After a very difficult year in 2022 for the artificial intelligence-assisted lender Upstart (UPST 0.55%), more pain is coming.
The company announced in a regulatory filing this morning that in its latest reorganization efforts to get back to profitability, it will lay off 365 employees, or roughly 20% of its workforce. (Upstart laid off 140 hourly employees in November.) It will also put the build-out of its small-business lending product on pause until conditions improve.
The Federal Reserve's intense interest-rate hikes have really knocked the wind out of the company's sails after a massive year in 2021 that saw Upstart reach close to $400 per share. With the stock currently below $19, what does this latest reorganization mean for Upstart's future?
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Expect struggles for most of the year
The new reorganization will result in $15 million of charges and a one-time $3 million noncash charge due to forfeited stock awards. But the layoffs are expected to generate $57 million of savings in operating expenses and noncash savings of $42 million related to stock-based compensation over the next three years.
In the near term, I would expect Upstart to continue to struggle for the majority of the year. The company is largely in the business of originating personal loans and auto loans to near-prime consumers, using proprietary algorithms to underwrite customers who might not normally be able to get a traditional bank loan or a traditional interest rate.
The company then sells the majority of its loans to institutional investors, while a smaller portion is sold to banks and credit unions. Fees from selling the loans are the company's main revenue source.
As the Fed has raised rates, institutional loan buyers have seen a higher cost of funding that is tied to the Fed's benchmark overnight lending rate, the federal funds rate. This in turn leads them to request higher returns on Upstart loans, which creates several problems.
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Key Data Points
Higher interest rates are going to naturally create less borrower demand to some extent, because some people won't borrow at higher rates and others will no longer qualify.
Upstart can reprice its loans higher, but there is a lag in timing. First, the Fed moves rates higher, then credit card companies raise their annual percentage rates, and then personal lenders (which typically refinance credit card debt) can follow suit. However, the Fed has moved so fast and aggressively that while Upstart has likely done some repricing, it has not been enough to keep up with funding costs.
The other issue is that many economists expect the U.S. to tip into a mild recession sometime this year, and high inflation has really cut into the financial health of many Americans, particularly in the near-prime space. So institutional investors likely have concerns about credit quality. As Upstart noted in its filing this morning, "many lenders and credit investors have significantly reduced or paused loan originations."
While most personal lenders are dealing with these headwinds, Upstart is uniquely challenged because it doesn't have access to cheaper funding sources like deposits. In the third quarter, Upstart reported a 31% drop in revenue from the prior quarter and a $56 million loss.
Can the company recover?
Once the Fed stops raising interest rates, which could happen in the first half of this year, that should allow Upstart to eventually reprice its loans better to meet investors' return thresholds.
Investors will also want more clarity about the trajectory of the economy, but I could see the marketplace for these personal loans returning to better levels in the back half of the year.
Over the longer term, however, Upstart really needs to address big parts of its strategy. The first is the funding model, because as we've seen over the last year, relying on investors to buy all of your loans can be a very cyclical and volatile strategy.
Upstart also needs to do a better job of showing how well its superior underwriting models work. I do think the company has shown some evidence of outperforming traditional models, but I don't think it's been enough to really win over the market yet.
