2023-05-11 14:06:14 ET
Summary
- Upstart has produced a vastly improved set of financials that can set it on a course toward profitability. It is now leaner, which will significantly improve margins.
- Upstart is likely to emerge from a difficult 2022 a stronger company with a better product and better visibility over loan funding.
- Upstart has provided guidance ahead of what the market was expecting, guiding for EBITDA breakeven next quarter and improved margins.
- Caution is advised, as the macro is still not supportive, but UPST is a buy in anticipation.
After a difficult year, Upstart ( UPST ) looks like it might have turned a corner. Management has introduced several cost cutting measures including a significant reduction in workforce. This has made the company much leaner and more efficient, while still allowing them to improve their AI models, service their customers, and originate loans.
Upstart has also made real progress on improving their platform, not just in terms of accuracy but by securing committed capital that will provide more visible funding for loans Upstart originates. This, along with an unnamed transaction expected in Q2'23, may mean Upstart's loan assets on the balance will reduce, which will be well received by the market.
Once the economic conditions that have beleaguered the company improve, the combination of these initiatives has primed Upstart for growth, making the company ready to take advantage of better lending conditions. For this reason, Upstart is a buy for investors with a high risk tolerance who are happy to take a medium term view and wait for that improvement in conditions.
Introduction
The story of Upstart's last 12 months or so has been a macro story. Interest rates rose rapidly leading to severe, if temporary, caution on the side of institutional funders. This made it difficult to package and sell loans, all the while lending standards dramatically tightened making loan approvals more difficult to get through.
The Q1'23 result showed promise. Not because the macro story has changed, but because the company financials drastically improved without it. In this article I'll briefly cover what the company does, what the company changed this quarter, and how the next 12 months could look.
Company Profile
Upstart is a lending platform that uses artificial intelligence and big data to assess creditworthiness in potential borrowers seeking unsecured personal loans. The company's platform uses data from over 21.6 million repayment events with 1,600 non-traditional variables such as job history, rental history, and education. The traditional method banks have been using for decades (the FICO score) looks at only 15-30 variables, which limits how it can quantify risk. In failing to identify this risk properly many individuals that could safely borrow are being left out of the credit system while those that are approved are forced to pay higher rates than they might otherwise to subsidise the bad loans that the lacking systems didn't properly assess.
Upstart connects borrowers with lenders and uses their platform to aggregate better insights and provide a more accurate understanding of repayment ability. This has the effect of increasing approval rates and lowering interest rates for borrowers, and it reduces fraud and loss rates for banks. Borrowers win. Banks win. And Upstart earns a fee for their troubles. Upstart's sweet spot is in identifying quality borrowers that FICO overlooks.
1Q23 Result Overview
Since interest rates began rising in the middle of 2022, Upstart's revenue has been falling on a quarter-on-quarter basis. This is encapsulated in the following chart.
Analyst presentation of data from FactSet
Revenues have been falling due to lower transaction volumes and a lower conversion rate, combining to result in a far lower level of loan approvals. The loan approval rate fell to 8% of all applicants, compared to 21% in Q1'22. Further, loans originated fell 78% to 84,000 loans totaling $997 million.
When revenues decline so rapidly, it therefore makes it very difficult to grow earnings. To their credit, Upstart has reduced expenses where they can, especially on marketing, which has declined from $133m in Q1'22 to around $31 million in the current quarter. This cost discipline shows good financial discipline and that management recognizes when incremental marketing dollars are a waste of capital. However, R&D continues to increase at a fast pace, shown below.
Analyst presentation of data from FactSet
That was mainly all the bad news, a lot of the release and the conference were dedicated to how the business is evolving and how the company will emerge from the downturn a stronger company.
Upstart has Reduced its Cost Base Substantially...
The good news for shareholders is that this recent period of weakness has led Upstart into a period of leanness. During the 3rd quarter of 2022, Upstart sacked 140 employees , or 7% of the workforce. In Q4'22, they dismissed a further 365, or 20% of the workforce . Now in 1Q'23, they have sacked another 30% of the workforce. Comments from Sanjay Datta, CFO, suggested that the staffing base is at a low and would grow from here as required but has been rightsized for the current size of the business.
