The artificial intelligence lender Upstart Holdings (UPST 2.21%) suffered the worst setback of its public life on Monday when the company reported first-quarter earnings results and lowered its revenue guidance for 2022. In today's investing climate, there is very little room for mistakes and the market can be unforgiving. Around midday Tuesday, Upstart's stock was down roughly 60% and trading around all-time lows. After peaking close to $400 per share last October, the stock is now hovering around $31 per share.
Is Wall Street being too harsh? Does this huge crash present investors with a buy-the-dip opportunity? Let's take a look.
Understanding the lower guidance
After beating earnings estimates for the first quarter, Upstart trimmed its revenue guidance for 2022 from $1.4 billion to $1.25 billion. The company also lowered its guidance for adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) margin, while slightly raising its contribution margin projections for the year. It's also unclear if Upstart will hit the $1.5 billion auto loan origination target it set earlier this year.
What's driving all of this? Well, Upstart, which uses technology and artificial intelligence to better assess the credit quality of borrowers for financial institutions and other investors, is no longer expecting the same kind of loan transaction volume it did a few months ago. The main culprit, according to management, is rising interest rates, which are wreaking havoc on several parts of the business.
High inflation, lots of economic uncertainty, and the Federal Reserve's aggressive monetary policy -- which has already involved raising its benchmark overnight lending rate by three-quarters of a percentage point this year -- have led investors to get very pessimistic about the state of the economy.
Investors worry there could be a recession and that consumers may have trouble repaying debt down the line. Upstart is in the business of originating unsecured personal loans and auto loans. This kind of consumer debt is often the first that consumers stop paying when they run into financial trouble. Furthermore, Upstart originates loans to a range of borrowers across the credit spectrum, making a certain portion of its borrowers extremely risky. Upstart has already seen default rates normalize, which management attributes to the fading benefit of government stimulus.
All of this has led investors that actually fund and take on Upstart debt to get more selective about what kind of risk they take on, and also request higher returns for taking on that risk. Rising rates also increase funding costs for Upstart's partners. CEO David Girouard said all of this essentially gets passed to the borrower and has led to average pricing on Upstart's platform to increase by 3%, which can be a lot of extra interest for a borrower. This might lead to an applicant deciding not to move forward with a loan.
In addition, loans that may have qualified for a certain investor's risk appetite based on their specific risk criteria may no longer qualify. As a result, Upstart expects to see less transaction volume for loans than it initially anticipated, as well as a lower overall conversion rate.
Issues with funding partners
Another huge red flag in the first-quarter report was the fact that Upstart significantly increased the number of loans it was holding on its balance sheet from about $252 million at the end of the fourth quarter to close to $600 million at the end of the first quarter. Now, most of these loans are new auto loans, which are essentially in research and development before being sold to investors. But a small portion of those loans were supposed to be sold to funding partners. Upstart runs a marketplace model, so it doesn't want to hold any loans on its balance sheet that it doesn't have to. It wants to run a capital-light business and also not have to take on any credit risk.
It looks like Upstart had to hold these loans due to funding drying up among some of its institutional investors in the capital markets during the quarter, as investors try and determine their new risk appetite, given the macro headwinds. Here is how Upstart's CFO Sanjay Datta described the situation:
And so when interest rates smooth and investors are ... deciding what their new return hurdles are, there can be a gap or a delay in responding to funding. And that's a situation where we've chosen to sort of step in with our balance sheet and almost sort of bridge to the new market-clearing price. And as that is happening often and abruptly, we've been sort of playing that role with our balance sheet.
Datta said he thinks the situation is temporary and the goal is to create more of an automated system for its partners in the capital markets, so they can adjust their risk premiums and appetite for certain risks more fluently.
Buy the dip?
I will not be buying the dip on this fintech stock right now. While it's hard to know the Fed's path on interest rate hikes, it is expected to continue raising them as the year progresses, which could exacerbate or at least continue some of the funding issues Upstart saw in the quarter. Higher interest rates could also continue to put a dent in transaction volume, making new revenue guidance hard to achieve as well.
Additionally, while consumers are still relatively healthy right now, they face a much more difficult economic backdrop in the future, as their savings continue to wind down and inflation remains high, which could lead to credit trends worsening. Finally, it's not good to see funding issues on the institutional side, which has led Upstart to hold loans on its balance sheet. Even though management says it's temporary, which it may be, I am not taking that risk in this environment.