Affirm Does Have Numerous Special Sauces If You Know Where To Look

May 27, 2022 12:36 AM ETAffirm Holdings, Inc. (AFRM)30 Comments10 Likes
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Bert Hochfeld
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Summary

  • Affirm reported a significant upside to expectations when it released its earnings earlier this month.
  • The company's CEO forecast that the company would consistently achieve non-GAAP profitability in its fiscal '24 year.
  • The major financial metrics the company reported for both growth and profitability continue to show encouraging trends.
  • Affirm's valuation continues to contract as its results are better than expected and its share price has declined.
  • As will be discussed, Affirm, despite being a species of a consumer lending company, has some unique properties that should allow it to thrive even as consumers cut back spending.

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Does Affirm have a secret sauce?

Tuesday, May 24th, has been another day of fear and doubt and pain for those investors remaining in the high-growth IT space. So why write an article now about Affirm (NASDAQ:AFRM), its outlook and its opportunities when investors are clearly making bets outside of high-growth tech.

There seems little doubt that the consumer in the US, particularly, is tapped out, or somewhat wounded because of inflationary pressures that are reducing real incomes and pressuring consumer discretionary spending. I am not the appropriate commentator to review the results of Walmart (WMT), Target (TGT), Kohl's (KSS), Best Buy (BBY) and Under Armour (UAA). I really don't want to try to review the results of Amazon's (AMZN) retail business. But I think the signs of a consumer pullback are visible, and falling real disposable income trends, if they last more than a couple of months, almost inevitably will be correlated with a decline in consumer discretionary spending.

As I wrote this article, Snap (SNAP) announced that its guidance from just a month ago is no longer valid. It said that the problem is that economic conditions have "deteriorated further and faster than anticipated." According to the CEO, the company's advertisers have pulled back from spending on the platform because of the impact of the war in Ukraine, inflation, and supply chain shortages. It is among a list of companies that have suggested that their business is seeing effects from deteriorating macro conditions, although not all companies have seen pullbacks.

I haven't the domain expertise regarding Snapchat or its competition with WhatsApp or TikTok or the many other social media alternatives to comment knowingly here. Not terribly surprisingly, SNAP shares were down by 30% after hours and finished Tuesday down 43%. But investors have taken a look at the statement and have sold many other tech stocks aggressively on Wednesday, even after having some time to reflect on what the SNAP statement might really mean in terms of demand in the space.

It was also reported that new home sales fell sharply last month and are at a rate as low as they were at the height of the Covid-19 pandemic. I don't do economic forecasts - a mercy I suppose. But why the drop in new home sales is surprising given the decrease in affordability is a bit of surprise. Higher interest rates and lower disposable income ought to produce that result. Decreasing the demand for homes and other consumer durables' is needed to reduce excess demand, and thus to cool inflation. I might have thought that this progression was already embedded in valuations, but obviously that has not been the case.

Interestingly, while the share of home builders fell slightly, the shares of most IT vendors, and Affirm in particular fell sharply. I suppose the theory is that the shares of home builders already reflect the discouraging data and outlook for that space - while the shares of IT vendors...well I might have thought their decline was related to growth concerns.

But this is an article about Affirm. Even if Snap's commentary was completely accurate, it might or might not read through to the likely operational performance of Affirm. As mentioned, Affirm shares fell by 15% on Tuesday And they have dropped by 80% since the start of the year, despite reporting quarters well above expectations.

Many payment stocks are also down sharply as a read through from the home sales numbers. From my perspective, which I will try to expound, Affirm's outlook is not correlated either to the outlook for Snap or to home sales. Does the slowdown in retail spending presage difficulties for Affirm's forecast growth? I doubt that is the case, or at least not the case to the extent now reflected in the share price - and whether I doubt it or not, I will quote management on the subject.

I have a harder time in even beginning to discern the logic that goes from new home sales to the outlook for Affirm, although I suppose this is another plank in the thesis of a recession which might impact Affirm. My thesis is that Affirm has a contra-trend business whose share gains in the consumer credit space will overcome the weakening retail environment, and whose credit parameters have been, and will continue to insulate the company from rising consumer defaults.

