Upstart: The Bad News Is On Full Display, What To Do Now

Aug. 10, 2022 5:02 PM ETUpstart Holdings, Inc. (UPST)121 Comments
Bert Hochfeld profile picture
Bert Hochfeld


  • Upstart's guidance for Q3 was a humbling moment for the company.
  • At this point, the negatives/risks of the company's model are on full display.
  • The company needs a committed, long-term funding source as a priority.
  • Until that happens, it will undertake the risk of using its balance sheet to maintain loan volumes.
  • The company's upside which encompasses the use of its models to penetrate most phases of consumer credit is huge, and in my view is worth the short-term pain of holding the shares.


Valerii Apetroaiei/iStock via Getty Images

Upstart's quarter and guidance - The good, the bad and worse

I am not, by nature, a contrarian. And I imagine the foregoing article will be controversial and elicit some negative comments. I have obviously recommended the shares of Upstart (NASDAQ:UPST) and I have most recently done so in May, after the company guided down. Despite some caveats at the time, I had thought the company's outlook was good enough to justify its valuation. That may have been true, but the company's Q2 performance and outlook were far below what I anticipated - simply put, I relied on their forecast and that was wrong. No excuse - just an inaccurate assessment of the mentality of the company's funding sources which had been better anticipated by some other analysts.

Upstart announced the results of FY Q2 on the afternoon of August 8, 2022. The results of the quarter had been pre-announced in July, so they weren't a great surprise. The forward guidance was awful, although I have to wonder what kind of surprise that may have been - it represents a year on year decline of 25%. The revenue forecast for Q3 was way below prior estimates. The company suspended its guidance beyond Q3; it opined that conditions in its market are just too volatile to forecast, and given the history of this company over the last few quarters that is certainly a reasonable position to take.

The company realistically suggested that the next year or so would see a significant slowing of the economy with a worse than normal macro environment. The company acknowledged that it had underestimated the impact that the macro headwinds would have on funding sources, and so far as that goes, so have I. While the results of the company's models are not yielding dire results, the company's current funding sources have pulled back, and this has resulted in the company only converting 13% of the rate requests that it received last quarter, a woeful result compared to the 24% conversion rate of the prior year.

The shares, after rising quite steadily for the last couple of weeks fell about 15% after hours but are now trading down a bit less than 10% percent as I wrote this on Tuesday morning. Partially a case of sell the rumor and buy the news, partially an indication that the pivots Upstart is making are the right strategy, and perhaps an indication that the shares may have reached a reasonable valuation in considering risks and rewards.

Further, there has been some recrudescence of the so-called meme mentality recently, and with a very high short interest, Upstart shares were able to rise even when most observers were well aware of a coming guide down. As of 7/15, the short interest had reached 35%, which is the most important metric considered by meme speculators. I am not quite sure I understand the meme point of view but the fact is that I can't imagine that anyone looking at the fundamentals and the environment might have expected some kind of positive forward guidance. While much can, and has been, said about the lack of transparency or the misjudgments of the company's leadership - sometimes by me, and often by others - on this occasion, at least, there was no attempt at obfuscation, although there was an element of defensiveness in some of the remarks of the company founder, and CEO Dave Girouard.

In addition to the guidance that was provided by management, were comments during the conference call that Upstart had no intention of becoming a bank, but that it would use its balance sheet to provide some funding for loans until it found institutional investors. It is probably a reasonable strategy, but one that is likely to prove to be off-putting to some analysts and investors. That said, the CEO's comments about information asymmetry resonate with me, and are worth considering.

Having said that, in the last few months, lenders and institutional credit investors reacted more quickly and abruptly than we anticipated. Despite the fact that our bank partners have seen consistently strong credit performing meaning portfolios performing at or above plan across quarterly cohorts, several of them have paused or reduced originations due to fear about the future of the economy. To be clear, these lenders and institutional investors have not left Upstart's platform, but have temporarily paused or reduced their originations.

As we shared in our credit performance FAQ today, we believe our models are well calibrated to the current economic environment. And in fact include a generous accommodation for a recession over the next 18 months to 24 months. And given funding constraints, we believe the opportunity for lenders to generate strong returns on Upstart is unusually high right now. Yet the reaction of lenders is often binary in nature, more so than we would've anticipated.

