2023-10-10 15:56:37 ET
Summary
- Upstart Holdings, Inc. stock lost over 34% despite exceeding Q2 earnings expectations in EPS and revenue.
- Upstart Holdings is still up 110% year-to-date but down 93% from its all-time high.
- Rising interest rates have led to increased default rates, impacting Upstart's lending business.
- Even though the macro outlook is uncertain, we believe Upstart Holdings has the potential to become a 10x in the next decade, which is why we rate the company as a buy.
Introduction
Upstart Holdings, Inc. (UPST) stock lost over 34% after its latest earnings report in August. What happened, you might ask? Initially, the earnings appeared promising, exceeding expectations in both EPS and revenue. However, despite these positive figures, the stock witnessed a significant decline.
In this article, we will take a deep dive into the company with a specific focus on what went wrong over the last few quarters. In addition, we will discuss where UPST might be heading in the future.
Far From All-Time Highs
UPST is still up over 110% year-to-date, but since the Q2 earnings release the stock has plummeted almost 65%. Furthermore, the stock is still down 93% from its all-time high in 2021.
While this could indicate that there is significant opportunity ahead for UPST, it is important to acknowledge that the 2020-2021 growth stock craze wasn't normal. In addition, Upstart was considered a meme stock at the time.
Before we dive into the earnings, let's shortly round up on what UPST actually does.
What Problem Does Upstart Try To Solve?
Upstart regards itself as a leading lending platform that utilizes artificial intelligence ((AI)) to evaluate loan applications. Many companies now try to jump on the bandwagon of artificial intelligence, but UPST does in fact incorporate AI in its process.
Let's take a look at UPST's mission statement to get a better understanding of the company's mission.
Upstart's mission is to enable effortless credit based on true risk. We are a leading artificial intelligence ((AI)) lending platform designed to improve access to affordable credit while reducing the risk and costs of lending for our bank partners. Our platform uses sophisticated machine learning models to more accurately identify risk and approve more applicants than traditional, credit-score based lending models.
While this all sounds pretty good, this also raises questions. The company tries to "enable effortless credit based on true risk. " Meanwhile, they want to approve more applicants than traditional, credit-score models. This seems to be somewhat contradictory.
Nevertheless, Upstart is able to accomplish this, as the data shows. Furthermore, UPST uses its models to help financial institutions, like credit unions and banks a better tool to assess the creditworthiness of loan applicants.
In addition, UPST's model is significantly better than the FICO model at analyzing the true risk of credit. Below, you can see Q2 (most recent report) on the left and Q1 (prior report) on the right. Nevertheless, we can see that the default rates are increasing, both for large financial institutions and for UPST.
This is due to the higher interest rates, and as such, the increase in loan payments people have to make.
For example, the people with a FICO of 639 and below, and a 1+ rating, saw their default rate increase with 1% in just one quarter for UPST. This is a situation that is harming UPST, but this is out of UPST's hands, unless they start making their models stricter, which will lower the amount of applicants.
"Why is UPST's model more accurate?" you might ask yourself. The Upstart model is trained on a data set of over 70 billion cells of performance data with an average of 88,000 new loan repayments added each business day, as per the latest earnings report .
Furthermore, UPST has shown that it is able to quickly approve loans based on its data set, as can be seen below. This indicates that Upstart is more efficient for both borrowing and lending.
Now let's look at how this compares to these numbers of last quarter (Q1 2023) . As can be seen, the instant approval and fully automated loans increase by 3% in the last quarter, while all the other numbers remained the same.
As such, the model seems to work, the fully automated loans are increasing and the default rates are lower compared to the large financial institutions.
In addition, the 83 Net promoter score is amazing. For those who don't know NPS, it's a score of customer satisfaction, ranging from -100 to +100. Tesla (TSLA) is known for having an incredibly high NPS of 97 , the biggest of all big brands. Starbucks (SBUX) has 77, but Upstart tops that.
Unfortunately, UPST stock performance isn't showing the same love. To understand that, you have to know how Upstart makes money. From Growth To Value wrote a great analysis about that in his last UPST article :
Most of its revenue comes predominantly from fees, a small percentage of the loans generated through Upstart's platform. These loans can be generated on the platforms of banks and credit unions or directly through Upstart. The loans are either held by the partners or sold to other banks, credit unions, hedge funds, etc.