Affirm, as most readers realize, is a company extending credit to consumers through a buy now/pay later paradigm, and some of its leading partners are Amazon, Target and Walmart as well as Shopify (SHOP), another company that has had its share of disappointing results in the last couple of quarters. While there is no direct analog between Snap and Affirm, the negative commentary from Snap has chilled the market for technology shares, overall, until some investors rethought the correlation.

Affirm shares are about as volatile as any tech name that I follow. The shares have ranged from a low of less than $14 set a few weeks ago, just before the latest earnings release, to a high of $176 when investors were counting the money from a then recently announced deal with Amazon.

The current calendar year is still less than 5 months old. In that time, Affirm shares reacted badly to company guidance that was provided at the end of its fiscal Q2 that ended on 12/31/21. And even after the company, in the wake of a failed sale of asset backed securities, raised in quarterly guidance and went on investor relations offensive, the shares continued their downward trend culminating in the dive under $14 that was seen in the wake of the release of Upstart's (UPST) quarterly earnings. Subsequently, after a quarter that turned out to be well above fears and expectations, and guidance that outlined a path to profitability and cash flow attainment, the shares have rallied, although they are far, far below where they have been.

Some SA authors seem convinced that Affirm's guidance is unduly optimistic, and that the company has been too aggressive in growing market share. Interestingly, company management has presented a diametrically opposed viewpoint about the thesis that it has chased growth barring any expense. This is an age old debate-a movie so to speak, that I have had the occasion to view on different screens and with different endings.

Before discussing the details of Affirm's business and differentiation, I think this quote from the company CFO needs to be considered:

"Credit performance was better than expected across all credit segments. As small optimizations across our Split Pay and large enterprise programs yielded very favorable outcomes, this led to lower allowance rates on new originations across a large percentage of our GMV. Allowance for losses as a percentage of loans held for investment declined for the second consecutive quarter to 6.4%."

That quote was from the May 11th conference. Whatever trends SNAP may have seen with regards to its business haven't spilled over into rising Affirm defaults. For some time now, the negative thesis regarding Affirm is that the company enables borrowing from borrowers with sub-standard credit who are most likely to default and thus cripple the company's business model. It appears to be a logical concern, but the CFO commentary flies in the face of what has been considered to be conventional wisdom.

Also of note, in evaluating the company's business prospects is this comment made by the CFO during a recent bus trip sponsored by the CS brokerage. Again, the reality is far-removed from what I might best describe as hedge fund rumors.

Loan sale pricing and investor demand: Affirm first and foremost sought to clarify that its business had far less floating rate exposure than people believe and is still seeing very healthy investor demand for its loans. The market has a large appetite for quality assets, and Affirm's loans are seeing very high demand as a result, which is supporting overall pricing. By way of example, management detailed a recent conversation they had with an investor that said that they had to discuss pricing given the current market environment, but the discussion was limited to just 10-20bps changes in pricing vs. the far larger rate moves seen in securitization costs. Affirm also has the ability to adjust rates to consumers in response to market interest rate changes, though management indicated that they have not yet begun to raise rates.

So, how can Affirm continue its growth when its business is lending to tapped out consumers whose ability to repay loans seems to be waning? And how can the company continue to outgrow its competitors in a crowded market? And where will it be able to find the funding capacity to facilitate hyper-growth if institutional buyers of asset backed securities pull back from the market?

I don't suggest that these concerns aren't real issues when analyzing Affirm shares; just as I don't intend to suggest that the economy is not facing problems that may cause a recession. But at some level, that is why the shares have fallen to a valuation that is exceptional, especially given the results of the most recent quarter and the latest company commentary even subsequent to the conference call 10 days past.

Affirm, in many ways, is not a straightforward company to analyze. It reports 5 revenue sources on its income statement, and these have different growth rates, and different levels of gross profit. And, to a certain extent, the impact of the IPO on reported stock based compensation, presents another layer of complexity - at least it has, although that should die away as this year progresses.

