Upstart Holdings (NASDAQ:UPST) has strong growth potential and after its recent share price weakness as now a reasonable valuation, making it an interesting play for long-term investors in the fintech industry.
Upstart is a Fintech company with a business based on a cloud-based artificial intelligence (AI) lending platform, to improve access of credit while reducing the risk and cost of lending for banking partners. It was founded in 201, it’s listed since 2020 and has currently a market capitalization of about $6.3 billion.
Upstart’s platform aggregates consumer demands for loans and connects its network of bank partners, using the company’s AI algorithm to price risk and reduce the cost of underwriting. This allows improved economics compared to traditional lending, which are shared between consumers and its bank partners.
Consumers benefit from the company’s platform by obtaining lower interest rates, higher approval rates and an efficient and digital lending process, while its bank partners gain from getting new customers, lower fraud and loss rates, and increased automation in the lending process.
Regarding the underwriting process, the FICO score is the standard in the financial industry for determining who is approved for credit and at what interest rate, and beyond that banks usually use a set of simple rules-based analysis that considers a limited number of variables.
This is where Upstart adds value and has some competitive edge, by having a lending platform with AI-based models that quantify in a better way the true risk of a loan, based on more than nine years of experience, incorporating more than 1,500 variables, and using growing datasets that allows you to recalibrate your models to real data.
Upstart uses data from all loan origination on its platform, which means that each bank partner also benefits from a higher dataset for its lending decision compared on just relying on its own underwriting experience. This access to data is critical in the technology industry to have a competitive advantage, something that Upstart leverages by obtaining higher approval rates and lower interest rates at the same loss rate compared to traditional banking lending processes.
Business Model & Growth
Upstart’s operations are based on its cloud-based lending platform, which are provided to bank partners through an application that streamlines the end-to-end process of originating and servicing a loan, while consumers can get a loan through Upstart website, through a bank -partner product, or the bank’s website. For its bank partners, Upstart’s platform is configurable allowing each bank to define its own credit policy and determine what parameters it wants in its lending process.
Regarding funding, the loans issued through Upstart’s platform can be financed in three ways: retained by the originating banking partners, distributed to investors, or retained in Upstart’s balance sheet. During the last year, the vast majority of loans were not supported by the Upstart’s balance sheet, which means that the company ultimately does not bear much credit risk and its business is more exposed to its technology capabilities rather than being a ‘financial’ institution. During 2021, some 80% of the loans issued through its platform during 2021 were bought by institutional investors and 16% were retained by the originating bank, which means that only a small fraction of loans are funded by Upstart itself.
Upstart’s major revenue stream is fees paid by banks, which can be referral fees for each loan referred through its website and originated by a bank partner, platform fees for each loan originated, and loan servicing fees as consumers repay their loans.
Regarding customer concentration, at the end of 2021, Upstart had 38 bank partners, but a large part of loans originated in its platform come from Cross River Bank (CRB), which accounted for 56% of total loans facilitated in its platform (vs. 67% in 2020) and represented 56% of Upstart revenues. The company’s agreement with CRB started at the beginning of 2019 and has an initial four-year term, with the option to renew for two additional years.
Its second-largest customer represents another 36% of loans originated in its platform and is responsible for some 27% of Upstart’s revenues, therefore, some 83% of Upstart’s revenues generated in the last year come from just two bank partners.
This means that customer concentration is a significant risk and, especially, CRB decides for some reason not to renew its agreement with Upstart, the financial impact on the company’s financials will be very significant. For the other agreements, they are usually for 12 months and automatically renew, subject to certain early termination provisions.
Regarding its growth strategy, as a startup company, Upstart has focused historically mainly on improvements in its AI models and technology upgrades, to show that its technology and platform works. As the business matures, Upstart has a lot of growth sources, from offering more types of loans, increasing the number of bank partners, and potentially expanding to international markets.
