Growth is stellar for payments operator Zip Co, particularly in the US, but is it being primed for a fall?

-Increasing competition a risk but growth still substantial
-Leading the sector on net customer additions
-Structural tailwinds strengthening despite risks
 

Is Zip Co ((Z1P)) on the verge of a major growth spurt that will narrow the gap to its main rival, Afterpay ((APT)), and create a substantial global payments operator, or is the company at risk of being enmeshed in a tighter Australian regulatory environment?

The company's US entity, QuadPay, put in a stellar performance in the March quarter, with total transaction value (TTV) growth of 234%. While the number of transactions grew significantly in Australasia as well, up 61%, average order values fell, which UBS attributes to the 'Tap & Zip' feature.

Yet, the top line is still expected to grow rapidly and the broker continues to believe in management's strategy although, as this is a relatively early-stage investment with significant execution risks, a Sell rating is maintained.

Citi, on the other hand, is buoyed by the latest numbers, particularly for QuadPay. While acknowledging increasing competition is a risk to growth and profitability over the medium term, the broker notes US BNPL (buy now pay later) penetration is low and QuadPay's Shop Anywhere offering is likely to drive growth in the short term.

Citi asserts Zip Co's offering in Australia is differentiated from other BNPLs and expects the account-based concept will take share from credit cards, while Tap & Zip is potentially more exposed to competition from new BNPL products, such as the Commonwealth Bank's ((CBA)) card-based offering.

Citi expects revenue growth for Zip Co will be stronger than other financial technology/payment peers but values the stock in line with these, given the higher credit risk in the Zip Co business model.

The broker envisages BNPL will end up being a "winner takes most" market, although there are risks to medium-term growth forecasts and margins for Zip Co. Shaw and Partners notes the company is leading the sector on net customer additions and this is its preferred metric for measuring growth.

Furthermore, Ord Minnett asserts growth in the business has not come at the cost of quality, as bad debts are trending down in Australasia and QuadPay's net transaction margin remains above 2%. Morgans agrees credit quality remains sound, as net bad debts fell to 1.78% from 1.93% in the second quarter.

There were 674,000 new shoppers added to the US platform during the quarter, a seasonally quiet period for retail/BNPL. QuadPay, Morgans notes, is now annualising an impressive US$2.8bn in TTV with merchant growth of 55% sequentially in the quarter.

The broker finds the US expansion highly encouraging and anticipates longer-term upside if Zip Co can execute on its ambitions. Morgans also expects the gap to Afterpay should narrow over time.

International Expansion

International expansion continued during the third quarter with strategic investments in the Philippines and Europe via TendoPay and Twisto respectively, although the size and percentage of the stakes was not disclosed. Morgans notes Homebase, JD and Fragrance shop have signed with Zip Co in the UK and the company has also undertaken a "soft" launch in Canada.

Zip Co did not provide customer metrics for the UK, signalling growth has been modest, and Citi suspects the company may be too late to that jurisdiction. The broker also envisages risks to QuadPay's revenue yield. Yet, Citi agrees QuadPay's strong growth will help close the valuation gap to peer Afterpay and on this basis upgrades to Buy from Neutral.

International markets stood out for Shaw and this underpins the valuation, with international TTV estimates, conservatively, upgraded to $810m for the fourth quarter.

BNPL Risks

The BNPL sector has been a material beneficiary of economic stimulus but UBS is cautious about the short-term outlook as policy measures are wound back. For Zip Co this may impact the top line, in terms of growth, and amplify credit risks, which are difficult to quantify.

The broker highlights the risks in particular to fourth quarter forecasts for Australasia amid the cessation of JobKeeper on March 28. In Australasia, UBS forecasts $990m in TTV for the fourth quarter with 2.8m active customers as of June 30.

Macquarie has assessed the 46 submissions from industry participants to the Australian payment system review being conducted by the Australian government and due for completion in the next few weeks.

The broker, which has an Underperform rating, notes around 63% of stakeholders referenced BNPL, which highlights the significance of that emerging sector. Respondents, in the main, were looking for more government regulation.

Macquarie notes around one third of the submissions made critical comments regarding BNPL. In particular the unequal playing field. As a result, the broker is convinced there will be "more pain before gain" for the BNPLs and, beyond industry consolidation, envisages increasing regulatory pressure as a key risk.

Yet, Shaw considers Zip Co, now one of the largest BNPL companies globally, represents the best leverage to growth. The US business is "smashing it out of the park" while multiple structural tailwinds are strengthening.

The broker asserts the company's functionality and app-based product is misunderstood. Customers are able to conduct a transaction anywhere and margins in the app globally are greater compared with direct integration because of the latter's mix of interchange, affiliate and customer fees.

This lends strength to a segment which is increasingly being utilised. The broker expects more app-based products will be launched with a focus on the millennials market with crypto currency, stocks and other lending products launching off the Zip Co ecosystem.

Shaw and Partners, not one of the seven stockbrokers monitored daily on the FNArena database, retains a Buy rating and raises the target to $16. The database has three Buy ratings and two Sell. The consensus target is $9.18, suggesting -12.4% downside to the last share price.

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