Upstart Stock: An Opportunity Of A Lifetime Or A Tragic Mistake? (NASDAQ:UPST)

Monopoly Chance - Question mark, concept

Marco Rosario Venturini Autieri/iStock Unreleased via Getty Images

Introduction

The speculative bubble of 2020-21 has burst, and there are no two ways about it. Despite broader indices hovering just around the bear-market territory, i.e., 20-25% off their highs, the damage in certain areas of the market has been tremendous. If you look up high-growth tech stocks, here’s the kind of price action that you are likely to see:

Upstart Price chart

YCharts

When Upstart (NASDAQ:UPST) came public in late 2020 (with an IPO price of $20), the meme stock euphoria was reaching its zenith (the peak was in mid-Feb 2021). In its first few quarters as a public company, Upstart, an AI-powered lending marketplace, registered (profitable) hypergrowth as the lending activity on its marketplace rebounded from a vicious ~70% drop during COVID. For multiple quarters, Upstart put up financial results that blew all analyst estimates and continued to gain lending partners throughout 2021. With a virtually infinite TAM and a growing list of bank and credit union partners, Upstart seemed like an unstoppable disruptive force. Naturally, a market pumped with adrenaline (liquidity from loose fiscal and monetary policies) sent Upstart’s stock soaring.

As you may know, I originally bought Upstart in the $50s, and I have been adding to my position using DCA plans, with my latest purchase coming in mid-May. I will discuss my entire position in Upstart in just a little bit, but before we do that, I want to admit that my investment thesis for Upstart was wrong. Well, maybe not entirely wrong, but I made two big mistakes:

  • I ignored cyclicality risk and valued Upstart as a technology company: While Upstart is a technology company, it is not immune from the gyrations in the debt markets, i.e., Upstart’s financial performance is heavily reliant on the state of debt markets, which are cyclical. I thought that Upstart could deal with downturns in debt markets by leveraging the size and diversity of its existing lending partner & institutional investor base and by adding more partners to its marketplace platform. Clearly, I was wrong (Upstart’s Q2 2022 results prove it). In normal conditions, Upstart is far superior to owning a bank (or a financial institution involved in lending); however, in times of macroeconomic uncertainty, most of Upstart’s partners are likely to hold back on lending as they did in 2020 (when debt markets froze on the breakout of the COVID pandemic) and are doing so in 2022 (as FED tightens its monetary policy). Such events will create massive business volatility at Upstart in the future too. Hence, Upstart is a technology company, but it cannot be valued as one. I did this, and it was clearly an error in judgment.
  • I trusted the management too early and far too much: Upstart’s management roster is filled with super impressive resumes, and the company’s employee reviews indicate a winning culture at the firm. When Upstart reported its first breakout quarter in early 2021, I sat in on their call, and I said to myself – “This is the best earnings call of my career.” Dave Girouard [Upstart’s CEO] and Sanjay Datta [Upstart’s CFO] were absolutely majestic, and Upstart’s potential just blew my mind. While I still believe that Upstart’s management is a talented bunch, I am not sure if they are ready to be public company executives. If you look at the last six to nine months, Upstart’s management has committed a string of mistakes -1. Changing Upstart’s business model by adding non-R&D loans to its balance sheet in Q1 2022, i.e., taking on balance sheet risk. They did so to keep revenues flowing and to show confidence in their AI models. 2. However, looking at Mr. Market’s adverse reaction to this move, Upstart’s management flipped their stance and decided to sell these loans off (incurring significant losses that will be showing up in Q2 results). While I support this move, I think Upstart’s management is reactive (and not proactive). 3. Upstart’s management also made a confusing capital allocation decision when they got the board to authorize a $400M stock buyback program in Feb-2022. While the idea to support Upstart’s rapidly-declining stock with free cash flows was fine, management’s failure to see a downturn in debt markets is unnerving. Additionally, the complete ignorance of this buyback program during the Q1 earnings call led to concerns around management credibility. A few days later, Upstart’s CEO mentioned during the annual shareholder meeting that the buyback program had started, but the damage was already done. I am interested in looking at the full Q2 report to see how this program is being executed, but with cash flows coming under pressure due to volume compression, I could see a suspension of this buyback plan shortly. 4. Upstart’s top brass [Dave Girouard and Paul Gu [CTO]] sold roughly $800M worth of stock in 2021, which is completely fine. However, Upstart’s management has not repurchased a single share with personal money and instead opted to use the company’s balance sheet cash to execute stock buybacks. In my view, this is a big mistake on management’s part as it seems they have no confidence in Upstart’s business. As an Upstart investor, I really hope to see some buying from Dave and Paul in the coming weeks. 5. We shall look at Upstart’s Q2 preliminary results in a bit, but I must say that it is a painful miss on revenue and earnings. Upstart’s management has failed at foreseeing the shift in debt markets, and we are about to see a big miss on guidance that was issued just 45 days back. When a management team can’t forecast their revenues over such a short period of time, we (as analysts and investors) probably can’t trust their guidance. Upstart’s management will now need to win back trust through concrete results, and that could take several quarters.

