Australia as they see the value in it. I think it’s only a matter of time for
the results to shine through in the US market (like it has in Australia) and as
a result pricing might revert closer toward the 4% it is in Australia on
average. As competitive pressures rise, this might offset the pricing power,
but in my model, I assume a long-term rate quite a bit lower than 4% and it
still makes economic sense based on my assumptions. It’s interesting to note
that Visa & Mastercard are lifting some of their fees in the US (however I’m
not certain whether it applies to online transactions just yet). If applied to online transactions, this
move would improve the relative affordability and value proposition of Afterpay
to credit cards as an alternate payment method.
Afterpay is set to begin its operations in the UK in CY19.
The UK launch will benefit from their existing operations in Australia and the
US, as many of the global brands in these two countries have operations in the
UK and so I believe they won’t be starting from the beginning. Moreover, the acquisition
in the UK will give them a customer base to leverage off as well. Carl Scheible
will lead the UK team who was an ex VP & MD of Paypal UK & Ireland and
spent over 8 years at the company.
To date, Afterpay have executed almost flawlessly. I commend
every single employee on their efforts to date. However, nothing is perfect and
it too has its share of negatives. 3M has a history of innovation and delivering
quality products. They are “famous” for going straight to the customer to
improve their products by reviewing complaints made to the company as a key way
to improve. I’ve done something similar by reviewing the common negative
reviews in the businesses US operations. While not backed statistically, my experience
suggests to me that the two common flaws (that are not user induced) are some
people are having issues setting up their account (and this has occurred enough
times for me to believe it’s not user error) and a lack of customer service. I
don’t have the details as to why the former is occurring and so cannot comment
on that one but the latter was and to some extent continues to occur in Australia.
The reason is that because they are growing so quickly, they simply are not
hiring people fast enough. I hope sooner rather than later, they are in a
position to sort this out. Another consumer related issue is that getting a refund
for the most part can be extremely difficult. So, while not perfect, the
management team are doing a great job when you factor in how fast they are
growing.
I believe CY19 will see Afterpay introduce adjacent revenue
streams, enter a new vertical and launch into Canada. I also believe a NASDAQ listing is on the
cards by FY20-21. The potential dual listing is on the back of the theory that
they don’t have the balance sheet to fund companies such as Nike in the US.
While the US debt facility of up to ~US$300m will facilitate in excess of $4.0bn
of sales per year, they will eventually need to diversify their funding sources
and raise fresh equity which may be completed in the US.
Some other positive contributions in the year came from
Infomedia (ASX: IFM), Netwealth (ASX: NWL) and Redhill Education (ASX: RDH).
I’ve copped a lot of crap from holding this stock but it’s
been well worth it. Almost nothing is without risk, and Afterpay has its fair
share of risks (which I’ve decided not to include here in this post), but as
Stanley Druckenmiller once said “I’ve
learned many things from [George Soros], but perhaps the most significant is
that it’s not whether you’re right or wrong that’s important, but how much
money you make when you’re right and how much you lose when you’re wrong. The
few times that Soros has ever criticized me was when I was really right on a
market and didn’t maximize the opportunity.” Until
I find a clear reason not to be owning this stock, I believe I’ve found that opportunity and I’ve put my money where my
mouth is. Time will tell.
All the best!
Performance figures
are annualised and the figures are quoted net of fees and expenses but before
taxes. All positions are long positions. Inception date is 22/02/2014. This article is general advice and is not intended to be personal
advice. Before making any decisions, consult a licensed professional.
