2023-08-15 10:40:31 ET
Summary
- Upstart achieved $135 million in Q2 revenue and decreased loans held on its balance sheet by $150 million.
- FICO comparisons are overblown by investors bullish on Upstart since FICO’s business model is more stable than that of Upstart.
- Upstart benefited from the interest rate pause in June and is currently 43% up since then.
- Upstart’s position as an AI stock may benefit it from future AI rallies.
Thesis
Upstart Holdings, Inc. ( UPST ) offers a service similar to that of Fair Isaac ( FICO ), and while investors always like to compare the two, I believe the two aren't really comparable and investors should value Upstart on its own fundamentals, not on the possibility of replacing FICO. Upstart has posted relatively positive earnings, met analysts' revenue estimates, and has decreased loans it holds on its balance sheet. That said, I need to see Upstart selling more loans first, which is why I'm giving it a hold rating.
Upstart's Q2 Earnings
Upstart has achieved $135.8 million in revenue, which is in line with analysts' estimates and above its management's own forecast in Q1. The company also decreased its operating expenses by 35% YoY and 28% QoQ. The impact of the lower operating expenses was apparent since the company achieved almost the same operating income despite its revenue declining by more than 40%.
Additionally, Upstart decreased its loans held sequentially by $150 million from $982 million to $837 million. Despite decreasing its loans held, Upstart seems to be comfortable holding loans of around $1 billion. While I don't like that Upstart is taking loans onto its books, I believe it should be able to sell more loans as the macroeconomic climate keeps improving in the US.
Furthermore, Upstart ended the quarter with $500 million in liquidity which should enable it to operate without needing to raise capital, especially since it has achieved positive operating cash flow this quarter.
Q2 earnings report
The FICO Comparison
Whenever Upstart is mentioned, you will probably see FICO's name following closely after. While I believe comparing the two has merit, since both offer a way for banks and credit unions to reduce risks regarding loans and lending, people take the comparison too far in my opinion. One of the areas where I believe the comparison is fair is Upstart's better risk assessment since it has 12 times the default rate between its highest and lowest grade, while FICO has 4 times the default rate. Additionally, Upstart has a 70% lower risk of defaulting with its highest grade compared to a FICO score of 700 or above.
Upstart Q1 investor presentation
I believe this is where the comparison ends since the two companies have vastly different business models that make it hard to value Upstart using FICO's current value. FICO mostly makes its revenues from licensing its technology to banks and financial institutions, which makes its revenues mostly independent of the economic climate.
Upstart, on the other hand, heavily depends on macroeconomics to realize its revenues since it depends on loan fees, and people normally take fewer loans in high-interest environments. The high interest rates are the reason the company started realizing fewer revenues starting Q2 2022 after the Fed started increasing rates.
All of that makes FICO a more stable business compared to Upstart and makes the comparisons useless since it doesn't factor in this stability.
AI
Upstart's main selling point is its AI, which I believe most of its value resides in. In addition to its model outperforming FICO's, more than 87% of Upstart's loans are automated with no human intervention whatsoever. This number is an improvement from the previous quarter, where it was sitting at around 84%. The company increasing its automated loans will enable it to decrease its expenses further since it will need fewer employees in the approval process.
Moreover, Upstart presenting itself as an AI-centric company can cause its stock to run on any new breakthroughs in the field or if any other AI stock announced overly positive earnings, which is what happened in the AI rally that started in May due to Nvidia's ( NVDA ) earnings. During the May AI run led by Nvidia, Upstart climbed more than 18%.
Bright Future
Since Upstart's revenue mostly depends on the macroeconomic climate and interest rates, the June CPI report was good news for it since inflation is cooling faster than the Fed expects, which means that the Fed could start cutting interest rates sooner than planned. The Fed raising the interest by 25 bps to the range of 5.25% to 5.5% means that only one more hike is expected in 2023 in the worst-case scenario. That said, the market expects that the Fed will not hike interest rates further , which means that demand for Upstart loans may increase as consumers become more willing to take loans as interest rates stabilize and the macroeconomic climate improves.
Secondly, because interest rates appear to be approaching their peak, financial institutions like Castlelake that purchased $4 billion of loans originated by Upstart might be more willing to buy loans held by Upstart.
Conclusion
In case Upstart is actually willing to take loans on its balance sheet, it needs to prove that it can sell these loans. I also believe that the comparisons to FICO aren't reasonable since FICO is more stable and has a clear business model, unlike Upstart. That said, the improvements in the macroeconomic climate will be a great aid for the company's future, especially with the current inflation cool-down rate which may see rate cuts coming sooner than anticipated. Rate cuts would help the company realize more loan fees as more people will be willing to get more loans. Due to all that, I believe Upstart is currently a hold.
For further details see:
Upstart Has A Lot To Prove