Further, as this is a company that finances consumer purchases, it has a conspicuously seasonal pattern in its revenues. Finally, the company is still dealing with the millstone of its partnership with Peloton (PTON) although that is obviously going to be far less of a factor as time passes. While I have, on occasion been upbraided for being tedious in my articles, I think failure to specifically account for these complexities will result in drawing inappropriate investment opinions regarding the shares.

For example, this last quarter, the company reported net revenue less transaction cost of $182 million, or 37% growth year on year, and this number was cited by one writer on SA as demonstrating that the company's revenue growth was less than the increase in operating expenses. But the reality is quite a bit different. A year earlier, the company reversed some of its bad debt reserve which shows up as an addition to reported revenue. This reversal was due to the company's actual experience through the pandemic vs. its assumptions regarding credit losses when the pandemic started. And its credit reserve now, is based on a return to more normal credit experience as the CFO has forecast on the last several conference calls.

When adjusting revenue growth to eliminate the impact of changes in the provision for credit losses, which is a far better way of looking at the growth of Affirm's platform, the result is that apples to apples growth was actually 88%. That is obviously far greater than the increase in opex last quarter, and shows a significant leverage at scale that some may not appreciate.

Actually, the growth picture is better than even 88%. Because the company recognizes revenues from a variety of business arrangements, and these business arrangements have different impacts on revenue, take rates and gross margins in a particular period, it can be important to understand which segment is showing the greatest percentage growth. When trying to adjust for that particular perturbation, it appears as though normalized growth pushed close to triple digits last quarter. In fact, lass quarter, revenue less transaction cost reached 4.7% of GMV, well above company targets, and one of the reasons why the company was able to outstrip earnings expectations so significantly.

But considered on an apples to apples basis, the company's "real" revenue growth last quarter was 88%, and of course that is one of the metrics that supports the ability to reach consistent non-GAAP profitability and free cash flow by the end of the coming year fiscal year…as forecast by this company's CEO. While I can't say whether the 85% increase in the share price since just before this latest earnings release until the setbacks in valuation seen since Friday, May 20th was a dead-cat bounce or something different, I imagine that many investors would have considered the real 88% revenue growth rate, and evaluated that growth rate against the growth in non-GAAP opex and seen a pleasing trend indicating a clear path to profitability. At least that is what I considered, and it's part of the investment thesis that I will present in the balance of this article.

Affirm's business and its differentiation

I confess that as a non-user of Affirm's offering, not all of its newest offerings resonate with me. In recommending Affirm shares, I veer notably from what is known as the Peter Lynch style of investing. But while the offerings are not for me, the company has millions of consumers as users, and these consumers appear to like the service given the high level of repeat users.

Affirm really does have a significantly differentiated set of offerings when compared to those of many other companies in the buy now/pay later space. It is not an accident, or even better marketing, or just first mover advantage that has enabled this company to reach partnerships with many prominent retailers and E commerce sites such as Shopify and Amazon. It negotiated new partnerships of note with Fiserv (FSR) and Global Payments (GPN) in the last quarter. It also announced an agreement with Stripe. To paraphrase a former president, "it's the technology stupid."

How complex could a buy now/pay later offering actually be? Far more complex than is imagined by many readers and commentators. Most readers who might be familiar with the BN/PL space are aware that the standard offering is one in which the merchant allows its customers to pay by using one of a number of vendors in the space - there is a payment button checkout that directs the customer to one of the several Buy Now/Pay Later options that are available. Typically, the payments are split into 4 bi-weekly payments. While that facilitates some purchases, it really isn't the preferred payment cadence for most BN/PL customers.

Affirm offers a solution it calls Adaptive Pay, which allows users to pay in monthly installments over a year, and it is rolling out an offering that allows merchants to offer simple-interest bearing installment payments as well.

Affirm has something which it calls its Super App which is a single platform/card from which most Affirm services can be accessed. Probably the most significant product offering that the company is rolling out is what it calls its Debit Plus app. Apparently, the introduction of Debit Plus has led to its users transacting twice a week using this card, and an order of magnitude higher engagement amongst these users. There has been a waiting list for this card-something that is difficult for me to credit-no pun intended-but it obviously has the potential to be a significant driver of both share and revenue growth.

