Upstart (NASDAQ:UPST) continues to be challenged by a weakening macroeconomic environment and rising rates environment as a company in the lending business. However, as will be explained in the article below, I think that Upstart continues to look attractive fundamentally as the business has seen improvements even as the credit market remains weak. I think that the risk reward perspective for Upstart remains attractive for long-term investors. Upstart has a superior artificial intelligence model and technology, bringing a strong competitive advantage to Upstart over peers. Also, the use of its balance sheet tactically remains to be a necessary move to adapt to the changing market environment. Even as the environment remains challenging, Upstart continues to add new partners to its platform, increase the use of automation in the business and see momentum in its new business segments.
Subscribers to my marketplace service, Outperforming the Market, benefited from Upstart as a key holding of The Barbell Portfolio as Upstart has contributed 41% returns to subscribers. I will be posting an Upstart deep dive article on the service next week. I have written other articles on Upstart that can be found here.
Loan volume and revenues down
Revenue was down in the third quarter of 2022 as a result of the lower loan volume on Upstart’s platform and due to increasingly cautious and dislocated credit markets. As a result of the higher interest rates we are seeing today, as well as growing macroeconomic risks lingering, Upstart approved 40% fewer applicants than they would have approved compared to 1 year before as well as 800 basis points increase for those applicants whose loans were approved in the recent quarter.
I think that investors in Upstart have to realize that cyclicality is part of the platform given that Upstart is in the lending business. With rising rates, this typically leads to lower lending volumes for all companies in the industry and Upstart is not spared from this. At the end of the day, lending partners tend to increase their rates or reduce their originations during this stage of the credit cycle to ensure that they remain prudent given changing economic conditions. As a result of the current high interest rate and relatively uncertain macroeconomic environment, this led to lenders and investors assuming a higher expected loss rates and expecting higher yields respectively. This in turn led to reduced loan volumes for companies like Upstart. At the end of the day, when looking at the longer term since 2018, loan portfolios powered by Upstart have continued to meet and exceed expectations.
Improving operational efficiency for long term investment
In the current macro backdrop, the company seeks to improve unit economics by reducing marketing spend and increasing its revenue per loan. Upstart also reduced 7% of its workforce, mostly in the loan operations team as a result of the lower loan volume on the Upstart platform to ensure that operating efficiency is maintained. Furthermore, hiring remains relatively limited to positions that are regarded as strategic to the Upstart platform. In addition, Upstart is calibrating its fiscal and operational plans in the near-term to ensure that the company remains solid and can bounce back once this cycle is over.
Improvement in the models
As a result of changing market conditions, Upstart is continually adjusting its risk models. I like that management continues to take a conservative position about the health of the economy in the next few quarters, assuming that we have not yet seen the worst. This conservatism ensures that positive upside is possible in the scenario where things turn out better than expected.
Management also claimed in the third quarter 2022 call that the higher default rates as a result of a weaker economy is helping the company train its AI models even faster. To be specific, the accuracy of the AI models has reached its highest level relative to a traditional FICO based model in the quarter and the model accuracy increase that Upstart saw in the past 4 months was equivalent to what management saw in the past 2 years. I think that what this means for Upstart is that during this challenging time, as Upstart continues to invest in and improve on its AI models, it has resulted in not just rapid progress, but also improved model accuracy. I think that through this down cycle in the credit markets, when others are turning away to super-prime consumers, Upstart can leverage on this to improve on its competitive position to serve mainstream Americans in varying market conditions. Over time, Upstart’s super AI models will then lead to the company being a leader in AI-enabled lending.
In the recent quarter, Upstart has also developed what it calls the Upstart Macro Index or UMI, which is meant to indicate how economy is doing, especially with regards to credit performance as well as consumer financial health. UMI should help predict the default rates expected given the current state of the economy. If UMI is indeed accurate and useful for lenders, this could be another value add to the Upstart platform to help lenders respond quickly to changes in the expected default rates.
Lastly, Upstart continued to work towards improving user experience and increasing automation on its platform. In the third quarter of 2022, it reached a new record of 75% of its loans being fully automated. This improvement came as the company made several improvement efforts to help accelerate approvals to improve the level of automation in the process.
Conservatism in the models
I am of the view that the conservatism that the company is taking with the near-term estimates and expectations is one taken out of prudence and will lead to a possible outperformance given the pessimistic outlook priced in.
Based on the latest earnings call, Upstart CFO Sanjay stated that their models are pricing loans with an expectation of a further worsening of the macroeconomic environment. As a result, this expectation drives Upstart’s near-term revenue and earnings guidance as well as loan volume assumptions.
