Upstart's Risk And Opportunities: A Dispassionate Consideration

May 16, 2022 1:13 AM ETUpstart Holdings, Inc. (UPST)65 Comments
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Bert Hochfeld
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Summary

  • Upstart shares imploded in the wake of a poorly received earnings report.
  • The company reduced guidance based on cyclical elements that affected loan pricing, loan approval and ultimately loan originations.
  • Analysts were exceptionally alarmed that the company doubled the size of its "loans held for sale" category on its balance sheet.
  • The misunderstanding of Upstart's strategy in terms of "loans held for sale" is substantial.
  • The company's progress in entering new loan markets is also significantly under evaluated.

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An implosion for the ages?

I have seen quite a bit in 30 years of reviewing tech stocks. Volatility is a fact of life. Drawdowns are a fact of life. I first recommended Upstart (NASDAQ:UPST) about a year ago, after the company reported quarterly earnings and the shares were at $103. And then back in October, just before the start of the current market implosion, I re-recommended the shares when the shares were just above $300. So my investment recommendation has been wrong, really very wrong. Is it time to acknowledge a mistake and walk away? Or is it time to look at the thesis, and determine if this company still has business merits that aren’t reflected in the share price?

I am a long term investor in tech, that is the only strategy I have found that works. I used to try to trade quarters-that has become increasingly more difficult, and it can lead to regulatory issues. I think anyone trying to trade Upstart at this point is entering into a fraught undertaking. Yes, probably the share price beating of Upstart is overdone! Part of that is a function of a lack of completely transparent communications during the call. Or perhaps I should just say, the CFO did not appear to be overly articulate in his response to conference call questions and he appeared to be unprepared for the tsunami that arose when questioned about loans retained on the balance sheet.

But at the end of the day the company did lower guidance, and the increase in loans on Upstart’s balance sheet was a shocker to many analysts. Those are real factors, not communication ineptitude. As the guidance is predicated on cyclical elements outside of the company’s control, and as the use of Upstart's balance sheet to fund some loans is a practice the company is likely to retain, some of the risks and uncertainties that led to the share price implosion aren’t going to change, or not change in the short-term.

There will be some readers who having been burned owning these shares will never touch them again. Some will suggest that management was misleading, or inept. And just to be clear, I have plenty of egg on my face as well. But having acknowledged my own error, and the fury likely on the part of some holders, I have to try to analyze what has gone wrong…and what is going right.

Noting issues of concern and controversy does not mean that the Upstart growth story is done. It does not mean that Upstart has a flawed business model, or that its AI algorithms don’t work. Consistent, steady and predictable growth without undue risk is the holy grail of investing. Yet achieving those attributes tends to be difficult, and indeed, in my own experience, it is a rare company that doesn’t have to deal with speed bumps.

Self-evidently, the guidance presented by Upstart is a significant speed bump. The speed bump is basically a factor of cyclical trends. The rise in rates, and the concerns about the macro environment producing a recession are well-nigh universal at this point, and those issues are likely to wind up impacting most companies. But in my view, as will be discussed in this article, the speed bump is just that and not an existential crisis for the company.

Upstart is not a machine for printing numbers. It exists in the real world, and the real world is a far less pleasant place these days than has been the case in the recent past. Should investors tailor their investment portfolios to try to account for the risks and exigencies that currently exist. Indeed, some investors do so, and do so with some success.

In this article, I am simply going to attempt in this article to look at the specifics of the Upstart investment case, with a view toward considering much of the negative commentary, but attempting to see if that commentary is warranted. It is my goal to try to determine a balanced approach to risk and rewards.

Basically, the Upstart investment thesis is not going to be upended by cyclical perturbations, but its operational performance is likely to reflect the macro issues of the moment.

Upstart has never been, and never will be a company that exists independent of cyclical and other exogenous factors. The influence of cyclical issues on Upstart is going to be far less than it might be for some elements of the economy, but it is not going to be absent either.

This is an article that explores the company’s solutions, its technology, its business model, its CAGR and its competitive moat. It is not an article that tries to suggest that current macro-headwinds aren’t a real issue for companies whose business is consumer lending, regardless of whether or not they use AI technology.

