Shame on me. This is the second time Upstart (NASDAQ:UPST) has forced me to write an article about them sooner than I intended. At this point, if you follow Upstart then you most likely saw the news that they announced Q2 preliminary financial resultsearly, and they weren't pretty. They missed big on both revenue and net income. The stock responded accordingly, dropping 20% on Friday. I'll break down the press release and what it means for the company going forward.
Wall Street Got What They Asked For
When Upstart reported Q1 earnings, they announced that the market for their loans had softened and so they stepped in with their balance sheet to make up the difference. That means they used their own cash to fund about $150M in personal loans. The market did not take kindly to this announcement for two reasons. First, using their own cash to fund loans means that if the loans go into default, Upstart is left with a loss. Funding the loans with their own money exposes them to increased risk. Second, choosing to fund loans from their own balance sheet changes the profile of the company from capital-light to capital intensive, another shift that increases risk and was frowned on by many analysts and investors.
Backlash was quick and widespread. Even Mad Money's Jim Cramergot in on the act, heavily criticizing CEO Dave Girouard on CNBC. Upstart reacted swiftly to the criticism,publicly statingon May 19 that they'd get those loans off the books ASAP and would no longer use their own balance sheet to supplement origination volume.
Fast forward to last Friday, July 8, and we get the news that they missed their revenue guidance by 24% and the net income went from an expected mid-range estimate of -$2M to -29M. That's a big miss on both, but the reasons for it are exactly what Wall Street wanted. In the words of the CEO:
Our revenue was negatively impacted by two factors approximately equally. First, our marketplace is funding constrained, largely driven by concerns about the macroeconomy among lenders and capital market participants. Second, in Q2, we took action to convert loans on our balance sheet into cash, which, given the quickly increasing rate environment, negatively impacted our revenue.
They cleared the balance sheet completely of non-R&D loans and only originated as many loans as the market was willing to fund. Both those activities dropped revenue and profits. Analysts and investors got what they wanted
These Results Were Predictable
In hindsight, at that point, it was obvious that they were always going to miss their Q2 guidance, and I should have thought that through. If Q1 wouldn't have had those extra originations, it would have been a miss. If they were already constrained by demand for their loans in Q1, there was no way they'd hit equal revenues in Q2 now that they weren't making up the difference with their own cash.
Additionally, the reason they had to use their own cash in the first place is because the market was pulling back from these higher-risk loans. Their idea was to hold them on the books until the market for their loans was stronger again, when they could sell them at what Upstart considered their true value. So when Upstart changed course and decided to clear the balance sheet of the entire portfolio in less than a month and a half (May 19 is when they declared they'd sell the loans for cash), it's no wonder they had to sell them at less than what they considered as "fair value" on their Q1 earnings statement.
Something I haven't seen written anywhere else is that the public backlash was also well into Q2 (May 9 was the earnings). If they had used their own cash as a backstop in Q1, I think it's safe to say they probably continued that practice in Q2 through May 19. That means it probably wasn't just $150M in loans that they had to scrub from their books, but significantly more. They ate all the losses from loans originated in Q1 and the first half of Q2 in less than 45 days.
So the main negatives, as I see them, are as follows.
In order to chase results, they overextended and became a lender.
The "fair value" of the loans as reported in Q1 was above market value.
They allowed the stock market to have a large guiding influence on their strategy.
Their loans are not in demand in the current market as liquidity dries up, most likely leading to low origination volumes over the next few quarters unless there is a change in the macroenvironment.
I believe that their full year guidance is absolutely going to drop, the only question now is by how much.
All of these are down to a failure of management to accurately predict and adapt to the recent shift in the stock market and in capital markets.
The Good News
There are two silver linings and two legitimately positive results from the press release. The first silver lining is that the big drop from cleansing the balance sheet is a one-time occurrence, and accounts for half the revenue miss. The second silver lining is their commitment to positive free cash flow at lower origination volumes. They are prepared to run lean in order to get through the hard times.
Loan Performance Remains Robust
The first and most important piece of good news comes from the performance of the loans. In fact, the loans outperformed what they forecasted in Q1, as seen here:
Upstart forecasted that actual default rates would increase just over their modeled default rates in Q2. The loans outperformed that expectation and their current forecast shows them continuing to improve. This is excellent news, as long-term performance of loans is the heart of their business. Upstart can withstand a few bumps in the liquidity road, learn from their mistakes, and emerge as a stronger business.
They are a newly public company and I think they felt the heat from their precipitous drop from a share price of $400 to below $100. They did not read the macro environment correctly and were overzealous in their guidance and then had to over-extend by using their own cash to fund loans. Those are mistakes, but they are easy to repair as long as management remains humble and learns from them. They are far from the only company who did not predict the macro environment correctly.
What Upstart cannot endure, however, is a deterioration of their core value proposition and performance of the technology as rates increase. An algorithm for loan delinquencies that only works when the sun is shining and the Fed is easing is of no use to anyone. If default rates stabilize at or below the 0% line in the graph above as rates continue to rise and as the Fed decreases the size of its balance sheet, the investment thesis for Upstart remains intact. CFO Sanjay Datta stated that "Lastly, we believe our models are well-calibrated to economic conditions and are currently targeting returns in excess of 10 percent." If they can prove that they are able to generate 10% returns in the current environment, demand for their referrals will come back in full force and will remain robust in similar future cycles.
Key Takeaways
The core reason I believed that Upstart is a good investment has not changed. The data continue to suggest that their ability to predict delinquencies is better than alternatives, especially the industry-standard FICO score. That aspect of the thesis has not changed. Their technology continues to perform in line with their expectations and outperform the competition.
Furthermore, the risks associated with funding their own loans are gone and they will not make that mistake again. In its place, they now have to deal with decreased demand for their product from capital markets. This shines a light on the importance of partner banks whose supply is less cyclical than capital markets. They only added 3 new partners this quarter compared to 15 in Q1, which is not what I'd like to see but is also to be expected in the current environment. If they hit their 10%+ return target, banks will continue to see the value proposition and partnerships should continue to grow.
However, their inability to hit their guidance and manage expectations surrounding their performance is a significant black eye to management. I want to see continued loan performance and I want to see them hit that 10%+ return threshold in the current environment before I consider them a buy. The best technology in the world does not mean anything if the company cannot execute on their business plan, and recent execution has been poor. I am neither adding to nor trimming my position at the present time and therefore I have changed my rating to Hold.
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