Upstart: Improved Outlook If Its AI Platform Can Survive Economic Downturn

Summary

• Due to its less stringent credit requirement, UPST has recorded higher loans 30 and 90 days past due thus far.
• With the reduced availability of market funding, the company also increasingly relied on its balance sheet to fund loan originations.
• Demand for the auto product remained underwhelming as well, due to the elevated interest rates impacting big-ticket spending.
• Combined with the raised terminal rates of over 5% through 2023, we think UPST may continue trading sideways in the short term.

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The UPST Investment Thesis Remains Shaky

UPST 1Y Stock Price

Trading View

Based on the price action thus far, Upstart (NASDAQ:UPST) has lost -82.86% of its value over the past year, while moderately bouncing off the December bottom of $12.25 as short-sellers covered their positions. However, it remains to be seen how the company may perform over the next few quarters, as the macroeconomic outlook does not seem promising.

The funding market has been tight for UPST indeed, since the company had been less stringent with its credit score requirements at >300, compared to Affirm Holdings' (AFRM) credit scores of >550 and SoFi's (SOFI) credit scores of >650.

With higher default risks, it was unsurprising that UPST had reported a YoY doubling in loans 30-days-past-due by the latest quarter, with a tremendous YoY 6.8-fold expansion in loans 90-days-past-due at the same time. The company had also reported up to 70% more defaults from its borrower base for the latest quarter, growing by 20% QoQ.

The reduced funding availability led to the expansion of UPST's overall financing costs by 15% YoY, significantly worsened by the pessimistic market sentiments. These contributed to the company's reduced loan volume and consequently, lower top-line growth thus far, complicated by the tougher YoY comparison.

This was interesting indeed, since UPST has supposedly added a total of 83 bank and union credit partners thus far. If we were to look closely, 76% of its YTD loans were still tied to two critical partners. This implied a lower average in the number of loans per partner, especially due to the drastic decline in loan originations thus far.

In addition, the UPST management had to backtrack its funding origination, while holding more loans on its balance sheet at $700M by the latest quarter. It further cast doubts on the robustness of its AI lending platform against banking institutions indeed. The limited ability to finance loans may have led to the drastic FQ4'22 kitchen sink guidance, with revenues of between $125M and $145M, against the consensus estimates of $185.3M.

Notably, with the deceleration in auto sales for new vehicles by -0.1% sequentially (5.9% YoY) and used vehicles by -2.5% in December 2022 (-8.8% YoY), it remains to be seen how UPST's auto segment will perform. For now, its auto lending declined by -71% QoQ, suggesting headwinds in consumer onboarding. We must also highlight that multiple legacy and new automakers offer in-house financing and leasing options, tempering some of its prospects.

Therefore, it was unsurprising that UPST also had to aggressively cut its headcounts by 20% for FQ1'23, while similarly halting the development of its small-business loan product supposed to be widely released in 2023. Through this optimization exercise, the company expected to incur ~$15M in one-time writedown, while reducing up to ~$57M in annual operating expenses and ~$43M of stock-based compensation through 2025.

Long-term investors might be encouraged by these recent developments, since they demonstrated UPST's short-term pivot toward operating sustainability and profitability at a time of market uncertainty. In addition, the prudence of approving -40% fewer applicants YoY may pay off once the macro headwinds subside. Dave Girouard, CEO of UPST, said:

I want to be clear, contraction in lending volume in a time of rising rates and elevated consumer risk is a feature of our platform, not a bug. In fact, it's required in order to generate the returns lenders and investors expect. Whether due to an increase in expected loss rates, caution on the part of lenders or higher yield demanded by credit investors, higher interest rates and reduced volumes means that as unhappy as we are with the numbers, the system is working as intended. (Seeking Alpha)

For now, the Fed's hike of a 25 basis point had lifted many stocks as well, with UPST recovering by 8.14% on February 1, 2023, due to the optimistic nature of a potential disinflationary process going forward. However, with no pivot in sight and interest rates remaining elevated, we may see prolonged uncertainty in consumer behavior through 2023. Chris Lapointe, CFO of SOFI, said:

From an interest rate perspective, we are assuming an outlook consistent with the consensus forward curve, with a peak Fed funds rate reaching approximately 5% in Q2 2023, with two rate cuts in the back half of the year to get us to a 4.5% exit rate in 2023. We are assuming a 2.5% contraction in GDP and a normalization of unemployment to around 5%. And from a credit perspective, we are expecting a continuation of elevated credit spreads across capital markets and a continued normalization of consumer credit. (Seeking Alpha)

Relative Valuation Amongst Start-Up Fintech

S&P Capital IQ

Depending on how the funding market develops as the Fed potentially turns dovish, we think UPST could return to 30% revenue CAGR moving forward. Combined with its sustained contribution margin of 55% thus far, the company may restore its normalized profitability sooner than expected in our view.

This would naturally help improve its valuations more towards a reasonable Price/Sales of 7x and P/E of 20x, against the current compressed numbers due to the peak recessionary fears similarly observed with its peers. On the other hand, investors must also note that it is likely impossible for UPST to return to the hyper-pandemic levels of 33x and 279x, respectively, due to the outlier nature then.

Based on those numbers and the projected FY2024 adj. EPS of $1.31, we would be looking at a moderate UPST price target of $26.2, suggesting an improved margin of safety for those who choose to add at the mid $10s. Naturally, this is assuming that the December bottom holds.

Otherwise, among the three fintech stocks mentioned in the article, we reckon SOFI may be the prudent pick. This is attributed to the excellent 2022 performance and robust 2023 guidance, especially aided by its banking license and growing deposit funding. Notably, it is expected to record GAAP EPS profitability from 2024 onwards, with UPST and AFRM only likely to do so by 2026.

As a result, we prefer to rate the UPST stock as a Hold, especially exacerbated by the elevated short interest of 36.62% at the time of writing. Only time will tell if its AI lending platform may survive the economic downturn and truly disrupt the banking industry, as the AI chatbot, ChatGPT, has done.

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.