The buy-now-pay-later (BNPL) company Affirm (AFRM 0.91%) recently reported strong quarterly results, in which the company beat analyst estimates on earnings and revenue for the quarter ending March 31. Founder and CEO Max Levchin also said on the earnings call that the company's plan is to achieve "a sustained profitability run rate" on an adjusted basis by the end of the fiscal year 2023. The news sent the stock surging last week, but while Affirm looks to be in solid shape, here's why investors should still be cautious right now.
Credit concerns
BNPL is the business of allowing consumers to purchase items with no money up front and then pay it off over several installments. Affirm has created innovative technology to allow merchants to offer numerous BNPL options. The company has formed several big partnerships with Amazon, Walmart, and Shopify, which have allowed it to significantly grow gross merchandise volume across its platform.
Image source: Getty Images.
Affirm's BNPL options include short- and long-term BNPL loans, some with no interest and others with annual percentage yields (APY) ranging from 10% to 30%. The company also has a product called split pay, which covers purchases of no more than $250 and is paid off over six to eight weeks. As Affirm has gotten more of its products up and running with different partnerships, more of its loans have started to shift toward bearing interest, as reflected on its balance sheet.
Image source: Affirm.
Nearly 61% of Affirm's loans held for investment on the balance sheet were interest-bearing at the end of the quarter ending March 31. Affirm does have an allowance for loan losses equivalent to 6.4% of total loans on its balance sheet, but the company makes it hard to understand the credit quality behind the borrowers holding these loans.
The company grades loans using a proprietary scoring method, but doesn't provide borrower demographics. Still, the greater the risk that a borrower will default on a loan, the more they'll have to pay in interest. While delinquency trends at the company are stable right now, consumers are still strong and have not really felt the impact of rising interest rates just yet.
Sure, the Federal Reserve has now hiked rates several times, but it can take several months before that impact is really felt. We had already heard about lots of BNPL borrowers missing payments when credit conditions were much more benign, and this debt could be some of the first to go unpaid when consumers start to get into trouble. And if it starts facing credit quality concerns, Affirm could run into funding issues from its partners in the capital markets, a problem that recently plagued Upstart.
Be cautious
Affirm delivered a strong quarter and looks to be on sound footing with regard to credit quality. Levchin, a former co-founder of PayPal, is a well-known technological genius, so perhaps Affirm's proprietary credit underwriting is superior, but it can be hard to beat the Fed and a rising interest rate environment.
Current high levels of inflation will continue to put pressure on consumers and hurt their finances. If loans start to go bad at higher rates, funding may dry up in the capital markets, or investors may require returns that could result in less gross merchandise volume, effectively slowing growth at Affirm. These are all factors to consider as you contemplate whether to invest in Affirm, and whether its current valuation offers a risk-reward proposition you feel comfortable with.
