Shares of Upstart Holdings (UPST), an AI (artificial intelligence)-driven lending marketplace, skyrocketed during the first seven months of 2023. Even though the economic environment remained turbulent, the company streamlined its operations, took a significant amount of fixed costs out of business, and secured multiple long-term funding agreements that lifted investor sentiment alongside its stock price.
Unfortunately, Upstart stock has reversed its positive momentum to lose about 52% of its value so far in August. Lower-than-expected Q3 guidance, a challenging loan funding market, and profit taking after the stock's big run higher have all weighed on the shares.
After this steep pullback, it's worth taking a closer look to see whether it makes sense to buy UPST at the current valuation. But first, let’s look at Upstart’s business model and how it makes money.
An Overview of Upstart
Upstart is a marketplace that provides lending partners (banks and other traditional lenders) with a proprietary AI-based loan origination platform. Its lending partners can retain loans that align with their businesses and risk objectives. Moreover, the loans its lending partners do not retain are sold to a broad base of institutional investors. In addition, Upstart holds a portion of loans not retained by lending partners or sold to institutional investors.
As of June 30, 38% of the loans funded through its platform were retained by originating lending partners. Meanwhile, 50% of its loans were purchased by institutional investors through loan funding programs. Moreover, the remaining 12% was funded through Upstart’s balance sheet.
Upstart primarily earns revenue through fees from its partners for using its platform. Also, the company makes money by offering borrower referral services to its lending partners. Upstart also charges a servicing fee to the loan holder on the outstanding principal over the loan's lifetime, and earns interest income from loans on its balance sheet.
Factors Supporting Upstart’s Bull Case
In its latest earnings report, Upstart’s revenues from fees came in at $144 million in Q2, reflecting a sequential improvement. Further, the volume of loan transactions across its platform was up 30% quarter-over-quarter. Its contribution margin was 67%, up 20% year-over-year. Moreover, its investments in loan processing automation and fraud models reduced onboarding costs and improved the conversion efficiency of its marketing costs.
Impressively, Upstart secured multiple long-term funding agreements with a collective value of about $2 billion. This adds resiliency and predictability to its business over the coming months. Further, the company is optimizing its fixed costs, expanding its footprint, and launching new products, all of which bode well for growth.
Reasons to Remain Cautious
Even though Upstart’s top line and contribution margin could show sequential improvement, the lending market remains challenged as banks and credit unions continue to focus on deposits and internal liquidity. While capital markets are gradually normalizing, funding remains constrained overall - hurting originations, volumes, and overall growth.
Moreover, Upstart’s net interest income will likely decline in the third quarter, due to higher discount rates and elevated charge-offs.
Overall, UPST’s high dependence on external funding remains a big hurdle, especially amid macro uncertainty. Further, the higher percentage of loans held on its balance sheet exposes it to credit risks, and can lead to losses on the sale of loans.
The Final Takeaway: Buy, Sell, or Hold?
Given the challenges facing UPST, most of the analysts covering the stock remain bearish. Out of the 13 analysts covering UPST stock, seven have a “Strong Sell” recommendation, one analyst recommends a “Moderate Sell,” four maintain a “Hold,” and one has a “Strong Buy” rating.
Further, the average price target for UPST is $23.43, signaling expected downside of about 28% from current levels.
Thanks to the improving operating environment and its focus on reducing costs, Upstart could start to see improvement in some key metrics. Moreover, the long-term committed capital agreements are encouraging.
However, given the recovery in its price in 2023, the positives appear to be priced in UPST stock. Further, the uncertain macro environment and a tight funding market could put Upstart under pressure and limit upside potential - making this stock one to avoid right now.
On the date of publication, Sneha Nahata did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
