Upstart: The 3 Risk Factors Investors Ignored

May 22, 2022 7:06 AM ETUpstart Holdings, Inc. (UPST)36 Comments13 Likes
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Summary

  • This article provides a post-prognosis behind why Upstart has declined significantly over the past couple of weeks.
  • A discussion around three key risks around growth, margin, and credit that Investors failed to recognize and underwrite when analyzing the company.
  • For a growth stock that trades for a Price-to-earnings ratio of <30x on 2023, the stock appears cheap but investors need to understand that it is cheap for a reason.

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Summary:

There has been a quagmire with Upstart recently after a significant drop which leaves it at a negative -70% year-to-date stock returns in 2022. This comes after such an impressive showing for the stock in 2020/2021. Many people including myself once believed that this founder-led, hypergrowth fintech company growing so fast and profitably could become a multi-bagger stock in the future.

However, a few people were left significantly disappointed after their recent earnings call. The stock currently trades in an interesting spot. At an Enterprise Value of $3.8B, if the bulls are correct that this recent quarter was only a balance sheet blip, this stock could become a home run winner. If the bears are right that the stock deserves to trade at a discount due to the current macroeconomic factors, the stock will likely remain flat and disappoint people for many years. The big question for investors right now is should they sell or buy more at this point.

I personally owned the stock twice last year and sold it twice. However, I bought it again after their Q4 result and got caught in the recent downtown after its most recent earnings result because I felt "it was cheap." I've come to understand that the stock is cheap for a reason and I believe there were three risk factors that investors failed to discount when studying the company. This article will probe into the 3 risk factors that Investors ignored when analyzing the company and I'll share 2 key post-mortem analyses as lessons from the stock.

Risk #1 - Growth was eventually going to stall:

One of the key reasons for the stock's 50% decline after its earnings call was the result of the company reducing its forward revenue growth guidance and increasing business risks through loans on its balance sheet.

After stellar revenue growth in H2 2020 and throughout 2021, it was inevitable that the company will have a hard time growing as fast in the upcoming quarters. Upstart's revenue growth had been gradually slowing down, albeit the law of large numbers started kicking in. In their recent first quarter of 2022, revenue grew to $310M, representing a 156% year-over-year (YoY) growth. This was a deceleration in growth that had not happened since Q1 2020 which was the last time they grew by 89%. However, the numbers are still respectable considering the tough comparisons from a year ago.

Upstart Revenue growth

Per Upstart Investor Presentation

The primary issue is that Upstart had raised its revenue guidance at the beginning of the year during its February quarter. Upstart guided to revenue growth of >70% and $1.4B for the FY 2022, so investors re-priced the stock and it sucked many people back into the stock - including myself.

After the recent Q1 results, Upstart now forecasts growing revenue to around $1.25B for the FY 2022, which represents a 48% YoY revenue growth rate. As for Q2 2022, they expect revenue to come in around $305, on the high-point, which represents a 57% revenue growth rate. As discussed, these are all significant slowdowns. Also, if we incorporate the fact that the sub-prime auto loans market is slowing down, there are factors that will drive down future growth for Upstart.

Unfortunately, Upstart should have known about the Federal Reserve's decision to begin raising rates higher this year. The fact that they even had such an ambitious growth target in the earlier part of the year broke trust with investors.

Quarterly Growth Metrics are declining:

Importantly, if we look at the quarter-over-quarter revenue metrics, they are all expected to be declining over the upcoming months compared to the past year. Obviously, we understand the current macroeconomic conditions surrounding their cautious guidance. However, if they expect negative sequential growth in future quarters, the current price might be reflecting the future reality. Investors need to be fully aware of this reality.

Upstart Quarterly Revenue Growth

Per Upstart investor Presentation

The % of beat rate for Upstart was the worse this quarter.

Upstart had averaged around +/-10% beat rate against their quarterly revenue. This past quarter of Q1 2022, they had a 3% beat rate. This is the lowest compared to the 17.2% beat in Q4 2021, 8.8% beat in Q3 2021, 22.9% beat in Q2 2021, and 4.3% beat in Q1 2021. This definitely signifies the weakness the business is currently experiencing right now.

