Sea of red for BNPLs as rate-hike rot sets in

BNPL valuations are hitting well beyond 12-month lows amid a risk-off attitude towards risky investments and technology stocks. 

Investors are exiting local BNPL names at a fleeting pace, with Afterpay (ASX: APT) plunging 10.5%, Zip Co (ASX: Z1P) down 5.1% and Sezzle (ASX:SZL) trading 4.1% lower on Thursday.

Zip shares are now trading at a lower valuation than when the company entered the lucrative US market via the acquisition of QuadPay on 2 June 2020.  

Rate hikes are coming 

Technology stocks had been running hot thanks a low interest rate environment, conductive to cheap money and allowing valuation multiples to balloon.

But the era of ultra-low interest rates is now coming to an end, with the 1, 2, 3 and 5 year US Treasury yields trading at their highest levels since the start of the pandemic.

These trends suggest interest rate hikes are on the horizon.  

The market is now pricing in a 67% probability of the first Fed rate hike occurring in March. A month ago, that probability was just 27%. 

According to the Fed fund futures expectations, the market is pricing a 64% probability of 4 rate hikes by December 2022. 

Why does this matter? 

The prospect of high interest rates shifts the 'opportunity' cost, especially for fast growing companies that might only begin to turn a profit in the distant future. 

For BNPLs specifically, rising interest rates can increase the cost of funding, lower profitability and create a more challenging environment to raise capital. 

A March 2021 research report from Macquarie Bank flags the prevailing interest rate risks for BNPL companies. 

“Assuming a 1% hike in effective interest rates for all the BNPLs, would result in a 1.7-7.1% decline in annual returns for BNPLs; Humm has the highest sensitivity as a result of the company’s low receivables turnover, resulting in its overall returns being more sensitive to changes in interest rate.”

The possibility of 4 hikes this year could bring interest rates from 0.25% to 1-1.25%, bringing into reality the cost-side pressures flagged by Macquarie.

In the same report, the broker highlighted a pain-before-gain narrative, where companies with "stronger balance sheets will be able to last for longer, while less well capitalised BNPLs are likely to come under financial pressure and either die out or... be acquired."

While small cap BNPL stocks aren't necessarily showing any signs of financial stress right now, the share prices of players like Splitit (ASX: SPT), Openpay (ASX: OPY) and Laybuy (ASX: LBY) are all down at least 70% in the last 12-months.

Despite all the doom and gloom analysis, the broker believes the industry will emerge at a "healthier supply/demand equilibrium".

Let the M&A begin

Latitude kicked off the first M&A deal of the year, proposing a $335m scrip and cash offer to acquire the BNPL business of Humm (ASX: HUM).

Humm is one of few profitable BNPL companies, generating $1.2m of net profit in FY21.

As pointed out today by the Australian Financial Review, the offer was made using "traditional corporate valuation techniques" rather than crazy revenue multiples.

If Latitude opted for outlandish revenue multiples used to value other BNPL companies, it would be forking out closer to $1bn for Humm's BNPL assets.

BNPL valuations appear to be stepping into a new era, whereby companies will be stress-tested against looming interest rate hikes and intensifying competition.