Introduction
In recent months, the wildly successful launch of OpenAI's ChatGPT has created a buying fervor among investors for AI-related stocks. However, Upstart's (NASDAQ:UPST$Upstart Holdings, Inc.(UPST)$ ) stock has largely sat out this wild rally despite being a derisked AIplay.
While the memes - "What does Upstart do?" - continue to float around the internet, most market participants seem to have forgotten about Upstart's AI lending marketplace. Now, we are not going to talk about the validity of this rally in AI stocks today, as the focus of our discussion is Upstart.
Upstart Q4 2022 Earnings Presentation
In this note, we will assess Upstart's Q4 2022 report. Furthermore, I will share three positive developments for Upstart. Lastly, we will round out this note with a brief exercise on valuations. Without further ado, let's get started.
Upstart Q4Review: An Absolute Horror Show
For Q4, Upstart delivered a beat on both top and bottom line estimates, with net revenue and EPS coming in at $147M (beat by ~11%) and -$0.25 (beat by ~47%). However, if we forget the Street estimates for a bit, Upstart's business (revenue) contracted by ~52% y/y in Q4, and losses widened significantly.
While Upstart's contribution margin came in strong at 53% of revenue, contribution profits fell 45% y/y. In Q4, Upstart's adj. EBITDA came in at -$16.6M, and net losses widened to -$55.3M.
Upstart Q4 2022 Earnings Presentation
Upstart Q4 2022 Earnings Presentation
With its marketplace platform still being funding-constrained, Upstart continued using its balance sheet as a bridge to facilitate loans. In my Q2 review for Upstart, I said that its loan balance could end the year at $1B, and unfortunately, that's exactly where we landed at the end of Q4.
Upstart Q4 2022 Earnings Presentation
As we discussed previously, the investor appetite for unsecured loans is just not there right now. And it's not that complicated - risk-free rates have shot up from 0% to 4-5% in a whisker, and suddenly unsecured credit yielding 7-8% is simply unattractive on a risk-adjusted basis. While I do believe that stabilization in interest rates (even at higher levels) will unfreeze the credit markets to an extent, Upstart will be forced to use its balance sheet as a bridge to enable loan originations until that happens. The impact of this activity is a pile-up of loans on Upstart's balance sheet. As of Q4, Upstart is holding ~$1B of loans, of which $518M are unsecured personal loans, and the rest are R&D loans (auto, auto refinance, etc.).
Upstart Q4 2022 Earnings Presentation
Upstart Q4 2022 Earnings Presentation
With liquidity concerns rising, Upstart's management committed to maintaining balance sheet liquidity at current levels on the Q4 2022 earnings conference call, i.e., Upstart's balance sheet is hitting the upside limit for supporting loans. The macroeconomic environment could be set to worsen over the coming months as the lagged impact of the Fed's aggressive tightening measures shows up in the real economy. And so, Upstart must preserve its balance sheet liquidity. With Upstart unable to use its balance sheet to park loans any further, the lending volume contraction we have seen in 2022 is set to get worse in Q1 2023. For the next quarter, UPST's management has guided for revenues of just ~$100M, and this was a significant miss on Street estimates.
Upstart Q4 2022 Earnings Presentation
Furthermore, Upstart's losses are projected to widen in Q1 2022, along with a significant drop in adj. EBITDA to -$45M. As you may have observed, Upstart has turned into a cash-burning business over recent quarters, with cash being converted to loans on the balance sheet. The absolute FCF number is deeply negative, but the real cash burn is much smaller.
Until credit markets unfreeze, Upstart's cash flows could remain under pressure, and they could even worsen further in case of a (very likely) recession. For Q1 2023, Upstart is projecting a cash burn (represented by adj. net income) of -$70M. However, with a cash balance of ~$532.5M (and a loan balance of $1.01B), Upstart has little to no bankruptcy or liquidity risk for the foreseeable future.
Now, as I see it, Upstart's Q4 report was worse than its Q3 report, which I felt was an absolute nightmare:
- Upstart Q3 Review: The Road To Recovery Looks Long And Bumpy
However, Upstart's future looks brighter to me than it did a few months ago due to some positive developments I saw in the Q4 report.
