BNPL's Next Phase: Shakeout and Profitability (#35)
Sustainable growth, consolidation, and pricing for profitability in BNPL
Welcome to the 35th issue of the Unit Economics. Some personal news before you dive in: I have joined the product team at Jupiter to help build their buy now, pay later payments application – Bullet. It’s early days here and we have openings for product, operations, and risk – so drop me a mail if you are interested in building payments on top of BNPL and UPI.
A little selfishly but the issue for this week also focuses on BNPL, where I wonder where the industry stands today, what’s next, and how companies are thinking about profitability.
I wrote on Buy now, pay later (BNPL) payments last November and discussed all the good things that it brings with it. Accessibility, transparent and simpler fees, and easy-to-use mobile applications were and continue to be big draws for the modern and younger population. For merchants too, the promise of higher conversion rates, order values, and hope for some differentiation is too hard to ignore.
This value generation on both sides of the payments explains the high adoption of BNPL. But over the last few years, the industry got further boosted by the infusion of large pockets of private capital and with the introduction of pay-later solutions from the likes of PayPal, Visa, Apple, among others. It comes with little surprise then that BNPL is expected to be the fastest-growing online payment method for the next few years, and will make up more than 4% of global e-commerce by 2024. The number is predicted to be as high as 13.6% for Europe and ~5% for North America.
This is a remarkable feat for BNPL in the era of continuous payments innovation and proves that there is something more concrete behind all the noise. There is, no doubt. But the fast growth of the payment method has also meant a few not-so-good things for the companies involved.
More regulations: Regulators are increasingly asking questions on the definition of BNPL services, and of the quality of consumers and the credit issuance practices of the providers. EU’s Consumer Credit Directive rules are up for review due to BNPL, UK’s Financial Conduct Authority has begun regulating such companies, Australian Finance Industry Association (AFIA) has introduced a BNPL code, and there are ongoing conversations in the US and elsewhere.
Entry of Payments Incumbents: the last year and a half has pushed many payments giants (Citi, Visa, Mastercard, Tinkoff, Pine Labs, etc.) to launch BNPL services of their own. Apple and Goldman are the latest and, arguably, the most significant of the lot. But they will hardly be the last. These entries validate the potential opportunity of BNPL, but also disrupt the original high cash-burn businesses, which will likely have to spend more on distribution and differentiation to gain legs.
Questions on Sustainability: Lastly, with more capital, public listings, and regulatory interventions, there are questions on whether the BNPL business models, which vary but often depend on merchant fees or late charges, can sustainably grow. This subject will be the focus of the rest of the article.
The Next Phase of BNPL Growth
It is a popular concept that every industry and business within go through multiple cycles before they reach maturity. A more generic visualisation of these cycles looks something like the graph below.
For BNPL, the startup stage was somewhere around the early to mid-2010s, wherein the likes of Affirm, Klarna, and Afterpay slowly developed their merchant base, iterated the installment payments model, and got buy-ins from early adopters. At this point, the merchant distribution, away from parts of Europe, was still negligible and left companies with little negotiating power and revenues. Even the categories of merchants onboarded were concentrated towards a few industries.
In the years since, as the pay-later model proved its worth to merchants through increased conversion rates, order values, and established high convenience for young consumers, the distribution grew. The proof that the model worked allowed incumbents to ask for a good 2-6% share of merchant revenues, and the belief from consumers pushed the product from early adopters to the early majority. The growth stage then was marked by:
A high number of companies (50+) that have popped up around the world offering some variation of the pay-later model,
The fast-growing volumes and revenues (Active users at Klarna: 90 Mn+, Afterpay: 13 Mn+, Affirm: 5 Mn+),
Expanding categories for merchant partnerships,
Development of BNPL applications into pseudo-e-commerce platforms, and
Increased VC focus on the industry
But despite this growth, questions remain on the sustainability of the revenue streams that presently power the cash flow of these companies. Look at the numbers for some of the largest BNPL companies, for instance.
All four companies have achieved tremendous scale in a limited time, but the need for expansion continues to weigh down their economics. This is partly because by going away from the frills of the credit card model, the BNPL companies have been able to establish trust. But this has come at the cost of forgoing income that allows credit cards to exist. For example, a credit card usually comes across two types of consumers: revolvers and transactors. The revolvers pay the interest accrued due to late repayments, which allows issuers to subsidise the rewards on credit cards for the transactors, and whatever is left after expenses makes up the profit. So, the value proposition of credit card rewards is sustained due to the existence of revolvers and the seemingly high fees.
But under the BNPL model, the low costs of defaulting or late payments make it incredibly challenging to overcome the company costs, let alone allow rewards to the users. This has pushed companies to experiment with the merchant and other transaction fees, but a sustained model of profitability is yet to be found.
This brings us to the next phase for the BNPL industry. As opposed to the industry lifecycle graph, BNPL is unlikely to experience sufficient profits or high positive cash flows before shifting to the Shakeout cycle. This is because the growth-craze of the industry has pushed it years ahead in the cycle without allowing the companies to justify their unit economics.
