2023-05-19 15:16:58 ET
Summary
- Upstart's stock has been on a tear this month.
- The recent price strength has come on the back of improving sentiment toward future earnings.
- The growth in AI is proving to be a tailwind for Upstart.
- To invest or not in Upstart shares depends on the investment time horizon of an investor.
Upstart Holdings' ( UPST ) stock has been on a tear this month, rising more than 50%. So far in 2023, UPST is up more than 90%, aided by the improving sentiment toward tech stocks and the rising hopes for a less aggressive Fed. I have been bullish on Upstart for many years at different prices - from $20 to $390 - and I did not even consider selling my Upstart shares when the stock surged close to $400 almost two years ago. If I booked my handsome profits back then, my portfolio would have certainly looked better, but as a growth-oriented investor, I remain focused on the long term where I believe Upstart can carve out competitive advantages that lead to ROIC substantially higher than the cost of capital.
In 2021, Upstart gained a lot of attention, causing its stock to skyrocket by over 700% from its IPO price. However, the stock took a major hit in December 2021, plunging almost 90% from its October high. This decline was primarily due to macroeconomic challenges affecting the technology sector and consumer spending. Investors were concerned that a slowing economy could lead to higher loan defaults. Additionally, poor market conditions forced Upstart to retain more loans on its balance sheet than originally planned.
On the back of these setbacks, the stock remained under pressure for more than a year before coming back to life this year amid Mr. Market's renewed focus on AI. Although the company experienced a decline in revenue in the first quarter of 2023, its shares surged last week after Upstart provided positive guidance for the second quarter. Investors were also pleased with the company securing $2 billion in long-term funding agreements from its partners for the next 12 months. This was seen as a positive sign, indicating confidence in Upstart's platform.
There are still concerns about Upstart's future - some of which are grounded on logic - but I believe the company's growth story is not broken and that handsome rewards await long-term investors.
Upstart Is At The Forefront Of AI-Financing
Artificial Intelligence has gained significant attention in 2023, with its applications expanding across various industries. AI technology is also impacting the financial services sector. Fintech has experienced remarkable growth over the years. According to data from Statista, as of the beginning of May 2023, the Americas boasted the highest number of fintech startups globally, with 11,651 companies. In comparison, the EMEA region had 9,681 fintech startups, while the Asia Pacific region had 5,061 fintech startups. These figures highlight the widespread adoption and importance of technology in driving innovation and transforming the financial landscape.
Exhibit 1: Number of fintech startups worldwide from 2018 to 2023, by region
While AI in the finance industry is still in its early stages, the early adoption of this technology has demonstrated its potential to revolutionize the way financial services are delivered. AI-powered solutions are being employed to automate processes, enhance risk assessment, improve customer experience, and optimize investment strategies. As AI technology continues to evolve, it holds promise for transforming traditional financial practices and unlocking new opportunities for businesses and consumers alike.
Upstart is at the forefront of this revolution, leveraging AI technology to disrupt the lending sector. The company has developed algorithms that it believes can assess credit quality more effectively than traditional loan underwriting methods. By doing so, the company aims to provide better loan terms to near-prime borrowers and help financial institutions discover creditworthy borrowers they may have missed otherwise. Automation makes the process efficient with 84% of loans being fully automated and instantly approved in Q1 2023.
Exhibit 2: Upstart's approvals and default rate trends in Q1
Upstart's AI lending platform has the potential to revolutionize the lending market, with a total addressable market of approximately $4 trillion in annual loan originations, encompassing personal loans, auto loans, home loans, and small business loans. The company has made notable progress to tap into this market opportunity over the last few years by feeding its algorithms enormous amounts of data, building relationships with partner banks, and introducing new products to branch out into untapped markets.
In January 2023, Upstart introduced two new applications - Digital Finance and Online Sales - to its Auto Retail platform. These additions provide dealerships with a seamless online-to-in-store car-buying experience. Upstart's auto retail software was the second fastest-growing in the U.S. in Q4 2022, as per Automotive Market Data. Upstart has partnered with reputable names such as Del Grande Dealer Group, the largest family-owned automotive group in the Bay Area, and 780 dealerships across the U.S. In addition, Upstart has been selected by Acura and Mercedes-Benz as a preferred and approved digital retail provider, further expanding its reach in the automotive industry.
However, Upstart operates in an industry with well-established traditions. The company faces the challenge of proving the effectiveness of its technology and convincing debt markets to purchase the loans it approves. During a tighter credit market with rising interest rates, Upstart has encountered difficulties holding loans on its balance sheet, which significantly impacted its financial and market performance last year. This is an ongoing risk that needs to be monitored closely with no visibility into the Fed's actions.
Declining Revenue Amid Rising Interest Rates
For the last few quarters, Upstart has been caught in a challenging situation. First, the rapidly increasing interest rates made Upstart loans less attractive, as borrowers currently face higher funding costs and concerns about credit quality amid expectations of a recession. Further, economic uncertainty has prompted lenders to become more cautious, resulting in a significant impact on Upstart's operations. Consequently, the company witnessed a steep decline in loan origination volume and encountered difficulties in selling off some of its loans, leading to a substantial volume of loans being held on its balance sheet.
Despite mounting challenges experienced by banks and lenders, Upstart managed to exceed revenue and earnings projections in the first quarter, leading to a surge in its stock price. However, when compared to the same period last year, the fintech company's performance still looks unattractive. In the first quarter, Upstart reported a significant YoY decline in revenue of 67% to $102.9 million. It's worth noting that Upstart derives its revenue from fees charged to banks and lending partners for utilizing its technology. Therefore, the lower revenue can be attributed to banks exercising more caution in their lending activities. The company provided approximately 82,000 personal loans, amounting to a total transaction volume of $952 million. These figures marked an 82% and 78% decrease, respectively, compared to the same period in the previous year, and a 46% and 36% decrease, respectively, compared to the fourth quarter of 2022. The company reported a net loss of $129.3 million.