Lending is a cyclical business. A mistake in my analysis has been just how cyclical the business can be, and further to what extent investors have reacted to that cyclicality. The cyclicality is creating a significant headwind for loan demand. Upstart funds its loans in a variety of ways. One source of loan funding is the asset backed security market. The ABS market is itself cyclical, and it follows broad market trends. That too, is having an impact on Upstart.

What hasn’t happened is some competitive issue, or some concept that AI technology isn’t producing better results for both borrowers and financial institutions than FICO scores. The company helpfully provided an investor deck that highlights credit performance of its loan cohorts, and compares those to the use of FICO scores. And management seems to be executing successfully on its plans to penetrate the auto lending market and to develop products using AI technology in small dollar lending and small/midsize commercial lending.

I personally won’t go near companies who lack the management skills to build a great company. And I try to look for company’s who have differentiated capabilities and are leading in their market space. I believe that the lending space is ripe for disruption using digital technologies. AI, coupled with digital transformation, and the use of a mobile first paradigm are the animating factors that are sparking this disruption. AI is not going to make lending less cyclical. And it isn’t going to create scenarios with zero defaults. But the guidance that Upstart has given doesn’t, at least in my mind, vitiate the investment thesis based on the disruption of the various components of the consumer lending market.

Upstart is a founder led business, and its founders including Paul Gu and Dave Girouard have a strong track record. Sometimes, it is necessary to step back a bit, and rather than look at some of the "trees" that analysts have focused on, to look at the forest. Part of that forest is the management team and the overall IP capability that Upstart has put together.

The Bad News First

Upstart’s conference call was not a thing of beauty. Indeed, at times it was excruciating listening. As it happened, there was some good news to consider. That said, the bad news is why the shares are trading at their current levels. So, I will focus on seeing whether the bad news is existential or a speed bump.

The earnings presentation Monday evening developed two negative themes. The one that has been talked about and written about for months now relates to the influence of macro-economic conditions on the company’s personal lending business. More than a few analysts had pointed out that Upstart's growth would be at risk as the macro environment deteriorated and as the Fed sought to use interest rate hikes to slow the economy. And that did prove to be the case, Specifically, the company said that higher rates had flowed through from funding sources to the rates it was charging borrowers. And with these higher rates, some prospective borrowers did not qualify for loans, and others who did qualify, declined to convert their applications. Here are the specifics of that discussion

Rather than trying to paraphrase management on the subject, here are the specific comments with regards to how inflation and higher rates are, and will impact Upstart’s business.

Dave Girouard -- Chief Executive Officer

Sure. This is Dave. I might actually jump in, at least once here. Yes.

I mean, I think it's actually fairly simple. We expect less volume than we would have a few months ago based on pricing in the marketplace being higher, and that's a function of both underlying base rates being higher as well as the risk in the environment and the risk premium that either lenders or investors are demanding. So you put that all together, and it's been an increase in sort of average rate to the consumer of several hundred basis points. And I think we've always said, we're not, in some sense, a terribly interest rate-sensitive thing.

And we've kind of said interest rate changes of 50 or 100 basis points are something that could well be offset by improvements to our platform. But in this case, it's much more significant than that. And of course, in the last few months, we've seen -- and it is probably 300 basis points or higher. And so that's what's giving us our guidance for the rest of the year.”

“It's really as simple as when the consumer rates go up, that means on the margin, a whole bunch of people that would have been approved are no longer approved. So there's a whole bunch of just loans that never happened at all. And there's a bunch of people that are still approved, but the interest rate is a few percentage points higher, and a certain fraction of them are going to decide that's not the product that they want. They don't need it.

It's -- in many, many cases, it's a discretionary loan where they're buying something or paying off something that they don't necessarily have to. So there's a fair degree of price sensitivity. And just put those together, when average rates go up, you're going to see less volume. When average rates go down, you're going to see more volume.

There's a lot of things we're, of course, doing in the mix of that to make the funnel more efficient and more performant. But all else being equal, of course, if rates go up, those are the effects that you're seeing there. On auto refi, I would just say there's a lot in flux because it is a new product and because it's also a refi product, meaning it has interest rate sensitivity to it. So a little hard to judge how those things will balance over the course of the year.

“So we can control that. So the bottom line is we -- when -- there were a lot of people that three months ago, might have been approved close to 36%, that today, would not be approved at all. So for sure, when rates go up and return hurdles go up, it has the effect of pushing people out of the approval band and into the decline band. And that's just the nature of the business.

