4 red flags for the future of Upstart Holdings

Upstart Holdings(UPST 9.62%) the stock price fell 12% on August 9 after the online lending company released its second-quarter earnings report. Revenue rose 18% year-over-year to $228 million, but beat analyst estimates of $7 million. Its adjusted net income plunged 98% to $1 million, to $0.01 per share, which also missed the consensus forecast of $0.07.

Its adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) fell 91% to $5.5 million. Under GAAP (generally accepted accounting principles), it posted a net loss of $29.9 million, compared to net profit of $37.3 million a year earlier.

Those numbers were disappointing, but they had already been partly telegraphed in its July 7 preliminary earnings report. And a deeper dive reveals four more red flags.

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1. Upstart management has a gloomy outlook for the third quarter

For the third quarter, Upstart expects revenue to decline 25% year-over-year to $170 million, while analysts had expected growth of 8%. It also expects to post an adjusted net loss of around $9 million and its adjusted EBITDA to break even.

Again, Upstart primarily blamed rising interest rates, which caused people to take out fewer loans through its platform while prompting its lending partners (banks, credit unions, and car dealers) to take a more prudent to finance these loans.

2. Upstart questions its own business model

Upstart initially attracted a lot of attention for two reasons. First, it analyzes non-traditional data — including a client’s educational background, field of study, standardized test scores, and employment history — with an artificial intelligence (AI) platform. cloud-based to approve loans.

Second, Upstart offers a wide range of loans on its website, but generally does not fund them from its own balance sheet. Instead, it acts as a middleman for its lending partners, who then fund the actual loans and pay Upstart fees to access its platform.

This business model exposes Upstart to less credit risk, but it also creates a bottleneck by making it dependent on its lending partners for new loans. To overcome this bottleneck, CEO Dave Girouard abruptly announced during the second quarter conference call that the company would begin to “leverage its own balance sheet as a transition bridge to this committed financing.”

It’s a risky move, as Upstart already ended the second quarter with a high debt ratio of 1.5. It still held $790 million in unrestricted cash, but that cash could quickly dry up as revenue growth slows and its losses mount.

Girouard said that while it “doesn’t make sense for Upstart to become a bank,” it needed to “upgrade and improve the funding side” of its market as interest rates rise. In other words, management is beginning to question the resilience of its own business model.

3. Upstart Sees Lower Loans and Conversion Rates

The number of loans to Upstart’s banking partners increased 12% year over year to 321,138 in the second quarter, but still fell 31% sequentially from the first quarter. Its conversion rate, or the percentage of its total applications that are converted into actual loans, was only 13% compared to 24% a year earlier and 21% in the first quarter of 2022.

These declining commitment rates are why Upstart is so desperate to fund its own loans. They also suggest that its smaller competitor, Pagaya Technologies (PGY 2.83%) — which provides comparable white-label AI services to financial institutions instead of acting as an intermediary platform for loans — could take a smarter long-term approach.

4. Management initiated unnecessary buybacks

As Upstart faces a grueling downturn, takes on bigger losses and takes on more credit risk, it’s also buying up more shares. In February, he announced a $400 million buyout plan. It did not repurchase any shares in the first quarter, but it repurchased for $150 million in the second quarter.

These buyouts are arguably a waste, as all that money could have been used to fund his new loans, reduce his debt, or simply expand his platform. Upstart repurchased 4.4 million shares (at an average price of about $34), but its weighted average number of diluted shares outstanding was down only 1% sequentially and actually increased by 1 % year over year to reach 94.5 million.

Consequently, Upstart is likely using these buybacks to offset the dilution of its stock-based compensation expense, which jumped 86% year-over-year to $55.4 million in the first half of 2022. instead of returning this money to investors by reducing its float.

Upstart deserves to stay in the penalty area

Upstart shares may look reasonably priced at three times this year’s sales, but that price-to-sales ratio is still tied to analysts’ expectations for 12% revenue growth this year. These estimates could be reduced after the disappointing report from Upstart in the second quarter. For now, she deserves to stay in the penalty box until she stabilizes her core business.

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