Investing is a difficult exercise for investors, big and small. Below we explore a number of examples and ways to mitigate your investment risk thereby increasing your chances of success.
1. Don't put all your eggs in one basket
Spread your investments across different assets and asset classes. While it may be simpler for an investor to invest solely in shares, a superior, less risky portfolio return may be achieved by investing in other asset classes such as fixed income and hybrids. There are a range of these products listed on the ASX or available via a specialist fixed income broker.
2. Don't be afraid to get a second opinion
It is important to trust your selected advisor's judgement but don't hesitate to obtain a second opinion from another professional. The small extra cost can repay itself countless times by helping to avoid a poor investment decision. In addition, examine the possible incentives being offered to the advisor. A good advisor should betransparent and disclose any incentives they may receive as a result of your investment.
Guvera was an unlisted music streaming service, which offered advisors up to $30,000 worth of referral fees or free options to raise money off their clients. This was in addition to subsidised trips to opulent fundraising events hosted by an associated company. The company raised approximately $180 million off investors before winding up, having never made a profit and wiping out the invested funds of over 3,000 investors.
3. Understand how your investments make money:
It is essential to understand conceptually how your investments make money and how returns are being generated. Without this level of understanding, investment risk is increased substantially especially in cases where leverage is utilised to generate more attractive returns. Whilst leverage can be beneficial in certain circumstances, it is often bad especially where used excessively.
Storm Financial was financial advisor aligned with a number of large financial institutions. Broadly, all of its clients were provided generic advice to mortgage their homes to the hilt and invest in indexed funds run by Storm's partners, with periodic re-balances and accentuated by margin loans provided by Storm's partners. In a rising market and conservative leverage this may have worked well for a time however, the GFC brutally exposed the flaws inherent in the business model. Towards the end of the jig, it turned out Storm was keeping it's clients permanently geared at 90% (ie. 90c of debt for every dollar invested) without notifying them of any increases in leverage; making its clients highly vulnerable to any downturn in the market. Storm and its partners were incentivised via a gamut of high fees including a large portion upfront and trailing commissions.
The GFC passed and 3,000 of Storm's clients were left destitute and many more badly affected with total losses estimated at $3 billion.
Scandalously, the principals of Storm were served with civil penalties of only $140,000 collectively; a slap on the wrist for those who destroyed the lives of so many.
4. Recognise the value of governance:
Good governance is critical for any successful investment. This covers aspects such as the use of internal controls and separation of duties within the organisation, the independence of the entity's auditor as well as accurate disclosure of related party transactions.
In addition, the value in the use of independent 3rd party providers should not be underestimated for investors in managed funds or schemes. Outsourced providers for administrative functions like unit pricing allows a 3rd party to critically assess the fund which theoretically reduces the risk of fraud. Independent auditors play an important role and their commentary should be read carefully.
A good board with the requisite processes, structure, and skills play the largest part in defining the entity's governance and culture.
In the entrepreneurial 1980's Laurie Connell's merchant bank, Rothwells, had a number of issues that were highlighted above. In particular, governance was exceptionally poor with Connell holding the position of both the managing director and chairman. The board of directors rarely met and investment practices were not enforced or reviewed. In addition, Connell's companies were the largest borrowers of Rothwell's funds however, these were cleared off the balance sheet before each audit date involving a number of mechanisms with friendly companies. The auditor, imported from Queensland to Western Australia, gave the accounts a clean bill of health until the end. Ironically, Qintex another 1980's Aussie fraud imported their auditors from Victoria to Queensland.
5. Private investments are far more difficult than public. Be wary of private entities held within a public structure.
Investments in private unlisted companies are far more difficult to assess and invest inthan public, listed opportunities. The major difference is the lack of liquidity in private investments. Generally, in a public listed investment; liquidity is available at an open and relatively transparent price. Private companies unless exceptionally attractive, generally struggle for secondary market liquidity and at a greater transactional price than the public markets.
Governance can be a big issue due to the lack of protection for minority investors, especially where no binding shareholder agreement exists. In addition, disclosure requirements vary significantly between private and public companies. Be wary of public listed companies that conglomerate private opportunities, without providing clear and transparent valuation metrics and disclosure for their downstream investments.
Blue Sky Alternative Investments is a recent example where a critical public report from an external party led to scrutiny from the wider investing community. Blue Sky was exposed for significant flaws in their disclosure, private investment valuations and performance calculations, which led to a loss of over 95% of its stock value from its peak in a period just over 12 months.
6. Beware products with a veil of secrecy. don't invest in products that you don't understand.
Beware of those bearing products that are sold with airs of exclusivity, veils of secrecy and little disclosure. In addition, be wary of schemes that appear to target a particular ethnic or religious segment of the population.