In my view, and particularly in this current environment, both with regards to investor preferences and with regards to business issues, the principal advantage enjoyed by Affirm is the technology it uses to evaluate credit of the consumers using the app to pay for their merchandise. In the prior quarter, the CEO discussed at some length, the factors that Affirm uses in evaluating the credit of the potential consumers of its customers. The technology is based on AI and machine learning, and this company has made significant investments in training its model to deal with different categories of merchandise, different categories of potential borrowers, and different levels of perceived risk emanating from the economic cycle.

Affirm's credit underwriting methodology is detailed, consistent and has significant procedural advantages over the technology used by competitors. What follows may be thought by some to be a commercial. I can't say it isn't that, at least at some level. But I do believe it differentiates Affirm from its many competitors.

James Faucette

Thanks very much. Thanks for all the details to day, guys. I wanted to ask about on your credit performance, you said it had been a little bit better than you thought, Michael. And can you talk a little bit about how you're managing that right now, especially with the changing environment? Are you being more restrictive at different points? Or are you finding that, that isn't necessary yet? Just wondering how you're - just wondering if you can give a little color in terms of how you're managing the credit applications and going out of credit right now?

Max Levchin

I'll start, and Michael will probably give a more precise answer. So we always manage it exactly the same way, like we have not at all changed our approach. We look at both vertical and horizontal slices. We asked the question, how is this in American Society is doing, Canadian, Australian., How are the overall in terms of their job security and sort of the policy set sort of this horizontal slice? And then vertically, we asked the question how is this - how are the sales in this version category? We know what folks are selling. We know if it's selling better or worse, which means that the advertising campaigns that drive consumer demand can reach audiences that are potentially overextended already and maybe shouldn't be borrowing. So, all of that feeds into the policy setting. And then we tune it, but we tend it all the time. It's not a thing that we sort of get together and say, all right, it's been a quarter, let's talk about it. Like we talk about it literally every Monday morning.

There is a triage conversation about credits with our head of risk in the room with the executive team and we review all of our numbers. And say, hey, how do we feel about the American consumer at the highest level? And then we dive deep into here's this product, it's old split, how is it doing on Shopify? And so that's what we're doing. And it's performing a little bit better typically means that the precautionary steps we took were slightly less necessary than we expected - at least 1 or 2 degrees to the right or to the left. It's a number - let's put a hand break and we over tighten or something like that.

No, not all BN/PL offerings are the same or will produce the same range of results.

Trying to Evaluate Affirm's Balance Sheet/Funding risks in an environment of economic uncertainty

Affirm, besides its analytical complexities, which can lead to a certain amount of confusion and uncertainty in evaluating the company, has a substantial balance sheet with a significant level of exposure to consumer defaults. At the end of the last quarter, loans held for sale amounted to $2.5 billion. Actually that amount, in terms of percentage growth, is quite a bit less than the increase in revenues. Affirm looks at its total funding capacity which includes its warehouse lines, forward flow agreements with whole loan buyers and ABS securitizations. So far in 2022, Affirm has brought on $2.5 billion in new funding capacity, and after the end of the quarter, it closed a $500 million ABS transaction, as well as a multi-year $500 million forward flow commitment with a large insurance company.

Overall, Affirm has closed 9 ABS transactions since the start of its program in 2020. Its most recent ABS tranche was rated as AAA. The ABS market has been volatile, and at times risk-off so far this year, but according to the linked article, the market apparently has stabilized and large deals, like that recently closed by Affirm are getting done.

While credit exposure is real, and has been emphasized by some, it can easily be over-evaluated. One thing to note is that Affirm's loans have a very short average duration. Currently, the average loan remains on Affirm's balance sheet for an average of 5 months. The ABS tranches that it sells also have relatively short maturity and that is an important reason why they have gotten high grades from rating agencies. Further, because of the short maturities, the company is in a position to continuously train its models as new data leads to changing correlations.

If there is a deep and prolonged recession then default rates will rise for Affirm, for Upstart, for Visa (V) and for every other large bank. One doesn't need AI technology to reach that conclusion. If a recession is of short duration and unemployment doesn't spike, then the models that are used by Affirm, Upstart and many other consumer finance underwriters will not be stressed to the breaking point. From what the Bloomberg article cited above suggests, ABS buyers have made the appropriate adjustments for risk, and the market is buying ABS tranches. Obviously, however, the equity markets still are dubious and this is a factor weighing on Affirm shares.

