Upstart: Overreaction Brings Excellent Buying Opportunity

seekingalpha2022-05-12

SummaryUpstart recently reported its 1Q22 earnings, which resulted in stock price falling 56%.Lower guidance of 11% acceptable given the rising rate environment and normalising delinquencies resulting...

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Comments

1588d1c0
2022-05-12
1588d1c0
😀
1588d1c0
2022-05-12
1588d1c0
Hope it recovers
1nquisit0
2022-05-12
1nquisit0
Please like
Jessie8590
2022-05-12
Jessie8590
閱
FattAgain69
2022-05-12
FattAgain69
Interesting valuation
Rara08
2022-05-12
Rara08
Ok

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There's lots that I am positive on with regards to Upstart, and here are the key investment highlights for the company:Upstart's superior Artificial Intelligence (AI) model brings real benefits to both consumers and its banking partners, and this AI competitive advantage will only improve and widen with time.Capital light model as an intermediary between consumers and its banking partners.Upstart is expanding its total addressable market (TAM) into the huge auto loan origination market, demonstrating a large market opportunity.Upstart's margins and unit economics have seen improvements and will likely continue in that trend as a result of increased automation and scale.1Q22 in-line while guidance slightly weakWhile 1Q22 results were in-line with expectations, the main disappointment came from the lower guidance as well as the increased use of the balance sheet for its loans (explained in the following section). The guidance was lowered to $1.25 billion for 2022, down from the initial guidance of $1.4 billion for 2022 in the previous quarter. Adjusted EBITDA margin for 2022 was also guided downward from 17% in the prior quarter to 15% in the current quarter.I think that the lower guidance is expected given the industry that Upstart is operating in. The lending industry is a cyclical industry and this is probably one of the more challenging environments in which it is operating right now. There are multiple headwinds for the lending industry and one of the biggest is the rising interest rates, rising delinquencies, and fears of a recession happening.With the increased perceived risk in the economy, this is resulting in higher pricing on Upstart's platform as the investors in these loans require higher returns to compensate for this risk. As such, Upstart has seen a 300 basis point increase in the average loan pricing since October, as highlighted by management. This high pricing then results in lower approval rates and lower transaction volumes.As such, the lowering of guidance is within my expectations as it represents an 11% decrease in revenue guidance. However, I think that we need to be aware of the downside risks, which includes a recession actually happening or the Fed increasing rates more than expected. These scenarios could result in significantly lower transaction volumes.Use of balance sheet raises concernsDuring the quarter, we saw Upstart's balance sheet loans rise from $260 million in the previous quarter to $605 million in 1Q22. Traditionally, if you recall from the previous article, the use of the balance sheet has only been exclusively used for Upstart's R&D. As such, with an $345 million increase in loans on its balance sheets, I can see why this raises the eyebrows of some investors.When I look closer into the management commentary during the earnings call, I gain a greater clarity into the context and the reason for use of balance sheet during the quarter.First, I will touch on the context of this balance sheet risk. As highlighted by CFO Sanjay, the amount of platform loans that ended up in its balance sheet was in the single digit percentage compared to its total platform loans. Furthermore, of that single digit percentage of loans that end up in its balance sheet, three-quarters of it, or $454 million, is still used for R&D, mainly in auto loans and other new products. As such, the remaining one-quarter, which makes up $150 million of loans, was put on the balance sheet. Putting this into context, Upstart had $4,535 million in transaction loan dollars in 1Q22, which means that this $150 million of loans that ended up in the balance sheet only account for 3% of total 1Q22 loans.Second, I will touch on the reason for use of the balance sheet for these loans. CFO Sanjay gave a very good explanation of this, in my view. As highlighted before, historically, the company only used its balance sheet exclusively for R&D. However, that was a different environment from what Upstart is operating in today. With interest rates changing quite quickly in the new interest rate environment, it needs to use the balance sheet loans as a market clearing mechanism, which acts as a temporary stop-gap measure in order for the platform to adjust to faster moving market rates. The need for this temporary measure is because the platform currently has a limited ability to react to fast moving rates as the process is rather manual at the moment. As a result, when rates move and investors are deciding what is the new hurdle return, the delay in funding as a result needs to be plugged in and that is where the $150 million of balance sheet loans not used for R&D is