2023-05-11 09:00:00 ET
Summary
- Despite recording an abysmal set of numbers for Q1 2023, Upstart's stock bounced +40% in the after-hours session last night.
- While most UPST bulls and bears are likely scratching their heads due to Mr. Market's exuberance about such a weak result, I think this report is a complete game changer.
- With Upstart securing $2B in committed funding, its AI-lending marketplace is set to return to positive growth once again in 2023.
- Upstart's credit performance has improved drastically with recent vintages, and management sees utilization of their balance sheet as a bridge to underwrite loans tapering off at $1B.
- Given Upstart's bright outlook and depressed valuation, I can see the potential for an easy double from here by year-end. Hence, I continue to rate Upstart a "Strong Buy" at $18.97 per share.
Introduction
In the aftermath of reporting its Q1 results, Upstart's ( UPST ) stock jumped by ~35% in yesterday's session. While the report itself was abysmal (as we will see in a bit), Upstart securing long-term funding agreements of ~$2B is an absolute game changer for the AI-lending marketplace.
Despite this post-ER bounce seeing Upstart breaking above its 50-DMA, UPST stock finds itself smack in the middle of a Stage-I base pattern in the $12-25 range and right under the 200-DMA level. With RSI hitting ~70 (overbought territory), we may get a rejection here or at least some sort of consolidation over the next few sessions. While the near-term setup for Upstart isn't ideal, a high volume break above the 200-DMA could lead the stock price up to the top end of its trading range, i.e., ~$25 per share [and maybe even higher].
Now, Mr. Market's reaction to Upstart's Q1 report was undoubtedly positive; however, the consensus on Wall Street remains bearish, with firms like JPMorgan ( JPM ) and Goldman Sachs ( GS ) reiterating their "Sell" ratings on Upstart in light of its Q1 earnings report. According to data from TipRanks, Upstart's consensus 12-month price target stands at $14.39 [range of $11-24]. And this price target represents a downside of ~25% from current levels.
While Upstart is a consensus "Sell" on Wall Street, it is rated a "Hold" by SA Analysts. If you have been following my work, I am sure you already know that my stance on Upstart has been "short-term neutral, long-term bullish" for several months now.
As an investor, I like to utilize a mix of fundamental, quantitative, technical, and valuation analysis to arrive at my investment decisions. In the case of Upstart, I have remained confident in the long-term business fundamentals, and a depressed stock price has allowed me to invest in the company over the last several weeks and months. That said, Upstart's poor technical and quantitative data have forced me to remain hedged. To learn more about my investment thesis and strategic (hedged) positioning for Upstart:
So far, we have talked about Upstart's technical chart, in which the stock appears to be bottoming out after a catastrophic decline in 2021-22. Before we review Upstart's business fundamentals through its Q1 report, let's discuss Upstart's quant factor grades.
According to Seeking Alpha's Quant Rating system, Upstart is a "Strong Sell" with a score of just 1.49/5. Despite solid improvement in Upstart's factor grades for "Valuation" (D- to C+), "Growth" (C+ to A+), and "Revisions" (D+ to C) in the last six months, an "F" grade on "Profitability" and "Momentum" continue to weigh heavily on the overall score.
SeekingAlpha
With macroeconomic headwinds still hurting Upstart's business, it is hard to get very bullish on the stock for the near term, given the current state of its technical chart and quant factor grades. However, as I said in Upstart Stock: An Unhyped And Derisked Bet On Artificial Intelligence , Upstart is a long-term investment for me, and that's the lens I'll be using to make my investment decisions in this counter. Yes, I am proactively managing near-term risk through tactical option hedges, but my holding period (investment timeframe) for Upstart is 5+ years.
In today's note, we will assess Upstart's Q1 2023 report. Furthermore, I will share an update on Upstart's fair value and expected returns. Without further ado, let's get started.
Upstart Q1 2023 Review
For Q4, Upstart delivered a beat on both top and bottom line estimates, with net revenue and adj. EBITDA coming in at $103M (beat by ~3%) and -$31M (beat by +$14M). However, if we look at these numbers in isolation, Upstart's business (revenue) contracted by ~67% y/y in Q1 2023, and losses widened significantly too.
While Upstart's contribution margin came in strong at 58% of revenue, contribution profits fell -54% y/y. In Q4, Upstart's diluted EPS came in at -$1.58, and net losses widened to -$129.3M.
While Upstart's financial performance in Q1 was worse than what we saw from the company in the back half of last year, we may already be past the trough for this cycle with committed long-term funding (easing of funding constraints) and expansion into new lending markets (auto and home) set to reinvigorate positive sequential growth at Upstart as soon as next quarter. Furthermore, Upstart's efficiency moves are starting to pay off, and the management expects a return to breakeven adj. EBITDA in Q2 2023.
