$UPST High Leverage Could Be Its DownfallAs we’re heading into earnings season, one report investors are anticipating is fintech startup Upstart Holdings, Inc. (Nasdaq: UPST). While the startup beat analysts’ expectations in its Q2 earnings, its stock is down 45% since then due to an underwhelming guidance resulting from macroeconomic pressures. With the fintech holding $837.5 million in loans on its balance sheet and delinquency rates rising near pre-pandemic levels, Upstart may suffer in the coming quarters as the macro conditions aren’t expected to improve anytime soon. In light of this, we’re downgrading our earlier hold rating on UPST stock to a sell.
UPST Fundamentals
Too Many Macro Challenges
Since inflation skyrocketed and the Fed started hiking rates, Upstart has witnessed fewer loans to approve. This resulted in its volume plunging, taking revenue and profits along with it. Originally, one of the fintech’s main attractions was that it doesn’t have the same exposure to economic fluctuations since it isn’t a bank. However, this view has been proven wrong by its financial performance this year as loan originations across its platform declined 64% YoY in Q2 to 109,447 loans totaling nearly $1.2 billion. This slow demand for loans has led the company’s revenues to decline 54.4% YoY in the first half of the year.
This headwind may continue impacting Upstart in the near term since while the Fed held interest rates flat in recent meetings, it signaled that it could further hike rates if inflation remains high. This would hinder the economy by curbing demand for new loans, and as a result, further impact the company’s ability to generate revenue. It is for this reason that Upstart may report underwhelming Q3 earnings on November 7th, especially since the average interest rate in Q3 was 5.42% compared to 5.17% in Q2. Additionally, high interest rates could lead to more delinquencies in the future which would severely impact the company in my opinion.
Upstart’s aim is to provide borrowers with fair credit – of at least 600 – access to personal loans by looking beyond their credit history. Instead, the fintech considers other non-traditional credit indicators like college education, job history, and residence. As a result, its platform is considered a good option for customers who don’t have a credit score that qualifies them for more inexpensive loans. In exchange for providing such a service for these consumers, Upstart charges origination, late, unsuccessful payment, and paper copy fees.
During the current macro environment, banks have been tightening their lending standards for both businesses and households, and they anticipate maintaining this cautious approach for the rest of the year, according to a survey conducted by the Fed. As such, lower quality borrowers or “subprime” borrowers that real banks don’t want have to lean on platforms like Upstart for their personal loans.
With that in mind, delinquency rates in the US are on the rise with them approaching pre-pandemic levels at 2.36% for all loans, according to latest data from the Fed. Meanwhile, delinquency rates (60 days or more past due) for personal loans reached 3.62% in Q2, according to LendingTree. Considering that subprime borrowers are more likely to miss payments or default on their loans than borrowers with better credit, Upstart appears to be in a tough position, especially with the resumption of student loan repayments last month.
To fully understand the extent of this on Upstart, investors should note that during the first half of 2023, 38% of the loans funded through its platform were retained by its lending partners, and 50% of the loans were sold to institutional investors through its loan funding program. Meanwhile, the company retained 12% of the loans originated through its platform.
This represents an increase from the 10% it retained at the end of 2022 which shows that institutional investors as well as its partners are becoming more cautious about purchasing its loans. If this trend continues in the coming quarters, it would represent a major threat to the company due to its weak balance sheet.
Risky Actions May Backfire
While banks are negatively impacted by high interest rates due to higher delinquency and default rates, they also benefit from them due to the higher interest they charge on their loans. This isn’t the case with Upstart since it isn’t a bank. While the startup started carrying around $1 billion in debt on its balance sheet, its balance sheet isn’t strong enough to handle this risk, especially since it only has $443.6 million in cash on hand.
As is, Upstart is dependent on funding from its partners to fund the loans originated through its platform. Earlier this year, the fintech secured $2 billion in funding over a 12-month period from its partners to support its loan originations.
Moreover, the startup isn’t profitable yet and is barely generating operating cash flow as it generated only $86.6 million from operations in the first half of the year. This means that in case the loans it’s holding on its balance sheet go sour, there might be risks surrounding its ability to continue operating.
However, the biggest risk facing Upstart may be the contractual derivative risk in its committed capital partnership where it is forced to invest capital with its partners, exposing its capital to exposure of losses on a larger pool of loans its partners are purchasing. The company describes this investment as “beneficial interests” in its Q2 earnings report. This arrangement may appear similar to holding ABS securities, however, ABS securities have a yield spread protecting the equity, which is not available in this arrangement.
