2023-08-10 11:39:16 ET
Summary
- In typical Upstart Holdings, Inc. fashion, the stock dropped by 34% in a single session after reporting Q2 2023 results, and is now down ~52% from its recent highs.
- Revenue guidance for Q3 fell short of street consensus, triggering profit booking from traders and investors.
- In this note, we shall review Upstart's Q2 2023 report in detail, and reevaluate its fair value and expected returns.
- Given Upstart's year-to-date run-up, the risk/reward dynamic has turned unfavorable for investors. As such, I am downgrading Upstart to a "Hold" rating at current levels.
- At my investing group, we took profits ahead of earnings, but I continue to believe in Upstart as a business. Hence, I will also share an entry point for restarting accumulation in this note.
Introduction
On the back of reporting its Q2 2023 results , Upstart Holdings, Inc. ( UPST ) stock tanked by ~34% in yesterday's session, and is now down by ~52% from its recent high of $72 per share [hit on 1st August 2023]. While Upstart reported a double beat for Q2 [revenue: $135.77M vs est. $135.32M, normalized EPS: +0.06 vs. est. -0.07], management's revenue guidance of $140M for Q3 2023 fell desperately short of the street consensus of $155M. And this guidance miss coupled with Upstart's pre-earnings run-up seems to have triggered a wave of profit booking from traders and investors.
Over the last year, I have provided extensive coverage on Upstart stock here on Seeking Alpha, with 7 "Strong Buy" calls issued in the $15-30 range:
However, despite being bullish on Upstart's long-term business prospects, I significantly trimmed our long position in UPST at $52.6 per share within my investing group ahead of earnings due to a significant change in its risk/reward dynamic after a massive YTD run-up:
Yes, Upstart is still the same company, but the risk/reward dynamic for an investor buying or holding UPST stock at $50 is completely different than buying UPST stock in the mid-teens. As an investor, I like to utilize a mix of fundamental, quantitative, technical, and valuation analysis to arrive at my investment decisions. And while I continued to believe in Upstart heading into earnings, the stock was no longer an attractive investment at $50+ per share. With UPST's projected 5-yr CAGR return dropping well below my investment hurdle rate, I chose to capitalize on the spectacular run-up in Upstart's stock before earnings.
Now that Upstart is back in the low to mid-$30s, I think the risk/reward dynamic of UPST stock is once again favorable for long-term investors. In this note, I shall share my key learnings from Upstart's Q2 2023 results, and provide an updated valuation model for UPST. Furthermore, I'll provide an entry point for restarting accumulation.
Brief Overview Of Upstart's Q2 2023 Report
For Q2 2023, Upstart delivered a beat on both top and bottom line estimates, with net revenue and adj. EBITDA coming in at $136.8M (beat by +0.4%) and +$11M (beat by +$14M). While Upstart's revenues declined by -41% y/y in Q2 2023, the business (revenue) has likely troughed (as evidenced by positive q/q revenue growth) and Upstart's losses also seem to have narrowed significantly in Q2 2023.
During Q2, Upstart's contribution margin rose to an all-time high of 67% of revenue, and this improvement in unit economics resulted in contribution profits falling just -21% y/y (vs. revenue decline of -41% y/y). In Q2, Upstart's diluted EPS came in at -$0.34, and net losses contracted to -$28.2M (from -$129.3M in Q1 2023). More importantly, Upstart reported a positive adj. net income of $5.4M in Q2, and it was profitable on a non-GAAP basis with normalized EPS coming in at $0.06 [vs. est. of -$0.07].
In my previous note on Upstart , I said:
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.
Source: "Upstart Q1 2023 Earnings Review: An Abysmal, Yet Game-Changing Report."
And in light of the Q2 2023 report, I think we were right about Upstart's revenue troughing in Q1. Now, Upstart's lending volumes were still down significantly on a year-over-year basis; however, the sequential jump in volumes gives us reason to believe that the worst is over for Upstart.
From a macroeconomic standpoint, higher interest rates are hurting borrower demand and banks' appetite to lend. However, with interest rates stabilizing (albeit at a higher level), credit markets are opening up. During the earnings conference call, Upstart's CEO, Dave Girouard, said (emphasis added):
Funding markets remain cautious and risk averse. Banks and credit unions are generally focused on deposits and liquidity, while capital markets are beginning to show signs of normalization . We added another committed capital partner in July and are in conversations with several more interested parties. We also completed a securitization after the close of Q2 with significantly tighter spreads than our prior deal earlier in the year.
By bringing additional committed funding to its marketplace during Q2 (added 1 committed capital partner), Upstart has further reduced the cyclicality risk associated with its business. And the company is looking to do more on this front in the upcoming quarters. That said, as of Q2, Upstart still expects loan volumes generated through committed funding to run at ~$500M per quarter due to constraints on the borrower side of the platform.
Upstart Q2 2023 Earnings Call Transcript (SeekingAlpha)
And I think these dynamics explain Upstart's weaker-than-expected guidance for Q3 2023, which saw revenue estimates [$140M] fall short of expectations [$155M] by ~10% [$15M].
With its marketplace platform being funding-constrained, Upstart has been utilizing its balance sheet as a bridge to facilitate loans over the past year or so. However, with interest rates stabilizing in recent months and Upstart's recent vintages performing in line with expectations (despite higher target cash flows - gross returns of ~11%), investor appetite for Upstart loans is starting to pick back up as evidenced by recent ABS deals from UPST.
