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By Pieter-Jan De Meyer and Eros Portillo Spetaliere,
Buy-side Equity Analysts at DPAM
In the last two years, a lot has happened in the payment ecosystem. As a result of the COVID pandemic, we have seen a significant adoption of contactless payments and an important move towards omni-channel commerce, both driven by the COVID-19 pandemic. We also saw the impressive rise of a new kid on the block: ‘Buy Now – Pay Later’, or BNPL.
WHAT IS BUY NOW PAY LATER (BNPL)?
As the name suggests, BNPL is a payment method that allows the consumer to purchase something and to pay for it later, in various instalments. There are two general categories of BNPLs: the first category, and the most popular of the two, focuses on instalments repaid over a relatively short period of time (a few weeks) without interest costs. The more common forms of instalments in this category are the Pay in 4 and Pay in 3. Its main players here are Klarna and Afterpay. The second category offers instalments repaid over a longer duration (a few months). This second category is very similar to the traditional credit business and customers do incur interest charges. The main players in this space are Klarna and Affirm.
Compared to credit cards, the main difference of BNPL is the absence of interest costs on their deferred payment. In addition, customers will not have their credit score impacted by what remains a short-term loan. Indeed, BNPL companies usually do not perform credit checks with credit bureaus to authorise the financing. Instead of using formal credit checks, BNPL companies manage their credit risk by making the user earn the ability to use the platform to a greater extent. In fact, the consumer is first granted a credit authorisation for a small amount. This authorisation can increase at a later stage if he repays the instalments in time. This light approach on credit checks is facilitated by the lax regulation that currently covers the industry.
‘CREDIT WITHOUT INTEREST’- WHERE IS THE CATCH ?
If you are wondering how BNPL businesses manage to cover their expenses without any interests charges, the answer is simple: Merchants pay a direct fee to the BNPL provider to accept this payment method at their point of sale (like the merchant discount rate paid in a traditional card payment). With BNPL, that fee ranges between 2% and 6%, somewhat higher than the fee the merchant would pay to accept a credit card or debit card payment. Those fees represent 70-85% of the revenue of most traditional BNPL companies. For the merchant, it is still an interesting proposition despite the higher fees, as consumers using BNPL as their checkout option tend to purchase larger baskets. The conversion rate of BNPL transactions is also higher than with traditional payment methods. This is crucial, as, in the e-commerce space, conversion rate is a key driver of success for merchants. There are also indications of more repeat purchases, increased traffic and lower customer acquisition costs. Merchants tend to use BNPL platforms as an effective promotion tool to advertise their product suite.
On top of collecting a fee from the merchant, BNPL companies also charge late fees to consumers who do not repay their instalments in time. This represents around 10% of the revenue of Afterpay and is another tool used by BNPL companies to manage their credit risk and credit loss. Finally, BNPL companies earn some extra fees by referring customers directly from their platforms to the web-shop of the merchants, leveraging the strong engagement of their userbase.
THE KEY TO BNPL’S SUCCESS
BNPL is a very fast-growing checkout category, moving from 1.6% of the global e-commerce transactions in 2019 to 2.4% in 2020 according to the Global Payments report from Worldpay. By 2024, it is expected to practically double to 4.2% of global e-commerce volumes, which implies a CAGR of >30% compared to 2020.
In some areas, it is worth noting that BNPL is already much larger than 2.4% of e-commerce volumes. This is the case in Australia, Sweden, and Germany, where BNPL respectively represents 10%, 23% and 19% of e-commerce checkouts. Sweden is the home country of Klarna, while Australia is the home domicile of Afterpay, which could explain the success of BNPL. Meanwhile, Germany has historically been more reluctant to use credit cards in general. These countries show that BNPL could cover a large proportion of online checkouts in due time, supporting the growth prospects of the market.
In the offline world, BNPL also exists as a payment method, but currently only covers a minor portion of checkouts today. Still, despite its strong growth, BNPL only represents 0.2% of total payment volumes and therefore remains a niche segment in the massive payment market (USD 37 trillion in 2020).
If we look at the strong value proposition that BNPL offers to customers, the current traction of these platforms does not come as a major surprise. In fact, on top of no interest costs, BNPL is a very simple and transparent solution compared to credit cards, with no hidden fees (a recurrent complaint about credit card loans).
Judging by the value the market ascribes to Afterpay (at USD 26.6 billion for USD 506 million in net revenue – FY2021) and the last valuation round of Klarna (at USD 45.6 billion in June 2021), the market participants clearly believe that this industry will continue to grow strongly and profitably in the future.
WHAT IS THE IMPACT OF BNPL ON THE ESTABLISHED PAYMENT INDUSTRY?
BNPL is often seen as an online alternative to card payments. The bulk of BNPL transactions are still going over traditional card rails though. It just shifts online volumes from credit to debit cards, which means that the impact of BNPL on global networks (e.g. VISA & MasterCard) and merchant acquirers (e.g. Worldline, WorldPay, etc.) is limited.
In this context, it is useful to split transaction flows. Upstream payments are those made by BNPL providers to merchants. Most of these BNPL providers have more profound, direct integrations with merchants to retrieve Stock Keeping Units (SKUs) / product data and shipping details for example. This direct connection enables them to pay merchants instantly over Automated Clearing House (ACH) rails. Merchant acquirers and networks seem to be omitted by BNPL providers in this scenario. If BNPL providers do not have a direct connection, a one-time virtual card is issued to pay the merchant. In this case the card networks and merchant acquirers earn similar card economics.
Downstream payments are the payments done by customers to the BNPL provider. The customer decides how to repay its instalments. If the customer decides to link its debit card (which is the case for 90% of the customers) or credit card to the BNPL platform, networks and merchant acquirers earn similar card economics. They are not by-passed. Today, there is no evidence that BNPL providers are successfully convincing or effectively enabling customers to link their bank accounts directly to the BNPL platform. If BNPL players strengthen their ability to link bank accounts (~open banking capabilities) a closed loop system could arise in the long run through direct debit mandates.
Wallet players PayPal and Square clearly spotted the potential of BNPL in the e-commerce space to further develop their two-sided networks. Square acquired AfterPay for USD 29 billion to increase their online exposure, international footprint and to diversify towards larger merchants. Again, we do not see substantial closed-loop threats for the payment ecosystem. Square remains skewed towards the US and processes only 1% of total commerce (Point of Sales and e-commerce). Their Cash App is mainly used for Peer-to-Peer transactions rather than to pay merchants. PayPal launched their own BNPL offering and acquired the Japanese BNPL player Paidy for USD 2.7 billion. These offerings aim to add value to PayPal’s wallet users while strengthening their value proposition towards merchants at the same time. Most PayPal users (60%) link wallet accounts to credit and debit cards. Others link their bank account or pay transactions through stored balances. PayPal is also not actively closing any loop yet. They still go for the ‘hand-in-hand’ or partner approach within the broad and dynamic payment ecosystem. Still, PayPal could become more aggressive in the long run by pushing people to non-card funding sources or by successfully rolling out direct deposits. The latter assumes that wallet users allow PayPal to automatically move a certain percentage of their salary into their PayPal wallet account.
In conclusion, BNPL has clearly become a checkout option within the online payment space that we can no longer ignore. It brings a very interesting and disruptive approach to the short-term consumer credit space. In due time, BNPL could (at least in theory) be a negative for the established payment ecosystem if they decide to go ‘closed-loop’. However, for the time being, they work hand-in-hand with the networks and merchant acquirers to grow the market and therefore represent a total-available-market increase more than a threat.