Investors may recollect that Affirm shares fell sharply in mid-March when news was disseminated about the cancellation of a proposed sale of ABS. Whatever the risk may have been with regards to that asset sale back in March, it seems to be more than reflected in the company's current share price, especially in the wake of reporting operating performance stronger than anticipated, as well as providing strong guidance both in terms of growth and margins.

At the end of the day, the "controversy" really was not about much more than creating discussion topics for hedge fund traders. Affirm's notes issued by securitization trusts were about $1.45 billion at the end of the quarter, up from the start of the fiscal year, but down seasonally from their level at the end of the calendar year. In this latest conference call, the CFO indicated that the company achieved an AAA rating in its most recent sale of an ABS tranche. Again, this is very removed from the conventional wisdom regarding the business environment for this company.

Affirm is seen by some as a company enabling consumers with marginal credit to get access to a lending source that takes sizeable risks. The negative thesis is that in a more difficult macro environment, these customers with marginal credit will default, and this will end the growth story. I can't prove the negative. We aren't in an environment of higher unemployment, although we are in an environment in which real wages have been declining. Not surprisingly, the company CEO, Max Levchin, was asked about this element of risk. I think it is more appropriate to let the CEO speak to the issue in his own words,

"The difficult thing was to build a product that commands a price and maintains a good margin and to be disciplined about credit. You can grow faster if you just approve everyone and some of our competitors do that. And it's a lot easier, but you then have to deal with bad losses. We are not okay with bad losses or losses that we can control. And so those are all things that we've always done, and that's the scale advantage that we have today is the variable revenue or adjusted."

Of course, that is what the CEO of a company like this might be expected to say. And no matter what steps are being taken to analyze risks by Affirm, a deep recession with high unemployment will have a very noticeable impact on this company, along with every other equity, growth, value, dividend paying or anything else. But I think the concept that Affirm's growth is a function of taking on substantial risk from marginal consumers is far off-base.

At this point, with the most recent ABS sale and the forward flow commitment, the company has funding capacity of about $10 billion. That is more than double the company's projection of $4 billion of GMV. Affirm is growing rapidly, and I think it will continue to do so for the reasons I outline below. It seems highly unlikely, based on the evidence in hand, that the company's growth is going to be constrained by its inability to fund its balance sheet.

Affirm's Opportunities

This has been an unusual article to compose. At the moment, investors perceive risk everywhere, and opportunity in the future has but little value. Many brokerage strategists are writing about their most dire predictions. The Jefferies strategist says more cathartic selling is needed. In the wake of that call, the Jefferies software group has reduced their price targets on most IT stocks that they follow. Similar calls are being heard from many other brokerage analysts including Wells Fargo. The point they make is that they expect corporate profits to deteriorate at an alarming rate and that positioning is still too bullish. I might, perhaps, observe that the selling in high multiple IT companies has been of epic proportions but perhaps that still doesn't signify to these commentators.

The reason to buy Affirm shares is not exclusively because the negative thesis is overblown, or that the risks are of an order of magnitude overstated. The rationale to buy the shares, at least in my opinion, is because at this point, the almost staggering opportunities are being ignored or depreciated beyond any reasonable degree. Is that what used to be called "purple prose?" Is the management team of this business either blind or lacking in integrity?

I am not a market strategist or a market timer. If markets for equities continue to deteriorate, then it isn't likely that Affirm shares will appreciate. If the economy enters a recession, then of course any company extending credit to consumers will see higher defaults. I have suggested why I believe the current expectation with regards to risk for Affirm are overdone. But trends do not last indefinitely, and quantifying the magnitude of a risk is as least important, if not more so, than identifying the risk.

