During the first two years of the pandemic, when demand for everything was soaring, stimulus cash was bolstering household budgets, and interest rates were near zero, buy now, pay later company Affirm (AFRM -0.45%) never turned much of a profit. If the business didn't really work then, when all the conditions were right, I find it hard to believe that it can work now.
Affirm's fiscal second-quarter report paints a troubling picture. While gross merchandise value rose 27% year over year, total revenue increased by just 11% as the company shifted toward interest-bearing loans. That sluggish growth is despite a dramatic rise in the number of active merchants over the past year. The company ended the quarter with 243,000 merchants in the network, up from 168,000 one year prior.
Revenue less transaction costs (RLTC) tumbled 21% year over year as the company generated less revenue from its network of merchants than expected. This led to a net loss of $322 million on about $400 million in revenue. Adjusted operating income, the company's preferred metric, was a loss of $62 million.
Affirm did point out that RLTC would have increased by 6% year over year if not for those pesky provisions for credit losses. But those provisions are very real expenses and should not be ignored.
Putting more loans on the balance sheet
Affirm sells some of the loans it makes to consumers, and others it retains on its balance sheet. A quick sale generates cash to make new loans and frees the company from any credit risk, while a loan kept on the balance sheet generates interest income.
Affirm greatly increased the number of loans it kept on the balance sheet in the second quarter, which can be interpreted in two ways. One, it could mean that Affirm is trying to tap into rising interest rates and generate additional interest income. Or two, it could mean that the company is having trouble finding buyers for its loans in a tough and uncertain economic environment.
The buy now, pay later industry is new, and it hasn't been tested in a recession. Affirm's delinquency rates look fine right now, but those can deteriorate quickly if borrowers come under financial pressure. When push comes to shove, my guess is that a borrower will put paying back an Affirm loan near the bottom of the list of priorities.
Cutting costs and raising prices
Along with its second-quarter report, Affirm announced that it was laying off around 19% of its workforce. The company plans on keeping its head count flat for the time being.
This cost-cutting initiative will help, but it won't be enough on its own. Affirm spent a whopping 47% of revenue on sales and marketing alone in the second quarter. This spending is partly to raise awareness of the brand, and partly to attract merchants to its network. However, the number of active merchants declined slightly on a sequential basis, an indication that the company is starting to have problems retaining merchants.
One reason could be Affirm's price hikes. Because funding is becoming more expensive, the company is attempting to pass on those higher costs to merchants and borrowers. Affirm is raising the fee it charges merchants on its 0% APR loans and boosting interest rates on other loans. The company's loans now max out at a 36% interest rate.
All of this makes Affirm a lot less attractive for both merchants and borrowers. Merchants will have to decide whether higher fees are really worth it, especially if it's not clear that Affirm is actually generating incremental sales. And with the company shifting toward more interest-bearing loans, potential borrowers will need to decide whether Affirm is really a better option than just using a credit card.
A product of ultra-low interest rates
Would Affirm or the buy now, pay later industry even exist if we didn't go through a long period of near-zero interest rates? I'm not sure. Demand for Affirm loans will almost certainly decline as they get more expensive for merchants and consumers. The golden age of easy 0% APR loans on everyday purchases is over, and that's going to put a lot of pressure on Affirm's growth rate.
It's not clear to me that the buy now, pay later industry is going to expand over the long run. Affirm accounts for just 0.25% of the U.S. retail sales market, which implies incredible growth opportunities are ahead. But if Affirm ends up being more expensive for merchants than taking credit cards, or more expensive for consumers than using credit cards, that percentage will likely stay low.
I'm not convinced Affirm can actually work as a sustainable business. For that reason, I'm staying away from the stock.
