After the artificial intelligence lender Upstart (UPST -0.64%) told investors last month to prepare for weak revenue and a wider-than-expected loss in the second quarter, you would have thought that the worst was behind the company. But shares tumbled again after the company reported full results from the second quarter after the market closed Monday. Upstart guided for revenue in the third quarter that is significantly lower than what analysts had been expecting, along with a few other surprises. Is it finally time to abandon this once high-flying stock? Let's take a look.
Why guidance is coming in lower
Upstart now expects to generate revenue of $170 million and a net loss of roughly $42 million in the third quarter ending Sept. 30. Analysts had been expecting revenue of nearly $249 million and a profit of $0.24.
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The slowdown of revenue is a continuation of struggles the company has experienced as a result of the intense rising interest rate environment. Unsecured personal loans originated through Upstart's platform are either purchased by whole-loan buyers; bundled into asset-backed securities, which are sold to investors; or funded by banks and credit unions and retained on their perspective balance sheets. The bulk of Upstart's loans are purchased by whole-loan buyers or securitized, funding outlets that have really dried up in recent months, as explained by Upstart's CFO Sanjay Datta on the company's recent earnings call.
"Despite not having suffered any adverse loan performance, some banks are moving to limit their overall exposure to unsecured lending," Datta said. "Investors who've earned significant excess returns over the benign cycle over the last few years are now anxious over the state of the economy and wary over the future prospects of less affluent borrowers, who have been most impacted by the termination of the stimulus."
On the institutional side, concerns about credit quality, the economy, and a higher cost of capital to fund loan purchases have led investors to pull out of the market and request higher returns from asset-backed securities. This results in higher interest rates being passed on to Upstart borrowers, which can lead to less loan demand.
Other surprises
Upstart largely makes money from fees when loans are originated through its platform, so the revenue shortfall is a result of lower origination volume of unsecured personal loans, Upstart's main product right now. The number of loans originated in Q2 fell 31.5% from the first quarter and total transaction volume was down 28.7%.
While I expected institutional loan purchases to be down, I was a little surprised to see such a drop-off in loans funded by bank and credit union partners. Total loans funded by this group fell 20.6% from Q1 and transaction volume declined 15.2%. Banks and credit unions are generally originating loans through Upstart's platform to higher-quality borrowers and can fund loans with deposits, which are a cheaper source of capital. Rising interest rates will increase the cost of deposits, but not as much as the other types of funding that institutional investors are using and there is a lag.
Credit has also held up very well among prime and super-prime borrowers so far and Upstart has added almost 30 bank and credit union partners in the first half of 2022. But the decline in funding from bank partners shows that small financial institutions tend to be quite conservative.
Upstart management also mentioned it is likely going to put more loans on the balance sheet in the near term, due to funding issues and the fact it has $790 million of cash. As you may recall when Upstart announced it was putting loans on its balance sheet in Q1, investors panicked and the stock fell close to 60%. Upstart's investor base has never liked this approach because it doesn't want the company to take on any credit risk and wants it to remain capital efficient and pump out as much loan volume as possible.
Is it time to abandon Upstart stock?
After falling from nearly $400 per share in October to less than $30 per share as of this writing, Upstart's valuation is a lot more attractive. But as I've said many times in the past, I still do not view this stock as a buy. I see far too many holes in the business model. The company is way too reliant on the capital markets and clearly not well positioned to deal with a rising interest rate environment. Management now wants to change its funding model by securing more funding in advance for longer periods of time so it is not so beholden to rapidly changing economic conditions and investor sentiment.
But this will take time to implement. Upstart will also likely have to give better terms to these investors for fronting money in advance, meaning less attractive margins for the company. It is very unclear right now if this strategy can be successful -- I guess it depends on how much capital the company can raise at one time.
I am also concerned about the drop-off in bank and credit union-funded loans. A big part of the Upstart thesis is getting its partner banks to get rid of Fair Isaac's FICO credit scoring requirements and use Upstart's proprietary credit underwriting algorithms instead. The decline in the quarter doesn't reflect well on this. I continue to believe that small financial institutions are too conservative to ever originate enough loans at scale to borrowers lower on the credit spectrum. For all of these reasons, I would recommend abandoning the stock until it can show that it has significantly improved its business model.
