With Afterpay Ltd (ASX: APT) readying itself to merge with Square Inc (NYSE: SQ) and (mostly) leave the ASX, Zip Co Ltd (ASX: Z1P) is set to become the Aussie market's largest buy now, pay later (BNPL) share.
But is it a buy? The Motley Fool Australia analyst Kate Lee joined our chief investment officer Scott Phillips to weigh up the sector's second-largest company.
Those interested in the entirety of the pair's conversation can find The Motley Fool Australia YouTube channel here. Otherwise, we've laid out the highlights below.
Right now, the Zip share price is trading at $5.36.
A quick note before we start: Lee and Phillips discussed the ins and outs of Zip a few months ago. Thus, some of the specifics may have changed in the time since but the fundamentals remain valid.
Breaking down the good and the bad of Zip shares
According to Lee, Zip shares have some definite strengths.
Zip is the ASX's second-largest BNPL provider by market capitalisation. With a valuation of around $3.1 billion, Zip is around 10 times smaller than Afterpay.
However, come the end of financial year 2021, Zip recorded $403.2 million of revenue. Meanwhile, Afterpay saw $978.9 million of income on a constant currency basis.
Additionally, as Lee points out, Zip's results for the fourth quarter of financial year 2021 saw its revenue boosted by 104% on that of the prior corresponding period. She commented:
In a way, and of course from a small base, they are actually growing faster than Afterpay… Yes, [Zip] is the second best, but surely there's some room to catch up in terms of valuation.
Zip is also branching out into the United States BNPL market. The company acquired QuadPay last year and has recently rebranded it to Zip in the United States.
Lee pointed that only around 1% of transactions in the US use a BNPL service.
For context, the global average is around 3% and, in Australia and the United Kingdom, it's approximately 5%.
It seems the United States BNPL sector has room to grow, and it is growing quickly.
However, Lee isn't entirely bullish on Zip shares. She said:
There are two big elephants in the room, which are: #1, Intensifying competition which is always a bad thing, and #2, regulatory risks.
Lee stated the company might have a tough time expanding into the United States, and further afield, as industry competition is rife:
There are big guys, small guys, some combination of banking and Apple (NASDAQ: AAPL), and there's PayPal (NASDAQ: PYPL), Square – with Afterpay now…
When the sector gets crowded, this means you can't increase your fees as easily because you need to compete… and you probably need to spend more to keep up your pace of growth.
Another shadow that could pounce on Zip is that of regulators, which could increase pressure on the industry. That is, of course, a risk to all BNPL providers.
Finally, as Zip's scale is smaller than some of its competitors, it may not have access to the same scale of information that players such as Afterpay do. Lee noted:
In this technology world, the value of information is very high… this user data [is fed] back to their algorithm or artificial intelligence to analyse, to do a better job of credit risk analysis, which is actually the core quality of [BNPL] providers.
So, maybe that explains why Afterpay's expenses are around 1% of its total transactions. As against Zip's [which is] actually creeping up and is now standing at about 2.2%.
I'm not saying it won't get better… but generally it has the winners in terms of economies of scale, in terms of cash spending.
Lee concludes that, while she sees value in Zip shares, she doesn't personally think it will be a market beater over the long term.
The opinions expressed in this article were as at August 2021 and may change over time.
