After a year of headline-grabbing initial public offerings in 2020, Affirm Holdings (AFRM 8.01%) is the first hot IPO of 2021. The financial technology company, or fintech, provides easy payment solutions for shoppers; its buy-now-pay-later options make big purchases more affordable, and it does this without imposing late fees.

Affirm's stock has already gained 32% since it first became available to retail investors on Jan. 13. But is this just IPO hype, or is it worth the high price?

How does Affirm make money?

Affirm, whose founders include PayPal co-founder Max Levchin, sees its function as liberating buyers from the unclear terms and fees of traditional creditors by being transparent, flexible, and fair. It offers installments for expensive purchases, some of which come with interest payments and some of which don't. Customers can choose Affirm as a payment option when shopping on a partner site and then see a range of payment alternatives, such as three-month or six-month installments, and choose the one that works for them. The technology is easily integrated into a partner company's payment platform, but users can also shop at non-partner shops with a one-time card number.

An Affirm customer using the service on a laptop.

Image source: Affirm.

Affirm sees this as a win-win for merchants and shoppers. Merchants sometimes miss out on sales when customers can't pay up front or customers are unclear about total interest payments. Customers can't make certain purchases if they require a high upfront payment or potential long-term interest. Affirm's services help stores make more sales, and they help customers with the ability to afford purchases more easily. The company also offers a virtual card that customers can use in storefronts, and that accounts for about 10% of total revenue, or $3.6 million in the third quarter.

This particularly appeals to a younger generation that's used to digital processes. In a case study, Christopher Kae, head of Americas for high-end watch maker Chrono24, said, "We now see more millennial potential luxury buyers engaging with our products via Affirm."  

Affirm makes money from customer interest payments as well as store processing fees. It also offers savings accounts with higher-than-average interest rates. Revenue grew 93% year over year in fiscal 2020, with a $509 million total. Gross payment volume also nearly doubled during the same time period.

Risk and opportunity

Affirm now has partnerships with 6,500 stores, including Walmart, Target, Best Buy, and Expedia.Some of its new partners are Karisma luxury hotels and upscale retailer Neiman Marcus.

But its main source of revenue is Peloton Interactive, which accounted for 28% of total revenue in the fiscal year that ended June 30 and even more in the quarter that ended Sept. 30. Ten top merchants account for 37% of Affirm's total revenue, which means a huge percentage of its eggs are in one basket. Its revenue is strongly tied to Peloton's in the short term, and the company pointed out that if the home fitness trend slows down, or one of its strong partners chooses to work with a competitor, that could adversely affect sales.

The connection with Peloton been great over the past year, as lockdowns have meant a turn toward home fitness, and Peloton's sales increased 232% in the latest quarter.The connected fitness company offers Affirm's 0% APR financing as an option for installment payment plans, and Affirm accounts for the majority of monthly online business sales.

But it does look like Affirm will expand both its network of merchants and consumer base. Notably, it recently announced a partnership with Shopify to be the e-commerce company's exclusive installment plan option. That's in testing right now, but should eventually be another large source of revenue.

There are other players in the field as well, such as PayPal's recently launched buy-now-pay-later feature, and Afterpay. Affirm is working on differentiating itself through more and better features as well as partnerships.

Affirm has yet to turn a profit, but it sees a path toward profitability as it builds its ecosystem. As more customers purchase, more merchants join, reaching more customers, with Affirm getting paid from both sides. As the cycle increases, Affirm gets more data and can offer improved options. It approves about 20% more transactions than competitors since it can assess risk better through its data collection. Net loss for the latest quarter came in at $15 million, about half what it was the same period the year before, but the company says that it expects future losses.

Investor takeaway

Affirm is a growing company that offers opportunity for shareholders as sales climb. It's committed to innovation and expanding in different ways. But while it faces competition, has sales concentrated in a small number of merchants, and hasn't turned a profit, I would recommend sitting this one out and keeping an eye on the company as it grows into its business.