2023-06-02 09:00:00 ET
Summary
- Upstart's stock is up 129% in the last month. Can this run continue, and is there enough upside left to invest now?
- We look at the basics of the business model and what the problem is that made Upstart's stock crater.
- We analyze the earnings, look at the product line update and Upstart's guidance.
- Investors often worry about Upstart's reliance on Cross River Bank, and management addressed this concern.
Introduction
If you follow Upstart ( UPST ), you have seen that the stock is up a lot in the last month. Right now, on Friday before the market opens, it's up 129.2% to be exact.
Now, if you zoom out, which you should always do in my opinion, the stock is still down 92.37% from its all-time high in 2021.
That could mean this is an opportunity if the fundamentals of the company are better than they were. Let's find out in this article if that's the case. I will analyze the earnings and attribute a Buy-Hold-Sell Scale score to Upstart. Before we go to the results, I want to bring into focus again what Upstart exactly does.
The Basics And The Problem
Fundamentally, Upstart wants to disrupt the FICO ( FICO ) score. FICO stands for Fair Isaac, not a biblical reference if you wonder, but derived from the founders, Bill Fair and Earl Isaac. Through the use of AI and big data, Upstart can give financial institutions, like banks and credit unions, a better tool to assess the creditworthiness of people applying for loans. And Upstart does this well. That can be seen in this chart.
Upstart's Q1 2023 earnings presentation
This graph also shows Upstart's model outperforms FICO by quite a wide margin.
Upstart's Q1 2023 earnings presentation
For banks, this is a crucial difference. Upstart's model is significantly more accurate than traditional lending models like FICO. The company also shared the sheer number power behind the model.
Upstart models train on over 100 billion cells of performance data with an average of 90,000 new loan repayments added each business day.
That resulted in 23 upgrades of the model in the first quarter alone.
I haven't sold my Upstart position because the data shows the model works. And that could be seen in this quarter again, not only in the much better default numbers but also in the percentage of fully automated loans.
Upstart's Q1 2023 earnings presentation
As you can see, automated loans made a big jump in the first quarter, now totaling 84% of all loans, up 13.5% year-over-year.
Upstart's management said that, as far as they know, nobody comes close to this number. Customers are often very positively surprised or even shocked that the approval process is over in five to ten minutes. That also leads to a high NPS or Net Promotor Score. If you wouldn't know, this score goes from -100 to +100 and everything above 50 is seen as outstanding. This is Upstart's score.
Upstart's Q1 2023 earnings presentation
Even brands with loyal fans, like Apple ( AAPL ), haven't seen NPS scores that high in many years.
But if the model can show convincingly that it works, why has the stock dropped so dramatically over the last years?
You have to know how Upstart makes money to understand that. Most of its revenue comes predominantly from fees, a small percentage of the loans generated through Upstart's platform. These loans can be generated on the platforms of banks and credit unions or directly through Upstart. The loans are either held by the partners or sold to other banks, credit unions, hedge funds etc.
But Upstart decided also to take some loans on its own balance sheet to fill some of the gaps. What this means is that Upstart generated loans but financial institutions were not willing to buy them. Seeing them as attractive, Upstart put them on their balance sheet, so they could benefit from the interest. That spooked investors, as the company now has credit risk. That was the first big reason why the stock dropped.
The company's nosediving revenue was the second and more fundamental reason for the drop. And, sneak peek at the rest of the article here already, that didn't change in Q1 2023. There is not enough demand from banks and other financial players who want to buy the loans Upstart generates. That's not a problem specific to Upstart; it's industry-wide and has to do with the rising interest rates.
This is the situation. Suppose you are the head of a financial institution. The interest rates are at 2% (so this is a while ago) and Upstart generates a loan that you can buy. It yields, let's say, 7%. But you know that interest rates are still going up, and Jay Powell said the Fed targets 5%. And with interest rates at 5%, the same loan, with the same conditions, yields 12%. What would you do? Buy the loan right away or wait until interest rates seem to be at their peak? Many institutions chose to wait, understandably.
A second problem, which we come back to later in the article, is that people still wanted loans, but they saw the high APRs (annual percentage rates) and postponed a loan or even made up their mind not to take a loan altogether.
Some might argue that this is a bit of a simplification, but it shows the fundamental problems Upstart has been dealing with.
Now we know this context, let's go to the earnings.
The Numbers: Just Awful
If you think Upstart's Q1 numbers caused the recent reversal in the stock price, I can already tell you that's not the case. Revenue was down 67% year-over-year, just a shocking number and even much more than the 56% drop in the previous quarter.
Revenue was also down 30% quarter-over-quarter, so it's not as if there is a re-acceleration that can explain why investors are more optimistic.
