Embedded Briefing: Klarna (and maybe BNPL) in trouble

“When we set our business plans for 2022 in the autumn of last year, it was a very different world than the one we are in today,” Sebastian Siemiatkowski, Klarna’s CEO and co-founder told his employees in a prerecorded message. 

“Since then, we have seen a tragic and unnecessary war in Ukraine unfold, a shift in consumer sentiment, a steep increase in inflation, a highly volatile stock market, and a likely recession. All of which have marked the beginning of a very tumultuous year.”

This is not the only hit Klarna has taken recently. A few months ago, in February, when the initial news broke that Klarna was looking to raise more funds from new and existing investors, it was reported that the firm was seeking a valuation between $50 billion to $60 billion. This month, reports emerged that the firm is looking to raise $1 billion from investors at a much lower valuation. The new round of funding could see the firm valued at $30 billion, down from $46 billion last June. 

The Stockholm-based fintech would lose its status as Europe’s highest-valued fintech, handing it over to Revolut, currently valued at $33 billion. In fact, as Klarna announced its layoffs, Revolut announced it is actively hiring, with over 250 job postings up on its website. 

Revolut, Monzo, and Curve have already been knocking on Klarna’s door, releasing their own BNPL-like offerings as they eye its market share. Revolut is testing a new feature that could compete with BNPL offerings, allowing customers to defer two-thirds of the payment for anything purchased using a Revolut Card. Customers will be able to spread the cost over two further installments. 

Furthermore, Klarna also faces competition from more established financial service providers. PayPal and Mastercard are interested in the BNPL business: the former has launched and grown its product internationally while the latter is expected to next year. Traditional operators also have intentions to compete with Klarna, as Barclay’s partnered with Amount to dip into the BNPL space, while Goldman Sachs is partnered with Apple to create a BNPL offering.

In 2021, Klarna doubled its losses to $487 million, while it showed growth in transactions processed and user base. That's no longer good enough as investor attitude sours. This is not exclusive to Klarna though, as other operators in the space also struggle to achieve profitability. Affirm reported net losses of around $430.9 million for the fiscal year ending in June 2021, as Afterpay’s annual losses shot up to $345.5 million in 2021. 

That’s a lot of red ink for such a fastly growing industry.

Consumers are spending more than they can and more than they have. 57% of consumers reported regretting buying something off of BNPL, and 56% have found themselves falling behind on payments. Additionally, with regulators lurking on top of the profitability issues, there still hangs a question over the industry’s future.

“The big question around the BNPL sector has always been around the sustainability of the business models in a more normalized credit and interest rate environment,” Michael Taiano, an analyst at Fitch Ratings, told Bloomberg. He added that incremental demand for BNPL is likeliest to come from low-income households, increasing the danger of non-payment and potentially affecting the lenders’ credit performance.

Maybe this question should’ve been brought up earlier, but is BNPL even a viable and sustainable business model? Some experts are beginning to argue that it's not. UK-based equity research house Redburn  published a report last year that said, “BNPL as a standalone business is not viable.” The inability of BNPL leaders to turn a profit supports this opinion. 

Firstly, the BNPL business is one that relies on high volume and small margins, with the bulk of the revenue coming in from merchant commissions and some from late fees. Additionally, as of late, charging late fees has gotten bad press for being exploitative. So much so that last year, PayPal announced that it would drop late fees with its BNPL offerings worldwide.

Let's review the unit economics for a BNPL business. Firms generally charge merchants 4% Against that, on the expense side, they pay 1.3% in interchange fees, 0.6% in network fees (which are paid twice, first when the provider pays the merchant and the second when it deducts from a user’s card), 0.1% in issuer processes costs (generated to pay merchant), 1.2% in credit losses, and another 0.5% in funding costs (raised to settle merchants). Doing the math, we see that firms operate with a gross profit margin of 0.3%, which is a small margin in and of itself, but add to that the credit risk BNPL providers take, and it's worrying.

The bad debt problem in BNPL is significant. With shoddy checks and balances, BNPL loans are often handed to individuals who may not be able to pay them back. Bad debts, on average, make up 30% of a provider’s revenue — which is very high. So with limited revenue streams and a disproportionate bad debt to revenue ratio, the business does not seem very feasible, and profitability in a pure-play BNPL business sounds far-fetched.

The way to profitability for BNPL providers, according to Redburn, is one of two ways: either get acquired by a bigger player that uses BNPL for its proven ability to acquire customers and cross sell other financial products to them, or that BNPL providers start selling such products themselves.

So what’s attracting all the VC money that poured into BNPL? Customer acquisition at scale, as with most tech businesses. But this metric alone does not mean much, especially when the business is not profitable and pure-play providers do not have any other revenue streams. Additionally, the fact that the space remains very lightly regulated, operators in the space have been able to grow substantially without any significant rise in their compliance costs. Those are expected to apply soon.

If sustainability is the aim here, BNPL operators need to figure out a way to move away from merchant-discount-dependent revenue streams and late fees, while figuring out new affiliate revenue streams.

“While BNPL is currently the talk of the town, ultimately it is simply a tool to attract new customers to new forms of payment, and to continue the move towards a world in which digital wallets reign and the costs are transferred from the consumer to the merchant,” Redburn concluded.

Chart of the day

Source: Cover Genius and PYMNTS

New data from Cover Genius and PYMNTS shows consumers have a growing taste for purchasing insurance at the time of purchasing what they want insured — be it a car, house, or travel. A recent study found that digital banking consumers look favorably upon embedded insurance offerings, with 70% reporting high interest in such offerings. What’s more interesting is that almost 1 in 2 traditional brick-and-mortar banking consumers also think it's a good idea, with 44% saying they’re highly interested.

Furthermore, 45% of consumers reported “extreme” interest in receiving insurance coverage options from their primary FIs, based on their transaction histories. According to the study, consumers desire embedded insurance offers most when the potential risk of financial loss is high, such as for making big investments in a house or a car. For example, a bank-embedded homeowner’s insurance sounded compelling to 28% of customers of traditional banks and 41% of digital bank customers.

A front runner in the embedded insurance space is Tesla. The firm set out to build its own in-house team of actuaries and is so dedicated to the cause that more than 30%-40% of its future revenue could come from insurance, according to founder Elon Musk. Traditional insurers were charging higher premiums for insuring Tesla cars than they do with regular cars, which could demotivate people from buying Tesla. The firm incentivized customers by taking matters into its own hands and launching its own insurance product.

Additionally, healthcare is one place where embedded insurance is really compelling for customers. Zoetis, the world’s largest producer of medication and vaccines for animals, started allowing pet owners to insure their pets with the launch of their embedded-insurance product called Pumpkin. Another example is the fintech Matic, which works with mortgage originators, servicers, banks, and other real estate firms to integrate home insurance products into the processes of buying/renting a place to live. 

Retail giant Amazon also has intentions to step into the space. The firm began experimenting with embedded insurance last month. Amazon Business Prime members, or its merchant partners, can receive insurance quotes and purchase a variety of policies, like a general liability to workers’ compensation, directly through the platform.

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