To The Moon

Affirm’s valuation and business model - is the pain of today worth the opportunity?

I think Affirm’s valuation is compelling or I wouldn’t have made the effort to write the article. And frankly, given the current sentiment about this kind of investment, the valuation needs to be compelling to make up for the perceived risks and the current risk-off sentiment that will likely limit the short term performance of Affirm shares.

Besides the negative sentiment gripping the market these days, Affirm’s valuation has to account for the steep ramp that will be necessary for the company to achieve profitability by the end of the fiscal year as it has forecast. And the fact is that this is a company whose business prospects, at least in part, are related to consumers buying merchandise and services on-line, which is currently not the seeing the kind of growth that had been achieved in the recent past. A further issue, at least for someone trying to model the company to help with a valuation analysis is the many different offerings the company has with regards to different revenue buckets and take rates. The company is projecting a margin improvement of significant magnitude from Q2 onward. And the company is projecting that it will be seeing an uptick in “0% APR” transactions as a means to incentivize consumers in this environment. These kinds of loans typically provide Affirm with greater margins than other split-pay transactions.

The company has increased its opex spending substantially over the last year, but the sequential growth in that spending has slowed substantially. Last quarter, non-GAAP opex spending grew by about 10% sequentially, far less than the percentage increases seen earlier in the fiscal year. The company is set to further decrease the rate at which it makes opex investments in order to achieve non-GAAP profitability by the end of the year. Given the cadence of opex recently, I think it is reasonable to model minimal increases in the various opex spending metrics in future periods. The single largest component of the company’s costs is provisions for credit losses. Provisions, on a sequential basis, continued to decline as a percentage of GMV, but it hasn’t declined as a percentage of reported revenue. The company’s management has said that this percentage will be decreasing over coming quarters, in part because of seasonal patterns, but more significantly because of tweaks to the company’s underwriting model that show up very rapidly in terms of improved provisions rates because of the very short average duration of its loans.

The company has said that it anticipates that its fiscal Q2 will be a valley for all of the key revenue metrics in terms of growth. Of course, to an extent, this is a function not of Affirm’s execution, but a function of how the economy evolves. Just to reiterate, the company, itself, is not making a call on the economy other than to say it really doesn’t know how macro conditions will evolve. Given the uncertainties in the economic outlook with different data points flashing different signals, that is the only reasonable forecast assumption to be made. There really was nothing dire or ominous with regards to guidance; simply an acknowledgement that providing a forecast based on consumer behavior 9 or 12 months in the future is not really any kind of high odds undertaking. That said, the combination of modest increases in quarterly revenue, lower provisions as a percentage of GMV, higher take rates from that GMV and slowing increases in operating expenses will indeed create the environment for the company to reach non-GAAP profitability by the end of this current fiscal year.

I have projected that reported revenues over the next 4 quarters will reach $1.75 billion, which would be growth of about 35% above the results just reported for FY ‘2022. As mentioned this company has had a record of exceeding its forecasts by varying amounts since it first started reporting which goes back 6 quarters at this point. Several of the company’s partnerships, and particularly that with Amazon, are just in a nascent stage at this point, and are likely to be ramping significantly, almost regardless of the state of the economy. And Peloton, once a significant merchant partner, has seen its share of GMV fall to low single digits - it is no longer a factor in constraining growth percentages. Further, the Adaptive Checkout offering, is just now starting to generate significant levels of GMV, and the company's Canadian operation is recording triple digit growth at this point.

Using my revenue forecast, and estimating a 3 year CAGR of 33%, Affirm shares, on an EV/S basis are significantly below average for the company’s growth cohort - almost 40% as of last Friday. The current EV/S ratio is about 3.75X. Of course, at this point, it isn’t really prudent to project any kind of longer term free cash flow margin. Currently, free cash flow is running slightly above non-GAAP operating income and I expect that relationship to continue.

The investment case for Affirm shares rests on several pillars. The company is the leading player in the BN/PL space, and despite all of the negative comments made by many, BN/PL will continue to emerge as a leading methodology for consumers to receive credit and as an alternative to credit cards and cash advances from credit cards. The company’s partnerships provide it with a strong go-to-market foundation. At one time those partnerships led to valuation excesses; currently they are not being valued at all. Again, contrary to much that has been written about this company, it is significantly differentiated from its competitors to an extent that is rarely understood.

The company’s technology that enables it to tweak credit levers is rarely considered by analysts and commentators, but it is a major element in the favorable credit performance the company is achieving. Equally, the ability the company has to offer brands and partners highly differentiated credit offers for different merchandise, almost on the fly, is not yet fully understood. The company’s outlook for growth over the next year is not a function of some existential issue with the space, or with the company’s execution, but a function of uncertainty with regards to consumer behaviors during a likely impending recession, and as inflation has limited consumer spending. No one really knows how that paradigm plays out over the coming months and no one really knows when monetary policies might start to change to relieve some consumer stress.

There can be little dispute that Affirm is a very broken stock. It is not, in my opinion, anything at all like a broken company. Its valuation no longer bares any real relationship to its opportunities or its progress in reaching profitability. While I don’t claim to know when a recession that is just now impending - sort of - will reverse, the valuation for the shares more than discounts that kind of headwind it terms of the share valuation. At this point, the shares have yet to achieve even a dead cat bounce from the compressed levels seen in the wake of the latest earnings report. I think that presents a very reasonable entry point, even if it takes some time for the company’s investment merits to become better recognized.