used.Although the use of the balance sheet does bring additional risks to Upstart, I think of this as a temporary measure that the company can leverage on to improve its response time to fast changing market conditions, and this will likely not be either sizable or long term, as reiterated by Sanjay as well. As Upstart uses its balance sheet in a controlled manner in the near term as a market clearing mechanism, this paves the way for Upstart to develop a more nimble and automated mechanism to improve its response time to market conditions.Ultimately, as management highlighted, they view Upstart as a platform and not as one that holds excessive balance sheet risks. This platform should work as a marketplace where the discovery of price takes place as well as the funding of loans by institutional investors. This has worked fluidly in the past, and currently, is less fluid. As such, to ensure sufficient fluidity in the system, Upstart decided to use its balance sheet to act as a bridge. As highlighted before, the company is investing in its market clearing mechanism to ensure no or fewer balance sheet participation in the future.Sensitivity to interest rates and delinquencies not unique to UpstartManagement highlighted several times both this quarter's and the previous quarter's earnings call that a rise in delinquencies is expected given the waning of government stimulus resulting in delinquencies normalising. As can be seen by the independent KBRA data, annualised net losses and delinquencies have risen across the board for tier 2 names like Upstart, Upgrade, Prosper and Lending Club Prime. This represents a normalisation of net losses and delinquencies to the pre-pandemic levels.KBRA Marketplace Consumer Loan Indices (KBRA; Citi)This means that Upstart's loans have underperformed due to the changing credit conditions, and along with rising delinquencies, this results in a lower conversion rate for Upstart in 1Q22 of 21.4% compared to 24.4% in the prior quarter.As such, for conversion rates to return to prior quarter levels, it is a function of interest rates and delinquencies. The higher the interest rates, the less likely conversion rates can improve as this means higher pricing for loans on its platform and lower acceptance rates. The higher the delinquencies, the higher the pricing for loans as well, leading to a similar outcome.On a positive note, management highlighted that they have seen delinquency stabilise for the past 2 months. Furthermore, this trend of normalising of loss rates and delinquencies is clearly not unique to Upstart as it affects other tier 2 players as well. This is encouraging and worth watching going into the next quarter how well Upstart does compared to the other tier 2s. However, I am surprised by how sensitive Upstart's business is to higher interest rates and this may mean that Upstart may be more cyclical than what many investors initially thought.ValuationI am adjusting my model that was highlighted in my initial article for the changes in guidance as well as changing macro environment this year. I lower my nearer term financial forecasts for 2022 and 2023 to be more in-line with the 11% decrease in revenue guidance for 2022 announced in 1Q22 results. Further, I apply a higher discount rate to incorporate the heightened risks in the current macro environment, brings WACC up to 13%. Lastly, I adjusted the terminal growth rate down from 2% to 1.5%.With that, my target price for Upstart is $80.17, implying an upside of 140% from current levels. The target price of $80.17 implies a 30x 2023F P/E and a 19x 2024F P/E, while earnings growth is expected to average 42% during that period according to Bloomberg consensus.I think that based on my target price, the higher valuation multiple is warranted given that Upstart is a pure play company with a lending platform based on a proven AI model with a large expansion opportunity into different credit products.RisksConcentration on unsecured personal loansAlthough I mentioned earlier that Upstart has started venturing into auto loans and are looking into options into new products down the road, the majority of its revenues today come from its bread and butter unsecured personal loans segment. This, in my view, is a concentration risk from a business point of view. The roll out and execution of its expansion into new products and new loan categories could be positive to the share price but any slowing of deployment into these new categories and segments could be negative to share price.Fluctuations in economic conditionsAs with all credit issuers and players in the industry, Upstart's business model and its growth of loan volumes are both very vulnerable to drastic changes in the economy or to financial shocks. This could prove to be particularly painful for Upstart due to its inexperience in handling a downturn. Also, I believe that the risk might be further amplified for Upstart since their AI models have yet to be very extensively tested during a serious financial downturn. Although Upstart does not take balance sheet risks, this could very severely impact the platform and AI model's credibility.CompetitionAlthough Upstart has an advantage in its extensive use of AI and machine learning, it could be detrimental to