Upstart: Probably Overvalued (NASDAQ:UPST)

upstart (NASDAQ: UPST) delivered a strong fiscal second-quarter earnings report on Tuesday, sending the fintech’s stock up 40% immediately after the earnings. The positive market reaction stems from Upstart’s strong outlook for the upcoming third quarter, which implies that The AI ​​lending startup is set to see a major acceleration in its top-line growth. Upstart isn’t profitable right now, but a transition to a low-rate world should help the start-up’s earnings prospects. I think Upstart will see an uptick in its business once the Federal Reserve decides to cut the Fed Funds rate, and while more patience is needed here, Fintech is well positioned to ride out the downward rate cycle. However, given Friday’s sharp upward revaluation, Upstart has now met my fair value target and I rate Fintech a retention.

Previous assessment

We rated Upstart’s stock a strong buy in May, mainly because the Fintech’s revenue base stabilized early in the year and finally returned to steady growth in the second quarter. This reversal of top-line growth is set to continue in the third quarter, as the start-up projects a sequential growth rate of 18%. As much as I like earnings growth, I think Fintech is now quite overvalued and has limited upside potential.

Upstart beats estimates

The fintech delivered a good earnings report for its fiscal second quarter. Upstart reported adjusted earnings of $(0.17) per share, which beat the average forecast by $0.22 per share. The lending startup also easily beat the top estimate: Upstart brought in $127.6 million in revenue, which was $3.1 million better than the average forecast.

Solid Q2 results, revenue stabilization, strong loan growth

Upstart generated $127.6 million in revenue in the second quarter, showing steady quarter-over-quarter growth. The change in revenue trajectory is particularly notable as the upstart suffered last year from slowing loan demand for its AI-backed lending platform, with signs of stabilization emerging earlier this year. Although Upstart is not yet profitable, I believe the company’s earnings outlook will gradually improve in the second half of the year, as well as in fiscal 2025, when the Federal Reserve should have cut the Federal Funds rate at least once.

Upstart’s lending business is doing well, with the start-up generating 20% ​​more personal loans in the second quarter on a T/T basis and 34% more personal loans than in the year-ago period . Auto loan originations also grew at double-digit rates (+35% Q/Q), but Upstart remains too focused on personal loans. Volume growth in the personal loan category will be a strong driver of profitability growth going forward, and as soon as the Federal Reserve cuts the Federal Funds rate, possibly in an accelerated manner after last week’s massive spike in market volatility, Upstart could see very favorable business tailwinds unfold soon enough.

In addition, Upstart has improved some of its platform metrics, which further improves the recovery prospects for Fintech. The upstart had a 15% conversion rate on its credit platform in the second quarter, showing a 1 PP Q/Q gain and a massive 6 PP Y/Y gain. Fully automated loan amount, a key performance measure, increased to 91%, also showing a 1PP Q/Q gain (and a 4% Y/Y gain).

Very positive outlook

The upstart drove for $150 million in revenue for its fiscal third quarter, implying a quarterly growth rate of 18 percent. Since revenue was flat in the previous quarter, the start-up expects a major acceleration in the top line for the current quarter, which is linked to the expectation that the Federal Reserve will finally cut the Federal Funds rate.

Rating of the upstart

Fintech has seen a steep decline in its valuation over the past two years as the market has adjusted to a higher market environment for longer. Still, Upstart shares surged 40% immediately after the earnings and posted fresh positive momentum between Thursday and Friday. As much as I like Upstart, I think the stock is now fairly valued.

Upstart is currently valued at a price-to-earnings ratio of 4.5X, which is significantly above the industry group’s average P/S ratio, further indicating that it may be time to cut back on Fintech stock purchases. The industry group also includes other Fintechs such as Affirm ( AFRM ), SoFi Technologies ( SOFI ), and PayPal ( PYPL ). The average fintech in this group trades at a P/S ratio of 2.8X, implying that investors are currently paying a 59% premium for the upstart.

In my last piece on Fintech, I said I saw a P/S to fair value ratio for Upstart of 4.0X given the historical valuation average. Fintech clearly has growth potential in a lower rate world when credit demand tends to increase and leads to higher origination volumes for Upstarts. However, at the current time, I think Upstart is roughly valued: a ratio of 4.0XP/S translates to an estimated fair value of $35 per share. With Upstart shares now trading at $36.25, my fair value target has been met and I am accordingly downgrading UPST to hold.

The risks of the upstart

The biggest risk for Upstart, in my opinion, relates to the Federal Reserve’s refusal to lower the Federal Funds rate. A higher rate setup for longer would likely be the worst outcome for the AI ​​lending start-up, but one that is increasingly unlikely. After last week’s market crash, there may even be pressure on the Federal Reserve to accelerate any rate cuts to calm jittery investors. What would change my opinion of the lending platform is if Upstart saw either a decline in revenue momentum or an increase in losses, even in a lower rate world.

Final thoughts

The upstart isn’t out of the woods yet, but the second quarter showed improvement in more ways than one. First, Upstart’s revenue trajectory improved in Q2, and its revenue growth rate was no longer negative. Second, Upstart is still losing money, but that could change as the Federal Reserve changes its rate path, which became more likely last week. Third, Upstart sees improvement in platform KPIs, such as conversion rates, which will benefit Fintech once credit demand increases. While I like the business setup, I don’t like Upstart from a valuation standpoint, and since the stock has reached its estimated fair value, a downgrade to hold is warranted in my opinion.