The Afterpay Ltd (ASX: APT) share price has been going nuts in 2020. In just six months, the share price of the buy now, pay later (BNPL) operator has risen by a staggering 120%. Afterpay now lords over a market capitalisation of more than $18 billion.
It's an eye-popping increase and a reflection of the rapid revenue growth the company is chalking up. Investors are expecting big things and, as such, the Afterpay share price is hot.
But Afterpay does not operate in a vacuum. In a market economy, high returns attract competition like honey attracts bears and eventually the high returns can get competed away.
The BNPL sector is crawling with ASX listed competitors including Splitit Ltd (ASX: SPT), Zip Co Ltd (ASX: Z1P), Openpay Group Ltd (ASX: OPY) and Sezzle Inc (ASX: SZL). And let's not forget FlexiGroup Limited (ASX: FXL) which is desperately throwing the kitchen sink at the BNPL space with its products 'humm', 'bundll' and OXIPAY.
Does Afterpay have a competitive advantage?
So it's worth asking; in such a competitive space, does Afterpay really have a sustainable competitive advantage? Without this economic moat, competitors will start to erode Afterpay's market share. If that is likely to happen, we'll want to ensure we pay less for the company's shares today.
One of the reasons Afterpay has attracted so much attention is because it looks like it has the makings of a company with a growing network moat. That is, the more places you can use Afterpay, the more valuable it becomes. This helps to explain the rapid roll-out of Afterpay to as many big-name retailers as possible.
The appeal of network-based moats is that they can result in natural monopolies and oligopolies over time. Facebook, eBay and Airbnb are examples of this 'winner takes all' type domination.
It is a juicy prospect. However, most powerful network moats also need to have high switching costs to keep users around. For example, a new auction website competing with eBay will have fewer buyers and sellers, making it hard for me to get a great price for what I'm selling.
Can the Afterpay share price continue rising?
What does Afterpay have to protect itself from the onslaught of competition, to trap both retailers and consumers on its island? You might think all that data is worth something. But as respected venture capital firm Andreessen Horowitz notes, data itself offers little additional protection to network moats.
Perhaps Afterpay can use its scale to lower the costs to merchants and therefore prevent competitors from stealing market share. But I feel like merchant fees are likely to be competed down over time anyway. The BNPL service is essentially a commodity offering and there is little that will stop competitors undercutting each other to win share.
Foolish takeaway
I think it could be argued that Afterpay's rapid growth has formed a small, network-based moat. But moats aren't worth much to us unless they are sustainable. My concern is that aggressive competition will compete away Afterpay's advantage over time and I would be careful to factor that in to the price I pay for its shares today.