Bernard Madoff has been one of the highest profile scams of late, with investors losing an estimated $18 billion. Madoff ran a Ponzi scheme, which involved paying returns to existing investors from the incoming funds of new investors; he managed to run the scheme over a time span of decades using a number of mechanisms. Primary was the fact that he claimed his fund was by invitation only, and he required secrecy from his investors. This provided his operation with an aura of exclusivity, and ensured that most existing investors stayed 'invested'. His industry links and associations also provided a veneer of legitimacy.
He also targeted specifically Jewish individuals and associations and played upon his own Jewish identity to build affinity with investors. Finally, his claimed annual 'returns' were consistently around 10%, enabling him to stretch the scam out over decades.
7. Beware of investments that sound too good to be true.
Firepower International was a fraudulent company that claimed to have invented a fuel additive pill that led to lower pollution emissions, increased fuel efficiency, and a cleaner engine. Scientifically, they claimed to achieve this by burning more of the heavier elements in fuel. Investors only needed to possess a rudimentary, high school level understanding of chemistry to understand the sheer absurdity of these claims. The company had achieved a level of credibility given the support of the Australian government agency Austrade and various government ministers; as well as a widespread sports sponsorship campaign by the company itself.
The charade ended when ASIC began an investigation into the company, for raising funds without adequate disclosure to investors. Firepower had raised anywhere between $60-$100 million from investors via intermediaries. These investors were sold shares 'cheaply' in the cents, with the projection that the shares would trade in the dollars one day. Interestingly, there was no actual Australian company, with no shares legally issued; yet the product was being sold by registered financial intermediaries. All the sponsorship and government agreements were with a legal entity that did not exist.
Needless to say, investors lost their entire amount invested. The promoter of the company walked free with no financial penalties or jail time.
8. Use your common sense
Don't invest without reviewing the appropriate issue documents such as a prospectus or an information memorandum. When in doubt, ask a trusted advisor. Don't sign legal documents without prior review by a solicitor to ensure that you understand the risks and your legal liabilities and obligations to be fulfilled under the contract. Don't be blinded by high returns or promises, there is no 'free lunch'. Beware the charismatic promoter.
Land schemes have always been a particularly notorious segment in the Australian market for the improper raising of funds. Typically, the promoter of the scheme secures an option over a parcel of land; with investors required to complete the acquisition. Investors are promised a high return dependent on the rezoning of the land at an unknown point in the future. The promoter is usually the only party to have a full understanding of the trail of funds, the issuing of shares or units and the rezoning process itself. This sole point of responsibility generally leaves the scheme open to abuse, and many investors get burnt by these schemes every year.
9. Consider tax but don't make it the sole basis of your decisions
In the 1970s the Australian government began offering tax incentives for rural industries and in particular tree plantations. The vehicle generally used for these investments were managed investment schemes (MIS). One of the biggest attractions with an investment in an MIS was that it gave the investor an immediate large tax break and allowing the deferral of tax until the end of the MIS or exit of the investor.Conventionally a plantation is an unattractive with substantial costs incurred at the front end of the investment, maintenance expenditure required annually and an uncertain return (or loss) achieved after an uncertain time period; this also assumes there are no natural disasters in the interim.
These structural impediments along with too much debt and the pursuing of unprofitable schemes burned many investors in the late 2000s. Thousands of investors were affected by the collapse of Timbercorp and Great Southern Plantations, two of the largest operators in the space, along with a litany of smaller operators.
10. Avoid where possible complex and international structures.
Allco was a financial services group which floated a number of different listed vehicles in the 2000s. The companies were largely involved in businesses which dealt with property and infrastructure as well as heavy fixed assets such as rail, aviation, and infrastructure all on a global basis. Whilst each segment is simple enough, Allco's engaged in a mind-numbingly complex array of cross-holdings and interrelated transactions in which the associated companies financed each other. The disclosures in financial statements were extremely difficult to decipher even for the dedicated professional investor.
In addition to the heavy borrowings within the companies undertaken as a course of business, the core identities in the group also held their stock in the companies with a high degree of leverage. This provided a strong incentive to attempt to support the share prices of the various satellites. Long story short, the advent of the GFC reduced the value of the assets and the cash flow available within the Allco satellites; the principals of the group were forced to liquidate their holdings due to margin loans and the majority of the Allco satellites were wound up. Ultimately, approximately $3 billion of equity raised went up in smoke.
Pulling it all together
If an investor has no appetite or inclination to perform due diligence upon their investments, they should consider outsourcing part of their portfolio to a trusted professional advisor. We would recommend speaking to an independent financial planning practice, to alleviate any concerns around incentives.
In addition, skilled active fund managers should be identified and explored as part of this consultative process.
Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way
 

