It's usually best to get ahead of bad news. That seems to be the approach the artificial-intelligence lender Upstart (UPST 3.39%) is taking after announcing some preliminary second-quarter earnings numbers ahead of schedule and telling investors to brace for results that will be well below expectations.
Shares of Upstart are down more than 17% in after-hours trading on the heels of the news. Is the stock a buy, now that it's trading near all-time lows?
Upstart said it expects revenue for the second quarter to come in at around $228 million, far lower than the $295 million to $305 million the company initially guided for. Furthermore, Upstart told investors to expect its contribution margin to come in around 47%, which is more than the 45% it had guided for.
The company now expects to report a loss of between $27 million and $31 million. Previously, Upstart had expected to either break even or report a loss of as much as $4 million. As Dave Girouard, CEO of Upstart, said in a statement:
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.
Upstart originates personal and auto loans with the belief that it can assess the credit quality of borrowers better than traditional methods like Fair Isaac's FICO scoring. It then sells the majority of those loans to whole-loan buyers or institutional investors, who often securitize the loans. Upstart does this in order to get the loans off of its balance sheet and keep funding new originations.
With the economy seeming to be heading for recession and interest rates rising aggressively, investors are a lot less willing to invest in and take on Upstart loans -- especially those to borrowers at the lower end of the credit spectrum. Their cost of funding has gone up and there's more likelihood borrowers will default in a down economy.
By converting loans to cash, it looks like Upstart took a loss on loans it had been holding on its balance sheet, which spooked investors when the company disclosed this information in its first-quarter earnings report. Analysts and investors want Upstart to run a capital-light operation and not take on actual credit risk from borrowers.
Meanwhile, Upstart's CFO Sanjay Datta said Upstart-powered loans being held by banks and credit union partners are still performing well and delivering returns in line with or above expectations. For non-bank loan investors, Datta said vintages from 2018 and 2020 have significantly outperformed, while 2021 vintages are within 1% of the company's loss expectations.
"We believe our models are well calibrated to economic conditions and are currently targeting returns in excess of 10 percent," Datta said.
Is Upstart stock a buy?
While the fintech stock, which at one point last year traded for $390, has come crashing down to below $28, I'd avoid buying shares of Upstart right now. Noone is sure how long the funding issues will last, and even if they clear up, investors are likely to demand higher returns, which will slow overall origination volume.
Investors aren't going to be willing to take on Upstart-powered loans made to borrowers with weaker credit any time soon, which is what enabled Upstart to really increase origination volume in prior quarters. All of this should lead to much lower origination volume this year than investors anticipated, and therefore lower revenue.
Furthermore, Upstart needs to prove its fundamental thesis of being able to better underwrite loans. Sure, its earlier vintage loans have done well, but those were made when the government was pumping lots of money into the economy, largely propping up borrowers. Upstart-powered loans being held by credit union and bank partners are likely made to mostly higher-quality borrowers.
I would like to see how 2021 vintage loans and those made this year hold up in the current environment. Until then, I'm staying away from the stock.