Post-Mortem Lesson #1:

The reality is that Upstart should have never raised its guidance so high during its Q1. Investors should have been very skeptical about their initial revenue raise (and stock buybacks) last quarter, especially considering we all knew that inflation was high as well as we knew the Fed was planning to increase rates aggressively this year. This puts an integrity question on the Upstart management team.

Secondly, Investors should have discounted that the business growth was always going to slow down in the near future. Hence, when it was trading at a valuation of almost 60x future sales in November and December 2021, this should have pointed towards a red flag.

One major reality with Upstart's business is that about a quarter of Upstart's loans are kept by their bank partners and the other 75% are sold back to Upstart and then immediately sold on to institutional partners like big hedge funds to purchase the loans away from their books. These hedge funds buy Upstart loans to get a yield return. However, in a case where we knew rates will move higher because of quantitative tapering, Investors should have had doubts about Upstart's ability to weather the storm. Primarily because Upstart would not have had the ability to re-price their loans easily and the fact that large institutional funds would no longer have an appetite for those loans. The problem with this is that Upstart has to absorb the cost and then becomes a bank lender instead of a technology facilitator.

Risk #2 - Operating Margins & Free Cash Flow Declining:

One of the most impressive aspects of Upstart's business in 2020 and 2021 was that it grew revenue rapidly while maintaining very high margins. Upstart's operating margins grew steadily around the 25-30% range in 2021 but most of those metrics have shrunk and the business has seen margin compression this quarter.

Many investors failed to underwrite the risk of declining margins in a different macro environment. Management mentioned that the margin compression this quarter was due to compression in the value of loans and its investments in the auto-loans business. The reduction in the fair value of the loans on their book is due to the rising rate environment. This will hurt margins and it will likely do so in future quarters based on the evidence from the early parts of the pandemic when Upstart experienced similar challenges.

Another key factor that will affect margins in the nearest future is needing to invest more to ramp up their auto loans and small business enterprise segment as demand grows.

Upstart EBITDA and FCF Margins

Per Upstart investor Presentation

Upstart's Free Cash Flow came in at -88%. This was their worst cash burn since the early days of the pandemic. The cash burn was significantly higher. Upstart's loans, notes, and residuals held on the balance sheet soared from $260 million to $600 million QoQ. The performance of the loans on their balance sheet will be important to how the stock performs in the upcoming quarters. If we go into a period of stagflation where the economy significantly slows down and consumers default on their loans, with only cash holding of around $757M, the company will be in a very tricky situation.

Upstart Cash flow operations

Per Upstart investor S1 Filing

Management during the last earnings call provided some insight into the reasons behind these negative metrics on their cash flow statement, but it gives Investors much more to be desired.

We used our balance sheet as a market clearing mechanism. When rates rise so quickly, it’s fair to say our platform’s ability to react to the clearing price is not as quick as we’d like. As rates move and investors set new return benchmarks… there can be a delay in reaction which is when we step in to bridge things with our balance sheet. This is not a long-term or large activity. Responding more nimbly to changing rates is something that we’ll invest in to automate."

Also, management recently at a Barclays conference call mentioned they took on many of the balance sheet risks to support the loan volume growth of the business. The CFO mentioned that as things got more volatile earlier in Q1, they had to step in with their balance sheet to keep the funding moving on until they could achieve a new market-clearing price by which investors would be willing to purchase off those loans from their books. They promised to avoid taking on such loans on their books in the nearest future, but this begs the question that if we see a more volatile capital market in Q2 and Q3 of 2022, where there is no investor appetite for purchasing loans, consumers are not borrowing and Upstart doesn't use their balance sheet, this should see loan volume significantly decline, and therefore, growth and margins decline for the business moving forward. These are unknown factors and unchartered waters, so it's important investors stay cautious.

Post-Mortem Lesson #2:

Margins and cash flows will likely be down over the one year. Importantly, we all made the mistake of thinking that Upstart was a pure AI-tech company. However, this could not be further from the truth, especially after this most recent quarter. The business has a core technology component, but it is highly cyclical. The high unpredictability of the business and the high level of exposure to macroeconomic factors have made it difficult to value the stock as a software business. Similar to banks or other cyclical industry sectors that have elevated levels of macroeconomic risk factors beyond the business control, these types of businesses will struggle during periods as long as the economy is in a slug. The business is not a SaaS-like or subscription-based business model. The challenge is that every quarter, Upstart must make an effort to start again from zero to earn their top-line growth. This makes the business metrics have high levels of fluctuations. Moving forward, the most important thing is for investors to avoid the mistake of analyzing a cyclical business as a secular-tech business. It’ll be important for investors to be fully aware that the business has all of the following risk factors priced into its valuation.