In the near-term, I am of the view that the outlook for Upstart could remain aligned to the trends in the macroeconomic environment. Without any clear signs that the macroeconomic environment is improving, loan volumes could remain relatively weak in the near-term. That said, I think that Upstart is well positioned if the credit market shows improvement as it has been investing and improving its platform and the accuracy of its models that will drive outperformance in the long run.
Continued momentum in new partners to the platform
In the quarter, Upstart continued to bring in 17 new lenders into the Upstart platform, which includes Alliant Credit Union, one of the top 10 credit unions in terms of asset size. In comparison, in the whole year of 2021, Upstart added 17 lenders to the Upstart platform. As a result, I think that there is certainly caution and prudence in the financial sector today and that is certainly justified. However, the fact that Upstart continues to add new lenders to the platform in a challenging period helps set a strong and solid foundation for the future. As a result of the new 17 lenders added to the platform, the company currently has 83 lenders in the Upstart platform.
New business updates
Upstart continued to see its new businesses progress and gain momentum. In its auto refinance business, the company launched a new and more accurate model that helps to identify loan payoff amounts with better predictive abilities. The company also adjusted their income verification models and improved the whole process of reviewing registration cards. With these upgrades in the quarter, the company saw an improvement of 20% to its auto refinance conversion funnel.
For its auto retail business, the company had its largest software release of 2022. The software is now used at more than 700 dealers and the company has included 3 more dealer groups for retail lending, and in total, Upstart now are in 25% of the US auto market in terms of population. Lastly, about a third of auto loan applications were verified automatically, twice the amount from the previous quarter.
Lastly, for small business loans, Upstart reached $10 million originations in loans as of the third quarter of 2022, up from $1 million in the second quarter of 2022. The small business loans team continues to look to improve the product, and this looks to be setting up well when the markets and economy normalizes, in my view.
I used a DCF model to derive Upstart’s target price. I forecasted Upstart’s financials 5 years forward and assumed cost of equity of 17%. The higher cost of equity is a result of the rising rates environment. I also lowered my 2023 estimates due to my expectation of a weaker first half of 2023, although this could surprise to the upside if the economy does not tip into a recession.
Using these assumptions for my DCF model, my 1-year price target for Upstart is $38.20, implying 125% upside potential from current levels. While I think that the near-term performance of Upstart is linked to the performance of the economy, I think that most of the negatives have been priced into the stock. Given that even the pricing of the loans by Upstart has already incorporated this pessimism, I think that the downside for the company is somewhat limited. Furthermore, the company continues to invest for the long-term and improve on its AI models, as well as improve on its new businesses. I continue to think the risk reward perspective is attractive for long-term investors able to ride out a recession and benefit from the strong bounce in the credit market once things stabilize.
Upstart’s performance is tied to the macroeconomic environment and a weakening macroeconomic environment could result in weaker business performance for Upstart. Given that Upstart is ultimately in the lending business, a poor economic outlook and rising rates could dampen demand for credit and result in a fall in loan volumes. At the end of the day, the cyclical nature of the industry is one that an investor needs to be able to stomach, but there are risks that the economy could become weaker than expected, which would bring further downside to Upstart.
Upstart continues to be well positioned as a leading platform with the use of AI models and technology as a strong competitive advantage. That said, there are other peers that could also threaten its positioning by investing resources into improving their own AI models to be able to compete with Upstart. At the end of the day, the superior and more accurate model wins. As a result, Upstart needs to continue to innovate and improve its models to ensure that it has the most resilient and accurate model in the market.
At the end of the day, Upstart is exploring new business segments, and this could bring along some execution risk if Upstart is unable to execute well in its other segments. As evident from recent times, changes in the macroeconomic environment require adjustments to the models and this applies across the segments that Upstart operates in. It needs to ensure that execution across segment is strong to continue to gain market share.
Based on an evaluation of the third quarter results, I think that we need to separate cyclicality from fundamentals. Fundamentally, Upstart continues to see its business improve even in challenging times. The company continues to add new partners to the platform at record rates, the company continues to improve model accuracy to record levels and the company continues to see momentum in its new businesses. Unfortunately, cyclicality affects the financial sector and Upstart is not spared. With its positioning in the market, Upstart is experiencing a reduction in loan volumes as a result of increasing prudence from banking partners, higher rates and an expectation for a worsening macroeconomic environment. This too shall pass, and I think that the company is well positioned for growth once the tide turns. My 1-year price target for Upstart is $38.20, implying 125% upside potential from current levels.