Good afternoon,

ASX200 had another pretty flattish week, adding 0.48% before open on Monday. Technology (Appen +8.7%) and Energy (Whitehaven Coal +5%, Woodside +3.5%) stocks outperformed whilst Materials (Syrah -12%, Sims Metals -12%, Orocobre -9.5%) lagged. Crown (CWN, +10.73%) the best performer for the week after it leaked that it had been in takeover talks with Wynn Resorts (WYNN-US, -0.74%).

Zip Co (Z1P)

Zip continues to make new high’s; it’s $2.48 (high $2.65 today) as I type this, up from $1 at the start of the year. Everyone keeps asking me why?

Long term shareholders/followers of this note will know that Z1P’s Q1 every year is its strongest (seasonally) while revenue and receivables have been growing 20-30% quarter-on-quarter for the last couple of years. Nothing has changed except scale.

Z1P is now doing $20m per quarter in revenue while it was doing only $4.6m back in April 2017. Currently, it’s still managing to grow at >20% qoq. As long as it’s growing at this rate/expected to grow at this rate, the share price will keep going up.

However, I’ve mentioned it in this note a couple of times before, “revenue yield” is an issue in my opinion. For the first time last week, I saw someone else raise this issue.

Back in the pre-IPO days, Larry and Peter were targeting 25% revenue yields. This fell to 20% as competition crept in a bit faster than they or I initially thought and their first mover advantage faded. The business had to pivot and compete with Afterpay; they introduced the ZipPay product which was higher volume/lower revenue than the original Zipmoney product designed to put Flexigroup (and others) out of business.

Z1P did an excellent job with this pivot, quickly gaining share and differentiating their offering – quality, responsible credit, fast and convenient (I’d argue that Afterpay still only offers the ‘fast and convenient’ bit.)

ZIP is currently doing sub-18% revenue yields. It’s already increased monthly account keeping fees from $5 to $6 and optimised the credit decision-engine to maximise revenue for their preferred level of bad debts.  This decision engine will continue drive further efficiencies (more data over time, better decisions), however I don’t know at what rate of change. Will it be fast enough to satisfy the market’s high expectations? Can Z1P pull another lever to drive up yields to over 20%? I don’t know.

Larry & Peter are pretty smart guys, two of the best early-stage management teams I’ve ever seen, but with all the competitors in the market place and customers mostly agnostic to brand (I think most people would at least try a competitor if the offer were strong enough), I don’t know how Z1P sells higher merchant fees in the high volume/ZipPay space. Perhaps with the recent signing of Bunnings, Super Cheap, Officeworks and Chemist Warehouse, Z1P will be able to increase the average ticket size. But I can’t imagine that these large merchants haven’t been able to negotiate sub-4% merchant fees (probably more like c.2.8-3.4%) which means while adding to volumes, it won’t increase revenue yields.

The only way I see them getting over 20% is to use Z1P’s two relative advantages:

  1. They can lend large amounts where others can’t – and they can lend on medical procedures (laser eye surgery, dental, plastic surgery etc.) as well as holidays, flights and travel. These merchants will pay way over 4% for consumer finance, and the customers are happy to pay larger monthlies or up-front origination fees as the loan balance and interest-free period is more substantial.
  2. Pocketbook – if Larry pulls this off, I’ll be super impressed as it shows insane foresight and is borderline visionary. If Z1P can integrate the budgeting app into their BNPL offering in such a way that you can pay a fixed monthly rate for the vast majority of your purchases (i.e. ‘expenses-as-a-service’) smoothing out your cash flow and maximising your interest-free periods, automatically, and providing cool feedback to the customer… Z1P will become THE way to manage your money and pay. They’ll be able to justify higher prices on both sides of their business as they will be able to show better conversion for the merchant and deliver more value to the customer.

Can Z1P achieve these one or both of these goals? Probably. I’ve got no reason to doubt them.

What’s it worth?  
Look, “I don’t know” is the actual answer. The best I can do is going to be a thumb-suck answer based on what Afterpay is trading. So if you say that these are “technology” businesses and we price them on revenue, then 20x revenue is the lowest ratio Afterpay has traded on recently.  Z1P is going to $80m in revenue, so it’s worth $1.6bn. That’s about $4.20 per share.

I don’t like that valuation though because it ignores ‘quality’ – somebody smart once said to me “there are endless opportunities for profitless revenue growth.” 

So let’s work on loan book implied profits. Loan book sits at $490m, let’s say it grows 100% this year and next year its at $1bn.
Revenue (18%) = $180m in revenue
BDD provision = 4% = $40m
Interest costs = 8% = $80m
Operating costs = $50m
Total = $170m  or Profit before tax of $10m.
But that triples to $30m if they can get Revenue Yields up to 20%…

Klarna (like Z1P in Europe) has 100k merchants (Z1P has 12,661) and did US$588m in revenue in 2018; it’s estimated value is US$2.5bn (private company). On the same sort of ratio, Z1P in 2020 is worth $750m-$900m or $2.00-$2.40…. ironically, almost its exact share price today.