And when the model gets a little smarter, it will approve some of them and it will disapprove others that it might have approved before. And that also is the nature of the business, the nature of the product getting better. But that's the bottom line. We don't, per se, have any say in what a bank or credit union's maximum APR is."

As was explained elsewhere in the conference call, increasing rates by 300 basis points undercuts the approval of marginal borrowers, and the increased cost of the loans means that some approved borrowers choose not to accept more expensive offers. Upstart is still gaining share in the personal loan market, but it appears that the personal loan market is likely to contract at some cadence as the cost of borrowing rises.

I would have liked to have heard a bit more about the specifics of what a 300 bps move in interest rates is expected to do to loan demand on the Upstart platform. Essentially, the new guidance implies that personal loan volumes will decline sequentially at some rate for the balance of the year.

A second major issue that seems to have upended the thought process of some investors/analysts was the dawning of the understanding that Upstart uses its balance sheet to fund some loans. Part of the investment story for Upstart is that it is a capital light business, in that it basically doesn’t fund the loans it makes. It has a variety of funding sources, including bank and credit union partners, institutional investors and access to what is called the asset backed security market. The financial results of this latest quarterly report apparently shattered that belief.

At the end of 2021, the company had $252 million of loans on its balance sheet. It now has $598 million. I think it is this increase of $346 million, that was a major element in precipitating the rout in the shares, even beyond the reaction to lower guidance. To try to encapsulate the negative thesis fairly, I believe that analysts are concerned that these loans on the balance sheet will turn out to be risky, particularly so in a recessionary environment. They are further concerned that the company will not have the capital resources to fund further growth in loans and to manage its balance sheet. The company does have $1 billion in cash and equivalents. Last quarter, the company’s operating cash flow was a burn of $267 million because of its loan funding activity, so, self-evidently, the company will be unable to fund future loans at the same rate it did in the first quarter for any significant period.

The negative thesis then considers that the increase in the loans on the balance sheet is a symptom of Upstart's inability to find market sources willing to fund its loans, and that its access to ABS funding has been declining. This, in turn, it is believed, will limit the company’s future growth.

In addition, the thesis goes on to assert that if the company needs to use its balance sheet to fund loans, then its valuation should be more in line with financial institutions, overall, and not anything comparable to the valuation of software companies.

Finally the thesis suggests that in an environment in which a recession is looming, and real income is being eroded by inflation, default rates will rise , causing investors in the ABS market to shun Upstart’s credit tranches. This, it is suggested, will limit the growth that Upstart will ever be able to achieve, resulting in the reduced price targets that have come from many analysts.

Counterpoint

I think the arguments presented in the negative thesis are both misinformed and overblown. Some of what I have read from brokerage analysts seems to me to present close to willful misunderstanding of the facts that have been presented with a fair degree of confirmation bias. There are, almost inevitably, two sides to every story, and some of these articles seem determined to be almost polemical in their essential disbelief in Upstart’s strategy and business model. And then, there have been other analysts, whose recommendations reflect that the market is completely attuned to mitigating risk, as it perceives risk. Personally, I doubt it does much value to readers for me to comment about the current state of the market. I try to provide an analysis of the company, and while acknowledging the factor of sentiment in valuation, I try to use more objective factors in quantifying valuation.

Further, I might observe that to me, Upstart is a technology company, and not a bank, and thus many of the covering analysts who follow banks, and even neo-banks have a harder time in recognizing the differentiation and the business model of Upstart than might otherwise be the case.

To restate, Upstart’s management could have done a better job in articulating the specifics of the company’s risks and factors in mitigation, but the reality is that just a little bit of digging would produce different conclusions than those I have seen in some reports. And the company should have been more granular in its discussion of how it arrived at its new guidance, and how it is managing, and is going to manage its balance sheet going forward.

The first issue, I think, has to do with the company’s core business, that of providing personal loans to borrowers. The basic reason as to why the company has reduced its guidance for the current year has nothing to do with funding, or access to additional funding, and everything to do with loan demand and cyclical factors in the economy. Contrary to some assertions, the use of Upstart technology does not sacrifice credit quality for loan approval.