The risks of the current environment for companies in all segments of the economy have been exhaustively catalogued. Today from what I read, it was the turn of chemical vendors. And share prices for many equities reflect that risk, and perhaps reflect more than that risk. An example of that is the reaction of Zoom Video (ZM) to its recently released earnings and forward guidance. If Affirm shares were too high at $176 - and I actually thought that was the case - then perhaps they are too low at $25. Pendulums swing, and overswing. Affirm has both a first mover advantage and a significant competitive moat in a market that is likely to reach substantial proportions.

According to the one of many industry forecasters linked here, the market is supposed to grow six or seven times over the next several years. Another forecaster, also linked believes the CAGR through 2030 will be 44%. Of course I don't know if the CAGR will be 22% or 44% over the next 7-8 years. I do believe, nonetheless, that the growth of the market is of a magnitude that suggests that Affirm shares, valued as they are now, are ignoring growth and focusing on risks.

Nine months ago, when this company announced its transaction with Amazon, the valuation for Affirm got to extreme heights. Now, after that partnership and other significant agreement coupled with broader acceptance of the buy now/pay later paradigm by consumers has driven growth and profitability beyond most expectations, the company's valuation reflects little of the potentials of its business.

For those readers unfamiliar with BN/PL, and I expect there are some, perhaps some background is in order. Many consumers who need to make a substantial purchase do so by taking on credit card debt. That has been the case for years, and in times past, this writer has used credit card debt to make some purchases. In general, many consumers are not entirely pleased with using credit cards as a vehicle to obtain credit. The service available from Affirm is viewed by many consumers as a more satisfactory alternative to credit card debt. For the most part, and this is based purely on anecdotal checks, their experiences with Affirm compared to credit card debt are better. While inevitably Affirm does charge for its services although this is often not visible to consumers, the consumers I have queried appear to be better satisfied with the credit options and overall experience available through the Affirm service. Overall, at least for me, this is the Peter Lynch component of an investment recommendation.

Because Buy Now/Pay Later has resonated strongly with younger consumers, particularly, many brands and on-line retail channels have determined that they need to offer a payment option that is tied to such a service. And of major retailers, Affirm has won an outsize proportion of the available business.

Retail, right now, is showing signs of stress in an environment in which real income is falling, and in which the tailwind of the stimulus has vanished. Neither I or anyone else imagines there is going to be some quick turnaround for retail in an environment in which real disposable income is falling. But what seems to be misapprehended is that the Buy Now/Pay Later paradigm is so nascent that its correlation to the exact level and track of retail sales is not great.

One point made by the CEO was that in the brief recession that marked the start of the Covid pandemic, the company experienced a sharp spike in consumer applications. The Affirm concept is one of replacing credit card debt with its offering. The replacement process can readily speed up during a recession, and while there hasn't been a recession yet, some of Affirm's verticals dramatically highlight the market share that Affirm is gaining in the payment space. For example, the travel and ticketing vertical GMV rose by more than 120%, and actually grew sequentially. Affirm has partnerships with American Airlines, Expedia, Priceline, Orbitz, Travelocity and CheapOair amongst others.

Affirm's largest category is that of general merchandise which reached $670 million of GMV last quarter or a bit less than 18% of the total. That was growth of 448%. The general merchandise category is where GMV from Amazon and from Shopify are reported, and it should be obvious that despite the well-advertised issues of those two companies, their partnerships with Affirm are achieving results above expectations. Affirm actually has partnerships with a variety of other retailers who have experienced disappointing results such as Walmart and Target, but the Affirm share of payments from those two companies is so small, that despite the problems of the environment, Affirm's GMV results continues to increase at very rapid rates. As part of the earnings release, Affirm and Shopify announced the extension of their agreement through 2025, and the company is now starting to offer monthly, and simple interest bearing credit plans as well as Adaptive Checkout on the Shopify platform.

Another likely tailwind over the next 12 months are the numerous integrations the company has announced with various payment vendors including Stripe, Verifone, Fiserv and Global Payments. These payment networks have millions of networks, and the integration with Affirm will allow those merchants to readily start offering Affirm's credit services.

Finally, and frankly the one I have the most difficulty in handicapping is the continuing roll-out of Affirm's Debit+ card. The Debit+ card is the brainchild and focus of Affirm's CEO, Max Levchin. Max has many of the attributes needed and expected in a tech CEO. And he has a track record from his role as one of PayPal's (PYPL) founders to back up his enthusiasms.