As a result, we've concluded that we need to upgrade and improve the funding side of our marketplace bringing a significant amount of committed capital on board from partners who will invest consistently through cycles. We're currently evaluating a variety of opportunities to do just that. So we expect this will take some time to bring to fruition. Furthermore, while we continue to believe that it doesn't make sense for Upstart to become a bank, we've decided it may make sense to at times leverage our own balance sheet as a transitional bridge to this committed funding.

I acknowledge that this is a shift relative to what we planned and communicated earlier this year. But a changing in volatile environment suggests we need to be flexible and responsive in our approach. We're taking this step for a few reasons. First, there's an obvious information asymmetry where we understand better than anybody, how our model is performing today and how well it's calibrated for the current economic environment.

Secondly, we believe the opportunity to generate outsized profits on our platform is unusually high right now. And third, we can bring a level of stability to our business. That's important to our longer-term goals while we work to put these committed capital structures in place.

Just to be clear, I don't think, other than meme speculation, that Upstart shares are going anywhere until the company secures and announces that it has put these "committed capital structures in place." I think most investors with an interest in the space know that things for Upstart are tough. That isn't really the question. The investment issues are: is the company taking the right steps to right the ship? How is it going to survive while the ship is being pumped out and what will the company look like when the process is complete? If a reader is a risk-off investor, don't bother reading further.

A subsidiary issue is that of meme speculation. I have no way of evaluating the latter but have seen the impact of such speculation on the shares of other companies so it can't be totally disregarded. There are going to be some who believe that the company's commentary on what it plans to do is a commercial and won't be realized. That is the risk one takes in order to achieve the potential outsize returns.

None of what the company has to do in terms of righting its operational ship is either easy or guaranteed to work. This is a tough environment for companies making loans to provide unsecured personal credit, and no matter what the facts about the quality of the company's credit models, many institutional lenders and financial institutions are simply not going to invest in this market or underwrite loans that have been analyzed by Upstart credit models. This is, I believe, somewhat similar to what was seen for a time during the financial crisis where it proved very difficult to get banks and insurance companies to lend, regardless of credit quality. Of course, eventually, the market unthawed because the returns were too high to ignore, but it took a while before credit started flowing freely.

The company has made more than a few pivots in dealing with the current environment. It has significantly increased the pricing that its partners pay to access its platform. And it has pulled back on sales and marketing spending quite substantially although it has continued to invest in data science and the roll-out of new lending offerings. The net result, which is probably not immediately apparent, is that the company forecast a rather substantial improvement in its contribution margin which was reported at 47% for Q2 and is expected to be 59% in the current quarter. And it did so, with a forecast that its revenues would fall from the $228 million reported for Q2 to $170 million it is now expecting this quarter. And during the call, the CFO did not suggest that July had seen any lessening of funding pressures.

Most often when I write an article, I discuss the specifics of the quarterly income statement and particularly the performance of free cash flow. At least at some level, the results just reported really won't help in determining the future course of this company. In the short term, the company is going to wrench its cost structure substantially, and its historical business model just isn't going to be useful in speculating about the future course of operating metrics. Until the company resolves its funding issue, it is basically in a state of suspended animation at least so far as its ability to generate consistent growth and profitability. Just for the record, the company reported marginal non-GAAP net income, and its adjusted EBITDA margin was 2%. It has $623 million of loans that have been adjusted to fair value and its non-restricted cash balance is marginally less than $1 billion.

Upstart was comfortably profitable when it was achieving strong revenue growth, and its business model should continue to provide reasonable margins... when or if the company solves its funding problem.

For the most part, Upstart's business... or perhaps better said, the business the company is supposed to be, is that of a lending marketplace, i.e. a platform where borrowers and lenders meet in which lenders provide loans, which maximizes the availability of credit optimized for risk. Notionally, that is a low fixed cost, frictionless business model, and thus, the company, presumably being exceptionally conservative in its outlook, was able to forecast a break-even level of adjusted EBITDA.

The question is should investors buy/hold the shares now that much or maybe all of the bad news has been presented. There is one catalyst and only one catalyst that is going to be of importance to the shares in the next 6 months. The company needs to find funding partners, and presumably, that is the single uppermost priority of management. If/when it does, the shares are likely to see outsized appreciation. I don't minimize the complexity and issues involved with finding long-term funding sources in this environment. But I don't think the task is insuperable either. And based on that expectation, I am continuing to hold the shares. If I were in the brokerage industry, I would rate the shares a speculative buy with massive upside potential.

