Affirm’s quarter – was it really that bad?
Writing a positive article on the shares of Affirm (NASDAQ:AFRM) in the current environment is more or less equivalent to being a champagne salesperson at a temperance conference. Or perhaps a wounded gazelle running into a pride of hungry lions. Negative sentiment toward anything that looks like technology is on full view. And that is compounded if the technology in question has anything to do with the Fintech space.
I don’t profess to have second sight, or anything approaching that. In the current environment, shares of Affirm are most likely to languish, other than occasional pops when they get egregiously oversold. As will be seen, the quarter that Affirm reported was not a catastrophe and the company’s outlook, while muted to an extent, is reasonable given all that seems to be known about the path of the economy. Affirm’s credit quality and its funding capability seem solid, and their differentiation from other BN/PL competitors seems to be increasing. But that hasn’t mattered to investors, and to some commentators, and when that changes, or what might precipitate the change, is not immediately apparent, at least to this writer. Affirm shares are an excellent long term commitment, based on the facts presented last quarter and my understanding of the space and anecdotal checks I have been able to make with some users. But fears are running far ahead of facts at this time, and while I would like to say that these fears will dissipate in short order, I would be doing a disservice to readers by making such an assertion.
Affirm shares have been more than a little volatile, seemingly reflecting shifts in sentiment more than actual business developments. Despite what I see as a massive disconnect between the reported results and the projection, and the market reaction, Affirm shares are hardly likely to show any kind of sustained uptrend until the overwhelming negative sentiment towards growth shares and fintech shares starts to dissipate. Even a relatively benign employment report, issued as I was in the process of preparing this article is having little positive impact, at least so far. At some level, that has taken Affirm shares into what might be described as an over-sold condition. But I am not trying to call a bottom or to make a trading call. My recommendation to buy the shares is based on the company’s very strong competitive position, its ability to underwrite credit to achieve better results than investors seem to anticipate, and the fact that the buy now/pay later paradigm will continue to resonate with consumers and become entrenched as a significant channel for retail sales.
These days, Affirm shares have a relatively elevated short interest ratio which was last reported to be 14%. While there is an old market adage that short sellers know more about their positions than other investors, that is obviously not always the case. Shorting Affirm shares has become a way of speculating on future macro conditions as much forecasting the company’s future operational performance.
Looking at half-full glasses ought to be a specialty of most commentators. That said, when looking at Affirm as an investment these days, it might seem as though its glass has scarcely a drop of any liquid remaining. Although most articles on Affirm start off by saying the shares are down by some percentage, just for the sake of completeness I will reprise the actual numbers. On a year-to-date basis, the shares are down by more than 75%, and they are down by about 86% since they made an all-time high just about a year ago.
Some of that decline was a reaction to the spike of the shares in the wake of the company announcing a partnership with Amazon (AMZN). The shares more than doubled in a few weeks after the partnership was announced, before starting their plummet to terra firma. The shares dropped by 20% in the week after the latest earnings release and that was after falling nearly 25% in the 8 trading days prior to that release. The Amazon partnership, whose results are just now becoming visible in Affirm’s numbers (the 466% increase GMV in the general merchandise category processed on the Affirm platform last quarter is mainly a function of that partnership), really was a positive and perhaps seminal event in the life of Affirm. It is probably difficult to quantify just how significant that partnership will become. On the other hand, the spike in the shares was obviously some kind of speculative blow-off event.
Analyst ratings on Affirm shares are mixed, with the latest data from the 1st Call showing less than half of the reporting analysts rating the shares as a buy. There are a couple of rather aggressive sell ratings including one from the analyst at Jeffries. None of the analysts changed their ratings after the earnings report although there were some price target changes.
Was the release and the guidance really that negative? Does the release fracture the investment case for the company? Did it reveal some existential issues in the business model? My answer to all of those questions is a flat no! I don’t think it’s confirmation bias, but some may disagree. I simply think it is my willingness to look at a half full glass and view the water level in context.
Before discussing why I think the market has this one wrong, at least at this time, here are a few salient highlights in the release and the guidance. Before starting the review, I want to note that dissecting Affirm’s numbers can be a bit of a fraught process due to the many different buckets of revenues. In turn, these different buckets of revenue have differing impacts on other cost metrics, so just simply looking at the revenue growth may be misleading in determining just how the company’s business is actually performing.