With all of this being said, I believe that a sharp downturn in debt markets (due to a sharp uptick in interest rates) caught Upstart’s management off guard [like most executives in the lending industry]. The mistakes committed by Upstart’s management team could be signs of naivety and inexperience as public market executives; however, Dave, Paul, Anna, and Sanjay have time on their side. Upstart has robust unit economics and a strong balance sheet whilst the business is operating near FCF breakeven (excluding loan purchases). Once debt markets normalize, Upstart could emerge as a big beneficiary since its credit underwriting will have been war tested (i.e., proven).

The big bull thesis for Upstart is the risk separation ability of its AI:

As you can see in the chart above, borrowers with Upstart’s risk grades of A+, B, and C have far lower default rates compared to FICO’s score ranges of 700 or above, 680-699, and 660-679, respectively. Hence, Upstart’s AI does a better job than FICO at identifying good borrowers.

Upstart risk separation

Upstart Q1 2022 Earnings Presentation

On the other hand, borrowers with Upstart’s risk grade of E- have greater default rates across all FICO scores. While this data may seem negative, it is very bullish for Upstart. This data tells us that Upstart’s AI is also able to identify bad borrowers with greater accuracy than FICO.

In the 700 or Above FICO score range, the average default rate is 3.4%; however, when Upstart’s AI classifies these borrowers under its risk grades of A+ to E- rating, the default rate is as low as 0.6% [A+] as high as 9.2% [E-]. That’s true risk separation, and this is the positive differential of Upstart’s AI-based credit underwriting over traditional credit underwriting. This is why I am bullish on Upstart’s long-term future.

Before I share my positioning for Upstart, let us discuss Upstart’s Q2 preliminary results, which led to the latest downdraft in Upstart’s stock.

Upstart’s Q2 Report Is A Disaster, But This Disaster Is Not Entirely Upstart’s Making

On 7th July 2022, Upstart released its preliminary unaudited financial results for Q2 2022, and boy, oh boy, it is a big miss on revenue and earnings guidance that was issued during the Q1 report (just 45 days back).

Second Quarter 2022 Preliminary Unaudited Financial Results

  • Revenue is expected to be approximately $228 million, previously guided at $295 to $305 million
  • Contribution margin is expected to be approximately 47%, previously guided at approximately 45%
  • Net Income (loss) is expected to be in the range of ($31)-($27) million, previously guided at ($4) to $0 million

While the full Q2 report will be available on 8th August, Upstart is clearly feeling the effects of a downturn in debt markets (ahead of a potential recession) as lending partners pull back on funding. Here’s some commentary from Upstart’s CEO on these disappointing results:

Inflation and recession fears have driven interest rates up and put banks and capital markets on cautious footing. Our revenue was negatively impacted by two factors approximately equally. First, our marketplace is funding constrained, largely driven by concerns about the macroeconomy among lenders and capital market participants. Second, in Q2, we took action to convert loans on our balance sheet into cash, which, given the quickly increasing rate environment, negatively impacted our revenue.