In Q2, Upstart reported that it had $40.2 million invested in risk-sharing as part of its committed capital arrangements to support $742.9 million in loans. As this amounts to an 18:1 leverage ratio, the company’s equity would be hit hard in case of losses on this investment. Currently, the company projects this investment to be worth $51.7 million with the potential to be worth between $0 and $83.4 million over time, dependent on future credit performance.
Given that delinquency rates are on the rise as mentioned earlier, the company may see a loss on its investment if the economy takes more than anticipated to normalize. As is, the Fed projects the federal funds rate to be around 5% at the end of 2024, as shared in the Summary of Economic Projections last month.
At the same time, it remains unknown whether the company will invest more capital to support committed originations. In that case, its balance sheet will be burdened with a lot of highly leveraged exposure amid a possible recession next year.
Valuation
In terms of valuation, we can start with the value of the company’s balance sheet. At the end of Q2, Upstart had $1.76 billion in assets and $1.12 billion in liabilities. This means that the net value of its assets is $638.14 million which puts its P/B ratio at 3.83. With that in mind, value investors prefer the P/B ratio to be under 3 which could indicate that the stock may be overvalued at its current valuation.
Assets $1,763,712,000
Liabilities $1,125,567,000
Net Assets $638,145,000
OS 83,887,658
BVPS $7.61
Share Price $29.17
P/B Ratio 3.83
Since Upstart is unprofitable, we can also use forward P/S to value its shares. Typically, investors prefer this ratio to be below 2, however, they may pay more for fast-growing companies. Currently, Upstart is trading at 4.6 forward P/S, and while it may not seem to be an unreasonable valuation, the company’s revenues are declining substantially as it reported a 44.3% YoY revenue decline in Q2.
Based on these metrics, a $15 price target could be given to UPST stock, implying a 50% downside from current levels.
Upside Risks
Despite the bearish thesis on UPST stock, there are upside risks that investors should consider. If the Fed starts cutting rates earlier than anticipated, the company may be well-positioned to see a positive return on its risk-sharing arrangement which could bolster its financial position. Moreover, institutional investors and the fintech’s partners may increase the amount of loans they purchase which would decrease the amount of loans it carries on its balance sheet – reducing credit risk.
Upstart’s loans have been performing better in recent quarters. While the fintech’s loans were underperforming in 2021 and 2022, the expected gross realized returns increased from 3.5% in Q1 2022 to 11.5% in Q1 2023, according to its Q2 earnings presentation. If the company’s loans continue demonstrating strong performance, banks may become more willing to work with it.
Technical Analysis
On the hourly chart, UPST stock is in a neutral trend as it is trading in a sideways channel between $25.82 and $30.62. Looking at the indicators, the stock is above the 200, 50, and 21 MAs which is a bullish sign. Despite this, the RSI is overbought at 82 and the MACD is curling bearishly, indicating a possible reversal in the trend soon.
As for the fundamentals, Upstart’s upcoming Q3 earnings report on November 7 is a major catalyst as it will determine the extent of the macro environment’s impact on the fintech’s operations, as well as shedding light on its risk-sharing agreement. Since there has not been much improvement in the macro environment in Q3 compared to Q2, it is likely that Upstart will report another underwhelming earnings report.
Given that the stock is trading near resistance, investors may find the current PPS a good entry point to start a short position in the stock ahead of its Q3 earnings. Take profits could be found on retests of the $25 support, $22 support, and $15 price target with a stop loss near $32.2 if it breaks resistance.
UPST Forecast
After looking more into Upstart’s Q2 results, we decided to revisit our earlier hold rating on UPST stock. As is, the macro environment is proving to be too difficult for the fintech to operate due to the rising delinquency rates which has led to the company retaining a larger portion of the loans it originates. Currently, the startup is holding loans worth $837.5 million on its balance sheet which could be a ticking time bomb if the trend of rising delinquency rates continues in the coming quarters. This could also impact the $40.2 million invested in risk-sharing as part of its committed capital arrangements. If this figure increases in the upcoming Q3 earnings report, the startup’s balance sheet would be exposed to high leverage in the midst of a recessionary environment, which doesn’t bode well for it since its balance sheet is already weak. Given our $15 price target on UPST stock, taking a short position in the stock may prove to be a profitable decision.
