While Upstart Holdings, Inc. (NASDAQ:UPST) offers a promising artificial intelligence, or AI, loan origination platform, the business model isn’t without flaws. As with other fintech lenders, the biggest issue with the business models are the access to committed capital with peers shifting towards digital banks to fund loans. My investment thesis remains Neutral on the stock, but the recent volatile action should remind investors that price ultimately matters.
On a lot of metrics, Upstart reported a turnaround quarter in Q2 ’23 as follows:
The lending fintech platform reported revenues grew over $33 million sequentially to $136 million. The revenue total still fell over 40% YoY, but Upstart returned to sequential growth.
Even more important, the company actually reported a profit in the quarter. One of the primary reasons for a negative call on the stock prior was the massive losses generated when sales slipped.
Upstart reported a Q2 2023 non-GAAP profit of $5.4 million, actually up from the $1.0 million reported in the prior Q2 when revenues were nearly $100 million higher. One a GAAP basis, the fintech was able to cut nearly 80% of sales and marketing costs while still spending the same on R&D in order to achieve this impressive turnaround without losing a focus on product development.
Upstart had reported a large loss of $39 million in the prior quarter. The turnaround was impressive.
Not Ready For AI Future
The biggest problem facing the AI and machine learning lending sector is a lack of confidence to invest in loans during weak economic periods. In a lot of cases, these lending platforms still generate positive returns, but banks and investment firms pull capital.
Upstart partners only originated 109,447 loans in the quarter for $1.2 billion, down 64% from last Q2. The loan conversion rate was only 9%, down from 13% last year.
Upstart has data showing the recent loan vintages are producing 11%+ gross returns with an 11.5% gross expected return for Q1’23. The company predicts the ability to beat these expected returns, but the 2021 period was characterized by far weaker returns than expected.
Due to the lack of committed capital despite a couple of large deals announced in the last quarter, Upstart guided to Q3 revenue of only $140 million. The company predicts adjusted EBITDA of only $5 million after reaching $11 million in Q2.
On the Q2 ’23 earnings call, CEO Dave Girouard highlighted this issue despite another partner apparently committing capital to the lending platform throughout the economic cycle (emphasis added):
We added another committed capital partner in July and are in conversations with several more interested parties. We also completed a securitization after the close of Q2 with significantly tighter spreads than our prior deal earlier in the year.
Meanwhile, we continue to manage Upstart cautiously, but optimistically in a funding-constrained environment.
The stock is collapsing due to the disconnect with the business reality. Upstart has a promising AI lending platform, but the company hasn’t solved the ability to obtain constant lending throughout cycles despite consistently strong gross returns and positive outcomes during a tough and volatile Covid period.
When Upstart soared to $70, the stock had a market cap of $6.4 billion. Investors should’ve used that elevated stock price to exit the stock considering the disconnect where personal loan lender LendingClub (LC) trades with a forward P/S multiple below 1x.
The lending platforms don’t have the same business models with LendingClub controlling a digital bank, but one can argue that stock is more appealing for this reason. Either way, Upstart is much more appealing as the stock comes back towards $30 and 3x forward sales targets.
The key investors’ takeaway is that the stock isn’t the same bargain as LendingClub, but Upstart Holdings, Inc. investors have a far better opportunity to profit on the next AI rally when Upstart is bought at a lower PS multiple. The fintech is set up to profit from the next economic cycle with expansion into auto loans and home equity driving growth over time. If one must buy Upstart, buy the stock on weakness versus chasing irrational exuberance.