Echo Resources (ASX:EAR) is a gold developer with it's operations based in Western Australia.

We believe that it provides the best exposure to ASX listed gold development plays, and is compelling value at the current market value of around $100 million. It is our opinion at the current gold price, the company is worth significantly more; especially considering it's exceptional project economics, strategic assets and exploration potential.

Echo's key differential advantage against other gold developers, is that it already owns almost all the key infrastructure required to operate a stand alone gold production operation. The Bronzewing Processing Hub is a 2 million tonne per annum processing plant, currently on care and maintenance, solely owned by Echo with a replacement value of approximately $120 million. Other key infrastructure available to Echo's operations are a 200 person mining camp, an operational airstrip, essential services (water, power, telecommunications) and an established network of haulage and access roads.

Having this infrastructure in place, heavily reduces the upfront capital expenditures ('capex') and time required to bring it's gold resources into production; making the project exceptionally attractive from a financial returns perspective. A Bankable Feasibility Study ('BFS') has been completed, demonstrating that the project requires pre-production capex of around $40 million to bring the project into production in a time frame of only 6 months. This is in contrast with similar projects, requiring between $130-160 million in pre-production capex depending on jurisdiction, and a time frame of 12-18 months to first gold production.

According to the BFS, at a gold price of AUD$1600, the project is projected to earn over it's lifetime of 8.5 years, a base pre-tax IRR of 155% and to payback it's initial capex within 12 months. Assuming a gold price of $1800, we modeled that the project would earn an IRR of around 300% and payback it's inital capex in around 7 months; almost unheard of economics for a commodity project. Taking a discounted equity multiple approach, we modeled that the project would return almost $8 for every $1 of capex spent over it's lifetime. 
EAR's all in sustaining cost ('AISC') for the life of the mine is projected to be around $1270 an ounce however, we expect this figure to fall in the optimised BFS.

These figures account only for EAR's existing resource base; whilst ignoring it's significant exploration successes since the issuance of the BFS and future exploration potential. An optimised BFS is currently underway and due to be released in the March quarter. We anticipate this confirm the robust economics of the Yandal project, and lead very quickly to a Final Investment Decision. We expect there will no issues at all with debt funding the entire capex requirement given the exceptional economics of the project; and the company have iterated that discussions with multiple Tier 1 resource project funders have been undertaken.

We note that the company currently has a 1.7 million ounce mineral resource, with a JORC reserve of 856,000 ounces. We expect, given the recent excellent strikes at Mt Joel, that this figure has the potential to increase substantially. In addition, there is still vast exploration potential for the company at depth, with almost all exploration to date has been done near the surface (<200 metres below ground level). With the project expected to produce around 95,000 oz a year, any further discoveries or resources defined will have the potential to extend the life of the project materially.

EAR's fantastic potential has not gone unnoticed by larger competitors. North Star Gold (ASX:NST) have over time taken a stake of approximately 22% of the company; at an implied value over 50% higher than the current market value. NST have appointed an experienced development executive to act as a board nominee. We believe there is a strong possibility that NST may ultimately make a takeover bid for EAR for a number of reasons.

The Yandal project in it's current incarnation, is projected to produce around 95,000 ounces per annum. This equates to over 10% of NST projected forward production from it's various mines. With NST current capitalised at over $5 billion, this implies a value of around $500 million for EAR once the project is in production; and if the market attributes a multiple similar to NST which is unlikely for the company on a stand alone basis. If NST were to acquire EAR, this becomes more likely as the acquisition would materially improve NST's company wide production metrics, as well as consolidating a large portion of the area around it's flagship Jundee mine and securing the valuable infrastructure and existing gold resources held by EAR. The Bronzewing Processing Hub has a lot strategic value and when functional will open up a lot of stranded deposits within the area. This asset will still have value at the end of the life of mine as it's likely to be able to generate ongoing income via 3rd party tolling agreements; as well as being able to scale up in size. 

