UPST - Upstart: Time For A Downgrade Mismatch Between Expectations And Reality

2023-12-23 01:26:19 ET

Summary

• Upstart stock has been one of the biggest winners this year.
• The company has made progress in cutting costs and improving operating margin, even while revenue growth remains pressured.
• The higher interest rate environment has significantly impacted conversion rates and access to funding.
• The stock is priced as if interest rates have already plummeted - it is time for a downgrade.

Like many tech stocks, Upstart ( UPST ) has had a great year - the stock at least. The company continues to face interest rate headwinds but has nonetheless managed to deliver incredible stock returns. The recent rally has been so strong that I now have a more pessimistic view of the business model quality, as it looks like the “zero interest rate policy” of the past is a necessary component of the growth thesis. The company has made impressive progress in cutting costs, which can help yield operating leverage upon improving macro conditions. It is time to downgrade the stock because the valuation appears to already be pricing in a material recovery, and terminal multiples are likely to be lower than expected.

UPST Stock Price

UPST has delivered “multibagger” returns this year after being decimated in 2022.

I last covered UPST in September where I rated the stock a buy on account of the attractive valuation and improving fundamental story. The stock has soared since then but I am taken aback by the aggressiveness of the recovery.

UPST Stock Key Metrics

In its most recent quarter, UPST saw revenues decline 14% YoY, an improvement from the 40% YoY decline seen in the second quarter.

In spite of the top-line pressure, UPST delivered $2.3 million in adjusted EBITDA, a big improvement from the $14.4 million adjusted EBITDA loss in the prior year. Like many tech peers, UPST has sought to offset pressured top-line growth rates with operating margin expansion.

UPST ended the quarter with $516.6 million of cash and $98.4 million of restricted cash versus $1 billion of debt.

The company also had around $972 million of loans held on the balance sheet, with $447 million of that being considered “R&D.”

Looking ahead, management has guided for the fourth quarter to see revenues decline 8.2% YoY to $135 million, but for the adjusted net loss to decline from $55.3 million to $14 million.

On the conference call , management talked up their ambitions in automotive lending, envisioning a future where consumers can seamlessly purchase a car online and have it delivered directly to their homes. Automated lending products like those offered by UPST would go a long way to enabling such a future.

Management also appeared optimistic with regards to their new home equity line of credit product. Management outlined expectations for very low annual loss rates of “1% or less” as well as its “countercyclical” nature to their refinancing product. Management expects their product to have advantages over competitors due to HELOC applications typically taking more than a month on average for completion - UPST is aiming for “less than five days” end-to-end.

Management continued to blame their pressured top-line growth on the higher interest rate environment, noting that they have had to employ more conservative underwriting standards which has held back loan originations. Management again cited their 36% yield limit as a headwind - the higher interest rate environment has caused UPST to simply outright reject many prospective borrowers if their calculated rate would have been above 36%. These headwinds are evident in the low conversion rates, which stood at around 8.5% in the quarter (after peaking around 24% during the pandemic).

UPST had previously garnered enthusiasm due to securing “long” term funding partners, but management continues to hold substantial loans on the balance sheets, and stated that they have “nothing explicit to really share” in terms of their balance sheet strategy moving forward.

Is UPST Stock A Buy, Sell, or Hold?

The strong recent price action is clearly not due to the fundamental results, which continue to show that the company struggles to find footing amidst a higher interest rate environment. Instead, I find it likely that investors are hoping that the Fed’s recent comments regarding 2024 rate cuts may imply an eventual return to a zero interest rate policy. UPST may also be benefiting from its positioning as an AI-first lender, as the company’s core mission has been to utilize artificial intelligence in order to increase approval rates.

UPST saw its risk algorithms underperform over the past two years but these results appear to be normalizing as of late.

As of recent prices, UPST was trading at around 7.3x this year’s sales. Prior to the 2022 tech crash, UPST was viewed by many (or at least by yours truly) as having secular growth due to being able to take market share in loan originations on account of its AI-powered platform. At this point, such a view looks shaky at best, as the company has seen growth rates struggle amidst funding issues.

The company has been generating higher-than-typical contribution margins at well over 60%, but I view 45% to 50% as being a more normalized rate as that is what the company was achieving in 2021. A 50% net margin based on contribution profits looks like a reasonable assumption long term, which equates to around a 25% net margin based on revenues. If interest rates can fall back to zero, then UPST might quickly return to generating a $850 million revenue run-rate as it did in 2022. Growth might hover around 20% or higher as funding partners are eager to earn a higher yield on invested capital. At a 1.5x price to earnings growth ratio (‘PEG ratio’), I could see UPST trading at around 7.5x sales, implying considerable upside even at just the 20% growth assumption.

However, that view is ignoring the more crucial detail: UPST has seen its business model struggle mightily over the last many quarters amidst the rising interest rate environment. The ever-present risk of interest rates rising may mean that UPST deserves to trade at more discounted valuations. At a 0.75x PEG ratio, the stock would trade around 3.8x sales, implying that the stock is already trading as if interest rates have collapsed.

The most important question is whether the company can deliver durable and profitable growth even without a decline in interest rates. I view this to be an insurmountable task given that funding partners may be reluctant to commit capital to high yielding investments as a higher interest rate environment seemingly increases recession risks. Buying UPST today appears to be based on hoping for both interest rates to fall as well as for the general investment community to quickly forget about the business struggles of the past year. Yes, the stock can deliver incredible returns if it can garner premium valuations, but it is difficult to recommend buying this stock at the current valuations with any sort of conviction. Given that the current stock price appears to be pricing in an improvement in the macro environment already, I must downgrade the stock to “hold” as I cannot say with great certainty that the stock will outperform the broader market moving forward.

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