At the end of Q2 2023, Upstart held ~$510M in cash and ~$838 in loans-held-for-sale on its balance sheet [$558M in net loan equity at fair value]. Of this loan balance, ~$345M were unsecured personal loans, and the rest were R&D loans (auto, auto refinance, small-dollar, etc.).
Notably, Upstart's loans held on the balance sheet were reduced by ~$140M (-15%) in Q2, and management said on the earnings call that they completed an ABS deal right after Q2 which removed a big chunk of the core personal loans held on its balance sheet (emphasis added):
Just after quarter close, we completed a one-off $200 million ABS transaction , funded entirely from our own balance sheet. As you may recall, we traditionally sponsor ABS transactions on behalf of our loan buyers who are usually the principal economic agents and loan contributors to the transaction. In this case, we took the unusual step of funding a deal from the Q2 vintages accumulated entirely on our own balance sheet. We did this both to reset the market understanding for how our more recent vintages should be expected to perform, as well as to serve as a visible signal to the market of our confidence in the adjustments that have been made by our own underwriting models and adapting to the new environment.
While non-R&D loans getting sold off from the balance sheet is good news for Upstart's shareholders, the auto-heavy R&D loan book is starting to deteriorate as charge-offs on older vintages are picking up. And this dynamic is set to create a negative impact on Upstart's net revenue for the foreseeable future.
Upstart Q2 2023 Earnings Call Transcript (SeekingAlpha)
With Upstart getting committed capital onto its marketplace platform, big loan sale losses are a thing of the past. However, there are no free lunches, and as a part of these committed funding agreements, Upstart has to co-invest in all of these deals.
In Q2, Upstart co-invested ~$40M as equity, and this capital covered lending activity of ~$800M from committed funding. The risk-reward for this equity investment is as under:
Upstart Q2 2023 Earnings Call Transcript (SeekingAlpha)
As per my understanding of management's commentary in the Q2 2023 earnings call, the $1B high watermark for loans on the balance sheet is still in place. Auto (and all other) R&D loans are likely to stay on Upstart's balance sheet for a while, and so, Upstart is unlikely to become an asset-light business any time soon.
With leading economic indicators still calling for an imminent recession, banks are likely to remain cautious and risk-averse with regard to lending activity in the near-term future. Despite having some committed funding on board, Upstart's growth recovery remains challenged in the current macroeconomic environment. And things could worsen over the coming months if the lagged impact of the Fed's aggressive tightening measures pushes the real economy into a deep recession. Hence, Upstart is not out of the woods just yet.
With Upstart holding ~$510M in cash on its balance sheet and the business now operating at a positive adj. EBITDA, I see little to no bankruptcy or liquidity risk at Upstart for the foreseeable future. The near-term business outlook for Upstart remains challenging; however, the long-term opportunity in AI-powered lending is humongous [$4T loan origination TAM], i.e., Upstart has a tremendous runway for growth.
Upstart's Fair Value And Expected Return
Securing committed funding for its lending marketplace was a transformative change for Upstart's business, with this move alleviating cyclicality risk to some extent. While Upstart returned to positive q/q growth in 2023, management's guidance for Q3 2023 fell short of street expectations. On the earnings call, Upstart's leadership team alluded to a tighter lending environment [caused by higher interest rates and banks pulling back on credit] as the primary driver of this shortfall.
As I see it, Upstart should manage to post a gradual recovery in loan volumes throughout 2023. However, the recovery is unlikely to be as rapid as I had projected earlier this year. Considering current macroeconomic conditions and management's weaker-than-expected Q3 business outlook, I am cutting my 2023 revenue expectation for Upstart to $550M (down from the $600M estimate we used at our last evaluation). All other model assumptions remain unaltered.
Here's my updated valuation model for Upstart:
According to our model, Upstart is now worth $41.84 per share (down from our previous estimate of $46.74 per share), i.e., UPST is undervalued by roughly 20% after yesterday's steep sell-off. Since the base case expected 5-yr CAGR return for Upstart [16.32%] falls short of my required IRR [investment hurdle rate] of 25% for high-risk, moonshot growth bets, Upstart is a "Hold" at current levels under our proprietary valuation methodology.
Concluding Thoughts
In my view, Upstart Holdings, Inc.'s Q2 results were decent, whilst the Q3 guide was disappointing. Unfortunately, there's not a lot more Upstart's team could do to alleviate the adverse macro environment. The business is improving underneath the surface [lower fixed costs, more automated loans, new funding partners, and new AI models], and I think Upstart is prepared for a strong recovery in the next credit cycle! That said, we are probably heading into a recession, and Upstart may continue to struggle for growth for a few more quarters.
Having sliced through its 50-DMA on this downdraft, UPST stock is now sitting right under the 200-DMA level. If the selling pressure intensifies in upcoming sessions, I can see Upstart heading down to the upper end of its Stage-I base at ~$25. Interestingly, this would be a price where UPST's 5-yr expected CAGR would rise to my required IRR of 25%. Hence, if UPST stock were to slide down to the mid-$20s, I would resume accumulation.
In light of Upstart's Q2 2023 earnings report and a stunning year-to-date run-up, I think the risk/reward dynamic for UPST is not favorable for long-term investors. If a 5-yr expected CAGR return of ~16% works for you, Upstart is a decent buy here. However, I see Upstart as a moonshot investment, and so, I plan to wait for a better entry point [mid-$20s] to start rebuilding my long position in Upstart.
Key Takeaway: I rate Upstart a "Hold" at $34.03 per share.
Thanks for reading, and happy investing. Please share your thoughts, questions, or concerns in the comments section below.
For further details see:
Upstart Q2: Significant Shift In Risk/Reward Warrants Caution (Rating Downgrade)