Upstart: An Uphill Battle (NASDAQ:UPST)

Upstart Holdings, Inc. (NASDAQ:UPST) continues to see headwinds in its business.

While Q4 2023 results were strong, guidance was lighter than expected as the company highlighted near-term headwinds.

I do expect these headwinds that Upstart is facing to continue into 2024 and look for fundamentals to stabilize before becoming constructive again.

I have covered Upstart extensively on Seeking Alpha, and in my last article, I warned readers that things were about to get worst in 2024. As I will elaborate more in the article below, things are indeed getting worse for the company as the guidance suggests a soft market environment for the company.

Q4 2023 results were better than feared

To be fair, the 4Q23 results were better than I initially feared. However, as I will explain later, it does seem that the market weakness will continue into 2024, and this creates an unfavorable set-up for Upstart.

But first, Upstart’s net revenue for 4Q23 came in at $140 million, 5% above consensus expectations. The volume of loan transactions in 4Q23 was 129k, an increase of 12% sequentially and beating the consensus expectations of 115k.

Conversion rate came in at 11.6%, 200 basis points better than expectations.

Contribution margin came in at 63%, 160 basis points above consensus, improving 10 percentage points from the prior year. Adjusted EBITDA came in at $0.6 million, beating consensus expectations of negative $1.3 million.

Upstart continued to improve on its loan processing automation and fraud modeling efficiency, leading to a new high in the fully automated loans percentage, reaching 89% in the quarter.

The company ended 4Q23 with $368 million of unrestricted cash on its balance sheet.

As of the end of 4Q23, there were $977 million of loans on its balance sheet, down from the $1.01 billion from the year before. 42%, or $411 million of that, are loans made for R&D purposes, mainly in the form of auto loans.

The above consensus 4Q23 report was nice to have, but the forward-looking markets are already getting jittery about the weak outlook that Upstart is giving

Economy and outlook

In 2H23, it was interesting that Upstart highlighted that the growth in personal consumption has been strong and resilient, which is in stark contrast to the peaking of real per capital disposable income in the summer of 2023 and has since been declining.

This contrast in the dynamic between the growth in personal consumption and real per capital disposable income looks similar to the fragile state the economy was in the Great Financial Crisis.

In addition, the company continues to see that inflation is on the decline, while it is unlikely for there to be a significant unemployment in the current labor market.

That said, despite the promising outlook, management believes that we are not yet out of the woods, with the declining cash balances likely to result in the contracting of the U.S. economy.

With regards to unsecured credit performance, Upstart is seeing that the less prime borrowers default rates are not stabilizing and showing signs of recovery.

However, what was happening to this less prime borrower group earlier is not working its way through to the more prime borrower segment.

In addition, management also highlighted that auto loans and credit cards have reached the highest delinquency rates since the Great Financial Crisis and continue to rise.

Thus, management expects that the primary and more affluent borrower segment will likely see rising delinquencies, which leads them to be more conservative in terms of their loan pricing to these borrowers.

Upstart expects revenues in 1Q24 to come in at $125 million, 17% below consensus expectations. This incorporates the increasing credit risk that management is expecting in the near-term as highlighted above.

The outlook also calls for a 250 basis points sequential decline in contribution margin to 61%.

Adjusted EBITDA is expected to come in at negative $25 million compared to the consensus expectations of positive $8 million.

While there has been somewhat of a stabilization in the delinquency trends from the lower prime borrowers, the weakening of the primary borrowers is causing a difficult road to recovery for Upstart.

As a result, Upstart is committed to react quickly to adjust pricing and conversions for the respective segments they serve according to the market environment and their outlook.

As expected, this road to recovery will be very bumpy for the Upstart given the uncertainty around the macro environment and the commentary and outlook by management confirms that there may be more challenges to come.

I think that this really dampened the 4Q23 report as management showed that 2024 is likely to be a challenging year for the company with the rising delinquencies among the primary and affluent borrower groups.

Funding markets remain a constraint

It has remained a funding constraint market, and that means that the funding headwinds remain, and that Upstart needs to work very hard to obtain new funding to grow.

There are large amounts of assets in the secondary markets that are coming from the banks which are looking to reduce their balance sheet through asset sales.

In turn, this means that the funding market is currently saturated and not working in favor for Upstart.

