Interest rates rose rapidly in 2022; it turned lending technology company Upstart Holdings (UPST -1.97%) on its head. Not only has the company's performance suffered, but so have shareholders. The stock is down 96% from its high.
Few stocks come back from such a plunge -- can Upstart beat the odds? If it does, it will take a rebound in Upstart's loan referral business, which currently suffers from funding constraints.
CEO David Girouard made an interesting comment during the company's fourth-quarter earnings call. I'll detail what was said and when investors might see the company turn around.
Referral partner growth isn't helping right now
Upstart offers credit-decision technology, algorithms that digest consumer data to approve or decline loans for borrowers. Essentially, Upstart wants to replace your credit score. Potential borrowers can apply for loans directly through Upstart's website or a network of partner banks. Upstart wants to make money from referral fees, not from holding loans to maturity.
When the lending environment was very relaxed, this worked great. However, the rapid tightening of credit via rising interest rates made it hard for Upstart, which couldn't quickly sell off the loans it approved. Rather than sell the loans at massive losses, Upstart began carrying some on its balance sheet, which has ballooned loans on the balance sheet from $260 million as of Q4 of 2021 to $1 billion at the end of 2022, nearly quadrupling in just one year.
During the company's Q4 earnings call, management noted its balance sheet was full and would stop taking on these loans. As a result, management guided for light revenue in the first quarter of 2023, expecting just $100 million in revenue, down from Q1 of 2022's $310 million.
Girouard discussed the behavior of its partner banks, noting that Upstart's continually growing network of lenders doesn't help the company if they all behave the same. In other words, it doesn't matter how many partners you have if nobody will dance with you (buy Upstart's loans). He noted that he believes this rough period will help prove Upstart's technology, making lenders more willing to carry its loans.
What's the solution?
Unfortunately, Upstart's hands are tied here. The company relied on a steady stream of buyers for its loans, which dried up once credit tightened. The solution to this is committed funding, partnering with buyers who trust Upstart and will promise funds ahead of time. That way, Upstart will know it has buyers for its loans.
It's hard to fault Upstart's banks for their caution; most of Upstart's partners are credit unions and local or regional banks, which are currently experiencing a confidence crisis. Depositors are fleeing smaller banks due to fears over the banking system, so going outside the box (using new technology for lending) is probably not a priority.
The good news is that Upstart's highly cyclical nature will benefit it when the credit markets begin recovering again. The company exited 2022 with 92 partnering lenders, up from 42 a year ago. Hopefully, management will have committed funding for the next downturn, but at least the cycle can still work for Upstart and not just against it.
Image source: Getty Images.
Three things investors must watch
Upstart isn't a slam dunk; nobody knows how prolonged or severe this credit downturn or recession might be. Therefore, investors must watch for a few important clues to how the company's doing.
First, Upstart must continue building its lender network. I know I just referenced the CEO's note about it not helping, but it's a clue to how sales efforts are going. More lenders partnering with Upstart means that lenders still believe that Upstart's technology works in the first place -- very important.
Second, the company must continue demonstrating that its algorithms better assess risk than a traditional credit score does. The company updates its performance against credit scores quarterly, so investors should watch to ensure it maintains an advantage.
Lastly, Upstart must stop taking loans on its balance sheet. Management declared that it wouldn't continue, but they've fallen back on their word before. Too many loans could put the business in a tight spot, only increasing the risk to shareholders. Investors will see if loans swell past $1 billion when the company reports its Q1 2023 results.
If shareholders can check those boxes, the company may continue moving in the right direction. The stock's massive decline could be a great opportunity, in hindsight, for long-term investors to accumulate shares. It's a big if, but one with a huge potential reward. The numbers won't lie.