During the second quarter, we improved our unit economics and oriented ourselves toward continued positive cash flow even at lower loan origination volumes. With a low fixed cost base, we expect to continue adding to our almost $800 million unrestricted cash balance as well as to continue repurchasing Upstart shares as it makes sense. And finally, despite limiting hiring to critical areas, we continue to invest in our models and products and are confident Upstart will emerge from this cycle a stronger company.

Source: Upstart Q2 2022 Preliminary Results

While I am pleased with the sale of loans from Upstart’s balance sheet (reduction in balance sheet risk), I am a little surprised with the implied loss on sale of ~$30-40M. If Upstart got rid of all the loans on its balance sheet, I would say this one-time loss would be forgivable, but I fear that more R&D loans will continue to show up on Upstart’s balance sheet, and this will create an overhang on Upstart’s financial results for multiple quarters. The ongoing volume compression could worsen, and Upstart’s cash flows could come under severe pressure.

Alright, enough bad news already! Let’s look at some positives.

Upstart’s contribution margins (unit economics) are highly-positive, and the company remains a free cash flow generative business (even with lower volumes). As you may know, Upstart is a well-capitalized business with roughly $800M of unrestricted cash on its balance sheet. Hence, Upstart could get through a downturn in debt markets (many of its rivals won’t).

More importantly, Upstart’s In-Period Defaults in Q2 were lower than the prior Q1 forecast, and this trend in defaults is expected to improve further in Q3, as shown in the chart below.

Upstart Default Rates

Upstart Investor Relations

The superiority of Upstart’s AI-based credit underwriting is under question; however, only time (and a recession) will give us the proof for this edge. A workaround for this situation is to look at Upstart’s partner base, which continues to proliferate despite ongoing volatility in debt markets.

Upstart Q1 Earnings Presentation

Upstart Q1 Earnings Presentation

Upstart Q1 Earnings Presentation

Upstart Q1 Earnings Presentation

Even in Q2, Upstart added five new lending partners (as per the news releases on its IR website), and I am optimistic about the auto dealer rooftops figure too. Here’s what Sanjay Datta (Upstart’s CFO) had to say about the growth of Upstart’s partner base and credit performance:

Despite the tumultuous economy, Upstart-powered loans have performed exceptionally well. For loans facilitated through our platform and held by our more than 60 bank and credit union partners, average returns have consistently met or exceeded expectations since the program’s inception in 2018.”

“For loans purchased by non-bank institutions, all vintages from 2018 thorough 2020 delivered significant excess returns, while our 2021 vintage is within 100 basis points of our loss expectations. Lastly, we believe our models are well calibrated to economic conditions and are currently targeting returns in excess of 10 percent.”

Source: Upstart Q2 2022 Preliminary Results

In a nutshell, Upstart is struggling during a tumultuous period in the debt markets (like any other player in lending markets). Considering the velocity of its move up, Upstart’s stock getting hammered now is natural capitulation. I think it is fair to say that Upstart is a victim of its own success. When businesses go from hypergrowth to negative growth in quick order, wild swings in their stock prices are commonplace. This is how cyclical growth stocks behave, and as we have seen today, Upstart is exposed to the cyclicality of debt markets, which renders it a cyclical stock.

Despite heightened fears of a recession, I am not willing to bet on a debt market freeze-up at historically-low interest rates. A rapid rise in interest rates is causing panic among lenders; however, lending activity will come back once rates stabilize. Hence, I will not throw in the towel with Upstart during this temporary period of heightened uncertainty and lower-than-normal origination volumes in lending markets.

