Upstart Holdings Inc. (UPST, Financial), an artificial intelligence lending platform, shot to fame soon after its initial public offering as investors rewarded its disruptive business model that threatens the practices of traditional banks and financial services companies.
Following a stellar run in 2021 that lifted Upstart's stock price close to $400, the company came under pressure with the Federal Reserve’s aggressive interest rate policy. As such, it lost nearly 90% of its market value in 2022. The company has made a strong comeback so far this year, however, rising more than 160% on the back of improving sentiment toward growth stocks and market expectations for a rate cut toward the end of the year.
After reporting second-quarter earnings on Aug. 8, Upstart's stock dipped 17% in after-hours trading. As the company is continuing to make progress toward achieving its profitability goals, this heightened volatility offers investors a great opportunity.
Long runway to grow
For the second quarter, Upstart reported a 41% year-over-year decline in revenue to $135.7 million. However, its adjusted earnings of 6 cents per share topped analyst estimates.
While the company has recorded double-digit revenue declines in recent quarters, a few promising signs have emerged to suggest it is moving in the right direction.
First, the company has prioritized profitability to mitigate some of the negative impact resulting from the revenue declines. Accordingly, the contribution profit margin reached an all-time high of 67% in the second quarter compared to 47% a year ago. Over the last four quarters, Upstart has successfully reduced its cost base, realizing notable operating efficiencies. In the next phase of the business cycle, when the demand environment for loan products normalizes, it will be well-positioned to convert revenue growth into strong earnings growth thanks to these operating efficiencies.
Second, Upstart has continued to invest in improving its AI algorithms to offer a seamless automated experience to its customers, which is an encouraging sign as these investments will help it thrive in more favorable macro conditions. In the second quarter, the number of fully automated loans approved on the platform reached a new high of 87%, surpassing the previous high of 84% achieved in the first quarter. The increasing number of automated loans is a testament to the success of the company's loan approval algorithm, which is being trained with billions of data points.
Third, Upstart has not held back on its market expansion plans despite macroeconomic challenges, which highlights the long-term-oriented thinking of the management team. After launching the platform with a focus on personal loans, Upstart is now expanding into auto loans, small-dollar relief loans and even home equity products. In the second quarter, the company started a pilot HELOC program in Colorado, marking its entry into the home equity product category. Diversifying into new lending categories will help it emerge as a 360-degree automated credit platform in the future, paving the way to enjoy competitive advantages.
In addition, Upstart has remained focused on working with new funding partners. As of the most recent quarter, the company has onboarded 100 bank partners to its platform. Securing committed capital to fund loans is critical to its success, and the expanding bank partner network gives investors' confidence in the company’s ability to disburse more loans in the future across its product categories.
Upstart is a disruptive force that has the potential to transform the financial services sector. The company has made noteworthy progress in recent quarters to position itself to thrive once lending conditions turn favorable, which is just a matter of time.
Short-term challenges will hurt Upstart
The challenges faced by Upstart stem from poor macroeconomic conditions in the financial services sector. Amid rising interest rates, many banks have taken a cautious approach to approving and disbursing new loans, making it difficult for it to cater to the demand for loans on its online platform. On the other hand, demand for credit has also declined with consumers preferring to push back their plans to buy new vehicles and upgrade their homes because of the rising cost of debt. Combined, these factors have created a dent in Upstart’s loan origination volumes and, therefore, fee-based income.
In light of the decrease in funding commitments from bank partners, Upstart has resorted to using its balance sheet to fund loans, drawing criticism from many investors as this strategy substantially increases risk. Funding loans from its balance sheet has also led to a valuation reassessment, as the company was previously valued at premium multiples since it did not carry a loan portfolio on its balance sheet. When lending conditions normalize, Upstart will likely be able to sell the loans on its balance sheet to a bank partner.
Takeaway
Upstart's stock crashed after reporting second-quarter earnings, but this negative market response does not accurately reflect the long runway for growth enjoyed by the company.
The company is well-positioned to thrive once macroeconomic conditions normalize. Further, earnings growth will likely surpass revenue growth in the recovery phase as Upstart is now more efficient compared to a few quarters ago. When the company offloads the loans on its balance sheet, it will once again attract tech-like valuations. The pullback is offering investors an opportunity to invest with a long-term view.