Upstart also posted a net income loss of $131.8 million or -$1.58 per share or -$38.7 million and -$0.47 on an adjusted basis. Those are not numbers that make the sun burst through the clouds either.
Contribution profit, more or less the same as gross profit, was down 52%.
84,084 loans were originated on Upstart's platform, down from 465,537 in Q1 2022. That means a drop of 83%. Even sequentially, so compared to Q4 2022, there was a drop of 45.5% in the number of loans.
If we look at transaction volume, the total amount of loans taken, that amount came in at $997 million for the first quarter of 2023, down from $4.535 billion in Q1 2022. That means down a whopping 78%. Even compared to Q4 2022, this is down 35%.
All of these numbers are horrible and still the stock is up so much since the earnings? What's happening?
Upstart focused on efficiency, like many other companies, especially in tech. It laid off almost 30% of its people. That's a lot and management called it "gut-wrenching," but the company is now better positioned. The company also reduced costs. Founder and CEO Dave Girouard on the conference call :
We also identified opportunities to reduce our technical infrastructure costs by as much as $10 million annually and sublet some unnecessary office space, both of which will go directly to the bottom line.
The result of the cuts:
it will allow us to return to profitability at a significantly lower loan volume
The conversion rate means the number of loan requests versus the number of loans that become a reality. That number was 21% in Q1 2022, but only 8% in the current quarter. Again, awful numbers. CFO Sanjay Datta explained on the conference call what was the reason for the much lower conversion rate. Just so you know, 36% APR (annual percentage rate) is the upper limit of what regulated banks can give for loans.
One is a lot less borrowers are getting approved, right? So a lot of them are being pushed above the 36% APR threshold. And then even for those who are still getting approved, their prices are a lot higher and they’re maybe less predisposed to taking the loan. So those two things combined have resulted in the contracting conversion rate.
But Dave Girouard, Upstart's founder and CEO commented on the conference call:
I’m hopeful that as we move through the year, you’ll come to see Q1 as a transitional quarter for Upstart.
This could be seen as general corporate talk, but it's more than just that.
The Numbers: Better
Everything so far was awful. But there must be some positive news as well or otherwise, the stock wouldn't have been up so much.
Guidance was better than expected. The company guided for revenue of $135 million. That's still down 41% compared to Q2 2022, but it's up 31% quarter-over-quarter.
Adjusted EBITDA is also expected to be around zero. While not great, especially not because it's adjusted EBITDA, it's a big improvement from Q1.
The contribution margin in Q1 was up from 47% last year to 58% in Q1 2023. In Q4 2022, the contribution margin was 53%, so this is a substantial improvement. 58% is 4% better than Upstart's best contribution margin ever. Moreover, management guided for a 60% contribution margin in the next quarter.
Management explained to an analyst asking if contribution margins were sustainable very well how the dynamics work. Dave Girouard started his explanation by saying:
I think they’re probably sustainable for as long as we want them to be.
Right now, the elasticity of loans is high. What that means is that enough people want to borrow money, but there is not much supply from financial institutions. Because of that, Upstart has leveraging power. Read: it can take higher margins without being punished for it. Once the volume of the supply side goes up, Upstart will generate more loans and will simultaneously drop its take rate to be more competitive. The higher margins are not just for Upstart but also for its partners to convince them to take the loans.
Upstart has cut its sales and marketing budget by 52.5% year-over-year. Once the pricing power is gone because there is more supply again, Upstart will open the S&M faucet to generate much more loans again, but at lower contribution margins.
So, Dave Girouard shows the communicating vessels between a bad macroeconomic environment coupled with higher contribution margins and better economic conditions with lower take rates and higher volume.
Also good was that Upstart didn't take any new loans on its balance sheet. The amount even went down slightly. That was a conscious decision. Upstart's management said they were not willing to go above the threshold of around $1 billion.
The Best News: Funding
Together with the earnings, Upstart announced that it had secured more than $2 billion for the next 12 months. Dave Girouard on the call:
I’m pleased to tell you that we secured multiple long-term funding agreements together expected to deliver more than $2 billion to the Upstart platform over the next 12 months. This is a critical first step toward building resiliency and predictability into our business. Together, I believe these efforts put us in a stronger position regardless of which direction the economy turns.
If you know that Upstart only saw a transaction volume of $997 million in this quarter, you know that the additional $2 billion could be meaningful, especially if you combine that with other great news that came out .
We are not sure if Castlelake was already one of the multiple partners for the $2 billion deal, but I suspect this is an extra $4 billion. As you see, there is no time frame mentioned for this deal, but this could mean another big boost to Upstart's sales. It could also implicate that Upstart's guidance will prove to be conservative. Maybe there are even more deals in the making. This is what Upstart's CFO Sanjay Datta said on the conference call ( my bold ).