EAR also possess around $65 million of carry forward tax losses that can be recouped before paying tax; which implies profits of around $215 million can be earned (not including depreciation) before becoming liable for tax. This fact makes EAR an attractive candidate for a corporate acquisition. We also note the commonalities between the CEO's of the two companies. Both have studied and worked at different times, at the same educational institutes and the same companies. Both have operational mining backgrounds and we regard the existing EAR team as a good cultural fit for NST so attractive as a bolt on acquisition. 

We note that EAR fulfills almost all of NST's stated acquisition criteria and we note that other transactions in the gold sector in recent times have been for higher prices per ounce of gold equivalent than EAR is currently valued by the market. It is our opinion that EAR shareholders could achieve significant upside at the current price, in a relatively short period of time.




​Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way

We have noted of late, increased commentary about particular ASX listed companies that are perceived to be expensive on traditional measures without regard for their actual business models. We will focus specifically on those companies that utilise scalable business models, and examine the nature of what a scalable business model actually is.

In it's simplest definition, a scalable business model increases profits over time by growing revenue whilst mitigating a proportionate increase in costs. The least scalable businesses are typified by: high cost of human capital and low scale. Businesses such as consulting and professional services we consider to possess linear business models. We generally find scalable business models in industry segments such as software, online travel agents, digital finance and goods, online advertisements.

Scalable businesses can grow exponentially, due to a range of factors, including but not restricted to: low capital intensity and human capital requirements, quick and low cost deployment, fast iteration of product and business processes to fulfill customer needs. 

We consider a the key elements of a scalable business model to be:

• A disconnect between sales growth and cost growth
• the removal of capacity constraints by collaboration via partnerships, creating platforms and capital efficiencies
• generally based on intangible assets like intellectual property (IP) such as patents, software, data etc. These typically have minimal replication costs while being able to realise full value from the asset.
• uses technology as a lever - for example, the advent of recorded music did not require a musician to be on site to listen to music
• utilises existing infrastructure - Whatsapp at the time of acquisition by Facebook had only had 35 engineers servicing 450 million users. Today has around 50 engineers servicing over 1 billion users. It's adoption was driven by the rise in smartphones and cheap, mobile internet access.

The scalability of a business model we consider to be driven by the following factors:
Concept - Inputs

• Technology - the automation of processes, scalability of technical infrastructure used in the delivery of the product or service
• Cost and Revenue Structures
• The ability to adapt to different legal environments and execute
• Network effects - defining and achieving critical mass and virality amongst the customer base
• User experience - solves a customer problem, simplicity in offering, knowledge of and by existing users
• Scalable revenue streams: Ecosystem, reoccurring revenue streams, network effects - increase in revenue corresponds to an increase in margins

Realization - Output

• Management: ability of the team, location, partnerships
• Market: potential, dynamics, awareness
• Investor attractiveness and valuation
• Company growth

A couple of ASX listed companies that we consider to possess scalable business models are Altium and Afterpay. Both operate and are leaders in 'winner takes all' markets, possess novel products and intellectual property, as well as holding customer-centric visions of the future.

Altium is a software company whose software assists in the design of electronic components critical to the operation of the technology that is ubiquitous today. In 2012, company revenue was $55 million and the EBITDA margin was only 0.5%. By 2018 the company had grown to revenues of $140 million and had achieved an EBITDA margin of 32%; with consistent increases in both revenues and EBITDA margins year on year. To me this typifies a scalable business model.

Afterpay is a payment solution platform, that has been growing extremely fast over the past couple of years driven by consumer and merchant demand. We feel the company has just reached it's tipping point, in the 2018 financial year gross sales were achieved of $2.2 billion, while it's EBITDA margin was circa 1.6%. We believe the company can achieve gross sales of $10 billion within 2 years, whilst increasing it's EBITDA margin to close to 3% or circa $300 million.
​
Investing in scalable businesses is an attractive proposition, and can lead to outsized returns over time. Investors should keep in mind, that investing in a scalable business in not a panacea as they can be disrupted themselves as well as being subject to market forces like all other businesses. 


​Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way

We were pleased to do a podcast with Rask Finance, a financial education service for individuals.
We broadly go through Emanuel's investing education and journey through life.

