Zip Co Ltd (ASX: ZIP) shares have given investors a rough ride over the past year.
After plunging as low as $1.03 last Friday following a disappointing trading update, the buy now, pay later provider has staged something of a recovery.
Its shares are trading around $1.72 on Tuesday, up significantly from last week's low.
However, they remain down approximately 58% over the past 12 months. That's an enormous fall for a company that continues to deliver strong revenue growth.
So, has the market become too pessimistic about Zip's future?
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Why have Zip shares fallen so heavily?
The latest sell-off followed an unexpected fraud incident in Zip's US business.
During the first quarter of FY27, the company identified individuals opening accounts using legitimate credentials to make transactions that subsequently went unpaid.
The incident cost Zip $10.1 million and forced management to introduce additional controls, temporarily slowing customer and transaction growth.
Credit losses also became a concern. Group net bad debts increased from 1.65% of transaction volume a year earlier to 1.97%, approaching the upper end of management's target range.
Meanwhile, cash earnings increased just 3.4% to $65 million, despite total income growing 17%.
I can understand why investors were disappointed. Zip has spent years trying to demonstrate that it can grow profitably, and the latest update raised fresh questions about its ability to control credit losses as it expands.
Why I think the sell-off could be an opportunity
I think the most encouraging part of Zip's announcement was the performance of its underlying US business.
Transaction volumes increased 34.1% in US dollar terms, while revenue grew 32%.
Existing customers are also using the platform more frequently, with transactions per US customer increasing 27%.
That suggests Zip is becoming a more established payment option among its customers. And the disruption from the fraud incident appears to be easing.
US transaction volume growth accelerated to 41% in September, with management reporting continued positive momentum in October.
Excluding the fraud-related expenses, group cash earnings would have increased 19.5% rather than 3.4%.
Management has also reaffirmed its FY27 cash earnings guidance of $340 million, representing 26% annual growth.
I think these figures suggest there's still a healthy business underneath the recent problems. The challenge now is demonstrating that its improved fraud controls can protect profitability without significantly restricting customer growth.
Are Zip shares actually cheap?
I think a buying opportunity has opened up for investors.
At around $1.72, Zip shares trade on a PE ratio of approximately 11.5 times consensus FY27 earnings of 14.9 cents per share.
Looking further ahead, analysts expect earnings to increase to 16.8 cents in FY28 and then 22.4 cents in FY29. That puts the shares on just 7.7 times forecast FY29 earnings.
In other words, analysts expect earnings per share (EPS) to increase by more than 50% between FY27 and FY29, yet the market is placing a relatively modest valuation on those future profits.
I think that's an attractive proposition for a business with Zip's growth opportunities in the US.
Of course, those forecasts assume the company can continue expanding while keeping bad debts and operating expenses under control.
If credit losses remain elevated, earnings could fall short of expectations. But I think the current valuation provides considerable upside potential if management delivers.
Foolish takeaway
At around $1.72, I would be happy buying Zip shares with a long-term view.
The latest trading update exposed some weaknesses that management needs to address, and I expect investor confidence will take time to recover.
But I don't think Zip's growth opportunity has disappeared. If the company can put its fraud problems behind it and deliver the earnings growth analysts are forecasting, today's share price could eventually look like a bargain.
