Square Buys Afterpay, Network Effects, Apple and the Cost of Time

Good morning,

In Monday’s Daily Update I said that YouTube’s Total Reach numbers were based on surveys; this was wrong. Nielson in fact matches YouTube user data with Nielsen TV panel data to say definitively whether a participating user saw an ad on both TV and YouTube, or only on YouTube. This obviously makes my point even stronger, but I apologize for the error.

On to the update:

Square Buys Afterpay

From the Wall Street Journal:

Square Inc. has agreed to acquire Afterpay Ltd. in an all-stock deal worth around $29 billion, illustrating how financial technology companies are seeking scale to challenge banks for a bigger slice of the payments industry. Square said a key attraction of the deal was a growing wariness toward traditional credit among younger consumers, a group particularly hard hit by the Covid-19 pandemic, as lockdowns crushed many hospitality and casual jobs.

Afterpay’s technology allows users to pay for goods in four, interest-free installments while receiving the goods immediately. Customers pay a fee only if they miss an automated payment, a transgression that also locks their account until the balance is repaid. Australia-based Afterpay, which has yet to turn a profit, says this limits bad debts, particularly in a downturn when job security is shaky and household finances are stretched. Most of Afterpay’s revenue comes from retail merchants, which pay a percentage of the value of each order placed by customers, plus a fixed fee.

One of the interesting things about credit cards is that it overstates the importance of credit: most of the money in the credit card ecosystem is made from fees charged to merchants; many consumers get the benefit of a short-term loan for free. Of course there is always the option to carry a balance for longer, and that is where the money-making aspect of credit comes in, with high interest rates that punish those who only ever pay the minimum amount due. Still, that’s a lot different than something like a personal loan, where all of the money-to-be-made is in the interest.

Buy-now-pay-later (BNPL) companies are on the opposite side of the spectrum from personal loans: with this model merchants bear all of the costs, paying around 6% of a transaction price (plus $0.30), while customers don’t pay anything as long as they make regular payments (four bi-weekly installments in the case of Afterpay; all of the companies have slightly different approaches, but I’m going to focus on Afterpay). If they miss payments they are charged late fees, up to 25% of the overall purchase price, and they can make payments with credit cards (the fees of which are then paid by Afterpay). Most don’t use credit cards, though: in the case of Afterpay around 85% of customers make payments via their debit cards.

If all of this sounds very strange to you, well, that’s because you’re old like me. BNPL companies are particularly popular amongst younger millenial and Generation Z consumers who came of age amidst the Great Recession and have a generally dubious view of credit; having dedicated payments for individual purchases, as opposed to one big slush pot, is a feature, not a bug, and the six week payment period, conveniently aligned to a direct deposit schedule, is more generous than a credit card’s monthly cycle (it’s also technically not a loan in most U.S. states, which means less regulatory oversight).

This popularity, meanwhile, is why merchants are on board with those higher fees (which net out to about 3%, since the merchant no longer has to pay credit card fees); the extra sales make up for it, and those sales multiplied during the pandemic. The Wall Street Journal reported at the end of 2020 that the Australian-based Afterpay’s U.S. customer base had reached 13 million and made purchases worth $770 million, triple 2019’s total.

This increase in customer usage feeds back into more sales for merchants in a classic network effect: the more merchants that offer BNPL, the more consumers there are who become aware of and interested in the offering; the more consumers who are familiar with the offering, the more likely they are to complete a transaction with nothing more than a username and password.

Network Effects

This network effect certainly sounds a lot like that of credit cards, which I illustrated in Visa, Plaid, Networks, and Jobs:

Credit cards are perhaps the best possible example of the power of a multi-sided network; Visa sits in the middle of banks, consumers, and merchants:

A drawing of The Visa Network

Everyone benefits from each other…Visa and Mastercard, the other major credit card network, sit in the middle of each of these relationships, across billions of customers, millions of merchants, and thousands of banks, collecting a network fee — on top of the interchange fee paid to banks — on every purchase (about 0.05%).

BNPL companies, though, don’t have quite as strong of a network effect, because they don’t have direct relationships with banks; they are creating two-sided networks, not three-sided ones, that look something like this:

Afterpay's network effects

This is where Square is an intriguing match. The company’s original line-of-business is focused on Square Sellers; this is a product business at its core, with minimal network effects.

