Upstart Crushed Wall Street Expectations. Why Is Its Stock Down?

Upstart (UPST 3.90%) went from taking little credit risk to a lot of credit risk, and the market responded. In this clip from "3 Minute Stocks Updates" on Motley Fool Live, recorded on May 25, Motley Fool contributor Brian Feroldi discusses Upstart's metrics, and what investors should keep an eye on.

Brian Feroldi: Man-oh-man, did this company have a bad day when they reported earnings. Shares absolutely collapsed and they are down enormously from their recent highs. Let's get into the details here because there's actually quite a bit to talk about. Here are the headline numbers. Revenue growth, 156% to $310 million, easily exceeding Wall Street's guidance and management's guidance. Earnings-per-share up 177% on an adjusted basis to $0.61. Again, easily exceeding Wall Street's guidance and management's target. Top-line numbers look absolutely fantastic. The rest of the financial numbers were OK. Contribution margin is up to 47%. Side note, this company does not allow you to calculate gross margin. They give you a contribution margin and basically say, "trust us, this is what it is," not something I like. Net income was $33 million, however, free cash flow negative, $270 million in the quarter. The balance sheet now looks OK. It used to be much better, but it's in OK shape. More to say about that in a little bit. A company's non-financial metrics though looked pretty good. The loan origination volume was up, transaction volume was up. The number of banking partners they have was up. Their car dealership business, a brand-new lane for them, that was up. Revenue was up. The numbers looking backwards were pretty good. Defaults actually continued to be doing OK. I really like this chart here. This takes a couple of seconds to explain. On the left-hand side is the FICO score, what Upstart is trying to displace. On the top is Upstart's proprietary grade. You see here the FICO score says 700 and above is perfect. What this shows is that Upstart, even though somebody has a 700 above FICO score, if they give somebody an E- in this grade, their default rate is 9% whereas their A-pluses, Upstart saying yes, their default rate is 0.5%. Upstart is basically saying, these are the consumers that you want, despite what their FICO score is, is having much better results than using the old traditional FICO score radio. They're really proving out the whole point of our model, which is our model is more accurate and more predictive of who is going to pay us back so this was really good to see. Now, a couple of things really took the wind out of this company's sales. First was guidance moving forward that the demand market is weakening. No surprise given the rise in interest rates. They only guided for 54% revenue growth next quarter, way below what Wall Street was expecting moreover for the full-year. Upstart just basically two months ago said we're going to do $1.4 billion in revenue this year. Now they're saying we're going to be $1.25 billion this year, market does not like that, but let's talk a little bit of that negative free cash flow for a little bit because that was the one that was really concerning. This company typically mix alone has it's on its balance sheet for literally seconds and then sells it to one of its banking partners. Some of the loans it keeps for itself is basically an R&D to prove out that its balance sheet, to prove out that its model is working, so it assumes the credit risk. However, that's only a minority of the company's loans. This quarter, the company's number of loans that it held ballooned. Hence, why there was a huge outflow in free cash flow. Why are they doing that? Because they are testing out their model in newer markets such as the auto dealership market. Some of their lending partners didn't want to take on those loans immediately. Upstart essentially funded itself. That moved the company in essentially a quarter from where a fintech company to world bank. All of a sudden credit risk, not a problem before, or at least a small problem before to all of a sudden, watch out that freaked investors out. That's a big reason why shares sold off. Management is aware of what is happening and they are going to be adjusting to it but that is certainly something for investors to keep an eye on. I think the guidance reduction makes sense given how bad the macro environment has deteriorated over the last couple of months. But the fact that this company went from taking very little credit risk, to taking a lot of credit risk, really spooked the market.