2023-07-12 14:11:05 ET
Summary
- The worst is likely over for Upstart Holdings, Inc.'s sub-prime market as the conditions continue to show improvements.
- Higher take rates in the recent quarter was a result of higher underwriting efficiency and lower competition.
- The overall funding environment remains challenging despite the new committed capital that were announced.
- Upstart is a leading AI lender due to its data advantage, huge investments in AI, and machine learning capabilities while having the necessary talent.
- While I am positive and optimistic about the long-term prospects of Upstart, entering into the name at this valuation offers no margin of safety.
I highlighted in an earlier article that I thought that the worst was over for Upstart Holdings, Inc. ( UPST ).
The Barbell Portfolio has held Upstart since 28 December 2022, and the stock has rallied more than 140% since then.
In this article, I aim to not only highlight my learnings after recently attending a meeting with Upstart CFO Sanjay Datta and the investor relations team. I note that the tone of the management team was somewhat encouraging, yet measured, and I share more about the details of the meeting below.
I am positive and optimistic about the long-term prospects of Upstart, and while the recent price action have shown us that we made the right call in being contrarian since 28 December 2022, I do think that entering a position into Upstart at these levels offer no margin of safety.
Worst likely over for the sub-prime market
Management reiterated that while the last 18 months have been a difficult, they expect that the worst is likely over for sub-prime borrowers.
In particular, as a result of the stimulus from the covid-19 pandemic, sub-prime borrowers benefitted from that to a larger extent, resulting in elevated consumption, higher savings rate, and arguably inflating some FICO scores.
For Upstart, the company's CFO admitted that they were relatively slow to recalibrate their underwriting models.
However, much has changed in the last 18 months as the company has tightened their credit box.
This means that there are about 60% of the borrowers that would have been approved previously that will not be approved under the new improved underwriting models.
In addition, Upstart's CFO commented that he thinks that it is time to be bullish on the sub-prime borrowers as the worst is likely over for them. What is to come ahead is likely a more challenging and vulnerable period for white collar workers given the huge headcount reductions in the big tech firms.
Improving underwriting efficiency and less competition
Upstart's gross take rate actually increased by 160 basis points in 1Q23, up 12% from the prior quarter. It was also nearly two times the pre-pandemic take rate of about 6% to 7%.
The reason for this huge increase in take rate was due to a combination of two reasons. The first is that the company has improved automation levels and made positive adjustments to the model, and the second is that there is less competition in the sub-prime space.
As a result, I do think that we will see this dynamic continue in the near-term before the take rates eventually normalize to Upstart's historical average as the overall market's risk appetite increases and more lenders come back into the market.
Upstart as a leading AI lender
While most fintech lenders would say they have incorporated some form of machine learning or AI capability one way or another into their loan models, Upstart is believed to be a step or two ahead of them.
The first advantage comes from its huge focus on its own AI and machine learning capabilities since inception. In fact, it is likely that Upstart has made the largest investment thus far into its own AI and machine learning capabilities, which then led to a more superior loan model. Upstart's management team knew their advantage and value proposition lies in their technology, which includes their AI models and thus, the investment in their AI and machine learning capabilities is crucial.
The second advantage comes from Upstart's massive data set. In just 2022, Upstart's lending partners originated about 1.3 million loans worth $12 billion. The data advantage, as I have argued multiple times in other articles in Outperforming the Market, is crucial in the AI race as the larger quantity and higher quality data the company has, the better the data the model is trained on, and this results in superior output from the AI model.
In addition, I would highlight that banks have a limited ability to implement new underwriting models as a result of regulatory scrutiny.
Lastly, Upstart has the right talent needed to maintain its edge on AI lending. There is scarce data engineering and machine learning talent that is needed for the top AI lenders and thus, the competition for these talents can be quite fierce. Upstart already has a head start in acquiring and retaining these talents needed to maintain its advantage.
Funding environment remains difficult
While Upstart received $4 billion in committed capital earlier when it was announced in 1Q23, management commented that the funding environment remains difficult.
Despite the improvement in funding dynamics, the consumer demand for loans continue to outstrip the supply or funding for loans. In addition, the ABS markets still continue to be muted and, as regional banks typically made up about 25% of Upstart's funding, the funding levels from regional banks will likely remain low for the rest of 2023.
The company continues to be in discussions with multiple other funding partners to add to its long-term capital funding of the business.
Plans in the near term and other initiatives
In terms of funding, the company is not just in discussions with other long-term, committed capital partners, but also planning to tap into the ABS markets in the near-term with its better performing vintages. This includes the vintages that were originated on or after October 2022.
In terms of the use of its committed capital, Upstart's management expects to be using this to fund about 50% of its originations over a period of time.
Management highlighted that their priorities for capital allocation.
Firstly, R&D will take priority, especially for Upstart's new HELOC product . Secondly, Upstart will then do stock or convertible bond buybacks. Lastly, management will continue acquisitions that will help improve the company's roadmap. Apart from HELOC, Upstart is also interested in expanding into non-qualifying purchase mortgages.
Valuation
Upstart is trading at 60x 2024 P/E based on today's prices.
I do think that at this valuation, there is insufficient margin of safety for me to recommend members of Outperforming the Market to enter.
I would emphasize that the higher and richer the valuation of the stock, the lower the implied future returns.
As such, I reiterate my entry price of $19.67, which can be found in The Price Target Report. This entry price would imply a 37x P/E, which would be more reasonable and with a sufficient margin of safety.
Conclusion
I think the recent conversations with Upstart prove that the company is well positioned and ahead of competition as an AI lender.
In addition, while the worst is over for the sub-prime market, the funding environment remains difficult.
However, Upstart is focused on its business, as it has been investing in its technology, improving its processes and AI models and positioning the business for the rebound when the macroeconomic environment improves.
As I have mentioned earlier, I remain optimistic about Upstart's long-term opportunity. While the recent price action have shown us that we made the right call in being contrarian since 28 December 2022, I do think that entering a position into Upstart Holdings, Inc. stock at these levels offer no margin of safety.
For further details see:
Upstart: Lacking Sufficient Margin Of Safety For Entry