Debit+ is a card that offers some of the functionality of Affirm. Currently, it can be used to automatically enable a consumer to split low value transactions into 4 payments. And there is a pre-approved button that facilitates larger transaction. The card is still in its nascent phase and its major contribution to Affirm can only start to ramp when additional features such as longer-term and interest bearing loans become available. Max has provided some basic insights on the results of the roll-out, and he is a strong believer in the likely impact of the service. It is not part of guidance. It is said that Debit+ users have an order of magnitude higher engagement compared to other Affirm customers.

There is what I consider to be an existential issue that some commentators have in understanding Affirm. The Affirm network and ecosystem has a high level of fixed cost. But the unit economics, or what we used to call the margins on incremental revenue are very high. Affirm's business model is not to seek revenue growth at any price; that is a significant misunderstanding as to how the business operates, and will continue to operate. But with a very high ratio of repeat customers, and stronger than planned unit economics, growth and profitability at this point in the company's development are inextricably intertwined.

Affirm's Business Model

As I mentioned earlier, analyzing Affirm can be tedious, and at the length of this article, I am not going to go through all of the captions of note in the income statement and the balance sheet. When I look at Affirm, the three KPIs that I consider include the company's sales excluding allowances, its revenue less transaction cost as a % of GMV, and its credit performance. All of these metrics were unusually strong last quarter, particularly its overall growth both in revenues but also in terms of its margin on GMV. Much of that is that the Amazon and Shopify partnerships are starting to achieve meaningful although not yet overwhelming contributions.

The company's costs are showing significant scale economies. While overall GMV rose by 73%, and revenues excluding allowances rose by 88%, the growth in non-GAAP opex was 38%. I think some readers might be interested that stock based comp fell by $80 million, both because last year's results were inflated because of the IPO, and because of the specifics of the formula used for SBC calculation.

The company is forecasting minimal sequential growth in GMV for the current quarter. Given the cadence of progress that is likely in some of the company's larger partnerships such as Amazon and Shopify, I imagine this forecast is unduly conservative-but consistent with the style of this company when it comes to guidance. Even the hyper-conservative CFO suggested that the company hasn't seen and isn't expecting to see slowing growth, and that its forecast for the following fiscal year, when it is formally presented will continue to show elevated growth.

The guidance implies that the company's margin on GMV will return to about 4.1%. This is a function of the minimal sequential growth expected in GMV and also consistent with the company's longer-term target for that metric. Overall, the company is forecasting revenues of about $350 million for the quarter. That result would be sequentially flat, which seems very unlikely, but which would produce reported revenue growth of 36%. The company's loss provisions in the year-earlier quarter were still be constrained by releases from loss reserves from the Covid period. Eliminating that non-recurring item from the mix would suggest that the forecast of apples to apples revenue growth would be about 55%. It is, without question, hard to forecast the ramp of Amazon, Shopify and other partnerships, but I think adjusted growth will be higher than 55%.

The company is also forecasting a ramp in opex which was noticeably below average trends last quarter. Affirm has hired an addition 100 data scientists, and has scheduled a campaign to promote brand awareness and its availability as part of the Amazon check-out process.

Currently, consensus expectations are for Affirm's reported revenues to grow 43% in the next fiscal year starting in July, after growing 54% this year. The consensus EPS expectation for the coming fiscal still is projecting an EPS loss of $1.69. Clearly, that latter figure is nowhere near the level inferred by the CEO in its presentation. Again, while the company has not yet formally guided to revenue or EBITDA expectations for the current fiscal year, the inference I drew from the conference call commentary and subsequent investor presentations and "fireside chats" is that revenue growth will continue at around the same levels as the most recent quarters-although the impact of the new debit card has not been estimated. That would obviously be higher than the specific guidance the company provided for Q4, and higher than the published consensus.

As Affirm is not yet generating cash, the shares have been existentially vulnerable in the current market environment. Last quarter, the company reported a small non-GAAP profit but also reported a cash flow burn, albeit substantially reduced from prior period levels. The major reason for the difference between cash flow and reported non-GAAP earnings is the change in the fair value of assets and liabilities, which was a more than $200 mill swing year on year.