This writer actually got an employee to apply for an Upstart loan to better understand its specific process for making loans. The process is mobile, and it is pretty straightforward for those with a moderate degree of computer literacy. It is also enabled in Spanish, which is helpful to many prospective borrowers. But in order for a borrower to secure credit, Upstart requires verification of income, bank balances, education, time in a residence, monthly utility payments and other monthly expenses. Pretty much the same things that a prospective borrower would have to provide other potential lending sources. The process is easier, because it is all mobile, and it is on-line, with almost instantaneous decisioning, but verification is required, although that can be downloaded through the app.

Borrowers can pick the term they want, and the loan amount, and if the verification is there, they then receive an offer. And the APR is not cheap for borrowers with limited credit history. In the case of my prospective borrower, the offer that was provided was for an APR of 27.5%, including an upfront origination fee. The concept that Upstart provides credit to unqualified borrowers simply can’t stand the test of actually using the app.

With higher rates have come a lower level of loan approvals, and a lower level of application conversions. Does the fact that consumer lending is a cyclical business upend the advantages of the use of AI technology to underwrite loans? Will Upstart continue to gain share in the consumer loan segment? When I try to evaluate an investment, I don’t necessarily look at performance in the context of cyclical perturbations. Business cycles will come and go, and the fact that consumer lending is not immune to cyclicality does little to alter a multi-year CAGR for Upstart.

What would be concerning would be some evidence that the company’s AI technology, or the predictions of its credit models were breaking down. There is simply no such evidence. What evidence was presented is that default rates have held steady over the last 60 days. The reason to own Upstart shares, at least for me, ought not to be the point in the credit cycle that is currently driving approval rates and loan conversions, but whether the company’s technology is producing better results for borrowers and lenders over the course of several years.

The question that investors should address isn’t that some lower percentage of borrowers are being approved, or that some prospective borrowers are declining loan offers-but how much the reduction in those particular metrics might worth in terms of the valuation of the shares. For anyone, like this writer, who does a DPV analysis, the actual answer to that question is very little. Presumably, the next 4 quarters represent some kind of trough cyclicality in terms of growth and cashflow for Upstart. When might investors start anticipating the turn in the credit cycle from extremely negative, as is currently the case, to first neutral and then positive?

I don't claim, that I have some crystal ball with regards to the economy or credit cycles, or even when investors might start anticipating an end to this particular credit cycle. But it seems to me, that investors, seeing slowing growth, and hearing that Upstart's results are correlated, at least in part, to the credit cycle, have extrapolated that correlation beyond a reasonable level.

The second issue is that of funding sources for Upstart’s loans. Some analysts, who specialize in the banking industry, have postulated that the performance of Upstart’s ABS tranches has been and will be a gaiting factor in the company’s growth. Further, some have suggested that the increase of loans on Upstart’s balance sheet is a function of the freeze-up of that market for the company's loans and unwillingness to accept the risk of the performance of Upstart loan tranches.

There is a serious misapprehension amongst some investors and analysts with regards to just how AI operates and what it can and cannot do, and what it is supposed to do. It is not supposed to eliminate defaults, although it could be trained to do that. The problem with doing that is that it would reduce the net yield on a loan tranche optimized for minimum defaults to such an extent that tranches composed of such loans would not produce yields that are competitive in the ABS market.

At this point, Upstart’s AI algorithms for personal loans are operating on very large data sets, with increasing levels of confidence in the specifics of their projections. They can always be made more accurate, and the company has said it will incorporate more proxy variables to account for macro fluctuations in the economy that could impact the ability of some borrowers to repay loans. What is simply inaccurate is the assertion that the increase in self-funded loans on Upstart’s balance sheet are a function of existential issues with the ABS market for loans underwritten using Upstart's credit models.

One can either accept the specific comments of the CEO and the CFO of Upstart as to the technical issues that lead to some consumer finance loans remaining on the company’s balance sheet. But the fact is, that those loans were evaluated at the end of the quarter by the company’s accountants and marked to market. We don’t know the precise amount of consumer finance loans that were held on the balance sheet, other than the comment of the CFO that this was not a major part of the increase in "the loans held for resale category.".

