The artificial intelligence-assisted lending technology company Upstart (UPST -0.58%) recently reported its fourth-quarter results, and while the figures beat analysts' consensus estimates, they were anything but reassuring.
One fact in particular that caught my eye is that the company now has roughly $1 billion of loans on its balance sheet. Holding debt in this way was never part of the plan under Upstart's business model, but as capital markets have dried up, it has found itself in this new position. Should investors be worried?
Why is Upstart holding more loans?
While it is common for banks to hold some of the loans they make on their balance sheets, Upstart is not a bank, and management has made it very clear they have no intention of pursuing a bank charter. Rather, Upstart views itself as more of a high-growth software-as-a-service (SaaS) business and a loan marketplace.
Image source: Getty Images.
The goal for the company is to assess would-be borrowers' credit quality and underwrite loans more efficiently than traditional methods so more non-prime borrowers can access traditional financial products. Upstart's main revenue source is the fees it charges on personal loans facilitated through its platform, so its goal from a revenue standpoint is to generate as much loan volume as possible. Those loans come from banks and credit unions using their own balance sheets to fund Upstart's loans or when the company sources the loans itself and then sells them to institutional investors.
As interest rates have soared, funding costs have risen for institutional investors too, leading them to demand loans that yield more so they can still make their desired returns. Meanwhile, credit quality among Upstart's loans has started to slip as Americans' personal savings have dwindled and the macroeconomic outlook has worsened.
On the company's Feb. 14 earnings call, Upstart Chief Financial Officer Sanjay Datta noted that "as we exit 2022 and enter a new year, consumer delinquencies remain elevated, and the funding markets remain limited in their appetite for risk."
Upstart reported $147 million in revenue in the fourth quarter and a bottom-line loss of more than $55 million. For its current quarter, management is only guiding for $100 million in revenue as loan funding continues to be pressured.
Cash burn is accelerating
Because funding from external investors and financial institutions has dried up, Upstart has started using its own balance sheet to fund loans. The loan balance on its books has topped $1 billion -- up from around $252 million at the end of 2021. Meanwhile, the amount of cash on the books has fallen from nearly $987 million to just over $422 million.
Of its roughly $1 billion in loan balances, about $492 million are for what the company refers to as "research and development loans" -- mostly for the auto loan product the company has been testing. But the remaining $518 million is for personal loans the company likely couldn't find anyone to purchase due to the recent economic conditions.
This adds some risk for Upstart. If the macro outlook deteriorates more than expected and loan defaults pile up, the company would have to eat those losses. That would result in it burning through more cash than it planned for, and could potentially leave it in dire straits.
It's a risk
Datta said on the earnings call that Upstart is "now roughly at the maximum size of balance sheet that we are planning to maintain, and we will, therefore, largely limit new additions to the balance sheet until we can find suitable sources of liquidity for existing loans." He added that the company will continue to look to sell loans as the market opens up.
With the Federal Reserve easing on the magnitude of its interest rate hikes, companies like Upstart will likely have an easier time selling loans to investors. But the big risk is the possibility that conditions in the capital market don't get better. What if high inflation remains persistent and the Fed is forced to raise rates higher than expected or keep them higher for longer? What if the U.S. economy cools too far and slides into a recession? That, too, could lead to an increase in borrower defaults.
Inflation has shown signs of easing, and the Fed is expected to stop raising rates at some point this year, but Upstart currently has more personal loans on its balance sheet than it has cash. However unlikely a dire scenario is, I have no interest in investing in this stock with this kind of risk present.