We've seen this play out at other platform companies such as Airbnb ( ABNB ) where a period of weakness forces them to downsize, they learn to live on a smaller cost base, then when revenues return they are a leaner, more profitable business. It is still early, but there is a chance that Upstart could do the same.
...And Will Likely Wind Down its Loan Assets
Investors who follow Upstart will know that the March 2022 quarter saw a huge inflow of loans onto Upstart's balance sheet. Investors were wary because Upstart is supposed to be an enabler not a bank, and indeed, to my relief, the company continues to reassure investors that they have no intention of becoming a bank.
This level of on-balance sheet loans increased from $252m in December 2021 to $1.1 billion in Q1'23. Meanwhile, interest rates have been increasing, which means the value of the loans on the balance sheet will be declining. These are marked to market and have been recognised as negative fair value adjustments within the net revenue figure. This has been another reason revenue has been weak through 2022.
Historically, Upstart has typically only used its balance sheet to take on loans that will be used for R&D - in other words, to feed their AI models with fresh repayment data. In Q1'22 Management noted that , due to the rapidly changing interest rate environment, investors that would normally be lining up to buy the loans Upstart was originating, were recalibrating what their own yield hurdles, resulting in a delay for funding. CFO Sanjay Datta referred to it on the call as a "market clearing mechanism".
Very importantly, Datta said at the time that he doesn't view this as being a "necessarily long term or sizeable activity for us". Although the loans did continue to grow on their balance sheet, management stated that a large proportion of these would be for R&D purposes for the nascent auto segment. By third quarter, the balance of loan assets on the balance sheet was $700 million, and $451 million (64%) of these for R&D purposes.
I might have been a little too skeptical of this pivot. Indeed, management stated early on how important it is to be responsive to the environment in which they operate, which is especially true in finance. Girouard stated on the Q2'22 call :
A changing, volatile environment suggests we need to be flexible and responsive in our approach.
And that's exactly what they've done. In reading back through the last 4 quarters of calls, I can see management executing on what they've said they will.
To this point, on the Q4'22 conference call CFO Sanjay Datta noted the following:
We are now roughly at the maximum size of balance sheet that we are planning to maintain, and we will, therefore, largely limit new additions to the balance sheet until we can find suitable sources of liquidity for existing loans.
And to their credit, Upstart appear to have followed through on this as well, as the loans on-balance sheet did actually decline slightly in Q1'23. It was not so much the decline that pleased me, simply that it didn't increase. It would have been concerning if the company continued to increase loan assets given the size it is already. This actually suggested to me that they have a good amount of control over what they take onto their balance sheet, something I think management have been trying to articulate all along.
Funding Secured to Stabilize Platform
Another example of management foreshadowing then executing regarded finding strategies to improve the consistency of available funding on the supply side of the platform. Girouard said on the Q2'22 call:
We've concluded that we need to upgrade and improve the funding side of our marketplace bringing a significant amount of committed capital on board from partners who will invest consistently through cycles. We're currently evaluating a variety of opportunities to do just that. So we expect this will take some time to bring to fruition.
It took them nine months, but the announcement this quarter that they have done exactly that was very well received by the market and received a lot of attention on the call from analysts. Specifically, Upstart announced they had "secured multiple long-term funding agreements together expected to deliver more than $2 billion to the Upstart platform over the next 12 months".
This will provide Upstart with more funding availability for loans their platform, providing better visibility and a more stable capital supply going forward. Separately, management also hinted at a "balance sheet transaction" that was slated for Q1 but will now occur in Q2. It sounds like UPST have lined up a buyer for some of their loans, which will free up the balance sheet and return cash to the company, which can be used for growth initiatives.