We have managed to more than offset these headwinds by securing multiple longer term funding agreements, which we expect to deliver more than $2 billion in capital over the coming 12 months. We believe that these deals, as well as others in the pipeline , will provide us with a stronger and more resilient capital supply over the coming quarters.
As you can see, he talks about "others", not "another." On top of that, most money was funded by new partners. Sanjay Datta gave more color:
I think a lot of it is coming from partners that are new to the platform that we’ve never worked with before. Some of it is coming from existing partners who had either sort of stepped away from funding during the sort of turbulence the past few quarters and are coming back to the platform or they’re re-upping in significant size and committing forward in exchange for the longer-term agreement.
So I think in almost every case, you can view it as sort of being additive to what we’ve been doing recently and sort of underpins the – both the improving guide that we have in our Q2 numbers as well as its sort of more general optimism we’re signaling qualitatively.
Later in the Q&A, Dave Girouard saw this as the long-term future of Upstart, next to the previous buyers who don't commit a certain amount of money:
I do believe there’ll be sort of longer-term partners and they’ll be at will partners coexisting in our platform.
I'm pretty sure this is what the market is also excited about. After all, because of these agreements, Upstart can reduce the volatility in its earnings. Add in a 40% short ratio that causes a short squeeze and you start to understand why the stock is up so much.
Upstart also made it clear that the agreements were not to put more loans on its balance sheet. They are for their partners' balance sheets. Dave Girouard had mentioned on the previous conference call that finding reliable funding partners was Upstart's top priority, but I hadn't expected them to come up with so much funding in such a short period of time. That's very promising.
Insights From The Conference Call
Management showed optimism about the macro lending climate. Upstart uses its own UMI or Upstart Macro Index. This is the chart.
Upstart's Q1 2023 earnings presentation
Higher means more defaults. As you can see, the peak up to now (we have to remain careful) was in October. Is it a coincidence that this is also the period in which the market bottomed, at least for now? Correlation doesn't mean causation, so this is a speculative question.
Dave Girouard on the conference call about this graph.
UMI suggests that the financial health of the mainstream American consumer deteriorated rapidly through the first nine or so months of 2022, but has since stabilized if not improved for the last several months.
And then he adds something very interesting. Upstart has identified several data points that can predict the UMI. The most important indicator is the personal savings rate and Upstart saw significant improvement there. Again Dave Girouard:
The personal savings rate, which may be the most relevant predictor of UMI bottomed out mid last year at 2.7% and has increased to 5.1% since then.
Upstart also shared this graph of its loan performance.
Upstart's Q1 2023 earnings presentation
Upstart's Q1 2023 earnings presentation
As you see, Upstart's loans outperformed expectations until mid-Q1 2021, then nosedived, but they seem to get back on track with the target cash flows, which have gone up considerably as well.
Upstart learned an important lesson from the downturn we have lived through and the UMI seems to play an important role. Upstart changed its loan pricing based on UMI.
Since late 2022, loans in our platform have been priced conservatively relative to UMI, so our bank and credit union partners can feel confident that recent vintages are today performing at or above expectations.
And that is appreciated a lot by Upstart's customers, despite their very conservative reflex during this time when smaller banks are scrutinized more because of the bankruptcies of Silicon Valley Bank and a few others. Dave Girouard on the earnings call:
And while banks are certainly treading carefully in the current environment, many lenders and institutional investors appreciate the combination of high yield and short duration that Upstart powered loans offer.
Upstart points out that gross realized returns have surged from 3.5% to 11%. It also proposes its partners to dollar-cost average.
Upstart's Q1 2023 earnings presentation
Upstart recently announced its 100th partner, CME Federal Credit Union . That means its partners are up 10x since going public in December 2020.
Products
What was also great to hear is that the tougher economy doesn't prevent Upstart from investing in its future of a more diversified product mix.
As a reminder, up to now, Upstart has only sold personal loans to its partners. It has had car loans on its balance sheet for a while already for R&D purposes. That means it holds the loans to learn and fine-tune the AI algorithms. About half of the total loans on Upstart's balance sheet come from car loan R&D.
Upstart now sees both the car refinancing model and the car retail service ready for launch. It also announced that it had sold its first external funding agreement for Auto Retail, an important milestone.
Dave Girouard also gave an update on the short-loans product. He said the regulators pressure banks to do away with overdraft fees, with short-term loans as an alternative for people who have short-term cash needs, like a few hundred dollars Banks have not been able to do this "meaningfully and profitably," according to Girouard.