Three Positives In A Sea Of Negatives
Without mincing any words, I want to reiterate that Upstart is screwed right now. The lending marketplace model simply doesn't work in recessionary periods, and Upstart continues to remain exposed to severe volume contractions. While the near-term business outlook remains poor amid a worsening macroeconomic environment, I see three positive developments for Upstart that could serve as an adequate impetus to invest in this counter.
1. Upstart Is Close To Getting Committed Funding
As per management's Q4 commentary, Upstart is in late-stage discussion to get committed funding for its AI lending marketplace from strategic investors -
We have traditionally viewed our business model in the simplest terms as a marketplace for loans, based on price discovery and at-will participation for consumers and lenders. And while this is true, it’s also useful to think of the funding on our platform as a strategic supply chain that needs to be scaled and strengthened continually. In our earnings call in August, I told you that we would begin to investigate partnerships that could provide more reliable and persistent funding to the Upstart platform. I’m happy to report that we’re in late stage discussions with multiple potential partners in support of this goal.
- Dave Girouard, Upstart's CEO
Upstart's biggest problem today is that its marketplace is funding-constrained, and getting committed funding onboard should ease off this pain. Furthermore, the availability of such funding should allow Upstart's business volatility to subside. And a reduction in Upstart's cyclicality risk (exposure to the macroeconomic environment) could easily catalyze a move higher in its beaten-down stock. Now, nothing is sealed on this front, and investors need to wait for that official announcement before celebrating this development. That said, I am happy to learn that Upstart's management is serious about getting committed funding on board in the near term!
2. Upstart's Credit Performance Is Improving Rapidly
Back in August 2022, I highlighted Upstart's credit performance, or I should say underperformance, as a big concern for institutional buyers. While Upstart's management did not share the "in-period vs modeled defaults" chart with us this quarter, we can see that Upstart's expected cash flows are getting closer to the targeted cash flows for recent vintages. This is a clear sign of improvement in Upstart's credit performance.
Now, I understand that lending volumes have dropped significantly, and the credit performance improvement could primarily be a result of avoiding higher-risk (non-prime/subprime) borrowers. As we noted earlier, Upstart has loaded its balance sheet with $1B of loans. The good thing here is that the quality and targeted returns of these recent vintages are higher. Hence, Upstart's net interest income should improve gradually in upcoming quarters.
Also, if Upstart's loan performance continues to improve, institutional loan buyers will return to the platform soon enough, getting the Upstart flywheel going once again!
3. Upstart Is Getting Ready For The Next Credit Cycle
With inflation staying persistently high, a Fed pivot is not in sight. However, the pace of rate hikes has slowed down to 25 bps, and we are getting closer to terminal rates. Now, higher interest rates for longer is somewhat problematic for Upstart's volume recovery, but if we can get stabilization in interest rates, then credit markets can unfreeze to an extent and Upstart can start delivering on sequential growth!
Looking at Upstart's credit performance from the last year and a half, I understand that it is hard to believe that its AI model is any better than FICO. However, the increasing number of bank and credit union partners is a telling sign of some sort of an edge. As of Q4 2022, Upstart's banking partners have risen to 92, and the company is adding auto dealership rooftops at a rapid clip.
The journey to having thousands of bank partners on its marketplace platform is long, and Upstart's investors could need to exercise patience for multiple years. However, a downcycle in credit markets is the right time to invest in Upstart as volumes are currently compressed. When we return to an upcycle, Upstart's volumes will bounce back, and so will it's stock. For now, Upstart's financial performance is crappy, and this will probably continue to be the case for the next couple of quarters; however, the underlying business is getting leaner and stronger.
Hence, I continue to like Upstart as a long-term investment. Now, let's determine Upstart's intrinsic value and projected returns to see if this is the right time to buy more.
Upstart's Fair Value And Expected Return
Before I share our updated valuation model for Upstart, I would like to share what I said in my last note on UPST:
In the face of heightened macroeconomic uncertainty, I don't know how deep or long the impending recession could turn out to be. Conservatively, I can see Upstart doing $100M in revenue per quarter even if the credit markets get worse from here. That said, a stabilization in interest rates should unfreeze the credit markets to an extent and bring volumes back to Upstart's marketplace.