Sanjay Datta -- Chief Financial Officer

And Simon, just to maybe put the numbers into context, but I think the amount of the total platform loans that ended up on our balance sheet this quarter was still a single-digit percentage. And of that amount, probably close to three-quarters of it is still -- was still R&D-style spending on predominantly auto loans and other new products and segments. So it was still a relative minority or a relatively small percentage, but it is just sort of an important new thing that we haven't been doing in prior quarters just because of the fluidity of the environment."

Based on this comment, it would appear that the volume of consumer finance loans on the balance sheet rose by about $85 million or less than 2% of the more than $4 billion of loans processed on the Upstart platform. For what it is worth, the CEO said that the company was looking to maximize the value of the loans in an environment where rates have been volatile. And this is the specific comment of the CFO with regards to those particular loans;

Sanjay Datta -- Chief Financial Officer

I would say those are being held as held-for-sale loans. Obviously, it will be a function of what that secondary market looks like. And we'll make an economic decision on them, but I think the preference would be to get liquidity and get cash back on the balance sheet rather than to hold the loans and earn interest income."

I imagine that as the company further automates the process it uses to price consumer finance loans, the amount of such loans on the company’s balance sheet will see declines. I think the share price reaction to this increase in consumer finance loans on the balance sheet was, to put it mildly, far out of proportion to any risk of material loan charge-offs. T

By far the greatest proportion of the increase in loans on the balance sheet of Upstart were related to the company’s auto loan refi product. I think it might be well to consider exactly what Upstart’s auto refi lending product is all about. I have linked here to a description of the product and a 3rd party review.

Consumer asset based lending is self-evidently less risky than unsecured personal loans. Refinancing auto loans that have a history of performing, is, again, self-evidently, less risky still. So far, Upstart has refinanced 11,000 auto loans which, which according to the CFO, are the vast majority of the loans on the balance sheet.. Why are these loans on Upstart’s balance sheet and are they a major risk for investors?

A significant part of the investment thesis for Upstart is that it has developed a capital light model. And thus, seeing $600 million of loans on the balance sheet was, in my opinion, a significant component in the share price reaction that the company experienced. And I won't try to suggest that it didn't come as a surprise to some. I will note that the company has consistently called out that it would use its balance sheet to fund loans in new categories, but the magnitude of that funding was surprising, and unsettling. That said, however, I believe the extreme reaction was unwarranted, and that essentially, Upstart has and will continue to have a capital light business model.

The CFO talks about using the company’s balance sheet as a way of funding research and development. That is, I imagine, not the most transparent way of describing what is actually going on.

AI technology in this space cannot not work without considering millions of repayment events. It is impossible to build a model without data. Any time Upstart enters a new lending category it has to create multiple new models to forecast the likely performance of loans. The new model needs data, lots of data, in order to establish specific correlations that enable it to predict the performance of a set of transactions.

At this point, it has actually been more than 55 years since I first haltingly built those kinds of models while a student. The technology is far beyond what was available in 1965, and the complexity of data science has multiplied infinitely, but data scientists-which I am not, just to be clear-still need lots of data to construct models.

And so, Upstart’s strategy to collect that data is based on underwriting loans, keeping them on their balance sheet, and determining what correlations work, and what correlations are meaningful. As the link shown above demonstrates, this company does not underwrite its auto refinance loans without using a carefully tailored set of parameters to evaluate borrowers and their collateral.. Its lending parameters are the same as all of the other financial institutions that offer auto loans. It is to be expected that some of the loans will default. Some of the loans have to default so that the model can determine which characteristics most accurately forecast risk. That is basically what training a model is all about.

Once Upstart is able to demonstrate that it has developed a trained model based on sufficient data, it will be able to sell the loans on its balance sheet. It will find plenty of willing capital partners who will be able to properly gauge the risks and expected performance of a tranche of auto refi loans. But it has to have that data before it can effectively engage with its capital partners or before those partners can, themselves, package loans and tap the ABS market.

At some point, these loans that are on the Upstart’s balance sheet will demonstrate the performance of the cohort, and they will most likely get sold. But investors should note that they will be replaced with other loans. As long as this company is entering new loan categories it will need additional models. Later this year, the company will start making loans through its program to finance new cars at auto dealerships. It will also launch a broad program of small dollar lending, and it expects to launch its SMB lending program by the end of the year. That is why it has hired thousands of data scientists and continues to hire scarce talent. But no matter the skills of these data scientists, they can’t produce models in a vacuum. They need data, and the data that they need basically has to be obtained through the process of training models based on a substantial number of repayment events. That is the “price” that investors will be paying for Upstart to continue its strategy to disrupt the consumer finance industry.