Overall, the gross merchandise value processed through the Affirm platform rose by 77%. GMV rose by 14% sequentially. GMV was at the top end of the previously forecast levels. Revenue growth was 39%. Revenues of $364 million were $9 million greater than the top of the range that had been forecast. The other revenue related KPI’s all showed very strong performance. The growth in revenue was limited because of a change in mix toward the split-pay offering, as well as by rapidly ramping volumes from Amazon. The company’s revenue less transaction cost metric rose by 25%. I find it more helpful to make an adjustment for the year earlier release of valuation allowances. Adjusting for that, revenue less transaction cost rose 48%. Revenue less transaction cost at $184 million compared to a prior estimate of $165 million.
Somehow overlooked in the rush to sell were two credit related metrics. The provision for credit losses as a percent of GMV fell by 4bps to 1.65%. Shocking! The company’s allowance for credit losses also fell sequentially from about $159 million to about $155 million, despite an increase of about 8% in the loans held for investment sequentially. That credit overperformance was one of the reasons the company’s revenue less transaction cost, after adjusting for the release of valuation reserves in the prior year, grew so strongly. The company sold another $372 million of its most recent securitization trust and overall, it added $1.6 billion in net new funding capacity. The platform portfolio as a percentage of funding capacity fell to 67%, a multi-year low. Also shocking!
I will discuss the income statement in more detail later in this article, but certainly, the company was executing well, and most metrics were better than had been forecast for Q4.
How can this be happening – Aren’t all BN/PL offerings the same?
I am an information technology analyst by trade. So, by definition, I look at technology. Affirm’s technology is simply more comprehensive and focused than the other offerings in the space. It uses AI and machine learning to set credit guard rails on a much more comprehensive basis than other BN/PL offerings. I am not going to argue here about whether or not we are in a recession. The statistics are quite contradictory and vary from one day to the other. But Affirm has far more ability to control the credit spigot than its competitors.
Ramsey El-Assal — Barclays — Analyst
Hi, thanks for taking my questions this afternoon. I wanted to first ask about the July and August delinquencies. Should we think about an ongoing increase as we move forward sort of a similar magnitude this year? Or can you adjust your credit box, as you kind of mentioned, to sort of engineer more of a plateau there? I guess, an easier way to ask the question is what provisions and losses are baked into the full year guide? Maybe that’s the way I should have characterized it.
Max Levchin — Founder and Chief Executive Officer
Thanks for the question, and I’ll start and Michael can help quantify it. So probably the most important headline is that we are in full control. You should start seeing what we mean by that relatively quickly. One good metric or [Inaudible] anecdote to offer, so we have been taking a fairly conservative posture, as you’ve probably heard on the call, or in the prerecorded part of the call, we have been keeping an extremely careful eye on the credit performance.
All the while, our approval rates have actually gone up. So what we’ve been doing in the background — and not a lot of, it sounds like we’ve opened up significantly. I think the three points of incredible approvals have been added. What that means though is that we’ve been optimizing credit very, very actively.
This implies things like tightening in durations, asking for a more down payment, in some cases, asking for incremental income information. So yes, I don’t think you should expect us to increase our provision. In fact, we intend to, if anything, be quite conservative. I know Michael want to quantify for us.
Michael Linford — Chief Financial Officer
No. Just look, I think what you’re seeing very recently in terms of the sequential build is what we consider to be a pretty normal seasonal pattern. That seasonal pattern should begin to abate and go down. As you know, there’s two things to think about.
There’s the numerator and the denominator. The one thing to keep in mind is that, obviously, is the base that you divide it by, both in terms of the impact that we have on total term lengths, as well as what we have, just in terms of the actual change in the total portfolio. We’ll change the measure that we report publicly, but when we look at the business and think about the state of credit, we feel very optimistic that we have it well in hand. And the ultimate proof is how that shows up in our confidence around our margins in the business, which we continue to believe are quite strong and on the higher end of our long-term range that we’ve given everybody.
We constantly monitor the credit performance of our portfolio, as well as the broader environment. Given inflationary pressures, we began to see the signs of stress during the quarter within certain low credit segment consumers. This stress without mitigation would flow through to charge-offs. However, the inherent advantages of our underwriting every application at the transaction level and the high turnover nature of our book provides natural agility.
Accordingly, we ever so subtly turned our dials and gave up a couple of points of growth this past quarter through small optimizations, and we still grew GMV by 77%. When we say we have the ability to manage credit outcomes, this is exactly what we mean. Our delinquency levels are healthy for our business, and we have demonstrated our ability to grow while controlling them. We’ve said it before and we’ll say it again.