Square's product business

Still, it’s a great product, which is why Square has millions of merchants able to accept card-based payments from anywhere.

Square’s second product, the Cash App, is a great product in its own right; it’s very easy-to-use, particularly if you want to buy Bitcoin, and it also has network effects: you can use the Cash App to send money to your friends.

The Cash App's network

There is also a tiny bit of a network effect with the Seller side of Square’s business, as you can pay Square merchants with the balance in your Cash App. That’s pretty great for Square, since they don’t have to pay off the credit card companies, but it’s a very small sliver of overall volume. The Cash App and Square Seller business are really two separate entities under one roof. At least they were a week ago.

What is so intriguing about the Afterpay acquisition by Square specifically is the potential for 1+1+1 to equal far more than 3. Start with the obvious synergies: Square’s merchant base will automatically have access to Afterpay, and and Afterpay’s merchant base will have access to Square (helping Square expand in Australia in particular). What is even more compelling, though, are the transformative effect this acquisition could have on Square’s network effects.

First, recall that Afterpay has created a network effect between consumers and merchants; Square is going to insert the Cash App directly into this relationship. The company even created mock-ups in the slide presentation explaining the deal:

Afterpay via Cash App

This will not only drive adoption of the Cash App by consumers who wish to BNPL, it also increases the frequency with which consumers might use the Cash App for purchases in general. This deepens the moat for both Afterpay and the Cash App and improves Square’s margins.

Second, the most obvious way to make your Afterpay payments will be with the Cash App, not your debit or credit card. Payments made from your Cash App balance will be very high margin for Square (which it can potentially pass on to merchants), and the obvious fallback will be the bank account already linked to the Cash App account, which should further reduce Afterpay’s credit card fee exposure. The end result is a multi-part network that is not quite as impenetrable as Visa’s, but it’s much more compelling than what Square had previously:

The Square/Afterpay network effect

This isn’t some grand insight by me, to be clear; this was the cover slide for Square’s investor presentation:

Square's vision

Square had a consumer business and a merchant business and it bought a network effect between them.

Apple and the Cost of Time

That network effect didn’t come cheap, of course: the all-stock deal’s implied purchase price of $126.21 AUD ($29 billion USD) is a 31% premium to Afterpay’s Friday stock price, and is nearly 20% of Square’s market-cap. Surely it would have been much cheaper for Square to build its own BNPL service (like PayPal has)?

Perhaps, but the real cost of doing that would have been time. BNPL is not only taking off now, it is also drawing the attention of some very large competitors. From Bloomberg:

Apple Inc. is working on a new service that will let consumers pay for any Apple Pay purchase in installments over time, rivaling the “buy now, pay later” offerings popularized by services from Affirm Holdings Inc. and PayPal Holdings Inc. The upcoming service, known internally as Apple Pay Later, will use Goldman Sachs Group Inc. as the lender for the loans needed for the installment offerings, according to people with knowledge of the matter…

The service is currently planned to work as follows: When a user makes a purchase via Apple Pay on their Apple device, they will have the option to pay for it either across four interest-free payments made every two weeks, or across several months with interest, one of the people said. The plan with four payments is called “Apple Pay in 4” internally, while the longer-term payment plans are dubbed “Apple Pay Monthly Installments.” When making purchases through an Apple Pay Later plan, users will be able to choose any credit card to make their payments over time. The service is planned to be available for purchases made at either retail or online stores.

This story dropped on July 13, and the impact on Afterpay’s stock price was immediate:

Afterpay's stock price

Note that pre-Apple-news price: $123.65 AUD is only $2.56 less than Square’s offer; when you consider that one of the problems with Apple Pay Later is that it can be used anywhere — a challenge that is directly addressed by Square’s huge merchant base — the price starts to look like a bit more of a deal. More importantly, though, Square’s network vision is about squeezing out credit card companies in favor of its ecosystem; Apple, on the other hand, is going to be riding on top of credit cards, which means that the company is not only a rival as far as customer acquisition is concerned, but also in terms of locking in the status quo. Square doesn’t have time to spare.

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