Affirm (US peer) has transaction volume of over $2bn per annum (Z1P running at $1.2bn) and is valued at $2.9bn (reportedly, also private).

Afterpay does $2.3bn in transaction volume and is worth AU$6bn… Affirm should list in Australia and double their value! 

Stocks stock stocks stocks stocks

Last week I promised I’d get down and dirty on a few stocks, so I better hop to it.

Gage Roads (GRB)
I love the management of this company; I think they do a fabulous job. The company raised $8m at a 2% discount to market last week to finance some new canning equipment for their Palmyra facility.  They ran a trial of can’s over summer, and it did well, so they’re increasing their investment (see what I mean, just sensible, good strategy) – can sales are growing 14% vs bottles at 1.3%, craft cans up 11% with 134% increase in market share. Cans have better margins.

The company has been investing in fixed assets this year, announcing their first microbrewery/taproom site in Sydney (branding) and now a bit more manufacturing capability with some plant and equipment. Clearly still on track with their medium-term targets.

  • Independent retail sales up 55% YTD,
  • on-premise sales p 62% YTD,
  • branded sales as a percentage of total production up 64%, margins up to 66% (targeting 70%) and
  • $2.1m in EBITDA booked in H1’2019, up 59%

Share price is still in that 9.5c-10.5c range, though as I’ve said before, as this thing scales up, it gets more and more attractive as a takeover target.

Shareholders can sleep easy at night knowing there is weekly product testing completed at Seneca every Friday afternoon to ensure quality remains high!

Imdex (IMD)
This little mining services business has been ticking along very nicely with 20% revenue growth, 25% profit growth and solid cash flow.  However, the share price has fallen from $1.40 to $0.95 on the back of Fidelity (a shareholder) losing their mandate with Australian Super and having to sell down the portfolio. I don’t know when the selling stops, but I do know that even on modest industry growth assumptions IMD should do >$50m in EBITDA which puts it on c.6x EV/EBITDA. This thing has traded on 7-11x over the past five years and at these prices would be a juicy acquisition target with strong IP and a nice suite of tech. Say it trades on 8x 52c that’s $416m, add cash of say $20m = $436m. Market cap is currently $360m… 20% too cheap on that basis.

National Australia Bank (NAB)
Look, the banks are probably stuffed because the economy is probably stuffed. But the market knows this, and whilst it might not be “the darkest night before the dawn” the lowest analyst earnings estimate in the market is $2.11, FY20. That put’s it at 11.75x earnings. That same analyst (Deutsche) thinks it’s worth $29 or 13.75x. I’m less constructive.
NAB has done 12.5% ROE’s throughout history.  It’s doing 11.3% now and let’s say that 10.5% is our bear case (GFC was 5.5%). Using the standard ROE vs P/B ratio line, we can plot what NAB (or any other bank is worth).

As you can see, CBA, BOQ and BEN have already report H1 numbers, all of their ROE’s came in lower (orange dots) than their annual reports (blue dots). I’d expect ROE’s to fall for ANZ, WBC and NAB and as such, their dots to move left.

It appears that ANZ and WBC share prices are already trading at Price to Book ratio’s that assume a lower ROE; however NAB has yet to fall. If NAB’s ROE were to drop to 10.5%, I’d expect it to trade on a P/B ratio of 1.3x trailing or c.$23.50 per share. At these prices, with adequate positivity around the outlook for loan growth, business confidence etc., I’d be having a look at the banks.

That being said, this is only 5% below the current share price, so for the long term, income-focused investors, you’d have to consider whether stuffing around for 5% was worth your time and effort + opportunity cost of earning 3% in a term deposit vs 7.5% fully franked in a bank share?

Movers & Shakers

Crown (CWN) as you probably saw in the news, got a takeover offer from Wynn Resorts (WYNN-US). This deal probably will get done eventually even though Wynn has apparently walked away. Bavura (BVS, +6.5%) utilising it’s high share price to buy GBST Holdings (GBT +25%) – the board haven’t recommended the takeover offer yet.

A few miners, Bellamy’s and a couple of financials (BOQ, PDL) who are battling make up the big losers this week. Bank of Queensland (BOQ) result was a bit nasty. Not much to like about it. It’s cheap, and you’d think the outlook is about as bleak as it gets, but who knows. I still think there’s a merger that these guys can do to make them more competitive. Suncorp (SUN) could surely demerge their bank, BOQ could buy it, and everyone would win?

Have a good week,