After reporting its first-quarter results, the artificial intelligence-assisted lender Upstart (UPST -0.58%) has seen its stock rally after providing improved guidance and making some improvements to its business model.
While the quarter was better than expected, I still think the stock trades on a lot of hype due to its success and popularity during 2020 and 2021. The company, in my mind, still has a long way to go to prove its model and concept. Here's why.
Improvements in the quarter
Upstart has developed algorithms that it believes can better assess credit quality than traditional loan underwriting methods. In doing so, the company can deliver better loan terms for near-prime borrowers while helping financial institutions find new creditworthy borrowers that they would have never found otherwise.
Image source: Getty Images.
But the rapidly rising-interest-rate environment has made Upstart loans much less desirable because the investors that purchase them currently have higher funding costs and are worried about credit quality as the U.S. economy braces for a recession. Meanwhile, banks and credit unions that used to fund and retain Upstart loans are tightening credit due to similar reasons, as well as concerns about liquidity. All of this has led to plummeting loan origination volume and revenue at Upstart because the company essentially has nowhere to place the loans.
In the first quarter of this year, Upstart saw revenue fall 67% and reported a loss of nearly $129 million. On a positive note, the company's contribution margin came in at a surprising 58% for the quarter, largely as a result of expense initiatives the company has taken. Furthermore, Upstart is now guiding for $132 million in revenue in the current quarter, which would be a rebound from the $103 million it just generated in Q1.
Trying to address the shortfalls
Upstart also announced that it had secured $2 billion of committed capital over the next year, which is something the company has previously discussed doing in order to try and shore up the funding issues it has experienced over the last year. The idea is that this committed capital will reduce some of the interest-rate risk the business model has thus far been susceptible to. Subsequently, Upstart made a separate announcement that it had received a commitment for another $4 billion from private investment company Castlelake.
However, we don't know the financial terms of the committed capital. Upstart's CFO Sanjay Datta said regarding the initial $2 billion amount that the agreements broadly include some "sort of return premiums or a take rate co-investment or modest discounting and risk sharing," which Datta said is made possible by the company's expanded margins. Still, I think it's fair to say that getting committed capital comes at a price.
Furthermore, I still do not think Upstart has proven its core investment thesis of originating loans at the same clip as traditional lenders with lower default rates.
In the first quarter, Upstart had net fair value and accrued interest adjustments to its loan balances, which are held for sale, of more than $58 million, which includes projected loan losses for loans on the balance sheet as well as markdowns on loan sales. With outstanding principal loan balances of $1.04 billion, that represents about a 5.6% adjustment downward to the value of its loans. Upstart also took a negative $17 million adjustment on the sale of nearly $352 million of loans to investors, which is a 4.8% downward revision but included in the total $58 million adjustment.
These downward revisions aren't necessarily bad, given the borrower Upstart is originating to, but more pain could be coming. Student loan payments will eventually resume this year, and unemployment is still at historic lows, although Upstart management does believe originations made over the last six to nine months will perform better than expected.
The other thing that seems off is Upstart's loan conversion rate, which looks at loan transactions divided by legitimate loan inquiries. The conversion rate has fallen from 21% a year ago to 8% in the first quarter of 2023. Datta said this has to do with the more difficult macro environment. Upstart's algorithms are currently pricing borrowers with much higher default rates, driving up interest rates on loans by a whopping 15% to 20% and, in many cases pushing loan interest rates above the 36% annual percentage rate cap set by many states on consumer loans.
It's good the platform is recognizing the increased risk in the environment, but this seems similar to a normal bank saying the environment is riskier, so let's tighten credit. Even if Upstart's algorithms are more effective than traditional underwriting methods, I continue to wonder if it's really enough to be a difference maker.
Still too much uncertainty
Upstart should be able to increase origination activity if the Federal Reserve pauses or cuts interest rates. The enhanced contribution margins and committed capital are also a step in the right direction. However, I still see issues with the core business model and whether or not the company will be able to fully solve its funding issues and if credit will outperform if the economy tips into a recession and over the long haul. I think there is still much to be desired from this fintech company right now.
