How Afterpay deal could transform Square

Square's $29 billion deal to acquire the installment lender Afterpay provides new muscle — and a powerful buy now/pay later product — not only to Square's sellers, but to its popular consumer-direct business as well.

While there are many lenders in the global BNPL market, Square's biggest rival in this space is PayPal, which has benefited heavily from its merchant reach and brand recognition. Square is best known to merchants, but has had a lot of success adding consumer-facing services to its Cash App, which contributes more than 80% of Square's revenue and supports peer-to-peer payments, bitcoin trading and other services.

The Melbourne, Australia-based Afterpay is one of the few firms to control more than 10% of the U.S. buy now/pay later market. At Square, Afterpay will be the key driver in offering cross-border omnichannel BNPL that can serve both Square's consumer-facing and merchant services businesses.

"Afterpay rounds out Square with a comprehensive feature," said Brian Riley, director of Mercator's Credit Advisory Service. "Integrating Afterpay allows Square to reach a wide range of buy now/pay later merchants at checkout. At the same time, Afterpay is a perfect match for Square's Cash app."

As the U.S. market warms up to BNPL, numerous companies are trying to make their mark, but very few brands stand out. While Afterpay is an Australian company, it is growing quickly in the U.S., recently reporting North American sales have tripled thus far in 2021.

PayPal is at the top of the list of firms providing BNPL in the U.S., controlling 45% of the American market, according to research from Arizent, American Banker's parent company. Afterpay lags PayPal, controlling 12%, but that's good enough for third place behind Affirm 13% and ahead of Karna's 7%. Square, which offers installment lending, is not on the charts.

Square and Afterpay did not return requests for comment on the acquisition, though the companies' release mentioned Square Cash will play a key role in managing BNPL transactions. "We're seeing strong demand for buy now/pay later from merchants and consumers," said Jack Dorsey, CEO of Square, during the company's earnings call on Monday. For the quarter ending June 30, Square reported earnings of 40 cents per share, up from a loss of 3 cents per share the prior year. That beat analysts' expectations of 30 cents per share, according to TheStreet.com. Revenue grew to $4.68 billion, up from $3.3 billion the prior year.

Afterpay's merchant clients include Urban Outfitters and major retailers such Target, Amazon, CVS, Kroger and Walgreens, a mix that should serve Square's goal of adding larger merchants to its network. In the release, Square also mentioned extending BNPL to smaller merchants, which are Square's traditional market.

Afterpay has added technology as it has grown in North America. Near the end of 2020, Afterpay added support for cross-border payments, following an upgrade to serve brick and mortar merchants in addition to Afterpay's core e-commerce business. Afterpay additionally redesigned its user experience to appeal to U.S. users.

Afterpay also reports its U.S. business has multi-generational support, drawing users from Gen Z to Boomers, according to Arizent's research. Afterpay's growth has been substantial enough for it to reportedly consider a U.S. public listing to grow its profile in the States.

The deal "starts to position Square as more of a three-party network akin to PayPal, where Square increasingly becomes a player that can bring consumers to merchants," said Jordan McKee, principal analyst for digital payments at S&P Global Market Intelligence. Acquiring Afterpay, he said, will catapult Square into one of the most prominent positions in BNPL globally while presenting synergistic potential, particularly in connecting Square services for consumers and businesses.

"One of the most significant is the opportunity for Square to begin connecting its seller and consumer ecosystems," McKee said. The ability for Square to meld its merchant and consumer businesses is in the early stages of exploration, he said.

The acquisition would allow Square to be a major competitor in BNPL without Square having to build out its own service. Square's Cash app, a peer-to-peer feature that Square uses for bitcoin trades and other merchant payment needs, has about 70 million users, while Afterpay serves 16 million users and 100,000 merchants.

Among the major installment lenders, PayPal's Pay in 4 produced $1.5 billion in payment volume between April and June, with 7 million consumers and 650,000 merchants. Affirm has about 12,000 merchants and 12 million consumers, both more than double its count from late spring 2020. Klarna has about 90 million consumers, and 250,000 merchants.

At PayPal, BNPL is an extension of a financial services strategy that includes payments, merchant lending, crypto support and its Venmo peer-to-peer payment subsidiary, which is part of PayPal's overall strategy to extend its merchant network. Affirm has added a debit card that's designed to make it easier for merchants to offer BNPL at the point of sale. Klarna in 2021 added a bank account in Germany as it pushes toward a diverse model similar to N26 and Revolut, payment companies that branched into financial services.

Afterpay will gain access to a broad reach of financial services by being part of Square. The combination would create new connections to consumer bank accounts using merchants as the distribution channel, according to Rick Oglesby, president of AZ Payments Group. "This will fuel the P2P business and the rest of the consumer financial ecosystem."

There are dozens of other companies pursuing BNPL. Apple is collaborating with Apple Card partner Goldman Sachs to offer a BNPL product that's designed to work at brick and mortar stores, creating competition for Afterpay's in-store redesign and putting pressure on other BNPL firms that are primarily designed for e-commerce.

American Express recently launched a buy now/pay later service designed for travel, while Visa, Mastercard and Citigroup have made investments or partnerships that support BNPL. Most BNPL pacts are not exclusive, but market experts have said BNPL fosters lasting relationships for merchants, lenders and consumers, making Afterpay's existing network attractive for Square — and a potential rival for banks.

With Afterpay's addition, Square can offer consumer loans, adding a business line on top of the lending Square does through its industrial bank license and its merchant credit product.

"If you're a bank you've got to be worried that there are big tech players that are building out customer-facing ecosystems to merchants," said Sanjay Sakhrani, an analyst with KBW. The competitive concern for banks is the ability of the Afterpay-Square combo and the technology-heavy BNPL market to boost engagement between merchants and consumers, he said.

"The play here is you're getting to the customer in a different way," he said.

As fast as BNPL has grown, it also has challenges. BNPL lending is drawing attention from regulators out of concerns that consumers are accumulating debt. The Consumer Financial Protection Bureau, for example, has warned consumers to consider the project's impact on their personal finances, a warning some have viewed as a prelude to tighter regulations in the U.S. Regulators in Australia and the U.K. are working on tighter rules following research that found higher instances of financial stress in BNPL than for traditional credit cards.

"There's a potential risk here given the BNPL industry has not gone through a real credit crisis," and Square's diverse revenue streams could provide some protection from that, Sakhrani said. "The value proposition" for Square and Afterpay, he said, "is finding another means to improve engagement inside Square's ecosystem."