Upstart Is One Of My Largest Positions

As I said before, Upstart has been a part of my portfolio since early-2021, and I have added to my long position on several occasions through my monthly capital allocation plans. After factoring in all my purchases, I own Upstart at a cost basis of $78. In this section, I will discuss my latest purchase of Upstart and my hedging strategy for the stock.

YCharts

YCharts

Post the release of Upstart’s Q1 results on 9th May, the stock imploded down to the mid $20s (down 56% in a single session), as the market was shocked by a revenue growth slowdown and change in business model (addition of non-R&D loans on to Upstart’s balance sheet). For months, I have been looking to concentrate into my highest conviction holdings to make the most of ongoing market volatility. With Upstart taking on balance sheet risk, its business model was now similar to Affirm. Comparing Upstart and Affirm, the former was a clear winner based on financial performance & valuation, and so I sold all of my AFRM shares to buy UPST on 13th May 2022. FYI, this was my last purchase in Upstart.

Ahan Vashi's Tweet on UPST

Twitter

After executing this move, UPST became the largest position in my portfolio at a weight of ~14%. I hope the logic behind this consolidatory move is clear from the tweet thread shared above, as we won’t be going into the details today. Now this move would have gone very wrong had I stuck to a “buy and hold” approach, but fortunately, I used the post-ER rebound in Upstart to hedge my position. As you may know, I am a big proponent of the “buy and hold” philosophy. Then, why did I hedge?

YCharts

YCharts

On May 17, Upstart’s top brass spoke at two separate events:

And the key takeaway I got from these events was that Upstart’s management believed that taking on balance sheet risk was a big mistake and that they were now willing to compromise on origination volumes (revenue growth) to avoid balance sheet risk. Also, management’s message on the disposal of existing loans (economic decision) was quite clear, and I just knew big losses were coming. With volume compression and losses on the sale of loans right ahead, I could just see a near-term decline in Upstart’s stock price.

Henceforth, I hedged out my entire Upstart position using options on 18th May 2022 and shared this move with my community members. At this time, Upstart was ~20% of my personal AUM (after a quick move up from $35 to $48). While you may say that I just got lucky with this trade, I say that my logical process warranted and created this luck.

Here’s the illustration of my hedging strategy:

Author's conversation with one of his subscribers

Rocket Chat (Author)

The core logic of my hedging strategy for Upstart was two-pronged:

  • Capital protection, and
  • Reduction of cost basis

By buying protective puts at $50 and selling covered calls at $55, I limited my downside to $48 per share and capped my upside at $55 per share. To bring the cost of my hedge lower and to increase my stake (no. of shares) in Upstart by ~2x [in other words, cut my cost-basis of $78 in half], I also sold 2x puts at a strike price of $25. All of these options are expiring in mid-August. For establishing this entire hedging strategy, I received $1 per share from the market, which brings my net value for Upstart to $49 per share.

Upstart hedge from may 18

Illustration of my hedging strategy for Upstart (Author)

Upstart is currently trading at ~$25, and if it stays around this level or slides further down, I will be able to exercise my puts and end up with twice the number of shares I originally owned. Currently, Upstart’s stock is down ~44% from where I placed my hedge, and I am down ~12%. While hedging is not perfect, it does provide capital protection. Honestly, I am not at all worried about my position in Upstart, and I can’t wait for August to exercise my puts to bring my cost basis for Upstart down to $39.

Generally, I do not recommend using hedging strategies or options; however, these financial instruments can be very handy in certain situations like the one I faced with Upstart. At my upcoming SA marketplace service, we will be designing robust portfolios that leverage the power of financial engineering to generate alpha and reduce risk. In two of our five model portfolios, we will be using financial instruments like options to execute DIY (do-it-yourself) financial engineering strategies, and so you can expect to receive more such ideas from me in the coming days, weeks, and months.

For now, let’s shift our focus back towards Upstart.