But Upstart decided also to take some loans on its own balance sheet to fill some of the gaps. What this means is that Upstart generated loans but financial institutions were not willing to buy them. Seeing them as attractive, Upstart put them on their balance sheet, so they could benefit from the interest. That spooked investors, as the company now has credit risk. That was the first big reason why the stock dropped. To me, this was not a reason to sell, as I thought Upstart's model would work, so the credit risk should be rather limited.
The company's nosediving revenue was the more fundamental reason for the drop. And, sneak peek here already, that didn't change in Q1 2023. Upstart still generates enough supply, so loan applications, but there is not enough demand from banks and other financial players who want to buy the loans. That's not a problem specific to Upstart, it's industry-wide and it has to do with the rising interest rates.
This is the situation. Suppose you are the head of a financial institution. The interest rates are at 2% (so this is a while ago) and Upstart generates a loan that you can buy. It yields, let's say, 7%. But you know that interest rates are still going up, as Jay Powell said the Fed targeted 5%. And with interest rates at 5%, the same loan, with the same conditions, yields 12%. What would you do? Buy the loan right away or wait until interest rates seem to be at their peak? Many institutions chose to wait, understandably.
In addition, it is pretty simple. Interest rates have gone through the roof over the last year, which caused people to postpone their loans or even decide against opening a loan altogether.
Earnings Results: Beats, But Weaker Guidance
After a bad Q1 investors were hoping to see improvement in Q2. When Upstart released the Q2 results, investors were happy, the company posted a profit. The adjusted EPS of the second quarter came in at $0.06 while consensus was negative $0.07, which is a significant improvement when compared to the previous quarter. In addition, this is a $0.05 improvement compared to Q2 of last year.
Revenue came in at $135.8M, beating analysts' estimate of $135.3M, but is a decrease of 40% year-over-year. In addition, this is a significant improvement compared to the $103M in revenue of last quarter. Nonetheless, this is still down compared to the $228.2M in revenue of Q2 last year.
You might ask yourself, "What happened?" Unfortunately, Upstart's revenue guidance for Q3 was simply disappointing.
The company expects Q3 revenue to be around $140M, below analysts' expectations of $155.4M. This expectation is based on $150M in revenue from fees, but the net interest loss of $10M takes this down to $140M.
Contribution profit margin came in at 67%, which is up 20% year-over-year. In addition, contribution profit came in at $95.9M, which is up 42% quarter-over-quarter, but a decrease of 21% on a year-over-year basis.
The contribution margin is calculated by (revenue from fees - variable costs for borrower acquisition, verification, and servicing) and this as a percentage of revenue from fees
What we like to see is that UPST was able to significantly cut back on its operating expenses, which came in at $169.1M, which is a decrease of 35% year-over-year. This is the main cause of the higher contribution margin.
Furthermore, adjusted EBITDA came in at $11.0M, which is up 99% year-over-year.
The volume of loan transactions was approximately 109,000 loans, which is an increase of 30% compared to last quarter, but still down significantly year-over-year. In addition, the average loan size was $11,000, which is an increase of 4% year-over-year.
The Glassdoor rating of Upstart dropped significantly due to the significant amount of layoffs the company did.
As you can see below, the rating is improving again, which is good to see. Last quarter, the rating was 3.6 stars with 69% CEO approval. Today, the Glassdoor rating is 3.8 stars with 75% CEO approval.
As you can see, the overall rating is still decent, but we would like to see this improve further in the upcoming quarters.
During the earnings call, analyst Simon Clinch asked about the UMI. But, before we get to that, first let us take a look at what UMI actually is.
UMI, also known as "Upstart Macro Index," is an in-house index UPST has built to show the current macro lending climate.
The higher the index is, the more defaults there are. As you can see in the chart below, the index is still trading higher. This indicates that we should be careful and that UPST still isn't out of the woods yet.
During the earnings call , the analyst asked about UMI:
I'm really interested in, I guess, what levers you -- or perhaps how you respond when you start to see the UMI flatten or improve. What are the levers that you would be able to pull? And how should we think therefore about the speed at which you can start to get a recovery in your conversion rates and your general loan growth and your market share gains as a result of that?
CEO Dave Girouard responded with the following:
Basically, we are watching UMI trends and effectively maintaining what we hope to be a buffer between the assumptions that are in a new loan model or in the loans that are being produced in any particular time to the trend in UMI. So, as we will hopefully see over time UMI trending back down, at some point, the underlying assumptions in the models will stick with that. And again, maintaining -- always aiming to maintain a buffer, but it should trend down.
