Upstart Holdings, Inc. (NASDAQ: UPST) The second quarter earnings release reinforced the recalibration of how investors should view UPST as part of a technology-focused portfolio.
As an AI-driven lending technology solutions provider that primarily derives its revenue from transaction fees based on on the volume of loans, it is inevitable that Upstart will be impacted by macroeconomic cycles. Coupled with the underlying higher-risk customer profile that its solution addresses, the pain will be felt even more during a downturn, as external funding begins to decline significantly, leading to a marked drop in the volume of loans.
What we heard on Upstart’s second quarter earnings call suggests that the worst of its underlying metrics may not yet be visible as the macro environment continues to deteriorate. Additionally, investors should also consider the potential impact on Upstart’s P&L as management has once again leveraged its balance sheet to provide a crucial source of liquidity to stabilize its lending volume. As a result, we believe it is becoming increasingly difficult for investors to assess UPST’s fair valuation, given the current momentum.
Nevertheless, it is also essential for investors to note that the UPST has already been beaten from its October 2021 highs. In addition, we note that the massive selling of UPST after the second quarter has not broken through its lows. of May and has been resiliently supported. Coupled with our confidence in a market bottom, we are confident that if Q2 has not broken the UPST, it has likely bottomed in the medium term.
Accordingly, we are revising our rating from buy to speculatively, with a medium-term (PT) price target of $48 (implying 38% upside potential).
Upstart’s Q2 helps reset expectations
Upstart reported transaction volume of 321.14K loans in the second quarter, down sharply from 465.54K in the first quarter. The company attributed the drop in volume to a significant decline in third-party funding as institutional investors became increasingly concerned about the deteriorating macro environment. In addition, investors were also concerned about deteriorating credit performance of its high-risk borrowers, which further reduced Upstart’s loan demand. Articulated management:
Industry data shows a general increase in delinquencies across all segments of unsecured credit, which has a disproportionate impact on the higher risk levels that make up a significant component of our borrower base. Macro uncertainty and the impact of economic stress on consumer delinquencies resulted in less funding available for loans on our platform, which became the operational constraints of the business. Do we really think we have passed the bottom of the cycle? I think in a word, no. So I think we expect a further deterioration in claims trends. We are projecting it now and preparing for it. (Upstart FQ2’22 call for results)
But, things should improve from FY23
Importantly, Upstart has highlighted that it plans to aggravate macros that could impact its business throughout FY23. Therefore, we believe the company’s planning standards considered that normal business conditions may not resume until late 2023. The company also withdrew its full-year guidance, which we believe is reasonable. We believe too many variables are in play now that could significantly impact its revenue visibility and credit performance through H2’22.
Nevertheless, consensus estimates (neutral) have already been revised down significantly. He predicts that Upstart’s revenue growth may continue to decline in the third quarter (in line with management’s third quarter guidance). Upstart’s adjusted EBITDA margins are expected to reach a nadir in the third quarter before reversing in FY23.
We believe the street modeled the company’s malaise as transient, though management stressed that it used conservative planning standards. Is it reasonable?
As seen above, the National Financial Conditions Index (NFCI) has eased in recent weeks, despite the Fed’s still hawkish stance. We think the market has adjusted to less “bad” surprises from the Fed, with recent CPI and PPI numbers less worrying than expected. Therefore, if the NFCI can continue to ease further, it could help Upstart regain support from its third-party capital providers and largely reduce the need to leverage its balance sheet.
Is the UPST stock a buy, sell or hold?
We observed that the UPST’s May lows held firmly even though it released a disastrous Q2 chart. Additionally, the robust buying momentum also rejected the post-earnings selloff as UPST benefited from positive market sentiments.
Therefore, we are confident that it has bottomed in the medium term and offers a favorable risk/return profile. Nonetheless, we urge investors to be aware that the UPST is unlikely to return to all-time highs anytime soon, as its growth profile has changed dramatically.
As such, we are revising our rating from buy to speculative buywith a mid-term PT of $48.