Running Upstart through TQI’s Quantamental Analysis Process

After recording hypergrowth in 2021, Upstart is facing a growth slump in 2022 as the FED tightens its monetary policy in a stagflationary environment. In Q1, Upstart’s q/q revenue growth flatlined, and according to the preliminary Q2 results released by the company, Upstart is set to miss revenue guidance by ~24%. Despite a stabilization in treasury yields in recent weeks, the growing threat of a recession could lead to a freeze-up in the debt markets. Upstart’s Q2 numbers indicate a drastic slowdown in lending activity on its marketplace, and if we look at numbers from 2022, Upstart’s origination volumes could fall as much as 70-75%. While Upstart’s near-term revenue outlook is highly uncertain, its unit economics are stronger than ever (contribution margin of 47% in Q2).

YCharts

YCharts

While Upstart’s management is set to get rid of the non-R&D loans added to their balance sheet in Q1 (and take a big loss), I still expect Upstart to have more loans on the balance sheet by the end of this year. Upstart is expanding to new loan categories, and with a cash balance of ~$800M, I see no reason for Upstart’s management not to invest for long-term growth. Since we won’t be seeing any more new non-R&D loans showing up on Upstart’s balance sheet, I think Upstart’s free cash flows are set to rebound sharply. Despite fears of an impending recession causing panic over volume compression, a low fixed cost base, positive unit economics, and an $800M cash balance should provide Upstart with enough impetus to emerge stronger on the other side of this cycle in debt markets.

According to Seeking Alpha’s Quant Rating system, Upstart is currently a “Strong Sell”. In recent weeks, more and more Wall Street analysts have been turning bearish (overall rating remains a “Hold”); however, SA Authors are still bullish on Upstart.

Seeking Alpha Quant Rating

Seeking Alpha Quant Rating

While I utilize SA’s Quant Rating system in TQI’s Quantamental Analysis process as a quick check on factor grades (quantitative data) to guide entry points, I don’t always agree with it for long-term buys (especially in the case of mispriced, early-stage companies). As a long-term investor, I am happy to be a buyer when quantitative and technical data is negative (bearish) [as long as the fundamentals justify the long position]. In the past, I have shared my thought process around bad technicals being the best time to take long-term positions [Meta Platforms: Bad Technicals Are A Boon For Long-Term Investors], and this idea applies to quant factor grades too.

Upstart's Technical Chart

WeBull

As you can see, Upstart’s technical chart is completely broken. While we may see some buying at the IPO price of $20, I don’t think there is any support zone left to be broken. The technical trend for Upstart is clearly bearish; however, with an RSI of 31, Upstart is nearly oversold, and its MACD indicator is turning flat (potential to turn up from a highly negative value). Hence, we may be close to a bottom (at least a tradeable one).

Is Upstart Stock Undervalued Now?

To find the fair value and expected return of Upstart, we will use TQI’s Valuation model, which is a simplified discounted cash flow model, with the following assumptions:

2022E revenue (ultra-conservative estimate) $900M
Forward 4.5-Yr Revenue Growth Rate (%) 30%
Terminal Growth Rate (%) 3%
Optimized FCF Margin (%) 35%
Discount Rate / Required IRR (%) 15%
Exit Multiple [P/FCF] 15-25x

Results:

Upstart's Fair Value

TQI Valuation Model (Author)

Under TQI’s required IRR [discount rate] of 25% (for moonshot growth investments), Upstart’s fair value came out to be ~$5.74B ($60 per share). With the stock trading at ~$24, it is currently trading at a significant discount to its fair value. Clearly, the pendulum has swung too far.

Where Is Upstart Stock Heading?

To find an appropriate exit multiple for Upstart, I don’t think an investor needs to look beyond Fair Isaac Corporation (FICO), the business Upstart is trying to disrupt. As you may know, FICO scores have become the industry standard for credit underwriting in the lending markets. Over the years, FICO has traded at a P/FCF of 5-50x, which is a wide range. However, I think the 10-yr median P/FCF of ~24x would make a lot of sense for Upstart.