Upstart is now building this product for banks. Girouard says Upstart's short-term loans have "the potential to eradicate more than 70% of payday loans in the next five years." That can only be good. These predatory loans are a disaster for people needing them. If Upstart can lower the fees, it will not only have a great new addressable market, but it will do society a favor as well.
Girouard shared that the small-loans product had gotten a new AI model and the results showed "the largest single accuracy improvement measured in our history."
The small-loan product already has 90% automation rates and the product is now for loans as short as three months, with 37% more approval rates.
There was also an important announcement. Upstart is launching a HELOC product. HELOC stands for 'home equity line of credit', so you borrow with your real estate as collateral. Upstart sees this as a great fit for four reasons:
1. Banks and credit unions, Upstart's customers, finance 95% of HELOCs.
2. HELOCs serve prime borrowers, and annual loss rates are expected to be less than 1%.
3. HELOCs are countercyclical. In Q4 2022, for example, HELOC volumes were up 32% year-over-year, while mortgage loans and refinances plummeted, just like personal loans.
4. The current HELOC process is not great. The average HELOC takes 36 days to fund, while Upstart aims for online approval in 10 minutes and funding within five days.
The Cross River Bank Problem Is Not A Problem
For the first time since I follow Upstart, there was a good question and a good answer about Cross River Bank in the Q&A of an earnings call. As an aside, I found management overall much opener, more relaxed and less promotional. I think this could be a part of Upstart's management growing up in public in a tough environment.
If you look at the disclosures of Upstart in its 10-K, you see that Cross River Bank ('CRB') originated 42% of the transaction volume, down from 52% in Q1 2022, but still very significant. When it comes to revenue, CRB brings in 30% of the total revenue, down from 46% last year. This is added in the 10-K to explain what CRB does with the loans:
CRB retains a proportion of the loans they originate on their own balance sheet, and sells the remainder of the loans to us, which we in turn sell to institutional investors, sell to our warehouse trust special purpose entities or retain on our balance sheet.
Upstart actually uses three banks, of which CRB is the biggest, as conduits . They retain a part of the loans and the rest is sold back to Upstart, which immediately sells them to its partners. If they know none of its partners wants that particular loan, Upstart can just let it go (as in not granting the loan) or put it on its balance sheet if it thinks the loan is attractive.
In other words, CRB and the two other banks make the loan packages, as it were. That means the concentration on CRB is much lower than the numbers suggest. CRB and the others, being banks, tend to hold the prime lenders. That's safer, but also with a much lower interest rate. The higher interest rates are sold to institutional investors.
Upstart's CFO said the biggest customers account for about 10% to 15% of revenue. CRB is a conduit, not the big source of revenue that the numbers suggest. CFO Sanjay Datta called this "source capital dependency" to make the distinction.
Conclusion
I understand the market's enthusiasm. The quarter itself was awful, but it does look to be the last quarter in which Upstart continued to slide into the abyss. The 31% quarter-over-quarter guidance looks good, although there is still a long way to go for Upstart to reach its previous revenue. But the funding is a real game-changer, with $6 billion already and, who knows, more potential deals.
To me, that makes Upstart investable again. Mind you, there is still substantial risk and the company will have to execute very well. But the reward for investors could be big. I would encourage everybody not to over-allocate money to this stock because there are still too many uncertainties, but a smaller starting position or adding a little bit to an existing position makes sense. If Upstart can really beat the higher guidance, it has now set for the second quarter, that will again raise its credibility.
To me, the macroeconomic circumstances, more than the company itself, have been the main (but not the only) reason for Upstart's horrible performance. If the company can now fight itself out of this difficult macroeconomic situation by securing funds. In that case, it has a powerful model with much more durability than most thought possible up to now.
But again, I don't want to get too enthusiastic here; Upstart still has much to prove.
Is Upstart A Buy, Sell Or Hold?
For the readers of Potential Multibaggers, my Investing Group here on Seeking Alpha, I have introduced the Buy-Hold-Sell Scale, a scale that shows my thinking. I will share my Scale for Upstart here with you as well.
As you can see, I rate Upstart as a very light buy, as its future looks better now. While I think there is substantial upside left in the stock, Upstart's stock remains a risky investment if the company doesn't execute well.
Upstart's financial position has always been solid, and there has never been a moment in which it was in danger of defaulting, so that's not the risk I am talking about. I'm not sure people yelling "I'll short this one to zero" have ever looked at Upstart's balance sheet.
The risk is more in how investors see Upstart: as an AI enabler of loans, which will mean it gets a higher multiple, or as a money lender, more like Lending Club ( LC ), which will mean a lower multiple. The upcoming quarters will decide on that dilemma.
In the meantime, keep growing!
For further details see:
Is Upstart Stock A Buy Or Sell Now?