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When I last wrote about Upstart (NASDAQ: UPST) at the end of November, it ended up that I was very early by calling for a Buy on the pullback because the stock continued dropping an additional 40% from my call. Hopefully, investors continued to buy the pullback on the way down because after Upstart released its latest earnings on February 15 after the bell, the stock shot up 36% at the close on February 16. The stock price rise was based upon very impressive results that validated the reasons that I originally recommended the stock.
Upstart uses Artificial Intelligence to create a very strong value proposition for both banks and consumers. The value proposition for consumers is higher approval rates, lower APRs, more inclusiveness of all demographics and lower loan payments for consumers over a full credit cycle. The value proposition for banks is more profitable lending programs, more automated loans, lower defaults and last but not least, the Upstart platform helps banks come closer to meeting government goals for financial inclusion.
Upstart’s valuation proposition for both banks and consumers have driven value for investors by producing triple-digit revenue growth while also generating profits on the bottom line in Q4. Upstart showed up with the best reported quarterly results in 2022 of any company that I have seen so far. This type of results in the current market environment was very unexpected by investors who have been dropping the valuation of Upstart from the astronomical levels that the stock traded at in the beginning of the summer to a P/E of approximately 130, which is not all that high considering the growth Upstart is putting up and is still expecting. The revenue growth that Upstart is expecting in Q1 2002 is between 144% to 152%. Upstart might be the only company expecting that type of revenue growth while still remaining profitable. Upstart deserves its premium valuation and growth investors should buy this stock as soon as possible.
Upstart Exhibits Optionality
Upstart first began its journey in 2012 by entering the personal loans business and then expanded into Auto Lending starting around June 2020. Over the last half of 2021, Upstart started building out products for Mortgages, Small Businesses and Low-income Personal Loans. Because of all of these moves, Upstart has consistently raised its Total Addressable Market. Since I have first wrote about Upstart in June of 2021, Upstart has raised its TAM from $4.1 trillion in annual loan origination to $6 trillion. Some of that growth in TAM is simply from some segments simply expanding over time but a large majority of the rise in TAM comes from Upstart constantly creating new loan products.
The reason that I look for companies that exhibit optionality as a key feature of the type of business that I like to invest in is because it opens up the opportunity to cross-sell products to existing customers. The ability to cross sell or upsell products has been well known by investors for some time for its ability to both raise LTV while lowering CAC, which improves a metric called the LTV/CAC ratio which can be key for growing sustainably. While the LTV/CAC ratio is used mostly for Direct to Consumer (“DTC”) brands, the metric applies to Upstart too.
One other thing to consider about Upstart is that its business is built on AI performing risk assessments and risk assessments can be done on other things besides loans. While I don’t believe I have heard management say anything about it, I do suspect that Upstart could one day turn its AI models on to such areas as insurance or even crypto-loan products.
Upstart Has Powerful Moats
In my past articles on Upstart, I don’t believe that I ever discussed the company’s moats. Upstart exists in an extremely competitive market and their business is threatened by two sources, which are legacy banks and neobanks. Upstart’s business could one day be threatened by legacy banks deciding to create their own algorithms to assess risk. One way that this could become a major risk for Upstart is if the larger legacy banks decide that they could also make money by selling their self-developed credit risk models to Upstart’s large potential customer base of small to medium sized banks and credit unions.
The second threat is from the most powerful neobank, Sofi Technologies (NASDAQ: SOFI) which is another company showing rapid growth that already has loan products in the categories that Upstart seeks to enter and also is building a direct relationship with consumers.
Upstart needs a powerful moat to deal with both threats. Upstart has two identifiable moats that I can see, which are a data moat and an intangible moat built upon brand. Of the two moats, the data moat is Upstart’s most powerful competitive advantage.
Data Moat: In my recent article on Google (NASDAQ: GOOGL), I described what a data moat is and I talked about how data moats can only be built upon data sets that have a lasting enduring value. For a company to build a data moat, they must own data sets that are either hard to replicate or take too long for competitors to replicate. The second part of the equation for a data moat is in the company having enough sophisticated analytic capabilities to derive enough insights from the data to be able to build increasingly better products. Usually, better products will bring in more customers and more data to then be used to iterate, improve and eventually produce even better products. These better products will then bring in even more customers and even more data.