Over a given 12 month period, I expect that operating cash flow will be more or less than the same as the company's adjusted operating income and that is what I have used in projecting the NPV for this company. Needless to say, the NPV is several times the current share price, but of course that implies that the world isn't on the cusp of falling apart.

To repeat, Affirm shares wound up Tuesday, May 24, down by 15%. Do I think that Snap's outlook or the decline in new home sales should be read through as an indication that this company's outlook has deteriorated? It is just hard for me to find the logic in those kinds of correlations. Will Affirm be hurt by a recession; unless it is a deep and prolonged one-not necessarily. Does Affirm have competitive differentiators in a competitive market. I think it does. The company has an enthusiastic and highly qualified CEO and seemingly he has recruited a highly qualified team of managers.

I don't like to anthropomorphize in writing articles. But that said, it is hard not to feel these days the market hates tech stocks almost regardless of any facts. And the market has basically rejected any kind of positive fundamental news for the past several quarters. Many analysts who write reports covering this space for brokerages have basically decided to abandon any thoughts that the space is near a bottom, even after many recommendations have fallen 60% or more. Yes, there is a significant amount of evidence forecasting a recession and projecting a recession of some level seems reasonable, although such an outcome is far from certain. And all things being equal, the growth of IT spending will moderate in a recession, and if it is deep enough, as was the case in 2008-9, IT spending could decline. That seems more than a bit unlikely, however. So recommending Affirm shares now is a contrarian call, and one that is not in sync with current market sentiment.

But that said, Affirm shares are now trading at 2X my projected 12 month forward revenue. There are those who believe that it is no longer reasonable to value companies based on EV/S ratios. But that metric, and similar metrics, have been used by private equity investors for decades now, and I imagine they will be used long after my tongue is stilled.

The company should be able to ride out any foreseeable economic storm; it presently seems to be valued as though we are in the midst of a Cat. 5 hurricane. There is every indication that this is, and will continue to be the leading company in a space that is mainly growing by replacing the use of credit card debt. It is simply a better mousetrap for most of the buyers who use it services and that is why its repeat customer rate is at 81%. It has no doubt been a disappointing ride for shareholder, and I remain a shareholder. But this is still early innings for Affirm, and I am willing to stick around till the home team rallies.

There are commentators on the SA site who have written that I am well-known for sticking with losers. To me, a loser would be one whose business implodes, whose market share is at risk from competitors, who has dated technology, or lacks appropriate partners. And of course a loser would be one whose business model, after considering it carefully, cannot generate substantial free cash flow. None of that is true of Affirm, and despite the pain, I still believe in the investment.

This article was written by

Bert Hochfeld profile picture
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Bert Hochfeld graduated with a degree in economics from the University of Pennsylvania and received an MBA from Harvard. Mr. Hochfeld has enjoyed a long career in the tech world, working for IBM, Memorex/Telex, Raytheon Data Systems, and BMC Software. Starting in the 1990s, Mr. Hochfeld worked as a sell-side analyst and won awards from the Wall Street Journal for his coverage of the software space. In 2001, Mr. Hochfeld formed his own independent research company, Hochfeld Independent Research Group, which provided research services to major institutions including Fidelity, Columbia Asset, SAC Capital, and many other prominent institutions and hedge funds. He also operated the Hepplewhite Fund, a hedge fund that specialized in technology investments. Hedge Fund Research, an independent 3rd party firm that specializes in ranking managers, rated the Hepplewhite Fund as the best performing small-cap fund for the 5 years ending in 2011. In 2012, Mr. Hochfeld was convicted of misappropriating funds from a hedge fund he operated. Mr. Hochfeld has published more than 500 articles on Seeking Alpha, all dealing with companies in the information technology space. Highly esteemed for his investment wisdom accumulated over decades, Mr. Hochfeld ranks in the top 0.1% of Tip Ranks analysts for his selection of information technology stocks and their subsequent successes.
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Disclosure: I/we have a beneficial long position in the shares of AFRM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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