If that strategy is not appealing to some readers, or if some readers believe that this is a riskier strategy than they had understood, then owning Upstart shares, even at this level of valuation will probably not fit their investment parameters. But many other investors will find that Upstart's "loans held for sale" is not a significant risk to its business and profitability.

The final counterpoint to discuss is the issue of funding capability. It has been a principle thesis of analysts with sell ratings on the shares that with rising default rates, the loans underwritten by Upstart will not be deemed as appropriate investment vehicles by the buyers of ABS, and the company will no longer have the capability to finance its growth. This is not really accurate and betrays a rather substantial misunderstanding of how Upstart’s technology is used to underwrite loans, and how its models are used to forecast the performance of loan tranches. It would be tedious to expose all of the fallacies in the commentary of many analysts in that regard. I will simply suggest that AI technology can be used to create loan tranches with varying degrees of risk, and can actually be used to create loan tranches that reflect different macro-economic assumptions.

Specifically, there is no evidence that capital sources are drawing back from the Upstart lending platform. There is evidence that capital sources want higher returns, and as indicated above, that means more loan declines, and fewer conversions on Upstart's consumer loan platform. That is what is already reflected in the reduced guidance. But rather than me expounding on the subject, here is a quote from the conference call on the point of if the company is having issues in finding sources to fund the loans that it underwrites:

Mike Ng -- Goldman Sachs -- Analyst

Hey. Good afternoon. Thanks for the question. So I just had a follow-up on the revenue outlook change.

It sounds like it was mostly driven by a lower origination outlook due to lower demand from rising rates. I just wanted to see if you're seeing any change in the lending parameters or shrinking of the credit box due to what's happening on the funding side.

Dave Girouard -- Chief Executive Officer

Hey, Mike. This is Dave. No, I don't think there's any significant change in that regard. I would say, generally, most on the banks and credit union side, there's been very little move in any direction.

And I would say in some cases, they've raised target returns a bit, but I think it's just at the margin. So largely, that side of the house has not changed significantly. It's really on the other side where expectations of investors and etc., has gone up in terms of return targets. So no, it's not really any real change with respect to the credit box of the various lenders."

There is likely some skepticism with regards to this contention. But so far as I can determine, the issue of funding for Upstart ABS tranches has been blown out of all reasonable proportion in a risk-off market environment.

The Good News

There really was some good news that Upstart presented in the midst of investor panic regarding the company’s balance sheet and its guidance cut. Specifically, the company continues to find new banks to participate in its lending program. It now has 57 banking partners, up from 42 at the end of the year, and up from 10 a year ago. And an increasing number of these banks have dropped the use of minimum FICO scores as part of their own loan underwiring process. Simply put the Upstart models are showing the kind of results that have given these lenders further confidence in the platform. At this point, has enrolled 500 “rooftops” in its Upstart auto program, up from 100 dealers when it entered the market through acquisition of Prodigy a year ago. It has also enrolled 35 auto brands including Toyota, Volkswagen and Subaru in its new auto loan program. The company has developed relationships with 12 lenders to finance its auto loan refi program. As it recruits more lending partners for this product it will probably result in loans on the balance sheet reducing, to some extent.

The launch of the new car auto lending product will be taking place this quarter in a few states representing 25% of the US population. It is this product, which encompasses consumers evaluating and buying a vehicle, and financing it on the same mobile first platform that is really likely to be the major growth driver to be expected from this company on a go-forward basis. As has often been stated the auto loan market is thought to be 6X the size of the market for personal loans. In the wake of the issues of the balance sheet and reduced guidance, it seems to this writer that no one is paying attention to the opportunity and the timeline for its realization.

But the best news of all is the fact that despite the macro developments in the economy, Upstart’s credit model is performing satisfactorily, and is outperforming FICO based models. If you own, or are considering buying Upstart shares, this is the most important consideration, and one that has apparently gotten little or no credence as the shares have melted down.