Recent bank failures are likely to result in credit tightening over the coming months, and this could play right into the hands of Upstart, which now has committed long-term funding of more than $2B in its kitty.
With its marketplace platform being funding-constrained, Upstart has been utilizing its balance sheet as a bridge to facilitate loans over the past year. However, with interest rates stabilizing in recent weeks and Upstart's recent vintages performing in line with expectations (despite higher target cash flows - gross returns of ~11%), investor appetite for Upstart loans should pick back up in the near future.
As of Q1 2023, Upstart is holding ~$1B of loans, of which $489M are unsecured personal loans, and the rest are R&D loans (auto, auto refinance, small-dollar, etc.). Notably, Upstart's loans held on the balance sheet were reduced by ~$40M in Q1, and management said on the earnings call that they had an ABS deal that did not go through during the quarter, so Upstart's loan balance could have been even lower.
From the Q1 2023 earnings call, I also learned that Upstart's CFO, Sanjay Datta, sees $1B as the high watermark for loans on the balance sheet. While Datta stopped short of committing to further reductions in loans on the balance sheet [citing near-term macroeconomic uncertainties], I think an unfreezing of credit markets could allow Upstart to get rid of these loans for good. The macroeconomic environment could be set to worsen over the coming months as the lagged impact of the Fed's aggressive tightening measures shows up in the real economy. Hence, Upstart must preserve its balance sheet liquidity, and getting rid of these loans is a very positive development for the company.
With Upstart holding ~$450M in cash on its balance sheet and management guiding for breakeven adj. EBITDA for Q2 2023, Upstart has little to no bankruptcy or liquidity risk for the foreseeable future.
Now, as I see it, Upstart's Q1 2023 financial performance was worse than its Q3 & Q4 2022 results, which I felt were absolutely nightmarish:
- Upstart Stock: An Unhyped And Derisked Bet On Artificial Intelligence
- Upstart Q3 Review: The Road To Recovery Looks Long And Bumpy
However, Upstart's near-term and long-term future is looking brighter than ever in light of this report, because the cyclicality risk of Upstart's business model has been reduced with committed long-term funding agreements.
Upstart's Fair Value And Expected Return
With Upstart securing committed funding of $2B for its core personal loans business, I now expect to see a gradual recovery in loan volumes throughout 2023. While preferential economics for partners providing this committed funding are likely to result in lower take rates for Upstart, management believes the unit economics will be similar to what Upstart makes with capital market partners. Hence, the impact on contribution margins is unlikely to be significant. And since this funding is mostly additive (the majority coming from new partners), we can expect to see higher personal loan volumes for Upstart's platform in upcoming quarters.
Also, Upstart's expansion into Auto lending is likely to start boosting revenue growth in the back half of this year. Given management's positive guidance for Q2, I am increasing my 2023 revenue expectation for Upstart to $600M (up from the $500M estimate we used at our last evaluation). All other model assumptions remain unaltered.
Here's my updated valuation model for Upstart:
According to these results, Upstart is worth $46.74 per share, i.e., it is undervalued by roughly 60%. The base case expected 5-yr CAGR return for Upstart from here is ~34%, which is significantly greater than my required IRR of 25% for high-risk, moonshot growth bets like Upstart. Hence, I continue to rate Upstart a "Strong Buy" for long-term investors.
Concluding Thoughts
While macroeconomic headwinds are unlikely to subside in the near term, Upstart looks set to return to positive revenue growth in the back half of this year with committed funding secured. Despite reporting an abysmal quarter, Upstart's stock is up ~30%, and I think this move is a result of UPST's massive committed funding news, depressed valuation, and high short interest (~32% of float).
During Q1, Upstart's leadership managed to reduce the cyclicality risk of their platform by getting committed funding of $2B, which is an incredible feat in the current market environment. Also, Upstart's credit performance in recent vintages is now tracking close to target returns. With both of these major issues resolved, Upstart's future is looking bright once again. Lastly, Upstart is winning more and more partners [i.e., banks and Auto dealerships] during these lean economic times. When the economy and credit cycle turns around, Upstart will emerge as a much bigger and more profitable business.
Upstart remains an unhyped and derisked play on artificial intelligence. With committed funding secured, I am a lot more convicted about my long position in the stock. Hence, I continue to rate UPST a "Strong Buy".
Key Takeaway: I rate Upstart a "Strong Buy" at $19, with a strong preference for staggered accumulation.
Thanks for reading, and happy investing. Please share your thoughts, questions, or concerns in the comments section below.
For further details see:
Upstart Q1 2023 Earnings Review: An Abysmal, Yet Game-Changing Report