Is Affirm's Deal With Shopify Too Good to Be True?

The buy now, pay later (BNPL) sector continues to balloon with new entrants, yet almost none have succeeded in making a consistently profitable business out of the lending model. Because it's hard for these payment providers to set themselves apart, it seemed like good news that Affirm (AFRM -0.45%) latched onto a major integration with Shopify to secure itself a stable revenue stream. Shopify merchants will have the option to offer the Affirm payment service at the checkout, and as of last quarter, the feature was live in over 10,000 of these stores.

But despite the deal quickly ramping up, Affirm shares have remained flat, so it's possible the company has given up a little too much for investors' liking.

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The perfect match

Affirm's lending products are designed as an alternative to credit cards. Businesses can offer the payment option on their website, and customers repay the money directly to Affirm in monthly installments over three, six, and 12 months -- at an interest rate of 0% to 30%.

The partnership with Shopify dates back to early 2020, well before Affirm was a publicly listed company. It made sense for both parties: Affirm gets access to a pool of hundreds of thousands of online merchants, and Shopify benefits from a payment option that is proven to boost sales for merchants.

However, the service is branded ''Shop Pay Installments'' -- a Shopify brand -- with a tagline reading ''in partnership with Affirm.'' It differs slightly from Affirm's regular offering in that customers pay 0% interest and no fees. Instead, the merchant pays 5.9% of the total sale value, which is split between Shopify and Affirm. The potential benefits are massive, with early signs indicating a 50% boost to average order volume. 

The merchant-paying model is similar to that of Australian BNPL giant Afterpay, which is expanding its reach in the U.S. While it has been successful in getting a market-leading valuation, the company continues to report significant losses, which might offer some lessons Affirm can learn from. 

All is not as it seems

Since Affirm is doing most of the heavy lifting in this deal by accepting the majority of the (credit) risk, it would be logical to assume it is being compensated by Shopify. However, that's not the case. Affirm has agreed to pay Shopify an undisclosed fee for each successful transaction.

Plus, prior to Affirm's IPO, it awarded warrants to Shopify equivalent to 20.2 million shares. The warrants were offered at a price of $0.01 each and vested at the IPO (converting into shares), giving Shopify a shareholding equivalent that's about 15% of Affirm's current outstanding shares. That's about $1.3 billion in value at Affirm's recent price of $66.

Any fees paid to Shopify as part of this deal will be recorded as generic ''sales and marketing'' expenses in Affirm's financial statements, making it difficult to deduce how much it's actually costing Affirm to maintain this relationship. For investors, this lack of transparency could impact the price they're willing to pay for Affirm shares, as it makes the company harder to value.

With Affirm delivering persistent net losses, including a $247 million net loss in the most recent quarter, it's going to take a significant amount of time to deliver enough value to justify how much it has given up so far in this Shopify deal. 

The financial picture

There is no denying the buy now, pay later model is popular with consumers. Affirm now boasts over 5.4 million active customers using its service, a 60% increase year over year. But more importantly, they're also using it more often. Average transactions per user are up 10% in the quarter ending in March (the third quarter of Affirm's fiscal 2021) compared to the same quarter last year. It's probable that as the Shopify installments experiment rolls out, it will supercharge some of these numbers.

This popularity has driven a high double-digit increase in revenue.

DATA SOURCE: COMPANY FILINGS. *SALES AND MARKETING INCLUDES PAYMENTS TO SHOPIFY. 

Interestingly, the $50 million in additional sales and marketing expenses comprised the majority of the increase in total operating losses; these were also the fastest-growing expense items. Since the Shop Pay Installment program is only just beginning, it's difficult to attribute the entire rise to that alone, but it will definitely be a closely watched metric in the coming quarters.

Widespread, general availability of the installments feature for Shopify merchants began in June. Over the next two or three quarters, it will be a little easier for investors to piece the puzzle together with respect to the direct impacts this deal will have.

Still, it doesn't change the simple fact that buy now, pay later is a business model without a moat. With growing competition and low barriers to entry, none of these hopefuls have been able to stave off losses that grow in lockstep with revenue. Affirm is no doubt in a unique position with one of the biggest e-commerce partners in the world, but it's concerning that perhaps the company has mortgaged too much of its future on this one deal.