4 Red Flags for Upstart Holdings' Future

The online lender faces severe near-term headwinds.

$Upstart Holdings, Inc.(UPST)$ stock price tumbled after the online lending company posted its second-quarter earnings report. Revenue rose 18% year over year to $228 million, but missed analysts' estimates by $7 million. Its adjusted net income plunged 98% to $1 million, to $0.01 per share, which also missed the consensus forecast by $0.07.

Its adjusted EBITDA(earnings before interest, taxes, depreciation, and amortization) declined 91% to $5.5 million. On aGAAP(generally accepted accounting principles) basis, it posted a net loss of $29.9 million, compared to net profit of $37.3 million a year earlier.

Those headline numbers were disappointing, but they had already beenpartly telegraphedin its preliminary earnings report on July 7. And a deeper dive reveals four additional red flags.

1. Upstart management has a bleak outlook for Q3

For the third quarter, Upstart expects its revenue to decline 25% year over year to $170 million, compared to analysts' expectations for 8% growth. It also expects to post an adjusted net loss of about $9 million and for its adjusted EBITDA to come in at break-even levels.

Once again, Upstart mainly blamed rising interest rates, which caused people to take out fewer loans through its platform while prompting its lending partners (banks, credit unions, and auto dealerships) to take a more prudent approach to funding those loans.

2. Upstart is questioning its own business model

Upstart initially attracted a lot of attention for two reasons. First, it analyzes nontraditional data -- including a customer's educational history, area of study, standardized test scores, and work history -- with a cloud-based artificial intelligence (AI) platform to approve loans.

Second, Upstart offers a wide range of loans on its website but doesn't usually fund them from its own balance sheet. Instead, it acts as an intermediary for its lending partners, which then fund the actual loans and pay Upstart fees for accessing its platform.

That business model exposes Upstart to less credit risk, but it also creates a bottleneck by making it dependent on its lending partners for fresh loans. To overcome that bottleneck, CEO Dave Girouard abruptly announced during the second-quarterconference callthat the company would start to "leverage our own balance sheet as a transitional bridge to this committed funding."

That's a risky move because Upstart has already ended the second quarter with an elevated debt-to-equity ratio of 1.5. It still held $790 million in unrestricted cash, but that liquidity could quickly dry up as revenue growth decelerates and its losses widen.

Girouard said that while it "doesn't make sense for Upstart to become a bank," it needed to "upgrade and improve the funding side" of its marketplace as interest rates rise. In other words, management is starting to question the resilience of its own business model.

3. Upstart is seeing declining loans and conversion rates

Upstart's number of bank-partner loans increased 12% year over year to 321,138 in the second quarter but still dropped 31% sequentially from the first quarter. Its conversion rate, or the percentage of its total inquiries that are converted into actual loans, came in at a mere 13% compared to 24% a year earlier and 21% in the first quarter of 2022.

Those declining engagement rates explain why Upstart is so desperate to fund its own loans. They also suggest that its smaller competitor, Pagaya Technologies(PGY9)-- which provides comparablewhite-label AI servicesto financial institutions instead of acting as an intermediary platform for loans -- might be taking a smarter long-term approach.

4. Management initiated pointless buybacks

As Upstart faces a grueling slowdown, incurs wider losses, and takes on more credit risk, it's also buying back more shares. In February, it announced a $400 million buyback plan. It didn't repurchase any shares in the first quarter, but it bought back $150 million worth in the second quarter.

These buybacks are arguably wasteful, since all that cash could have been used to fund its new loans, reduce its debt, or simply expand its platform. Upstart bought back 4.4 million shares (at an average price of about $34), but its number of weighted-average outstanding diluted shares only declined 1% sequentially and actually rose 1% year over year to 94.5 million.

Therefore, Upstart is likely using these buybacks to offset the dilution from its stock-based compensation expenses, which jumped 86% year over year to $55.4 million in the first half of 2022, instead of actually returning that cash to investors by reducing its float.

Upstart deserves to stay in the penalty box

Upstart's stock might look reasonably valued at three times this year's sales, but thatprice-to-salesratio is still pegged to analysts' expectations for 12% revenue growth this year. Those estimates could be reduced after Upstart's disappointing second-quarter report. For now, it deserves to stay in the penalty box until it stabilizes its core business.