Were there any saving graces in the company's operational report?

Upstart's raison d'etre is all about its predictive credit models and their performance. The company presented a rather exhaustive set of materials detailing the performance of the company's credits over the last several years. Whether or not investors choose to evaluate the accuracy of the company's models in the wake of the guide down is an open question, and perhaps an opportunity. I have linked here to the analysis for those wishing to look at the details. Some of the salient details include the following: 1) the accuracy of Upstart's models has improved significantly, and that is true, particularly as of 7/22; the expected return for Upstart loans, while below target values has ticked up since a trough one quarter ago; 3) Upstart's platform is producing more accurate results than FICO scores.

One contributor on SA sneered that Upstart is a loss-making $680 million company with a set of models. I would turn that on its head; the value of the company is its IP, and its stable of data scientists, as well as an efficient infrastructure to turn the IP into a successful loan underwriting paradigm. Having high-performance predictive analytics models has immense value; the company needs to figure out how it can find funding partners who appreciate the differentiated returns that can be achieved using Upstart's credit models.

At the moment, there is a disconnect between the net returns that Upstart's models can achieve and institutional interest in providing capital to make such loans. Although Upstart added an additional 17 partner banks last quarter, reaching a total of 71, some of those banks have pulled back from the market and are not providing credit to Upstart underwritten loans.

That may not be a particularly logical response to current conditions and the anticipated returns, but current sentiment in the credit markets, as well as many other corners of the economy has dictated that many financial institutions take a risk-off approach toward personal, unsecured lending. That is basically the stumbling block that Upstart needs to overcome, and it is unlikely to be able to do so immediately.

How can Upstart surmount its difficulties?

Right now, Upstart needs to husband its resources to keep its financial ship afloat. It is doing so by taking pricing action, and by restricting opex. That is how it plans to break even despite forecasting a sequential decline in revenues of almost $60 million, or 25%. I might normally say that kind of expense reduction is going to be difficult to achieve, but my impression is that the leadership of the company is focused on ensuring that it at least produces a break-even EBITDA result. While playing defense is never a strategy that most entrepreneurs like to deploy, it is more or less inevitable for Upstart at this point.

On the conference call, as noted earlier, Upstart said that it has to significantly modify its funding strategy. Its funding strategy had been based on accessing the ABS market and developing a stable of partner FI's/banks who would be willing to fund loans. It was not an unreasonable strategy, but in the current macro environment it isn't working and waiting for it to work is not an option. The company needs partners with a more longer-term horizon with regards to returns, and partners who are willing to make contractual funding commitments.

It is worth noting that this is the strategy that Affirm (AFRM) has pursued with some apparent success. Not all funding sources are focused on current yields; some are going to want to develop a longer-term relationship in which Upstart's access to funding is guaranteed in exchange for pricing and other advantages. Or it may be that a deal might be struck with a PE firm to take the company private and to provide a significant funding channel.

The company, on its call, gave no indication whatsoever that some kind of an agreement with a long-term funding source was imminent, or even that it had identified counterparties or potential partners. While I don't think that Upstart's financial viability is at issue, I would be guessing and nothing more, if I offered some kind of definitive opinion regarding the probability or the timing over which Upstart finds appropriate funding sources. Seemingly, it has much to offer institutional lending partners, but this is a difficult environment and one that may not produce the results the company seeks in a couple of quarters. Rather than me attempting to spin anything here, I have included a rather substantial quote from the conference call that sums up the current state of play.

Atlantic Equities.

Simon Clinch

Hi everyone. Thanks for taking my question. I was wondering Dave or Sanjay, if you could talk a little bit more about what - how you actually go about sort of refocusing your institutional buyer investor base to sort of longer term investors and I guess, how long that might take and a sense of the steps that you need to take to achieve that goal?

Dave Girouard

Hi there. Sure. This is Dave, I'll give a quick answer and then Sanjay, may want to chime in. Sure. So essentially, the nature of our agreements today by and large are at will agreements with the volume that anybody, any particular entity is originating or purchasing is decided on a month-by-month basis. And we're talking about instead about structures where there's committed funding over a significant period of time, many, many months or even years. And really that's, in return in some form for access to yield over that period of time, in some form of economics that make sense for those entities.

