Upstart Stock: Solid Near-Term Outlook, But Remains Overpriced (NASDAQ:UPST)

We previously covered Upstart Holdings (NASDAQ: UPST) in August 2023, discussing the massive volatility in stocks attributed to the FQ2’23 rate and staggering short interest.

While management continued to demonstrate tight control over operating costs while improving its loan automation process, net interest income (NII) and net interest margins (NIM) remained largely negative in a period of high interest rate environment.

UPST 1 Y share price

Since that Hold rating, UPST has recovered +16.8% versus the broader market to +25.4%, partly attributed to growing market optimism around the Fed’s upcoming rate cut at the FOMC meeting in September 2024.

The same recovery was seen in other grades and other fintech/fiering grades, due to lower medium-term borrowing costs and the cumulative impact on their results.

Even so, we’re not sure if UPST’s rally is well-deserved as it has failed to achieve positive profit margins despite alleged rich spreads in the high interest environment.

While the fintech operates as a cloud-based AI lending platform with the goal of improving access to credit for all, it appears that revamping the lending process to more accurately quantify the true risk of its loan continues to yield mixed results.

This is because UPST delivered a relatively rich FQ2’24 NII of USD 41.41M (+2.3% QoT/ +39.7% YoY), which unfortunately was severely moderated by fair value still higher and other adjustments of -$44.31M (+12.6% QoT/ -18% YoY).

With unrealized loan loss, credit write-downs and other fair value adjustments rising steadily to -$31.94M (-7.9% QoT/ -32.2% YoY), it appears that the credit quality of of its loan portfolio was less than optimal. , as “the fair value of the loans on our balance sheet has declined and may continue to decline.”

At the same time, UPST continues to report a relatively high APR of 38% compared to the average US credit card interest rate of 21.48% for consumers with “very good credit” as of September 10, 2024, as best explained by the CEO during the recent earnings call:

All else being equal, a higher APR will select for a riskier borrower, a notion known as adverse selection. Conversely, a lower APR will select for a less risky borrower. (Looking for Alpha)

Coupled with high operating expenses of $183.11 million (-6.2% QoT/ +8.2% YoY), it’s no surprise that the fintech was unable to report GAAP profits despite NII generation relatively rich.

Advance consensus estimates

On the one hand, UPST has already provided quite promising guidance for FQ3’24 with revenues of USD 150m (+17.5% QoT/ +11.1% YoY), a contribution margin of 57% (- 1 point ToT/ -7 YoY) and adj EBITDA of -$5m (+46.2% ToT/ -317.3% YoY).

Perhaps this is why the consensus has moderately raised their forward estimates, with fintech expected to generate improved top/bottom-line growth through FY2026.

The headline numbers don’t appear to be too aggressive, as an increasing amount of UPST’s loans were fully automated at 91% last quarter, up from 73% two years ago, making it undeniable that fintech is likely to it enjoys more than decent growth in the medium term.

This is especially so as the fintech continues to expand its Home Equity Line of Credit (HELOC) availability to 30 states (+11 QoQ), the 5% “magic mortgage rate” that can trigger a boom in the market real estate and with it a new opportunity for growth.

These developments are significantly supported by UPST’s growing financing partnerships and the significant reduction of its balance sheet utilization with S2’24 to deliver an improved financing mix.

On the other hand, while the market may already be pricing in UPST’s higher loan originations as borrowing costs normalize, up from the $1.1 billion reported last quarter (inline QoQ/ -8.3 % YoY), we are not sure if the volume growth alone is enough to boost its bottom line performance.

This rules out any drastic improvements in portfolio quality and operational efficiency, in our view, given that the fintech has “tripled the number of Upstarters (employees) in our product and service engineering teams” – one that was an obstacle thus far.

As a result, investors who remain bullish on UPST’s outlook may indeed want to temper their near-term expectations.

So UPST Stock is a buysell or keep?

2-year UPST share price

For now, UPST has already given back most of its recent gains, while it appears to be well supported at recent support levels of $33.

UPST Assessments

Even so, UPST is undeniably expensive at FWD Price/Sales valuations of 5.30x, compared to its 1Y average of 4.08x and sector median of 2.81x.

Compared to its fintech/lending peers such as Affirm (AFRM) at 3.86x, SoFi (SOFI) at 3.05x, and Block (SQ) at 1.53x, we think there is a minimal margin of safety here.

This is especially so as UPST is expected to generate lower top-line growth at a CAGR of +18.7% through FY2026 compared to AFRM at +23.6% and SOFI at +18.5% , apart from SQ at +11.6%.

Readers should also note that UPST remains heavily shorted at 26.71% at the time of writing, with insiders continuing to sell over the past twelve months.

Additionally, while stock-based compensation moderated to $138 million in absolute terms versus LTM (-22% sequentially), the ratio to total revenue increased dramatically to 24.5% (+8.1 points sequentially).

This also meant that UPST’s shares outstanding grew at an accelerated rate of +6.3% sequentially or +514.1% from FY2019 – with equity erosion occurring at a faster pace than increasing the top line.

Coupled with management’s laser focus on expanding “access to bank-grade credit rather than generating huge profits”, ie: erratic monetization and minimal margin of safety, we prefer to cautiously reiterate our Hold rating here.