Followers of Palantir (PLTR 2.53%) will know that the company likes to use the Rule of 40 as a performance benchmark.
This standard in the software industry means that a company should have a combined revenue growth rate and free cash flow margin, or a similar profitability measure, of at least 40 in order to be investable.
Palantir Chief Executive Officer Alex Karp hasn't been shy about touting the company's strong performance based on the Rule of 40, noting that it had a Rule of 40 score of 94 in its second-quarter report. That was made up of 48% revenue growth and 46% adjusted operating margin.
There's no doubt that that's an impressive result and helps show why Palantir stock continues to soar. However, Palantir didn't have the best Rule of 40 score in the software sector this quarter.
Upstart (UPST -1.01%), the artificial intelligence-based lending platform, beat Palantir in the Rule of 40. With revenue growth of 102% and an adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) margin of 21%, giving it a Rule of 40 score of 123.
Unlike Palantir, which rose after its earnings report, Upstart actually tumbled despite that blowout Rule of 40 score. Should investors buy the dip on Upstart? Let's take a closer look.
Image source: Getty Images.
About Upstart's quarter
A year after Upstart unveiled its improved screening model, Model 18, the company is delivering blistering growth, and that model has improved its conversion rates as the company predicted.
Transaction volume jumped 159% to 372,599 loans approved, with a 23.9% conversion rate, meaning applications that became loans, up from 15.2% in the quarter a year ago.
Revenue from fees, its core business, rose 84% to $241 million, and total revenue of $257.3 million was well ahead of the average analyst estimate at $225.4 million.
Upstart impressed on the bottom line as well, as it flipped an adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) loss of $9.3 million to a profit of $53.1 million. It also reported a generally accepted accounting principles (GAAP) profit of $5.6 million, or $0.40 per share on an adjusted basis, up from a loss of $0.17, and better than the estimate of $0.25.
Upstart's outlook was strong as well, as it raised its full-year forecast and third-quarter projection was ahead of expectations.
However, the reason the stock fell, according to analyst commentary, was that Upstart's take rate shrank, a sign that it could be getting harder for the company to convert origination volume into revenue. In the second quarter, originations reached $2.8 billion, and revenue was $257 million, giving it a take rate of 9%, which was down from 12% in the quarter a year ago.
Is Upstart a buy?
Although the critique about the take rate may be valid, that seems to be a result of Upstart moving into the super prime loan market, where risk and default rates are typically lower, so it's worth the trade-off.
Additionally, Upstart is just starting to tap the vast home and auto loan markets.
Auto loan originations jumped more than sixfold from a year ago to $114 million, and home loans reached $68 million, up ninefold from the same quarter a year ago.
Those categories are still small and contribute just a fraction of total revenue, but they have the potential to be huge in the future.
Furthermore, Upstart's surge in revenue and return to profitability has come without any help from lower interest rates. If interest rates fall, demand for loans through its platform could soar even faster.
Overall, the sell-off in Upstart looks worth taking advantage of given the rapid growth, improving profitability, and its opportunity in the home and auto markets. If you've been impressed with Palantir's recent results, Upstart is worth taking a look at.