Upstart if its competitors are able to build an AI model more superior to that of Upstart. Thus, it is crucial for Upstart to continue to invest in R&D and continuously improve its AI models and machine learning capabilities to ensure a stronger competitive advantage and to have strong barriers of entry for competitors to establish a similar product.ConclusionAll in all, I think that Upstart's valuation is currently very attractive given the recent share price fall, which has skewed its risk/reward perspective positively. I think that while the lowered guidance may be disappointing, we have to remember that Upstart is in the lending business, which is inherently cyclical. This lowered guidance is understandable given the rising rates environment and normalising of delinquencies as the pandemic subsides.However, the sensitivity of rising rates and delinquencies to the conversion rates and hence transaction volume, is something that I took away from the recent results. Lastly, on the increase of balance sheet loans, I think when we understand the context that it is small and temporary, and the reason behind it, the controlled use of balance sheet loans to act as the bridge to improve fluidity in the system is an essential one for the business in a challenging time. With a target price of $80.17, this implies an upside of 140% from current levels.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[{"id":9064707103,"gmtCreate":1652366481002,"gmtModify":1676535086238,"author":{"id":"4104481054115720","authorId":"4104481054115720","name":"1588d1c0","avatar":"https://static.laohu8.com/default-avatar.jpg","vip":1,"crmLevel":1,"crmLevelSwitch":0,"idStr":"4104481054115720","authorIdStr":"4104481054115720"},"htmlText":"😀","listText":"😀","text":"😀","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":2,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9064707103","repostId":2234991443,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"},{"id":9064704473,"gmtCreate":1652366460192,"gmtModify":1676535086223,"author":{"id":"4104481054115720","authorId":"4104481054115720","name":"1588d1c0","avatar":"https://static.laohu8.com/default-avatar.jpg","vip":1,"crmLevel":1,"crmLevelSwitch":0,"idStr":"4104481054115720","authorIdStr":"4104481054115720"},"htmlText":"Hope it recovers","listText":"Hope it recovers","text":"Hope it recovers","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":2,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9064704473","repostId":2234991443,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"},{"id":9064544226,"gmtCreate":1652351824465,"gmtModify":1676535083066,"author":{"id":"3553900041025922","authorId":"3553900041025922","name":"1nquisit0","avatar":"https://static.tigerbbs.com/3c22511f65f9157a35a7f105f2b1d9bf","vip":1,"crmLevel":4,"crmLevelSwitch":1,"idStr":"3553900041025922","authorIdStr":"3553900041025922"},"htmlText":"Please like","listText":"Please like","text":"Please like","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":1,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9064544226","repostId":2234991443,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"},{"id":9064562040,"gmtCreate":1652345961081,"gmtModify":1676535082162,"author":{"id":"3571194868777759","authorId":"3571194868777759","name":"Jessie8590","avatar":"https://community-static.tradeup.com/news/ae62e8ad7c913a19f3613c117b492985","vip":1,"hat":"https://static.tigerbbs.com/a3dee1aa3a3a3c1814833a4d3f8a5669","crmLevel":3,"crmLevelSwitch":1,"idStr":"3571194868777759","authorIdStr":"3571194868777759"},"htmlText":"閱","listText":"閱","text":"閱","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":0,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9064562040","repostId":2234991443,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"CN"},{"id":9064506960,"gmtCreate":1652337116750,"gmtModify":1676535080987,"author":{"id":"4107015407846850","authorId":"4107015407846850","name":"FattAgain69","avatar":"https://community-static.tradeup.com/news/a4e3d511c15de9227ee9ebca3021f903","vip":1,"crmLevel":5,"crmLevelSwitch":0,"idStr":"4107015407846850","authorIdStr":"4107015407846850"},"htmlText":"Interesting valuation","listText":"Interesting valuation","text":"Interesting valuation","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":1,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9064506960","repostId":2234991443,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"},{"id":9064276146,"gmtCreate":1652335322285,"gmtModify":1676535080694,"author":{"id":"3579125484417577","authorId":"3579125484417577","name":"Rara08","avatar":"https://static.tigerbbs.com/ee915a47f3c554f599dce721c2397b4d","vip":1,"hat":"https://static.tigerbbs.com/1c1eed764d9c7ff83dc093fbb9a96bc2","crmLevel":1,"crmLevelSwitch":0,"idStr":"3579125484417577","authorIdStr":"3579125484417577"},"htmlText":"Ok","listText":"Ok","text":"Ok","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":0,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9064276146","repostId":2234991443,"repostType":4,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"}],"isCommentEnd":false,"newsSizeData":{"likeSize":21,"commentSize":8,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; 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