As I’m sure you’re aware, the ASX buy now pay later (BNPL) sector has been an extremely hot topic this year.
Zip Co Ltd (ASX: Z1P) and Afterpay Ltd (ASX: APT) have both seen staggering amounts of growth accelerated by the COVID-19 restrictions.
Undoubtedly, raising money through the issuance of shares has contributed significantly to this growth. However, this isn’t the only form of capital that these companies use to drive further sales.
Both Zip and Afterpay heavily engage in debt financing to fund its operations. Borrowing money, of course, comes at a cost, so when these companies are borrowing such large amounts of money, achieving a lower cost of borrowing relative to their peers can have a large impact on profitability in the long-run.
What’s the difference between Afterpay and Zip?
On an operational level, Afterpay and Zip are very similar. They both provide point of sale credit and repayment arrangements on goods and services.
However, one major difference I have observed is the methods in which these companies acquire debt to finance further growth.
I’m sure there are many ways you could compare these two companies, but I think this is important because as every new BNPL player competes for market share, future profitability can be driven from a decreasing cost base.
Whichever company can borrow money at a cheaper rate will have a significant advantage over the other players.
Afterpay’s debt funding sources
Afterpay has access to five debt warehouse facilities from large banks such as Goldman Sachs, Citi and National Australia Bank Ltd (ASX: NAB).
The amount of drawable funds grows in line with Afterpay’s accounts receivable balance. Meaning, the more that is owed from customers, the more money Afterpay can borrow to further expand the business and pay down its costs.
If Afterpay was to potentially default on one of the facilities, accounts receivables are held as collateral by the bank, meaning the bank can recover its losses by collecting owed payments from Afterpay’s customers.
The weighted average interest rate on drawings varies across the different lenders but is around 2-3%.
Afterpay has also used unsecured notes as a form of debt sourcing. $50 million was raised by institutional investors in 2018 with a fixed rate of 7.25% per year, which matured in April this year.
How does Zip borrow money?
Similarly to Afterpay, Zip also uses warehouse facilities to drive sales and grow its accounts receivable balance. However, Zip broke new ground in 2019 with the launch of an asset-backed securitisation program called Master Trust. Without getting too technical, I will do my best to explain the basics of how it works.
Last year, Zip engaged with NAB to help issue (raise) $500 million worth of asset-backed notes from multiple investors. The proceeds were then used to acquire a revolving portion of Zip’s accounts receivable balance (money owed by Zip’s customers), which is then held in the master trust.
As Zip collects revenue from customers, money is passed back through to the investors who funded the original $500 million notes issue, with interest added to the principal amount.
The master trust operates like a revolving account of money coming in from investors used to grow the business, then money coming back from cash collected from Zip’s customers.
Due to having a limited track record of creditworthiness, Zip and many other new fintechs are forced to pay higher funding costs initially. However, Zip has already established a rated trust. The asset-backed notes can be rated higher by rating agencies, allowing them to achieve a lower average cost of funds and diversify its funding sources.
Significant cost savings in the medium to long term are the primary reasons why Zip uses a master trust to finance its growth. Additionally, it is used to manage its default risk.
As Zip sells its receivables balance to the securitised trust, this shifts potential risk from customers defaulting on their payments to the noteholders. Default risk is further minimised by Zip performing credit checks on all new applicants.
Final thoughts
As I mentioned earlier, there are so many other ways you could compare these two companies. It can take years to fully achieve significant cost savings, so I’m happy to hold my Zip shares for a while and let it play out.
I think both these companies will do well in the long-term, but I recently wrote an article on some of my favourite ASX tech shares at the moment which I’m more excited about.