So, UMI, as you see it really is the output of what's going on out there in the economy and we always want to stay ahead of it. And the best thing we can really do is make sure UMI is as accurate and as recent as possible, that's why we're sort of continuing to innovate on it. But it will be a good indication of when the assumptions that will go into the next loans that are being originated.
The analyst asked a follow-up question to Sanjay Datta, the CFO of Upstart. This was due to a new slide that popped up in the Q2 earnings report.
This slide shows what UPST has at risk as part of its committed capital.
Now, let's take a look at the follow-up question.
I was wondering, maybe, Sanjay, you could talk through the slide on the long-term funding commitments and your share of the risk and just make sure we understand sort of what's going on that -- in that particular situation as an example.
CFO Sanjay Datta replied with the following:
Yeah. Hey, Simon. This is Sanjay. Happy to do it. Yeah, so we have a new slide in our materials that's meant to sort of pull together the punch line for, essentially, what we have at risk as part of our committed capital partnerships. They're a little bit hard to pull together in the financials directly because the contracts are all a little bit different and they're all accounted for a little bit differently.
But I guess at a headline level, as part of those deals, we have invested or co-invested to date on the order of $40 million. So that, I guess, you can think of as the maximum exposure we have. That $40 million over time will be worth as little as zero or as much as around $80 million or $83 million, I guess, depending on the timing extent to which these loans over or underperform. Our best current estimate given the trends is that, that $40 million, we believe, is on track to be worth about $52 million. So, some marginal overperformance there. But that's something that we will obviously forecast and track for you guys over time.
It's good that Upstart gives us more insights into the business and this new metric is one.
Valuation
While UPST's revenues and gross profits have declined. The numbers are still significantly higher than in 2020, with the stock now close to its IPO price one could say that Upstart is at an interesting valuation as the company has significantly improved since it went public.
UPST has a gross margin of over 70%, which indicates that the company has strong pricing power. In addition to a 5Y revenue CAGR of 46.65%, based on 2022 numbers.
Nonetheless, it has to be addressed that UPST is free cash flow ("FCF") negative. The company has a negative free cash flow of $272M. While this is a significant improvement compared to 2022, when the company had an FCF of -$679.1M, it still leaves much to be desired.
Furthermore, as previously discussed, the company is clearly facing challenges due to the prevailing macroeconomic conditions. However, we maintain our confidence in UPST's ability to perform admirably in the current turbulent economic climate.
If UPST is able to survive even in times of recession, which we believe they will be able to do, UPST could give you a significant ROI in the next decade.
Immediate catalysts for Upstart would be an improvement of the current macro conditions and more importantly declining interest rates. Nonetheless, the stock is currently at a reasonable valuation for investors willing to take a high-risk/high-reward opportunity.
Technical Analysis
If we look at the technicals for UPST, it is clear that the company is in a slow decline once again, after reaching its high back in August of 2023. Since then, the stock has declined over 60% in a rather short period.
Optimistic investors hope that UPST can bounce back and regain this vital support level soon. However, there's a real risk that the stock might continue to drop, possibly reaching a price range between $38 and $40 before finding support.
Looking at the EMAs, the stock is trading below all of its EMAs on both the daily and the weekly charts. This shows the immense bearish pressure currently put on the stock.
Investors should hope that the downward-trending green support line holds. In addition, the $22.57 level is a crucial one to hold as this was
Unfortunately, we do not see any signs of a significant move to the upside for UPST on a technical level in the short to medium term.
Conclusion
After the insane rally of over 500% since the beginning of May till the Q2 earnings release, Upstart Holdings, Inc. stock has now come back down, mostly due to weak Q3 guidance.
In conclusion, Upstart's recent earnings report paints a complex picture. While they managed to beat expectations on EPS and revenue, there are underlying challenges. Rising interest rates have led to increased default rates, impacting Upstart's lending business.
The company's impressive Net Promoter Score indicates satisfied customers, but this sentiment hasn't translated to a positive stock performance. The shift in the lending landscape due to interest rate fluctuations remains a key challenge.
Moreover, the Upstart Macro Index ((UMI)) continues to signal elevated default risk, reminding us that uncertainties persist in the lending market.
While there's potential for Upstart's innovative AI-powered lending platform, investors should remain cautious and keep a close watch on how the company adapts to changing economic conditions.
Investing is about understanding the narrative behind the numbers, and in Upstart's case, that narrative is still evolving.
For further details see:
Upstart: The Story Is Still Evolving, But The Price Is Getting Attractive