2023-05-16 16:06:17 ET
Summary
- Upstart Holdings reported better-than-expected earnings, leading to a surge in its stock price and catching short-sellers off guard.
- The company secured a $4B deal with alternative asset manager Castlelake, indicating increased funding capacity from such institutions.
- Despite the positive news, investors should be cautious about Upstart Holdings' valuation and potential bull trap, with a Hold rating reiterated.
Upstart Holdings, Inc. ( UPST ) short-sellers were likely caught napping as the company reported its earnings last week, which saw UPST take off. The company announced that it managed to unload " up to $4 billion of consumer installment loans to private credit shop Castlelake."
As such, the company followed up closely with its commitment to provide investors more assurance over the stability of its funding pipeline, a critical risk that I highlighted in a pre-earnings article (Hold rating) on UPST.
While I wasn't bearish in my previous article, I also wasn't ready to plunge into UPST's previous lows, as it's questionable whether the company has a sustainable competitive moat that relies significantly on third-party funding to make its business model work.
Therefore, the "nasty" surprise that Upstart leveled against the short-sellers ( 37% leading up to its recent earnings) compelled them to flee to the hills, as Upstart demonstrated that it could still execute well.
However, does that mean investors should confidently bet on a continued recovery in UPST following its remarkable surge from its May lows, leading to a potential bull trap or false upside breakout?
Upstart banking partners are likely still holding back from lending in response to the recent turmoil. Recent data suggests that " banks have tightened standards for commercial and industrial loans, commercial real estate loans, residential mortgage loans, and consumer loans." However, there's "no evidence of financial instability evolving into a systemic problem."
As such, management's optimism that it has likely seen the worst of its troubles is not without basis. Moreover, institutional investors are still "hungry" to deploy their capital if the opportunity is right. As such, I believe it explains why Upstart's recent $4B deal was transacted with Castlelake, an alternative asset manager.
Bloomberg reported that Castlelake " will buy a book of loans Upstart has already created and will invest in future origination via a so-called forward-flow agreement." As such, alternative asset managers have come to the rescue of funding-strapped Upstart, which is in line with recent market trends.
Blackstone Inc. ( BX ) is reportedly exploring partnerships with regional banks, sensing an opportunity to act as a conduit to provide necessary funding as these banks tighten.
Therefore, the opportunity for institutional investors such as insurance companies (which don't face deposit outflow challenges) to fund the loans for the regional banks at attractive prices likely appealed to these players.
As such, while Upstart could likely benefit from increased funding capacity from alternative asset managers moving forward, investors still need to study its economics carefully. Therefore, assessing the impact on Upstart's P&L is essential, as its contribution margin could be expected to peak in the near term.
Upstart posted a contribution margin of 58% in FQ1, well above last year's 47%. The company also posted strong Q2 contribution margin guidance of 60%. Upstart sees robust tailwinds from improved take rates and fair value adjustments on its loans, given the interest rate regime.
However, the company also cautioned that take rates would likely fall in normalized economic conditions, which is expected to impact its contribution margin. Therefore, while the company is able to share profitability through " preferential economics offered in the agreements," it's still too early to assess the normalized effects on its P&L.
Moreover, management highlighted that the funding agreements are "customized and not broadly generalized." As such, investors should not expect that it's "business as usual" for Upstart, as the model transition is still in the early stages as Upstart seeks to stabilize its forward flow arrangements.
UPST price chart (weekly) (TradingView)
With the surge from its May lows over the past two weeks, Upstart Holdings, Inc.'s valuation has worsened further. While I don't think Upstart Holdings, Inc. stock is significantly overvalued, the current entry levels look unconstructive, reminiscent of a possible bull trap.
Hence, I will not consider adding any Upstart Holdings, Inc. stock positions at the current levels. However, investors who added aggressively at UPST's recent lows should consider taking the opportunity to cut some exposure.
Rating: Hold (Reiterated). See additional disclosure below for important notes accompanying the thesis presented.
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Upstart: Strikes Back With An Explosive Surge