For instance, today, the global BNPL market is getting overcrowded, seeing competition from the payments incumbents, offering standardised pay-later products, losing negotiating power with merchants, and facing pressure from investors for high growth. In short, there are enough reasons to worry for the smaller BNPL providers in the more developed markets. With these challenges, how do the companies then find a way out? There are three ways.
Acquisition: as would happen in the approaching shakeout phase, the larger companies in the hope to expand fast would prefer acquiring the smaller players with a similar customer base or manageable product economics. For others that are unable to sustain growth or find an acquirer, the consolidation in the cycle is likely to end up less pleasant. Some have even forecasted a Hunger Games-style race to the death for many in the Australian market.
Cross-Sell to Existing Consumers: a lot of smaller BNPL companies have succeeded in gathering noticeable scale. If their pay-later model is unable to sustain their growth or justify the numbers, then a likely solution could be to offer complementary products to the existing user base and to focus on average revenue per active user. It could be insurance, investments, prepaid cards for family, or something else. Cross-selling different forms of financial services products is common across other payment methods. For example, banks cross-sell banking products to credit card holders and mobile wallet applications have often expanded to micro-lending and investments.
Pricing for Profitability: the less saddening and, perhaps, a more challenging way out is to figure out a formula for profitability with BNPL. Even if that requires some pivots in the pay-later model. Tough, but possible. Klarna, pre-2019 had returned positive net profits for consecutive years operating on the merchant-based fees model. Similarly, companies such as Zilch and Slice have adopted models that depend on credit card transaction fees but combined with the convenience of pay-later. Slice even earns interest on longer-tenure EMIs (~80% of the portfolio income) and has justified the model with profits.
The last points brings us to the billion-dollar question.
How can BNPL providers price for profitability?
We know that payments are almost always a volume game. Eventually, at a large enough scale, the small commissions accumulate and overpower the falling costs. The math is simple if it is restricted to volume.
But with BNPL, the debt financing costs complicate the math. If the focus is solely on the scale, companies stand at the risk of onboarding sub-prime users. Fall towards the other end and the growth rate and revenues will likely be lower. Managing the unit economics for BNPL then resembles one for lending business than the one for payments.
So, how can such companies limit the risk while achieving scalable unit economics? I do not suggest any definite solutions for the same, but I do believe that the following five ideas should be the core of a sustainable BNPL business:
To start with the obvious ones: negotiate better take rates from merchants, card networks, or banks depending on how the business model is positioned. There is an increasing number of new companies/banks that are partnering with card networks or offering split pay on bank cards to earn through transaction fees. These businesses leverage the existing network of merchants, and the BNPL solutions likely see significantly lower distribution costs.
Next, constantly improve your classification of risk profiles. The best BNPL providers, for instance, have focused hard on improving collections and reducing the percentage of consumers that are paying late fees. If the business is positioned to earn through merchant revenues, the incentives of the company are aligned to that of the consumers and late fees avoidance should be a mutual goal. The metrics, publicly available for some of the large BNPL providers, should be carefully selected.
Loyalty programs: Card issuers and large-scale retailers realize the value of strong loyalty programs. Solving for low retention and multi-homing in crowded markets, Klarna (Vibe) and Afterpay (Pulse) followed the same and launched loyalty programs to the world in mid-2020. Through Vibe, Klarna rewards users that repay on time and has already enrolled ~20 Mn consumers in less than a year. This should set a good example for all the BNPL companies that are fighting retention.
Feature-differentiate Across Tiers: the risk classification solves for acquisition, but it can also help companies feature-differentiate across users. For instance, to the prime consumers, BNPL providers can extend riskier payments alternatives to manage risk and potentially increase revenues at the same time. An example of this would be to offer transactional EMI to such users, wherein they can transact beyond their limits at select categories or merchants in exchange for a small overdraft or service fee. Similarly, one could offer flexibility in the existing payment model (extend the credit limit, repayment period, or ability to convert the balance into EMIs) as a service and charge a fee for the same.
Subscriptions: to keep up with the times, the businesses can also explore bundling value-added services and offering the bundle on subscription. These services would be privileges and can potentially involve providing flexibility in payment model features that were discussed in the last point, offering an aspirational physical card that you can flaunt around, allowing offers on select merchants for a fee, among other services.
If you have worked on this problem statement before, you have likely thought of all these and more solutions and yet came out scratching your head. Managing the risk of a short-term credit product while building at scale is incredibly challenging, but if done right, it should be equally rewarding because not many of your competitors will be able to.
Finally, as BNPL companies get more creative on pricing, fees and the industry moves to the shakeout phase, we must realise that large parts of the developing world (including India) continue to be in the first stage of the BNPL industry lifecycle and provide great building and investing opportunities. And since I will be more closely involved with BNPL now, expect to hear more about it in the upcoming issues.
If you have any thoughts on BNPL and profitability, write back to me on Linkedin or drop a comment below. In case you feel your friends or family would be interested in reading about payments, feel free to share the blog with them as well. See you in a couple of weeks!
Can you make the BNPL content specific to India?
EXCELLENT ARTICLE, I WOULD LIKE TO ACQUIRE MORE KNOWLEDGE OF THIS BNPL BUSINESS MODEL, ANY READING RECOMMENDATION WILL BE VERY WELCOME.