1 Big Shift in Affirm's Business Model That You Should Know

It has not been a fun few weeks for shareholders of buy now, pay later (BNPL) company Affirm Holdings (AFRM 5.31%), which has seen its stock roughly cut in half since reporting earnings results on Feb. 10. Affirm had a big quarter on strong seasonality, but investors seem confused about the lighter guidance for the rest of fiscal 2022.

One thing investors should understand is that Affirm's business model is changing somewhat rapidly, and that will be important to monitor moving forward. Let me explain.

A big shift in product mix

Affirm is in the business of helping merchants increase their sales while providing consumers with more flexible purchase options -- largely through BNPL, in which consumers put zero money down up front and then pay for their purchases over multiple fixed installment payments. The company offers different kinds of BNPL payment options depending on the merchant and the consumer. Some BNPL loans charge 0% interest, while some have annual percentage rates (APR) of up to 30%. Some loans have durations of just six to eight weeks, while others can last as long as 60 months.

Image source: Getty Images.

Affirm has formed partnerships with huge merchants including Peloton Interactive, Walmart, Amazon, and Shopify. In prior quarters, particularly during the pandemic, Affirm was seeing a lot of loan volume come through Peloton purchases. A lot of the BNPL products for Peloton charged zero interest but could charge high fees to merchants for facilitating the transactions, typically around 12.5%. That's all revenue processed up front and helps increase a key metric known as the take rate, which is revenue as a percentage of gross merchandise volume (GMV). 

But as Peloton deals with slowing growth and other issues, Affirm has seen its loan product mix change, especially as it has formed other key partnerships with Amazon and Shopify. Affirm only launched its initial product with Amazon last November, which, unlike the Peloton product, is an interest-bearing loan product.

The core interest-bearing product at Affirm only charges merchants between 2% and 5% for facilitating the transactions but then has APRs between 10% and 30%. The interest is not paid up front, but rather each month, so revenue rolls in more gradually. These products actually have the potential to be more profitable over the life of the loan because interest payments come in each month and might amount to much more than an initial 12.5% fee. But this is also changing the accounting at Affirm, because for any interest-bearing loans the company chooses to hold on its balance sheet and not sell to investors, Affirm must set aside capital in case the borrower stops making payments and the loan goes bad. As a result, Affirm receives less revenue up front and takes more costs up front, but can be more profitable long term. It also drives down the much-watched take rate.

With Shopify, Affirm uses a product called split pay. The merchant fee on this product has bounced around a bit in recent quarters but came in a little below 5% last quarter. Split Pay seems to get used for small purchases ranging between $100 and $250 and has a short payback period of six to eight weeks with 0% APR. Management has seen Split Pay really take off and is now expecting the product to make up 15% to 20% of GMV in fiscal 2022.

Trying to make sense of guidance

Here are some of the key results that Affirm reported for its most recent quarter.

Source: Financial statements

Then here is Affirm's guidance at the midpoint of the range for the current quarter and for all of fiscal 2022, which ends in June.

Source: Financial statements

The difficult thing about the guidance is that on an annualized basis from the most recent quarter, most metrics would not imply any growth but would in fact imply a decline from what occurred in the fourth quarter. This is due to seasonality, as management said on its most recent earnings call that the final three months of the year tend to benefit from strong holiday shopping and events like Black Friday and Cyber Monday.

In addition, while GMV guidance for the full fiscal year has risen by nearly 17% from what management provided in September, guidance for revenue is only up about 10% and guidance for revenue minus transaction costs are only up about 5%. This could be a direct result of taking expenses earlier and revenue later, as well as seasonality, but investors are probably not entirely sure.

Does the changing model make Affirm less attractive?

The market certainly does not seem to like what's going on, although it is entirely possible that investors are misunderstanding the shift in Affirm's loan mix. The model has transitioned from higher-fee loans where revenue is paid up front to more interest-bearing loans that incur credit expenses up front and more revenue over the life of the loan. Split Pay is interesting because it's a smaller-fee product, so it may hurt the take rate, but these are shorter-duration loans, which likely makes the product less impacted by rising interest rates and more capital efficient.

The loan shift could result in higher revenues and could also be more profitable over time. But it doesn't exactly alleviate the near-term concerns I still have about the business and that the market is likely thinking about right now. The main concern is likely that Affirm is not profitable yet and still carries a market cap around $10 billion. As the Federal Reserve hikes interest rates this year, the business could struggle from a slowdown in consumer demand and higher default rates, as well as other issues related to funding and capital markets. The concern over growth stocks and their high valuations is why I am still cautious on the stock right now, despite the significant decline in the share price recently.