Risk #3 - Macro environment slowing down the business:

The future business dynamics for Upstart have changed. The high level of liquidity and money growth the economy experienced in 2020 and 2021 is no longer present. A higher interest rate environment and a possible recession will dampen consumer sentiment which will affect the underlying business for Upstart. Inflation has tightened the US consumers' pockets and there are no longer stimulus cheques available to provide an extra cash cushion for the average US consumer.

The consumer discretionary index just had its worst-ever trading session due to the slowdown experienced by Walmart (WMT) and Target (TGT). These companies that reflect a large part of the US Consumer seem to show that the consumer might be tightening their spending patterns due to inflationary pressures. These factors will most likely affect Upstart since the business is tied to the health and risk appetite of the consumer.

Investors just need to be aware of the present risks. However, I'll note that I still believe that over a 5-10 year horizon, Upstart has an opportunity to redefine the credit loan market, especially within the auto-loans market. On their recent earnings call, management discussed that it expects the auto retail lending business to contribute meaningfully to Upstart's monthly transaction volumes by the end of the year. They were able to increase the number of car dealership rooftops to 525 compared to 162 last year. The overall number of banking partners grew to 57 from just 18 Partners, representing a 216% year-over-year growth. Hence, the business has the potential over a 5-year period, but I believe the next 12-18 months will be challenging.

Post-Mortem Lesson #3: Valuation and the stock is cheap for a reason.

Depending on the traditional valuation metric used to analyze Upstart, there is no doubt the stock is cheap. As I mentioned earlier, I got sucked back into Upstart because I felt the stock was cheap and I felt all the risk factors were discounted at around $100/share.

However, Investors need to be fully aware that the stock is cheap for a reason. The risk factors around slowing growth due to the macro environment, loans on their balance sheet, and the tight pockets of the average US consumers are major realities that investors must be willing to embrace moving forward. As a result, it is possible that despite Upstart’s rapid growth (which is in question), the market will no longer give it a valuation of a SaaS-like business in the future. It will likely trade around the valuation for a LendingClub (LC) or Silvergate Exchange (SI), but perhaps slightly higher than those two businesses. The primary reason will be how tied the business has become to the macroeconomy and its banking partners.

Future Valuation

Upstart stock Valuation Metrics

In Summary: Moving Forward

I'm neither bullish nor bearish on Upstart over the next 6-12 months. I believe a neutral perspective is required right now - where we need to acknowledge the current macroeconomic risk factors the business has to navigate while keeping in mind the long-term potential.

A period of aggressive monetary tightening, inflation, and the potential of an economic slowdown for the consumer will not be straightforward for Upstart. Meanwhile, rising rates push the return requirements higher for Upstart partners and investors as their access to capital becomes more expensive. Conversely, capital markets are quite vulnerable to aggressive moves in Treasury yields and that leads to them demanding higher APRs from borrowers, which should lower conversion rates for Upstart's loans.

Investors need to be aware that Upstart is cheap for a reason. The asymmetrical risk-reward due to the valuation isn't as straightforward as investors might be expecting especially since we are entering a new part of the economy that we haven't experienced in a long time. It's important for investors to be patient to see how Upstart handles all those loans on their balance sheet over the upcoming quarters (primarily Q2 and Q3) before jumping back into the stock. There are more questions surrounding Upstart than there are answers, so it's important that investors wait until they execute.

This article was written by

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Equity Research Analyst conducting comprehensive analysis into the best companies.Led Data Analytics technology projects within the Banking Industry. Background is in Business and Finance/Economics.--1) I write for the Seeking Alpha community2) I share short daily insights on Twitter | https://twitter.com/InvestiAnalyst 3) Personal full write-ups on Substack | https://investianalystnewsletter.substack.com/welcome
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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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