FICO trading multiples

YCharts

Just to be conservative, I used an exit P/FCF multiple of 20x for my base case projections, and with this assumption, I see Upstart trading at ~$18B in market cap by the end of 2026 [685% higher than current levels].

Upstart's expected return (price target)

TQI Valuation Model (Author)

Furthermore, Upstart’s management could deploy its free cash flows to drive shareholder returns even higher. Assuming Upstart deploys 50% of its (optimized) free cash flows in stock buybacks over the next 4.5 years, Upstart’s stock could generate returns of 855% (~9-10x of the current price).

Upstart buybacks to drive alpha

TQI Valuation Model (Author)

Even if Upstart were to trade at ~5x P/FCF in 2026 at the lower end of FICO’s historical multiples [in a bear case scenario where Upstart’s AI-based credit underwriting fails to outperform FICO], an investor buying today would generate a return of 199% (with buybacks) and 96% (without buybacks) over the next 4.5 years. At these levels, the risk/reward in Upstart is clearly in favor of long-term investors.

Concluding Thoughts: Is UPST Stock A Buy, Sell, or Hold?

Debt markets are cyclical, and Upstart’s business is inherently volatile due to its dependence on lending partners. Hence, Upstart investors will need to get accustomed to business volatility and wild swings in its stock. If you are not on board with these sorts of fluctuations, I don’t think Upstart is a suitable investment for you.

Despite Upstart being a tech company, it cannot be valued as one due to the nature of its business. And I have learned this the hard way (losing a lot of money on the stock). As an early-stage investor, I am willing to accept the volatility inherent to Upstart’s business as its disruptive AI-based credit underwriting has the potential to create a paradigm shift in the consumer lending space. With a virtually infinite TAM, Upstart’s management can build a large and profitable business worth tens of billions of dollars.

Upstart Q1 Earnings Presentation

Upstart Q1 Earnings Presentation

Yes, Upstart’s executives have made some mistakes, but their decision to tighten up the belt and focus on profitability over volumes is the right way to go in the current market environment. I like the fact that Upstart is being managed with a focus on long-term sustainability over short-term stock price fluctuations. Upstart’s management has acted naively in recent months in my opinion, but I think they can get their act together and win investors’ and Wall Street’s trust once again in due time.

Credit is the bedrock of the American economy, and we can be sure that debt markets will come back (as they did after the Great Financial Crisis). Upstart will come back stronger at the other end of this cyclical downturn, and I say so with utmost confidence based on Upstart’s accumulation of new lending partners even during this tumultuous period.

Investors will need to be patient, but a long-term investment from current levels is likely to be rewarded handsomely. Due to the sheer conservatism of my model, I believe that Upstart offers incredible returns from current levels with a spectacular margin of safety. And this is why I think Upstart is a generational buying opportunity for long-term investors at $24 per share ($2.29B in market cap).

Sell when others are greedy, Buy when others are fearful

– Warren Buffett

I missed the selling part when Upstart was flying high (and I was up 400%+); however, now that there’s so much fear, I am working on getting my cost basis down. My hedge at $48 is set to help me to bring my cost basis down to $39 in August (from ~$78). Over the coming weeks and months, I will continue to monitor Upstart and look to add on deep red days. The goal is to reduce my cost basis by taking advantage of a panicked market. I am still long on Upstart and will hold my shares (at least) until 2026.

Thanks for reading, and happy investing. Please share your thoughts, questions, or concerns in the comments section below.

Key Takeaway: I rate Upstart Holdings Inc. a strong buy at $24.

Housekeeping Note: I’ll soon be launching a Marketplace service on Seeking Alpha focused on generating long-term outperformance through financial engineering. While “The Quantamental Investor” won’t be live until early September, we are already building an exclusive (and free) community for retail investors at TQI Network. You can find more details in my profile bio. Stay tuned for more updates!

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