We’ve rated Zip Co (Z1P) a Hold and hope that subscribers who took our advice to buy at 66 cents in May 2017 have held on. They would be sitting on a 1539% return. If they invested $10,000 it would now be worth $164k. Even if they hopped back on board when we said to last year in September when it purchased the US business Quadpay, they’d be almost doubling their money. What to do now is always the question.

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What is Zip Co (Z1P)?

Zip Co (Z1P) is a Buy Now Pay Later (BNPL) provider operating in Australia. Its “zip pay” product is similar to a credit card, being a digital wallet where a customer has approval to make purchases up to $1,000 at merchants. The customer is not charged interest but is liable for late fees. Merchants pay Zip Co (Z1P) a commission. Zip Co (Z1P) has another product “zip money”, which provides credit above $1,000, on which interest can be payable.

What has excited investors?

The COVID-19 lockdowns have accelerated the shift to online and the BNPL sector is a big beneficiary. NAB’s Online Retail Sales Index for May was up 50% from a year ago; well up on the 6% increase in total retail sales. But remember, the bigger you get the harder it is to grow. Could some BNPL providers become a victim of their success?

For Small Caps, the big driver for earnings growth is perennially offshore expansion. It is an understatement to say that Afterpay (APT) benefits from this. Its market valuation is over $43bn, which is bigger than Telstra’s $37.5bn. What has excited investors in Zip Co (Z1P) is recent news that it’s been on a US roadshow drumming up support to expand its operations into the world’s biggest market and a potential US listing.

What are the risks?

Deteriorating Credit Conditions

We expect bad debts to rise, especially when they remove JobKeeper in the next two months and lower JobSeeker, the unemployment benefit. Afterpay and Zip Co (Z1P) are essentially unsecured lenders to low credit risk borrowers. Their business models have not been tested through a full credit cycle. While fiscal and monetary policy levers will continue to be pulled we expect economic conditions to become tougher and bad debts to rise.

Lower Consumer Spending

In a weaker economic environment, we expect consumer spending to slow, particularly discretionary consumer spending. This puts their high growth rates at risk. The BNPL sector provides very short-term credit; in order to grow it has to write new loans as well as replace repaid loans.

Greater Regulation

Regulators have not kept pace with the growth of BNPL, which are currently not technically lenders as they do not charge interest. It’s a new area of credit for regulators to get their heads around. The sector is getting increasing scrutiny from regulatory bodies such as ASIC. Greater regulatory requirements will impose costs and may require changes to business models and slow growth.

Increasing Competition

The growth of the sector and low barriers to entry is seeing competition increase; the e-commerce portal Shopify announced plans to launch a product. However, established players such as Afterpay are building a network effect between retailers and customers.

Blue Sky Valuations

The market is pricing in huge expectations, leaving little room for missteps, and is largely ignoring risks.

The Australian finance sector remains a growing market with increasingly attractive dividends. Learn more on how to time the market using greater insights to make a return.

What should investors do now?

We are becoming more enthusiastic about Zip Co following product enhancements and now significant US growth potential from its US BNPL business QuadPay, purchased last year and undertook a $150m raising late last year in order to promote its growth. We hopped on board the Z1P bandwagon again after the announcement and the chickens are well and truly coming home to roost. We’re holding on and reassessing Zip’s value but for now, it’s definitely a case of hold on and enjoy the ride.

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