We are different from our competitors who had to dramatically slow their growth rates because this is the only lever they have for managing risk. We are confident that these differences will only become more apparent over time.
I think many investors and more than a few commentators are simply ignoring the reality of what is happening. They focus on data available with regards to delinquencies of the securitization trusts on a monthly basis, and simply don’t take account of the various factors animating some of those specifics. Affirm is a company built on technology. It uses AI and machine learning at a high level to underwrite credit to potential borrowers. Its offers are very specific as to merchandise type, and by the credit qualifications of borrowers related to merchandise type. And the offers it makes to potential borrowers are also individually tailored.
Because of Affirm’s technology, it can offer its merchant partners a variety of much more flexible options than competitive BN/PL services. Affirm’s Adaptive Checkout allows merchants to offer their customers more choices in terms of payment options, payment lengths and down payment requirements. Affirm partners can offer low and zero per cent promotions on a product by product basis, and can do so on their Affirm consoles. I believe that Woo Commerce recently chose to extend its partnership with Affirm because of the adaptive checkout technology.
Affirm’s results have been more resilient to macro conditions than most of its competitors for one basic reason. It has better technology. It is this technology that has fostered the partnerships the company has made with many high profile merchants. It is this technology that has encouraged institutional credit investors to increase their commitment to the platform despite macro headwinds. And it is this technology that has allowed it to demonstrate decent credit performance despite concerns about defaults.
What about guidance – wasn’t it pretty bad?
These days everything has to be carefully considered in context. Was the guidance bad? This is where skills of considering half-full glasses come in handy. The specifics of the guidance that the company provided are as follows: GMV growth of between 32%-42% for the year reaching $20.5 billion-$22 billion, revenue growth of 20%-28%, revenues less transaction costs of $760-$810 million or growth of about 20%. The company is expecting a non-GAAP operating loss for the year of about $85 million, compared to this year’s non-GAAP loss of $78 million. The company reaffirmed its projection that it will reach non-GAAP operating income at the end of the fiscal year. This implies a very significant ramp over the course of the year in terms of profitability and a noticeable ramp as well in terms of GMV. Q1 GMV was forecast to show no sequential increase; its estimated level of $4.2 billion-$4.4 billion compares to the $4.4 billion of GMV reported in the company’s fiscal Q4. Given the most recent rate of GMV growth from Affirm’s two largest partners, i.e. Walmart (WMT) and Amazon, which was 27% last quarter, this is a very conservative forecast; it would not be terribly surprising, based on the historical experience of this company with regards to guidance, the strong momentum with key partners and specific verticals, as well as the comments by the CFO, if GMV for the quarter were significantly greater than had been forecast.
I think that it is important to present facts both about delinquencies and about the construction of Affirm’s forecast that produced such consternation and share price reaction. I think that there are probably some subscribers and readers on Seeking Alpha who think I am a perma bull, or a perma bull on this company. I did, after all, write an article on SA in May praising the company and outlining its opportunities. That said, Affirm is not the only company which has reacted to the macro environment by hedging its guidance. Its business is based on lending to consumers, and most of the loans it makes are being transacted by on-line merchants. The conventional wisdom has been that those factors will make it difficult for a company such as Affirm to continue its strong growth.
Rather have me characterize the company’s thinking both with regards to its outlook over the next year, and with regards to delinquencies, here are the answers on both points. The first relates to the issues of macro headwinds and Affirm’s growth projections.
Okay. And then I mean, you sound decidedly more conservative and may be concerned about the macro and the consumer on this call relative to maybe previous calls, rightfully so. But how do we think about how big maybe that cohort is when you’re talking about lower credit quality, seeing signs of stress? Is there any way you can size that for us or just give us some context about what that looks like inside of your overall portfolio? Thank you.
Yes. The answer that we’ve been giving folks up until this quarter is that we saw “no signs of stress” and that was something that was the first quarter we saw any signs. I think what you saw, though, in the quarter was all of our tools to manage that on full display. The reality is we dissolved the stress and we began to have to react to it.
So I don’t know that we’re making a statement about things into the future beyond that. What we saw today is extremely manageable. And that’s just not the case for other lenders out there right now. In these credit segments, we’re trying to differentiate us is that we actually have the levers to control it and we did. And we continue to feel very good about being able to do that into the future. The statement around macro environment really should be heard as uncertainty.
I would politely tell anybody who thinks they can predict where the economy is going to be in 10 months or 11 months, and I think that gives us reason to be prudent in how we operate the business, given the lead that we’ve built, where we have the ability to be very careful and thoughtful about how we run the business.