So, we don't have more specifics just to share than that, other than certainly I think a lot of marketplace businesses in many different types of industries take actions to secure effectively, secure inventory on their platforms one way or another. And we've decided this is just necessary for us. And so we're beginning the steps toward taking in a getting that done.

Sanjay Datta

Yes, I'll just add Dave that, this is Sanjay. I think that we've demonstrated, and we'll be able to demonstrate certainly as we go through this cycle, pretty attractive long term yields for anyone who's willing to hold and invest through cycle and Dave cited some of those numbers and we've got some of those in the releases we've provide. And so, I think there's a class of capital provider out there for whom access to that would be attractive. And those are sort of, more - arrangements that, that will take a while to put into place. But I think that, predominantly what we have today are capital providers who are vintage-by-vintage. And in some sense may depend on either leverage or liquidity for ABS markets, which creates more volatility.

So, I think now that we have some proof points, which demonstrate what yield looks like through a cycle, we will use that to enter into negotiations and arrangements with partners that are more of the style of, wanting predictable stability in terms of access to yield. And so I think that's all we really have to share at this time. As they've said, these aren't going to happen overnight. They're pretty complex relationships, but I think we're all very convicted that's, that's the direction that will provide stability for our platform to get to the next level of volume.

To my mind, everything else is subsidiary to the company finding committed funding sources mimicking the success that Affirm has had in that endeavor. Of course, Affirm's loans are different than those of Upstart; they are smaller and have an average maturity of just 5 months. But there is likely a market-clearing price for Upstart underwritten loans as well.

Opportunities abound - It getting to those opportunities is the issue

Upstart is in early stages of rolling out lending solutions in three significant markets. Probably most important is its auto lending initiative, but it is also starting to make both small dollar loans to consumers, and has underwritten its first loans to SMBs. The opportunity for Upstart to disrupt many segments of the personal credit market remains, and it is just as substantial as ever.

Upstart's auto lending program is off to a decent start, although it is perhaps not something of focus to investors at this point. The company has over 400 dealerships using its software to facilitate the auto buying process, and it has 29 dealers who are originating auto loans on the platform. In Q2 auto loan originations were $10 million; the growth ramp is going to be a function of the ability the company has to fund loans. I don't imagine there will be any dearth of demand for the offering from dealers and consumers. In addition, it has originated $1 million of SMB loans since that offering was released at the end of June to 40 borrowers. And it has launched a small dollar lending program for Spanish language borrowers.

All of these are substantial opportunities, but none of them will achieve the results needed to fuel hyper-growth at Upstart until it locates and establishes funding sources with a long-term perspective. I am not going to try to evaluate TAMs which are meaningless until the company solves its funding issue. Fact is, that the TAMs are so massive relative to the valuation that it is simply unnecessary to quantify the magnitude of those opportunities in the current environment. But in evaluating reward, these opportunities dwarf the current focus of the company's business that has focused on unsecured personal lending.

Wrapping up - What should investors do with Upstart shares now

Upstart's forward guidance presented on the evening of 8/8 was more than ugly. It illustrates, if more illustration was necessary, the cyclical components of the consumer lending business. And now everyone knows it. Unremarked, but of some significance, at least to me, was that despite the company issuing such dreadful revenue guidance, it was able to project breakeven EBITDA. It suggests that the company should be able to weather through the macro storm.

The company presented a wealth of data about the performance of its models, and the performance of its loan cohorts. While the data might seem complex, and subject to different interpretations, I think it illustrates the validity of the company's credit models and their ability to produce substantial returns over time for institutional sources of funding. But the data also shows that there are cyclical components to returns which won't please all classes of potential funding sources.

I don't expect the shares to do much, other than as a target for meme speculators, until the company identifies long-term, committed funding sources. It is a risk that not all readers are going to want to take. I generally take a 12-month view of my investments; I own a modest position in Upstart shares and plan to continue to do so. If I were a brokerage analyst, I would rate the shares a speculative buy - I am willing to suffer some pain and the risk of relative underperformance to see if/when the company is able to a permanent funding source. I think that if/when the company is able to attract funding sources, the upside is enormous and is certainly not encapsulated by the company's current valuation. It also seems possible to me that with the capital available to so many PE firms a take private transaction coupled with guaranteed funding is a possibility. So, for now, I will accept the risk in order to reach for the upside.

This article was written by

Bert Hochfeld profile picture
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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