Nevertheless, over the next few years, Upstart’s growth should be more focused on technology improvements and gaining more confidence from bank partners in its platform, which should lead to higher loan volumes direct to its platform and also potentially a lower cost of funding, making loans. more competitive compared to other sales channels and leading also to higher volumes.
As the banking industry is usually quite conservative, adoption of Upstart’s lending platform is not expected to be rapid, but as the company shows that its AI models can provide an advantage over traditional lending processes, more small and regional banks may be attracted to its platform . Considering that currently Upstart’s revenues are very concentrated in the two largest customers, there is significant growth potential if Upstart can further diversify its bank partners and, over the medium to long term, maybe be accepted by a large bank that could provide a great boost to lending volumes through Upstart’s platform.
Regarding the verticals, Upstart started offering personal and has expanded to auto loans in 2020, but there is an opportunity to expand to other types of loans, including small business loans or mortgages, beyond others, being an important growth source in the near future. By including more products on its platforms, Upstart can both cross-sell to current consumers and expand its consumer base, being an important growth driver for its business over the long term.
Financial Overview & Valuation
Regarding its financial performance, even though Upstart is a recent company and therefore is still in an early-growth phase, it is already profitable, which is something quite rare for a company with a high-growth profile.
Its recent growth history is quite good, given that revenues have increased from $164 million in 2019 to $848 million in 2021, while it initially guided for about $500 million in revenues. Its bottom-line also improved markedly during this period from a net loss in 2019 to break even in 2020 and a profit of $135 million in 2021. This was justified by much higher loan volume achieved last year, which together with good cost control, including stock-based compensation, enabled the company to reach profitability in a very short period of time.
Beyond reaching GAAP profitability, Upstart’s free cash flow was $159 million, which is a very good cash conversion rate, showing that Upstart has a great business with high margins and strong cash flow generation capacity. This is good for shareholders of a high-growth company because Upstart can finance its growth through its own resources rather than diluting shareholders with further equity bond, a financial profile that is rare for early-stage growth companies.
Moreover, the company’s balance sheet is also quite strong with a net cash position, thus Upstart is already making share repurchases, it authorized a $400 million share repurchase program, a remarkable achievement and very unusual for a very young company. This happens because Upstart’s business is highly profitable and already allows it to both invest in growth through retained earnings and distribute excess capital to shareholders.
For 2022, growth is expected to remain quite strong considering the company’s guidance of revenues around $1.4 billion, representing an increase of about $550 million or 65% YoY, supported by growth in both personal and auto loans. The market seems to think this number is achievable, taking into account that current analysts’ estimates are also expecting revenues of $1.4 billion in 2022, while net income is not expected to increase much from the past year due to higher costs. For the following years, revenue growth is expected to slow down due to a higher base, but nonetheless, current estimates are expecting revenues of $3.15 billion by 2025, representing a CAGR of 39% from 2021-25, still a very high growth rate.
Regarding its valuation, like most high-growth companies, Upstart’s multiples have de-rated considerably since its peak valuation achieved last November and has now a much more reasonable valuation. At its peak, Upstart traded at more than 200x forward earnings, while currently is trading at about 32x forward earnings as seen in the next graph.
Even though Upstart’s trading history is not much long, this is its lowest valuation since it has meaningful profits, and buying a high-growth company at slightly above 30x earnings seems reasonable for long-term investors.
Upstart is not the usual high-growth company given that its business model is already profitable, is highly cash generative, its balance sheet is strong, and the likelihood of shareholder dilution in the coming years is very low. Moreover, the company is already repurchasing shares, a strong signal that management seems to be its cheap stock after recent weaknesses.
On the other hand, Upstart is still a risky investment because its business is concentrated in two large customers and its AI models have not been tested during an economic recession. I think that is the final prove that Upstart needs to show to bank partners to mature its lending platform and grow even further from there. This will certainly take some years, and investors need to be patient and invest for the long-term in this stock, considering periods of share price weaknesses as a buying opportunity.