The podcast can be found at the following link: ​http://bit.ly/2Q7IhFn

It is great that the market has recognised the potential within Afterpay's business model and subsequently repriced the company substantially since our last blog post. Even though our investment thesis and comparison with Amazon has been questioned by a number of market commentators, it appears as though the broader market in general has now agreed with our analogy.

Brief Summary of Annual Results
Afterpay achieved annualised gross sales of $240 million in the US after only 3 months of trading. We perceive that there will be strong upside going forward as Afterpay builds it's brand recognition amongst customers and availability with merchants over time.

We note the reduction in net transaction losses to 0.4% of gross sales. This demonstrates great practical credit control from the company, as well as the strength, quality and usefulness of their credit database. 

Gross sales rose by circa 290%; however, net revenue to the group rose by 390%. This demonstrates the pricing power and scalability evident within the Afterpay business model.

Group Capital (equity+debt) post raise can support annual gross sales of in the region of AUD $5-6 billion. They have guided international sales of circa AUD $1 billion in 12 months; this implies that the ANZ region business may generate circa $4+ billion annualised. 

We actually consider this figure conservative given the speed of their customer uptake in the USA. For example, Morphe Brushes a popular cosmetics company started to offer Afterpay as a payment option on the 5th of August. Referral web traffic just from this brand was almost 30% that of Urban Outfitters referral traffic (who have been on the platform since May) just 26 days after offering Afterpay as a payment option. Amazingly, Afterpay's web-mall accounted for over 7% of Morphe Brushes referred traffic in these 26 days; further cementing its reputation as a source of incremental demand for merchants.

The near-term upside from merchant onboarding we expect to be significant with Chemist Warehouse now offering Afterpay in-store. Chemist Warehouse controls 25% of the Australian pharmacy market by revenue to provide some idea of the size of the opportunity. In addition, we note that ASOS Australia will soon be offering Afterpay as a payment option. It is very likely that ASOS will be the cornerstone merchant in the UK market rollout. For context, ASOS has revenue roughly 25% smaller than Urban Outfitters however, has web traffic more than 3 times greater reflecting a more diverse, global clientele.

We consider that the in-store rollout in the US will provide the highest mid-term upside given the majority of retail sales are still made physically, this is in line with Afterpay's Australian experience. In addition, we note that the recent weakness in the Australian dollar will provide a positive tailwind in their overall sales figures.

We anticipate that Afterpay will raise debt facilities in US, sooner than later to fund the US expansion. It makes sense for them to match their assets to their liabilities in terms of currency. The US Private Placement (USPP) Market is very sophisticated relative to the Australian market, and terms are often more flexible at a similar price to major bank financing. This would be a precursor to a NASDAQ listing, as a USPP raise would build awareness amongst institutional investors in the US.

Industry dynamics
We have noted recent chatter in the media regarding the competition in the payment space. From our global study of the industry we have not found a single instance of a truly cost free customer solution comparable to Afterpay's model; with all apparent 'competing' solutions typically charging interest and/or monthly account fees.

We note that the presence of competitors does not necessarily mean that presence of additional risk. On the personal note, I remember using a large number of social media platforms such as MySpace, Friendster, Hi-five, Orkut; all were virtually wiped out once Facebook had achieved traction in the space and are now all practically defunct. This demonstrates that the confluence of factors in terms of usability/satisfaction for customers, networks effects and simplicity/standardization in a product offering can lead to the evolution of a monopoly player or market structure. I believe that this will be the case over time with Afterpay as their market position, brand and credit database, become stronger with every transaction that runs through the platform; providing a sustainable competitive advantage or 'moat'. Afterpay's viral growth amongst consumers and merchants alike is further evidence of it's competitive advantage in the space.

We have been following at the high level the findings of the banking royal commission underway. From our perspective, the majority of unethical behaviour by financial institutions was due to ambiguous terms in the terms and conditions between the financial provider and the consumer; along with a strong dose of human nature. We think Afterpay's vanilla terms and conditions that are clear, precise and concise; along with the fact that the system possesses a very high level of automation, insulates the business from regulatory risk. Funnily enough, we heard a rumour that National Australia Bank (NAB) who provide Afterpay's bank facilities may have had the opportunity to invest in Afterpay at an early stage but passed even though they have a specialised fintech investment mandate. This demonstrates to me one of the single largest advantages smaller companies and investors have over entrenched incumbents.