Exhibit 3: Lending details by product
There were some positive aspects amid the challenging situation. Upstart managed to achieve a surprising contribution margin of 58% for the quarter, primarily due to expense reduction initiatives undertaken by the company. Additionally, Upstart provided positive guidance for the current quarter, expecting to generate $132 million in revenue. While this would signify a rebound from the $103 million reported in the first quarter, it remains considerably poor compared to the previous year. Q1 financial results indicate Upstart is seeing some positive developments, but the turnaround remains in the early stages.
Upstart Secures New Funding: Is It Enough?
According to Upstart's 2022 Annual Report, the company relied heavily on institutional investors, who funded 60% of its loans, while originating lenders retained around 30% of loans funded from the platform. As institutional investors started to pause their funding because of high-interest rates, Upstart's management decided to fund the remaining 10% of loans internally to meet the growing demand. This decision significantly changed Upstart's balance sheet composition. The company now holds $982 million in loans on its balance sheet.
Exhibit 4: Upstart's commentary on loan funding activity
When Upstart's revenue started declining during the second quarter of 2022, management committed to securing long-term funding agreements with institutional investors, aiming to protect the business from cyclical fluctuations. In the fourth quarter, Upstart disclosed being in advanced discussions with multiple potential partners and recently announced that it has secured $2 billion in committed funding over the next 12 months. Although this is a positive development, Upstart's capacity may only reach about half of its 2021 levels this year.
Upstart also announced a significant development with Castlelake, a private investment company. Castlelake has committed to purchasing up to $4 billion in consumer installment loans from Upstart. This includes both existing loans on Upstart's platform and future loan flow. Castlelake's interest in this partnership stems from its belief in the potential of the consumer credit and specialty finance sector, particularly in areas that traditional funding is yet to fully explore. As interest rates rise and bank financing becomes more limited, Castlelake recognizes the growing role of private capital in facilitating business growth. This agreement is beneficial for Upstart as it increases the company's capacity to expand its platform and originate new loans. Castlelake's interest in Upstart is valuable because it addresses concerns about Upstart keeping loans on its balance sheet. This will allow the company to focus on improving its credit-scoring technology.
It's important to understand that the long-term viability of Upstart remains uncertain. To determine the true potential of Upstart's AI-based lending approach, it requires complete credit cycles or multiple cycles. Further, the company might need additional funding, especially when it is expanding its auto loan program and launching HELOCs, a home equity product. Upstart anticipates that its HELOCs will have a low annual loss rate of less than 1%. Unlike mortgage refinances, which saw a decline in volumes, HELOC volumes increased by 32% year-over-year in Q4 2022. It is worth noting that there is significant room for improvement in the HELOC origination process. Currently, the average time for funding a HELOC is 36 days, but Upstart aims to streamline the online approval process to just 10 minutes, with funding completed within five days.
An additional risk arises from the recent consent order entered by the FDIC with Cross River Bank, a key partner for Upstart. Cross River Bank plays a crucial role in enabling many fintech companies, including Upstart, to offer banking services. According to Upstart's regulatory filings, in the three months ending March 31, 2022, and 2023, CRB originated 52% and 42% of the transaction volume and number of loans, respectively. Additionally, the bank's fees made up 46% and 30% of Upstart's total revenue during the same periods.
CRB being a primary buyer and retainer of Upstart loans poses a significant challenge because bank funding is the most stable source of financing for Upstart in the current high-interest-rate environment. Although Upstart has a network of over 90 bank partners, the heavy reliance on a single bank raises concerns about the stability and diversification of Upstart's funding sources. This also suggests that other banks and credit unions may have limited business with Upstart. In this uncertain climate, committed funding from other sources provides some relief. However, Upstart's future growth hinges on its ability to attract additional loan buyers and diversify its funding base to mitigate the risks associated with relying heavily on a single bank partner.
An Earnings Catalyst Is Beginning To Shape
At Beat Billions, we believe there is a strong relationship between earnings revisions and long-term stock prices. After reaching a high of $4.79 in April 2022, fiscal 2024 EPS estimates have declined to $0.73 today. We believe a reversal in this trend will prove to be a catalyst driving the stock price higher.
Exhibit 5: EPS estimates
As illustrated above, fiscal 2023 earnings estimates got a much-needed boost following the Q1 earnings report last week, but estimates for 2024 have not received the same boost. Although it seems like a catalyst is beginning to form, there is no conviction today, which has a lot to do with the uncertain interest rate environment.
Takeaway
Upstart's stock price has recently surged due to improved guidance and adjustments to its business model. The company's previous success and popularity have generated significant excitement among investors. The anticipation of a potential pause in interest rate hikes by the Federal Reserve has further fueled the stock's momentum. The company's positive guidance and cost-cutting measures have been positively received by analysts, resulting in raised price targets from Morgan Stanley and Piper Sandler. However, these analysts do not foresee substantial growth in the short term. Additionally, concerns persist regarding Upstart's core business model and its ability to address funding issues, especially in the event of an economic recession. Although, long-term investors may find an enticing opportunity to acquire shares while the company undergoes a transformation, short-term investments in Upstart carry high risks given the challenging operating environment.
For further details see:
Upstart Stock: Can The Rally Continue?