That said, with the increasing expectation that we will see a soft landing and rate cuts in 2024, the institutional loan buyers that Upstart are talking to appear to be more comfortable with higher risks.

There were two partnerships with the institutional funding markets that Upstart did in 4Q23.

The first was with Ares, which is expected to acquire $300 million in personal loans. This first partnership with Ares is one that is a good deal for both sides and Upstart looks to broaden this relationship in the long term.

The second one was an agreement signed with a lending partner which Upstart expects will originate $500 million in loans in the next one year.

Management is optimistic about its growing partnerships with institutional funding markets.

As the macroeconomic backdrop improves and with that, an improvement in the funding market, these partnerships forged during the depths a very difficult time for Upstart will ensure it is well positioned in future downturns.

I think management will have to continue to grow the number of partnerships and committed capital deals in 2024, which will continue to be watched by the market.

Risk sharing structures have increasingly become more relevant to attract more large and long-term committed capital. With risk sharing, I think that it is needed to grow the relationship over time and for partners to grow conviction in the Upstart model.

Looking ahead, I expect that Upstart will need to continue to look for more of these committed capital deals to not just take on more loan volume, but also help improve its liquidity and balance sheet.

With more committed capital deals to plug in the funding constraint environment, along with deals that help to remove loans from its balance sheet, I expect that over time, in the next few quarters, we will see the loans on the balance sheet reduce.

Expansion in products

The goal Upstart has here is to ultimately grow its product suite such that it has a product for all environments, and that they are somewhat countercyclical to one another.

This could help the company grow its portfolio into one that is more diversified, balanced and with less volatility in the long run.

With that, Upstart crossed its first $5 million mark in cumulative HELOC originations, as it is seeing great progress in its first home lending product.

This product helps with improving countercyclical nature of its product portfolio as the HELOC product does well in high-rate environments when consumers are less willing to see their homes or refinance their mortgages.

Upstart has expanded to 11 states in the US and plans to expand into more states in 2024.

The company also reduced the average HELOC time to close to nine days in 4Q23, inching towards its long-term goal of a five-day close. This number is already better than the industry average, which is more than five weeks.

That said, Upstart’s auto loan business is struggling due to the high interest rates. The company continues to improve on the auto offering by expanding to 88 dealerships as of 4Q23, up from the 27 just one year ago. It also recently expanded its AI-powered vehicle financing capability nationwide and expects it to reach 90% of US consumers by the end of 1Q24.

Management remains confident about the auto loans business, especially when we see rates start to fall in 2024.

Last but not least, while AI is now the hype, Upstart has long focused on this area since it was founded. It continued to extend its AI leadership as its models have continued to be improved and learned immensely as the macro conditions changed so rapidly in the past few years.

Valuation

Upstart currently trades at 121x 2025 P/E, which is undoubtedly expensive.

This is largely due to a depressed earnings as scale has been reduced dramatically by the funding constraint market.

Unless the constraint in funding goes away, Upstart will continue to trade at such expensive valuations.

My 1-year price target for Upstart is reiterated as per my last Seeking Alpha article.

My 1-year price target is $25.20, based on 3x P/S multiple, given the company is currently unprofitable due to the challenging market environment. This price multiple is reasonable in my view because if the company were to stage a recovery in the second half of 2024 and through 2025, we would see the company grow its top line by close to 30% in 2025. As such, the multiple is justified by the expected inflection in revenue once funding is no longer a constraint.

Conclusion

It has certainly been a difficult environment for Upstart and those in the industry.

While Upstart has tackled the challenge and stayed in the business, the macro environment continues to look vulnerable, especially for the more prime group of borrowers.

Funding remains a constraint for Upstart and without a significant improvement in this constraint, the company will not be able to go back to its old days of growth.

That said, the company has been relentlessly focused on improving its models and launching new products. With a growing portfolio of products from HELOC to auto loans, the company’s product portfolio may start to look more diversified and less volatile.

In addition, the current market environment with the rapid changes in interest rates have enabled Upstart to grow and become a stronger and more resilient company.

That said, I think that it will continue to be a difficult operating environment in the near-term, with the vulnerable macro environment, weakening prime borrowers, and an oversaturated funding market likely to weigh on the company in the near-term.

While the company continues to improve on its products and models, it will take some time for rates to be cut and for that to work its way through the economy to benefit Upstart.

This remains an uphill battle for Upstart.