It’s usually best to anticipate bad news. That appears to be the artificial intelligence lender’s approach upstart (UPST -20.15%) after releasing some preliminary second quarter earnings numbers ahead of schedule and urging investors to brace for results that will be well below expectations.
Upstart’s shares are down more than 17% in after-hours trading following the news. Is the stock a buy now that it’s trading near all-time lows?
What happened
Upstart expects revenue of about $228 million for the second quarter, far short of the $295 million to $305 million the company originally forecast. Additionally, Upstart told investors to expect a contribution margin of around 47%, which is up from the 45% it had forecast.
The company now expects a loss of between $27 million and $31 million. Previously, Upstart had expected to either break even or report a loss of up to $4 million. As Dave Girouard, CEO of Upstart, said in a statement:
Our sales were negatively impacted by two factors in roughly equal measure. First, our market’s funding is constrained, largely due to macro concerns among lenders and capital market participants. Second, during the second quarter, we took action to convert loans into cash on our balance sheet, which negatively impacted our earnings in a rapidly rising interest rate environment.
Upstart originates personal and auto loans believing it can better assess borrower credit quality than traditional methods Fair Isaacs FICO scoring. It then sells the majority of these loans to bulk loan buyers or institutional investors, who often securitize the loans. Upstart is doing this to take the loans off its balance sheet and continue to fund startups.
With the economy appearing headed for recession and interest rates rising aggressively, investors are much less willing to invest in and accept upstart credit — particularly those from borrowers at the lower end of the credit spectrum. Your funding costs have risen and borrowers are more likely to default in a weak economy.
By converting loans into cash, Upstart appears to have suffered a loss on loans it had held on its balance sheet, which startled investors when the company released the information in its first-quarter earnings report. Analysts and investors want Upstart to operate a capital-poor operation and not assume actual credit risk from borrowers.
Meanwhile, Upstart CFO Sanjay Datta said Upstart’s operated loans, held by banks and credit union partners, are still performing well and delivering returns that meet or exceed expectations. For non-bank credit investors, Datta said the 2018 and 2020 vintages have fared significantly better, while the 2021 vintages are within 1% of the company’s loss expectations.
“We believe our models are well matched to economic conditions and are currently targeting returns in excess of 10 percent,” Datta said.
Image Credit: Upstart.
Is Upstart stock a buy?
While fintech stock, which was trading at $390 at one point last year, has fallen below $28, I’d avoid buying shares of Upstart right now. No one is sure how long the funding issues will last, and even if they are resolved, investors will likely demand higher yields, which will slow overall issuance.
Investors won’t be willing to take on Upstart-funded loans to borrowers with weaker credit ratings anytime soon, which has allowed Upstart to really ramp up lending volume in recent quarters. All of this should result in much lower issuance this year than investors were expecting, and therefore lower earnings.
In addition, Upstart must prove its basic thesis that it can better underwrite loans. Sure, its previous legacy loans have done well, but these were forgiven when the government pumped big bucks into the economy and largely propped up borrowers. Loans held by credit unions and banking partners are likely to be made primarily to higher-quality borrowers.
I would like to see how old loans for 2021 and those issued this year hold up in the current environment. Until then, I’ll stay away from the stock.
Bram Berkowitz does not hold any of the shares mentioned. The Motley Fool has positions in and recommends Upstart Holdings, Inc. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.