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Afterpay, Zip: Tech bubble 2.0?

·5-min read
Afterpay, Zip: Tech bubble 2.0? Source: Getty
Afterpay, Zip: Tech bubble 2.0? Source: Getty

The post-COVID rally from ASX tech stocks — particularly the buy now, pay later (BNPL) sector — has got some investors throwing the ‘b’ word around.

Some would describe the BNPL sector as a bubble, but it depends who you ask.

For example, analysts at UBS most recently valued Afterpay (ASX:APT) at $25, whereas the team at Bell Potter reckon it’s worth over $100 (APT stock closed on Tuesday at $75.05).

The BNPL sector isn’t the only space that has outperformed since March, with a number of other listed fintechs also building strong momentum.

With tech still the topic of much discussion, Stockhead recently spoke to an expert in the space to get their thoughts on valuations as well as broader market dynamics

Tech bubble 2.0?

A common frame of reference for recent activity in the local market is the late 90’s tech bubble, when a rising tide (in the form of the internet) lifted stock prices to new record highs before that same tide went out just as quickly.

But for tech specialist Hugh Richards, principal at Sydney-based advisory firm TMT Partners, the “Tech Bubble 2.0” comparison doesn’t quite stack up, for three reasons.

Firstly on a macro level, the policy response to the pandemic has given rise to excess liquidity that needs to find a home. Concurrently, those same stimulus measures have also helped to make other assets less attractive.

“Money has to go somewhere and normally it would move back into safe stocks like banks, but in today’s market nothing’s safe,” Richards told Stockhead.

Corporate bonds aren’t necessarily a safe bet (see: Virgin) while cash in the bank has a lower yield than ever. The result is that institutional capital flows are moving into different opportunities.

Which leads to the second difference: a “paradigm shift” to digital business opportunities that have been accelerated by COVID-19.

“I think there’s been a prevailing shift in this crisis, so even if eventually the market gets back to normal, there will still be a legacy impact,” Richards said.

“All those themes accelerated by COVID-19 — e.g. the move away from cash, online sales — aren’t going to go backwards. So companies that have done well through this crisis, we don’t expect that to be reversed.”

Lastly, Richards said companies that had managed to survive the disruption had earned something of a “gold star” in the eyes of the market. To back his view, he pointed to anecdotal evidence in global M&A from TMT’s partner firm, Arma Partners.

Through April and May the only activity in capital markets was for equity raisings, and “that’s because the market perception was if you’re selling a business in the middle of COVID-19 there must be something wrong with it”, Richards said.

However, “all of a sudden there’s been a lot more M&A activity in that global private equity tech sector than there has been for several months”.

“So I think there’s a newfound regard in market for companies that have shown they can survive and thrive in what’s otherwise been an exceptionally challenged market,” Richards said.

“That differs from the previous tech bubble which was based on hype about what the future could bring. In this case, it’s been driven by what tech alternatives are the most attractive and what their performance has been like.

“Markets are bidding prices up based on that performance. Whether they’ve bid too far is a live question but there’s a contrast in that foundation.”

Investing framework

While it may not be Tech Bubble 2.0, Richards highlighted that specific sectors do go through “hype phases”. He cited some red-hot valuations for digital media companies back in 2015/16.

“You had companies valued at up to 100x revenue, and it looked hugely profitable until everyone figured out all the money was going to be taken by Facebook and Google,” Richards said.

He added that evidence from more mature global markets indicated that the online lending model — e.g. small business loans — was actually a difficult market to make money in.

In addition, some of the values being ascribed to BNPL stocks are “eye-watering” and “I wouldn’t necessarily say valuations in that space are fair”.

Within that complex environment, Richards said that investors should focus on two key variables when appraising companies — gross profit margin, and recurring revenues.

For example, one criticism levied at BNPL stocks is that none of them are currently profitable, but Richards said that didn’t necessarily have to be the focus.

“What these tech companies are quite rightly doing is raising capital and spending it as fast as they can to grow, because they’ve got a huge market opportunity ahead of them,” he said.

“And that’s exactly what they should be doing, but then as those investments hit the expense line in their P&L they may become loss-making. These companies don’t need to be profitable, but they should be profitable at the gross margin level.”

And in terms of recurring revenues as it applies to the BNPL model, investors should then be looking for metrics around growth in return customers.

“It’s still a relatively new sector, and there’s not much evidence overseas of a BNPL company that’s collapsed or underperformed,” Richards said.

“So I wouldn’t necessarily call BNPL out and say it’s an overhyped space. Whether it is or not is still a live issue, but I would say digital lending is an example where there’s enough evidence overseas that valuations in that space are getting toppy.”

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