Does This 1 Number Change Upstart’s Investment Thesis?
Artificial intelligence (AI)-based loan determination company Upstart Holdings (UPST 16.77%) and its shareholders alike have had a rough 2022. The stock has been crushed, with the majority of the drop coming from its first-quarter earnings report earlier this month. While the company posted some underwhelming guidance that showed it’s expecting slower growth this year, it also disclosed a risk it took that struck many investors as an unwelcome surprise.
Investors will be wise to monitor that particular risk closely — but here’s why it isn’t a deal-breaker.
Upstart’s worrisome figure
Upstart caught fire among investors because of its AI-based service that it touts as a more accurate judge of creditworthiness than the FICO score and standard bank determinations. The company has an AI engine that analyzes over 1,500 variables to provide a more holistic determination of creditworthiness, whereas larger banks typically rely on only a limited number of variables.
One of the main concerns investors had with Upstart’s quarter was the number of loans it held for sale on its own balance sheet this quarter. Holding loans on its balance sheet is irregular for the company. In fact, its low credit exposure risk was one of the reasons investors were drawn to it. Therefore, many shareholders ran to the door when they saw this huge jump:
|Q2 2021||Q3 2021||Q4 2021||Q1 2022|
|Loans held for sale (at fair value in thousands)||$82,311||$129,625||$252,477||$597,981|
Most of these were auto loans, which are being held for research and development purposes before being sold to investors or banks, but the rest of this increase was because funding from banks and investors dried up. The company traditionally facilitates loans; then its bank partners or institutional investors fund them. However, in this rapidly changing economy, its partners have been funding fewer loans as their risk tolerance has been changing. This leaves Upstart with the bag, and it ended up keeping them on its own balance sheet, acting as a bridge to the market-clearing price.
Is this thesis-busting?
But there’s good reason to think this won’t be a problem in the future. In fact, management recently announced that the company will no longer park unwanted loans on its balance sheet. But even before that, in the earnings call, CFO Sanjay Datta said that this “middle-man” role of holding loans will not be “a long-term or necessarily sizable activity” for the company. One of the ways Upstart planned to make sure something like this didn’t happen again is by developing automated mechanisms to adapt more quickly to the new price rates that banks and credit unions demand. This automation would allow the company to move more nimbly so it would not have to take on these loans in the short term.
This is a great sign that this risk is, in fact, short-term. It will be critical to monitor this to make sure management keeps up on its promise, but management seems to be confirming this will be a temporary issue and shouldn’t severely concern long-term investors.
Why I’m holding onto my Upstart shares
Aside from this unexpected event, the first quarter of 2022 looked quite strong for Upstart. It is continuing to see rapid adoption in the industry, and it now has 57 bank partners, which grew 217% year over year. This allowed the company’s total loans facilitated on the platform to jump 174% year over year to 465,500. This rapid adoption from banking partners helped the company generate impressive profitability. Upstart’s net income in Q1 was $33 million, which soared 224% year over year.
The company’s full-year guidance was lower than it had previously projected, but this was understandable. The company lowered its full-year revenue estimate from $1.4 billion to $1.25 billion, primarily because of macroeconomic uncertainties for the rest of the year. Management took a conservative approach to guidance, which is what nearly all businesses are doing during this precarious time.
At recent prices, Upstart is valued around 26 times earnings, which is close to its lowest valuation in its brief history as a public company. This valuation is extremely tempting, and with the company planning to resolve the issue it saw in Q1, shares look extremely appealing today. This risk does not seem to be a major issue in the long term and the business is continuing to see rapid adoption, which is why investors should think about buying more shares.