Margins
There was more good news regarding the improved contribution margin ((CM)) and the improved outlook. Contribution profit shows the profitability of the unit economics on the actual loan issuances, ignoring the overheads of the business. It subtracts borrower acquisition costs ($19m) and borrower verification costs ($29m) from revenue from fees ($117m) to arrive at a sort of quasi gross profit number. Contribution margin is the percentage of revenue that contribution profit represents.
While contribution profit was down significantly on the pcp, the contribution margin was up materially on Q4'22, suggesting unit economics on loans had improved by either being able to acquire and verify borrowers more cheaply, or by charging higher fees to the banks for doing so (or both). CM for the quarter was 58%, up from 47% and the company expects this to improve again in the second quarter to 60%.
Looking Ahead
Perhaps most importantly, the best news was the outlook. Upstart expects revenue to recover 31% from Q1 to Q2, to $135m, with a $5m contribution from net interest income. This is an improvement on the FactSet consensus number of $125m as at the end of April.
Net income is guided to be a loss of $40m, where consensus was expecting -$44.8m. Adjusted EBITDA is guided to be breakeven, an improvement from the consensus forecast of -$16m.
This points to the changes made to the cost structure of the business having a positive impact already. These changes include the reduction in workforce, the reduction in spending on marketing, the reduction in infrastructure costs, and they have also sublet some of their office space.
This should bring forward the ability to turn profitable again at a reduced loan level, while the company awaits the improvement of credit conditions.
A Leaner, Stronger Business
I have mainly spoken about the business and what the company is doing to rightsize the business considering the material reduction in volumes and revenues. This demonstrates how cyclical the business is, which has been painful for investors to learn. But this means when the macro turns in the company's favour, Upstart could come roaring back to life.
As difficult as it has been for the company and its investors, I believe the last 12 months will make it stronger. Prior to 2022, Upstart - a platform enabling lending, advising on creditworthiness - has only ever operated in a low interest environment. This fact cannot be understated. The company has never known a recession and did not know how their product would respond to a period of rising interest rates. Now they do and this corporate knowledge will be valuable. On their technology, CEO Dave Girouard said in the Q4'22 result conference call:
I believe we made more progress with our technology in 2022 than in any year in our history. And as capital markets and the overall economy normalizes, I expect this will become obvious to all of you… The increase in our model accuracy in the last seven months is more than what we delivered in the prior 2.5 years.
And after mentioning they pushed through 23 model improvements in the quarter, he followed this up in the Q1'23 conference call by saying:
We're confident that our AI has never been as sophisticated or as accurate as it is today.
We are almost certainly closer to the peak of the rate cycle than the bottom. While we are unlikely to return to 0% policy rates anytime soon, if the Fed starts cutting rates later in the year like the market expects, this will be a tailwind for Upstart and should improve the approval ratio of borrowers, which has been the main cause of lower lending volumes and the resulting revenue to Upstart.
Outlook and Conclusion
Before the result, FactSet consensus was forecasting EPS breakeven to occur in the December 2023 quarter and EBITDA breakeven in the September quarter. This is likely to be brought forward now that the company has guided for EBITDA to be breakeven in the June quarter.
The forecast increase in revenue coincides with the timing over which markets are pricing interest rates to begin declining. In other words, the market expects the Federal Reserve to start cutting rates later in the year. It may be a case of correlation, not causation, but either way, if interest rates do decline, this creates a much more friendly environment for Upstart.
So there is light at the end of the tunnel for Upstart and the ability to come up with an investment case is a lot easier today than it was one quarter ago. The company has made great progress in improving their cost base, all while significantly improving their AI models to better understand different macroeconomic forces. This will make it a better product and make it more attractive to prospective banks and credit unions. Upstart can tread water for now, but when the funding environment improves - and it will improve at some point - Upstart will be ready and should see strong growth on a reduced cost base.
This, more than the guide ahead of consensus, is likely what the market is getting excited about. Upstart remains high risk, especially considering we have not seen the end of the current rate cycle, but with an eye on the medium term, it is a buy.
For further details see:
A Leaner Upstart Can Grow From Here