Capital recycling: Here's how Afterpay earns its margin.

How Afterpay makes money

BNPL companies like Afterpay earns their revenue in two ways:
Merchant fees from retailers: the company takes a percentage fee of every dollar that is transacted via its platform. This commission rate, referred to as “Afterpay Income” varies is between 3% and 6%, varying depending on the size of its is retail partners; and
Late fees from consumers: the company charges late payment fees of $7-$10 per late payment.

Breaking down Afterpay income

Merchants pay Afterpay a commission, referred to as Afterpay Income. This commission ranges between 3% to 6%. The more volume you do with them, the lower the rate I gather.
In FY20, the income as a percentage of underlying sales, or Gross Merchandise Value (GMV) transacted through the platform was 3.9%.
This indicates that there is a portion of retail partners that pay less than 4% of fees to Afterpay.
Hot Tip: If your retail business offers Afterpay and you’re paying more than 4%, then perhaps it’s time to get a price check.

There are costs of sales associated with earning Afterpay income.

Afterpay’s cost of sales include:
- Provision for bad debts (customers that are at risk of not paying);
- Other variable transaction costs (processing fees); and
- Financing costs (cost of working capital).

After deducting these variable cost of sales, Afterpay’s gross profit was 2.25%, referred to as Net Transaction Margin (NTM).

In other words, for every $100 that you spend using Afterpay, the company collects $2.25 of gross profit.

Finance costs

Like most businesses, a constraint to Afterpay’s growth is working capital. Afterpay needs cash to fund the gap from when funds are paid to its retailers to when it eventually receives the cash from consumers in six weeks.

Let’s break this down. Say you buy a $1,000 pair of Yeezys via Afterpay. The retailer will get paid $940 upfront, being $1,000 less a 6% commission. On the same day, Afterpay collects its first installment from the consumer of $250. Afterpay is out of pocket by a total of $690. Aftepay will collect the remaining $750 from the consumer over six weeks.

Afterpay needs capital to fund this $690 gap. It does so by borrowing from several Tier 1 lenders: Goldman Sachs, CitiBank, Bank of New Zealand and NAB. The average interest rates on these facilities ranged from 1.65% to 3.2% in FY20.

How it really makes money: Capital recycling

So summing up, after starting with a 4% merchant fee, Afterpay’s Net Transaction Margin drops to a mere 2.25% after paying transaction fees, interest and bad debts.

Doesn’t sound that special, does it?

Well yeah, it doesn’t.

But here comes the big reveal that gets investors salivating about the BNPL business model.

It boils down to the company’s velocity of recycling capital.

Traditional banks make money by earning the difference of interest between what they charge to borrowers (mortgage holders), versus what they pay to depositors (savers). Most banks make a net interest margin of ~2% per annum.

But what the banks earn in a year, Afterpay makes in six weeks. Customers are required to repay Afterpay over 42 days (six weeks), and Afterpay makes the same amount of commission even if they decide to pay it earlier.

In fact, it’s better for Afterpay if customers pay off their debt faster, because it means that Afterpay can redeploy the capital faster.

To put this in practical terms, let’s assume that a consumer spends on average $100 per transaction via Afterpay.

If this consumer only uses Afterpay once per year, Afterpay makes $2.25 per year of transaction margin and a 2.25% Return on Capital (ROC) before operating expenses.

But if the consumer uses it 10 times per year, Afterpay makes $22.50 per year. The initial $100 of capital that Afterpay borrowed is redeployed every time a new transaction is made. The return on capital is now 22.50% because the same $100 is now generating $22.50 of annual net transaction dollars.

In its FY20 report, Afterpay reported that its longest cohort of users are transacting up to 25x per annum — which implies that Afterpay could be generating a whopping 56% of ROC per annum on its oldest users.

Source: Jason Andrew