And it doesn’t show up in, as Max said, doesn’t show up enough throttling approval rate substantially. It shows up maybe in the timing and type of products that we want to launch and being careful about introducing a lot of net new because we don’t feel like we need to right now. We can be very careful and thoughtful about the state of the consumer and play with the lead that we have right now.
The CFO is basically presenting the view that no one really knows how the economic scenario plays out over the next year, and thus, it is prudent and reasonable to present a view that is biased toward a less robust forecast. I think using a conservative forecast at this time is reasonable, and doesn’t suggest that the investment case for Affirm has been vitiated.
There are many other companies that I follow, or are in the news indicating that they have seen macro headwinds, and are thus reducing their growth estimates. Just the other day, Smartsheet (SMAR) which is a holding of mine, reported results for its quarter that ended 7/31. While the results of that quarter were quite strong, and actually were well above expectations, management noted a distinct pattern of deals getting more scrutiny with some deals downsized. It wound up, based on the demand signals it has been seeing, reducing its forecast for the balance of the year for the second time in two quarters. Most investors, and this holder, felt it was the right call for the company to make, and the shares rose by more than 10% in the day after the earnings release. Of course the valuation of Smartsheet shares is very compressed. But my point here isn’t to extol the virtues of Smartsheet as an investment, but simply to note how tech investors viewed similar guidance for two different companies. Of course, not all, or even most companies reducing guidance will see their shares rally. MongoDB (MDB), which reported last week as well, fell 30% because of cautionary commentary regarding usage as well as commentary regarding ramping opex. MDB had been valued at exceptional levels prior to its recent share price implosion – it still is far from cheap on an EV/S basis, and it doesn’t generate cash flow.
In considering the investment merits of Affirm, it is necessary to consider the details of its credit profile. Given Affirm’s business focus, it is hardly surprising that many investors and analysts are fearful that its business will turn into a credit sink, with rising defaults wiping out the company’s viability. The fear seems dramatically overblown, but the facts are seemingly not be evaluated by investors.
Thank you. I wanted to just ask a clarifying question on the rising delinquencies. I mean, it seems like they’re kind of, at least in the last month or six weeks or a little outside of where you’ve historically targeted. Are you saying that through the incremental changes in the way that you’re managing that, we should expect those to come back towards that 2%? Or what’s kind of the right range for us to think about where those should be at? And are the – and I guess along with that, are there adjustments you need to be making to your provisioning? And then I have a follow-up question on funding.
Yes. So let me start with the second question first. Our allowance that we have on the balance sheet, which determines the provision and the income statement is that for the third quarter declined. So we have – I can’t find any other words to describe how comfortable we are with the current state of credit other than we provided for a full expectation of credit losses at the time of origination, and that outlook has been improving for the third consecutive quarter. So we feel very strong about the state of the portfolio.
The delinquency data that we show publicly is the portion of the total platform portfolio that’s 30 days delinquent or more. And as I was probably mumbling through a little bit earlier, there’s a numerator and denominator effect there. And it’s a little bit difficult for us to want to be prescriptive on where that number needs to be.
Obviously, we have a guardrail. We’re way away from the guardrail. The guardrail, as we talked about earlier this year, is many points above anything that we’ve ever operated the business at. The real thing we would like to do is make sure that the unit economics or revenue less transaction costs are still printing at really high levels with the provisions that we are – we would need to be taking.
And those are the numbers that we feel really, really strong about. And on top of all that, we are hitting the seasonal peak for delinquencies and therefore would expect the seasonality trend to work into our favor from here.
What to make of this discussion? My takeaway is that credit defaults are not an existential problem at this point, and seem unlikely to become so even during the likely economic downturn. The analyst who asked the question, James Faucette of Morgan Stanley, reaffirmed his buy rating on the shares and has an $80 price target on the shares. Another analyst, Vincent Caintic of Stephens, claimed that “credit deteriorated further” with a rise in delinquencies and further acceleration through the on-going quarter. I must confess I find that statement a bit hard to reconcile with the comment of the CFO and the actual results, and the current forecast, but that difference in perception is what makes for the opportunity. Amongst other analysts, one provided a $50 price target, and another a $40 price target. With the share just above $22 as of the close on Friday, September 2, 2022, the specifics of the price target don’t really matter that much. If the investment thesis is valid, eventually the valuation will reflect that, and it is hard to gainsay that the present valuation doesn’t really allow for even a reasonable potential for the investment thesis to play out.
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.