For those analysts bashing the shares, the following quote from the CEO is a significant counterpoint,

“With respect to credit performance, we're pleased how our models performed on behalf of our lenders during this tumultuous period. While not perfect, our model significantly outperformed traditional FICO-based risk models and learned quickly while doing so. For Upstart loans originated and funded by our banks and credit union partners, we saw significant overperformance since the beginning of COVID, which has normalized to on-target performance in recent months. There has been no meaningful underperformance of returns with any of our more than 50 lending partners since the program's inception in 2018 despite significant periods of economic disruption.”

Valuation And Wrapping Up!

I follow enterprise software companies and don’t follow the consumer finance sector. One of the great investment debates with regards to Upstart shares, I suppose, is whether or not the shares ought to be valued as an IT/Tech vendor or as a bank. That is not an issue that I think I can solve in this article. For the most part, the vast preponderance of Upstart’s revenues comes from fees, and not interest income. It is not a bank in that sense. Some investors and analysts have discovered that its asset light model still encompasses using its balance sheet as a venue to test its models. And while software companies, by and large, have less cyclicality than other elements of the economy, lending is, and will continue to be a cyclical business.

Looking at companies on an EV/S basis has not proved to be terribly useful in recent months as investors have fled growth for perceived safety and stability. But for what it is worth, Upstart shares, even after a bit of a dead cat bounce are trading at an EV/S ratio of about 1.85X.

Last quarter, the company’s free cash flow was substantially constrained by its investment in the category of loans held for sale. While I think that category will continue to grow as Upstart enters new markets, the growth seen last quarter is probably going to be a high point, although the CFO has forecast that the category will not see any reductions. I have chosen, nonetheless, to substantially reduce my free cash flow estimates for the 2022/23 period, although I have left estimates alone thereafter. That still leaves the calculated NPV of Upstart shares several times its present quotation. It isn’t necessary to value Upstart as a software company in order to make the case that its current share price valuation is unduly compressed.

The fact remains that Upstart is a key disruptor in the consumer finance space. It has disrupted consumer lending, and it will soon be disrupting auto lending, lending to small businesses, and small dollar lending. It is doing so in a profitable manner. Its models appear to be accurately analyzing credit risk and are also being improved through the addition of macro-economic variables as part of the underlying process of evaluating credit. The company’s investor deck shows the outperformance of the company’s models vs. the use of FICO scores to evaluate credit.

Upstart shares have been pummeled severely for analyst perception of risk and investor disappointment the guidance reduction. This has left the shares at a valuation that I consider to be exceptional. I own a position in the shares, and have purchased additional shares in investment advisory accounts in the wake of the share price implosion.

I have no specific idea as to when the Fed will complete its tightening or the course of this economic cycle. I don’t think it is really feasible to handicap those kinds of things with any degree of accuracy just considering the notorious record of the Fed's dot plot or other economic forecasts. But I consider Upstart to be one of the better opportunities in the technology space in the wake of its share price implosion. Unloved, misunderstood, with a fair amount of negative confirmation analysis in published articles. That can be a very powerful combination to produce positive alpha and that is my expectation.

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Bert Hochfeld graduated with a degree in economics from the University of Pennsylvania and received an MBA from Harvard. Mr. Hochfeld has enjoyed a long career in the tech world, working for IBM, Memorex/Telex, Raytheon Data Systems, and BMC Software. Starting in the 1990s, Mr. Hochfeld worked as a sell-side analyst and won awards from the Wall Street Journal for his coverage of the software space. In 2001, Mr. Hochfeld formed his own independent research company, Hochfeld Independent Research Group, which provided research services to major institutions including Fidelity, Columbia Asset, SAC Capital, and many other prominent institutions and hedge funds. He also operated the Hepplewhite Fund, a hedge fund that specialized in technology investments. Hedge Fund Research, an independent 3rd party firm that specializes in ranking managers, rated the Hepplewhite Fund as the best performing small-cap fund for the 5 years ending in 2011. In 2012, Mr. Hochfeld was convicted of misappropriating funds from a hedge fund he operated. Mr. Hochfeld has published more than 500 articles on Seeking Alpha, all dealing with companies in the information technology space. Highly esteemed for his investment wisdom accumulated over decades, Mr. Hochfeld ranks in the top 0.1% of Tip Ranks analysts for his selection of information technology stocks and their subsequent successes.

Disclosure: I/we have a beneficial long position in the shares of UPST either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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