We noted with interest that just 2 weeks ago Berkshire Hathaway run by Warren Buffet, considered by many to be the epitome of a value investor, made an investment of over $300 million at a valuation of $10 billion in an Indian payment platform company Paytm. This represents a large shift in Berkshire's previously articulated philosophy, and readers should be advised to watch this space closely.

Geographical expansion
As we flagged ambiguously in our last blog post, Afterpay have announced the expansion of the platform into the UK, the world's 3rd largest online retail market. We feel that the strategy to take over an existing company shell with the requisite financial licenses but with no residual exposure to the company's IP or legacy business is a very positive move in terms of executing with speed. From our research this has saved them between 12-24 months of scrutiny from the UK financial services regulator, and we consider the price paid to be fair.

We have come across further evidence in the public domain to support Afterpay's global expansion. We anticipate that expansion into various North American, Asian, European and Middle Eastern nations will provide the next steps in global growth. We expect these plans to be released in another 3 to 6 months. We think that current expansion strategy to first offer the platform digitally, and then roll out in-store once sufficient scale and demand is achieved is a very pragmatic and risk mitigating method of market entry. Once again we iterate that the in-store rollouts will provide the most upside in the mid-term.

Products
We have made a suggestion for a new expansion to Afterpay's core product that has been positively received by the management team. We are not privy to whether the idea will be pursued, but it has the potential to massively increase their addressable market by a factor of 4-8 times from our analysis, cut credit risk drastically, while being able to be deployed utilizing the existing merchant agreements and infrastructure; so benefiting from massive scalability at very low incremental cost. We will only disclose this information to our Fund investors on a case by case basis due to commercial sensitivities and uncertainty around whether the concept will be pursued.

Management Team
We believe the quality of Afterpay's management team is outstanding. A few attributes that we look for namely: longevity, alignment with investors and commercial acumen; are held in abundance by the key management personnel. 
The model of the young, conceptual founder supported by a well recognised and experienced management team has worked well in our experience. Examples are Google where the two young co-founders were ably supported by Eric Schmidt and Ebay where Meg Whiteman supported the founder during a period of rapid growth.


We leave you with the 6 Principles that drove Amazon's success also typified by Afterpay:

1. Take advantage of the window of opportunity - Execute with speed and precision, before larger players can react. 
2. Make decisions for the longer term - 5-7 years -  For example, the rewrite of Afterpay's code base for global expansion
3. Long term market share leads to long term profits - Aim for market leadership which leads to greater capital velocity and stronger returns on capital over the long term
4. Acting with boldness in decision making - Typified by the UK market entry via the acquisition of Clearpay
5. Focus on Customer service and satisfaction - Afterpay's focus on a clear, customer-centric product; and validated by repeat customer usage in excess of 80%
6. Be the first in a large addressable market -  Capitalising on a first mover advantage, in a product that is absolutely unique in the space.

Afterpay is one of our key equity investments, and we consider this a permanent holding.


​Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way

​We respond to some recent spurious claims put out by a fund manager with a Q&A below.
 
Is Afterpay similar to Zippay or other providers of consumer credit/finance?
Credit can be defined as providing funds to another party in exchange for a promise to repay the principal plus an additional agreed amount (interest) generally linked to the duration the funds are drawn or advanced.
 
Afterpay does not provide complying consumers with credit per se being a truly cost free instalment payment solution for compliant customers. 
Note my emphasis on consumers complying with Afterpay's terms of service. Non-compliant consumers occur a fine or late fee as they accept under the terms of service. 
While there have been critics of these 'fines', consumers are under no obligation to use the service if it does not suit their needs or if they find the terms of service onerous.
 
In summary, Afterpay is free to use for compliant customers in contrast to providers of consumer credit who charge interest to the customer as their core business.
                                                                                                       
Is Afterpay just a factoring business in disguise?
Afterpay is not a factoring business, but rather an innovative blend of modified supply chain finance and lay-by tailored for the mass consumer market. The table below illustrates the key differences between Afterpay and a 'vanilla' factoring business.

Aren't merchant fees a bit thin at 4% considering the credit risk?
The rate merchants pay for the facility is set by Afterpay. The 4% rate assumption was probably valid 12-18 months ago when Afterpay was an unknown quantity in the market. We have spoken to numerous retailers who use Afterpay; the recent commission structures in the sub-$20 million revenue business category appear to be between 6-7% plus a nominal fee per transaction. Customer satisfaction is very high with over 85% of revenue being generated by repeat customers.
 