During the Q4 earnings call, Upstart's management committed to maintaining balance sheet liquidity at current levels, and still guided for sequential growth throughout 2023 (Q1 will be the trough in Upstart's business). Now, the macro conditions could get worse and Upstart may struggle to deliver on management's outlook; however, we shall work with the data available to us.
While 2023 remains a bit of a mystery at this stage, I think a scale-up of Upstart Auto Retail could allow Upstart to return to positive revenue growth in the second half of this year. For today's valuation exercise, I am resetting Upstart's revenue base to $500M to account for the ongoing malaise at the AI lending marketplace. Here's how Upstart's valuation looks now:
According to these results, Upstart is worth $39.5 per share, i.e., it is undervalued by more than 50%. The base case expected 5-yr CAGR return for Upstart from here is ~30%, which is significantly greater than my required IRR of 25% for high-risk, moonshot growth bets like Upstart. Hence, I continue to rate Upstart a "Strong Buy" for long-term investors.
Strategic Positioning For UPST
Upstart's stock is cheap; however, if its AI models fail to outperform FICO-based models, Upstart will fail as a business and as a stock. Moreover, Upstart's revenues are shrinking, and losses are widening. In the current market environment, Upstart is likely to see more selling pressure. Hence, I am staying hedged in this counter. And here's how I am positioned:
For more details on my positioning, read this note:Upstart: The Good, The Bad, And The Ugly
Final Thoughts
Upstart is an unhyped and derisked play on artificial intelligence. While Upstart's marketplace model is clearly struggling in a rising interest rate environment, the positive update around "committed funding" is noteworthy as a reduction in cyclicality risk could catalyze a move higher in the stock.
Despite persistent macro headwinds, Upstart managed to beat estimates on both top and bottom lines for Q4 2022, and while Q1 2023 guide is awful, long-term investors should be looking beyond a few quarters (towards the next credit cycle). In this note, I shared a conservative valuation model for Upstart accounting for a revenue reset in 2023, and the stock clearly offers asymmetric risk/reward for investors.
Upstart is a long-term investment, and despite its current malaise, we see yet another uptick in banking partners and auto dealerships as good news. In my view, Upstart is gearing up to shine in the next credit cycle.
Here's my investment thesis for Upstart -
Debt markets are cyclical, and Upstart's business is inherently volatile due to its dependence on lending partners. Hence, Upstart investors will need to get accustomed to business volatility and wild swings in its stock. If you are not on board with these sorts of fluctuations, I don't think Upstart is a suitable investment for you.
Despite Upstart being a tech company, it cannot be valued as one due to the nature of its business. And I have learned this the hard way (losing a good bit of money on the stock).
As an early-stage investor, I am willing to accept the volatility inherent to Upstart's business as its disruptive AI-based credit underwriting has the potential to create a paradigm shift in the consumer lending space. With a virtually infinite TAM, Upstart's management can build a large and profitable business worth tens of billions of dollars.
Yes, Upstart's executives have made some mistakes, but their decision to tighten up the belt and focus on profitability over volumes is the right way to go in the current market environment. I like the fact that Upstart is being managed with a focus on long-term sustainability over short-term stock price fluctuations. Upstart's management has acted naively in recent months in my opinion, but I think they can get their act together and win investors' and Wall Street's trust once again in due time.
Credit is the bedrock of the American economy, and we can be sure that debt markets will come back (as they did after the Great Financial Crisis). Upstart will come back stronger at the other end of this cyclical downturn, and I say so with utmost confidence based on Upstart's accumulation of new lending partners even during this tumultuous period.
Investors will need to be patient, but a long-term investment from current levels is likely to be rewarded handsomely. Due to the sheer conservatism of my model, I believe that Upstart offers incredible returns from current levels with a spectacular margin of safety.
Source:Upstart: An Opportunity Of A Lifetime Or A Tragic Mistake?
With all of this said, the near-term macroeconomic environment is likely to be challenging, and hence, I am staying hedged in this counter for now. If you are looking to buy UPST, be patient, accumulate slowly, and manage your risk proactively.
Key Takeaway:I rate Upstart a "Strong Buy" at $18, with an insurance policy (options-based hedge).
Thanks for reading, and happy investing. Please share your thoughts, questions, or concerns in the comments section below.
Source: seeking alpha
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