This to us demonstrates the pricing power of a market leader or incumbent. We have also noted that once a merchant within a particular market segment adopts Afterpay, it's competitors follow suit fairly quickly adding to the products virality.
 
Afterpay as the payment intermediary captures value in a number of ways:

• monetarily via fees and commission
• information wise via its transaction and credit databases
• intangibly via building up brand awareness and recognition. Brands are more important online than they are in the physical world.

Does Afterpay lend to people who don't have a credit card?
Yes, you do not need a credit card to be eligible for Afterpay. A credit card is not necessarily evident that a consumer is credit worthy. 
Credit card usage has actually been on a slight decline in terms of per capita usage in Australia. In fact less than 30% of Millennials possess a credit card in the US market. 85% of Afterpay transactions are via debit card ie. not credit card.
 
But what about the credit risk?
Afterpay transfers 100% of the credit risk from the merchant to itself, with genuinely no recourse for any shortfall in the case the customer does not complete their payment plan. This is attractive from a merchant perspective, and puts the onus on Afterpay to develop systems that accurately assess a consumers ability to repay the instalments. 
 
Credit risk is mitigated by the fact that if any payments are late, new transactions are impossible; so the quality of the credit book continually improves with the number of transactions that go through the system. Afterpay relies on a mathematical principle called the Law of Large numbers. This probability theorem stipulates that as the number of occurrences (or in this case, transactions) increases, the average of the result of these transactions will be closer to the expected value. We see this principle at work commonly within the insurance industry and other industries which assess and transfer risk.
 
What if there is a recession, could Afterpay lose money?
We feel that in an economic downturn, it is likely thatAfterpay’s utilization may increase due to attractiveness of paying off discretionary purchases via instalment plans; it is evident that customers use the product as a budgetary tool.
 
Afterpay can be thought of as a microfinance tool, as the average customer use is circa $200 in value, being used 5-6 times per year. Given the regular usage, relatively small amount advanced and large utility value of the service; we think that it’s highly unlikely that customers would risk the loss of access to a service they use regularly.
In contrast, the average credit card debt in Australia is $4,200 and average personal debt is circa $8,000 per head; these payments can be deferred without any immediate consequences and have a differentiated risk profile when compared to Afterpay.
 
The potential for credit risk is actually highest at the time of a consumer's first purchase, with it falling rapidly with each subsequent purchase as users do not want to lose the utility gained by using the system.
 
OK, what about companies offering competing services; what are Afterpay's key differentiating factors?
Afterpay product offering is clear and vanilla to customer; with no variation in terms whatsoever, in contrast to competitors.
 
Competitors are at least 2 years behind Afterpay in terms of technological integration, merchant reach and services levels from both customer and merchant aspects. One only needs to possess a rudimentary knowledge of technology to know that the company with the most functional application, API and User Experience generally does best over time.
 
Afterpay's execution has been outstanding to date. It has successfully taken exploited its first mover advantage and scaled up to become the dominant player in the Australian market. We note that in developing segments of the market, it is typically who can take the most market share at the earliest stage that eventually survives and thrives. An example of this is Paypal, who fought off a number of competitors to emerge as the market incumbent due to its virality and success in customer acquisition.
 
Feedback from merchants suggests that revenue rises with the adoption of the service and it is a service that is in high demand with customers. Afterpay's merchant directory and promotion via its social network channels is a valuable form of 'free' promotion for merchants. In addition, in regards to merchant service issues are typically resolved the same day in contrast to the extended support timelines of competing products.
 
It is NOT in Afterpay's best interests to have customers spend beyond their means and be in arrears. This is because Afterpay earns more from recycling its capital quickly (ie. receiving customer payments and purchasing merchant receivables) than the late fees it charges to customers in arrears. This is in contrast to its competitors.
 
Why is Afterpay's revenue so low? Is this the same as gross sales?
Afterpay according to the notes in its financial statements recognises revenue as the economic capture between the gross amount and net amount paid to merchant. Gross sales they define as the total amount of receivables that they purchase off the merchants.
We consider the gross sales to be the most relevant figure in measuring growth however, both measures should be monitored.
 
So what makes Afterpay so compelling for you?
When analysing growth companies we look for the following key attributes:

1. Growth in top line gross sales
2. Growth in operating margins
3. Balance sheet optimization and capital allocation policies
4. Potential for valuation multiple expansion
5. Network effects and oligopoly potential

  
Afterpay ticks all our boxes. We have made the analogy to Amazon previously and we compare some key metrics below.

​Key Points:

1. Afterpay is experiencing faster top line and user growth at a far lower acquisition cost than Amazon experienced at a similar stage of growth. We note that the company have disclosed that they are achieving gross sales of $3 billion on an annualised basis; we expect this to grow materially in this half year.
2. The table demonstrates the sheer virality of Afterpay's product; it enjoys network effects from both consumer and merchant sides. This is an extremely rare attribute. We note that in the digital services space, oligopolies are the norm as opposed to the exception.
3. We note a number of non-monetary elements that are similar to Amazon namely:
   • Cultural: "what's good for customers is good for stakeholders"; market participants with the greatest scale wins by building market share quickly at the lowest relative margin.
   • Technological and service advantages: best application, website and API among competition, superior service for both customers and merchants. User Interface and Experience is similar to Amazon (see below)

Potential to grow into other complementary business lines: Credit reporting, online mall offering etc.

Why are you writing this?
The main purpose of this Q&A is to correct inaccurate statements put forth by a fund manager as well as to put misconceptions around Afterpay's business model to rest.
 
Once again this highlights the important of selecting an investment manager who possesses the necessary skills, objectivity and intellectual humility to understand and capture profits from investing in a company with an innovative business model, experiencing viral growth.
 
We expect Afterpay to release additional positive news regarding further growth in the coming months. We have come across information in the public domain that demonstrates the growth path ahead for Afterpay.
 
Afterpay is one of our key equity investments, and we consider this a permanent holding.
 
Thank you to those in our network who contributed information material to this article.
 
This is an extract from Datt Capital's forthcoming monthly report
Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way

We got lucky. A few days after our last wire, discussing two stocks to watch, one of them, Afterpay, released a positive business update and the share price exploded, gaining in excess of 30% within a matter of days. Reading market commentary, a common perception is that Afterpay is overvalued at its current price. The real question is: how do you value a company that is growing at an almost exponential rate?


We consider the major growth avenues below:

• AU in-store - Afterpay's market share is currently only 0.5% in this $160+ billion segment. There is still tremendous scope to grow considering the product has achieved virtually mainstream recognition in the AU market. We anticipate that Afterpay can capture, over time, a low single-digit share of this market.
• The USA online retail market is growing steadily with a total size in excess of $200 billion.
• USA in-store non-food retail market is the largest in the world, with a size in excess of $1.5 trillion.
• UK, EU expansions - These longer-term potential markets in terms of size are multiples of the Australian market.

Afterpay also possesses a number of sources of unquantified value, namely:

• Its database of credit information. In many cases, Afterpay has the 'first touch' of millennials in contrast with credit assessment/agencies; so this data is extremely valuable.
• We consider there is significant scope build ancillary businesses/income streams utilising this information
• The network effects and influence that Afterpay possesses with consumers is unquantifiable from a financial perspective. It has managed to build a strong brand identity, especially considering the company name has entered the Australian millennial vernacular ("Afterpay it").

We consider Amazon to be a close comparable to Afterpay due to its historically large growth potential, gross sales and slim margins. Amazon, up until the start of 2016, traded at an average Price to Sales (P/S ratio) of 2 times. Of late, it has traded higher due to recognition of its market dominance and ability to enter new markets.


We consider the P/S ratio a reasonable valuation heuristic for a company experiencing rapid growth above 100% per annum like Afterpay. We would consider a P/S ratio of 1 times to be reasonable for an ASX listed company however, if a dual-listing was pursued in the US markets (for example, on the NASDAQ) we would consider a P/S ratio of 2 times to be most reasonable in that particular market.


We note the latest business update disclosed the annualised gross sales were running at circa $3 billion. We anticipate Afterpay in 12 months to be achieving minimum annualised gross sales of $5.5 billion, with the US contributing over $1 billion to this figure. Using the P/S ratios above, this equates to a share price range of between $25 and $50 assuming no further equity is raised.


We applaud the efforts and decisions of management to date and are enjoying watching the evolution and growth of another great Australian company.


Disclaimer: This article does not take into account your investment objectives, particular needs or financial situation; and should not be construed as advice in any way.