As Upstart’s data sets get increasingly better, the more banking customers and loan originations the company gains. The updated numbers for the numbers of banks that are on Upstart’s platform are 42 banks and credit unions, which is up from 18 banks on the platform from when I first wrote about the company this past June. This past quarter those banks and credit unions helped originate approximately 495,000 loans, up 301% year-over-year, while representing over 400,000 new borrowers. In addition, there are more than 150 institutional investors funding loans on the Upstart platform. The more banks and credit unions that partner with Upstart, the more loan originations the company will complete, which will make it more and more difficult for any other company to replicate Upstart’s data sets. So, there is a network effect associated with Upstart’s data moat.
Upstart is doing everything it can to accelerate data collection too. In Q3, Upstart introduced its low-income personal loan product which is designed for very small dollar loans to the underbanked. The side effect of that product is that Upstart will gain even more data that the company believes can be used to significantly accelerate the pace of learning by the company’s AI models.
Brand Moat: Upstart’s brand moat is not as strong as its data moat but it does exist. Upstart is building a brand, mostly among banks but also to a lesser extent among consumers, as a better way to both give and receive loans. Both banks and consumers are waking up to Upstart’s value propositions
The brand moat will become more important down the road as competition for Upstart heats up. Currently, Upstart and SoFi don’t really directly compete much because Upstart’s loan products seem more focused on the underbanked and non-prime lending, while SoFi is more focused on young professionals in the prime lending category but eventually Upstart will move more upstream and SoFi will move more downstream and both company’s loan products might compete against each other. I will talk more about SoFi later on in this article when I discuss competitors.
Auto Loans is where the big-time growth will likely come for Upstart over the near and medium term, which is why the company focuses attention to the subject in each earnings call. CEO Dave Girouard mentioned in the earnings call that the company is now in a position to begin scaling the auto lending business moving forward. Based upon the progress the company has made in auto loans over the course of 2021, Upstart is now projecting $1.5 billion in auto loan transactions on its platform in 2022.
Part of building out the auto loan business is getting the loan product into dealerships. The process of getting into dealerships started when Upstart acquired Prodigy, in early 2021. This acquisition has allowed Upstart to triple the amount of dealerships year-over-year in 2021 and increase dealerships 41% sequentially. On the earnings call, the CEO indicated significant work still needs to be done with auto loans but the upside is that Upstart has a runway to practically own the auto loan business
But even though channel development will require significant time and effort, the good news is that we’re confident we’re in a class by ourselves. Upstart has a unique and proprietary auto refinance product with far less competition than we’ve had in personal lending.
Source: CEO Dave Girouard – Upstart Q4 2021 Earnings Call
Currently, Upstart does not have any real significant competitors for what they do. Right now, it is unknown if major banks like Bank of America (NYSE: BAC) or Wells Fargo (NYSE: WFC) will build out similar capabilities. When I mean similar capabilities, I mean having a system good enough to cease reliance on the FICO score. So far, Upstart claims to have seven lenders on its platform that don’t require a minimum FICO score.
Upstart does have many neobank competitors like Upgrade, Avant, LendingClub (NYSE: LC) and Rocket Loans (NYSE: RKT) but the only company that I think has both the scale and competitive advantages to compete with Upstart is SoFi. The reason why I believe that is because SoFi has built out a significant platform that offers consumers virtually every finance product under the sun. SoFi is set up to eventually take significant share from legacy banks that include Bank of America down to the smallest credit union. What Upstart will do for banks is give them the tools to compete in loan products against a company like SoFi in the future. If anyone wants to see why I think SoFi can be a significant competitor to Upstart’s business, they can read the article I just wrote about SoFi here.
The Q4 2021 Earnings Report
As can be seen in the above graphic, Upstart’s Q4 net revenues was $305 million, up an explosive 252% year-over-year. This beat Wall Street analysts’ expectations by $42 million. Most of Upstart’s revenues come from fees charged to banks. Those revenues from fees were $287 million or 94% of total revenues. Fee revenue was up 37% sequentially from last quarter.
Our profits are neither marginal nor ephemeral. We generated more cash in 2021 than we burned in our entire eight-plus years as a private company. Profits matter for a reason. They allowed us to invest significantly in our future by more than doubling our headcount in product, engineering and machine learning in 2021. This unusual combination of growth and profits in a heavily competed industry is evidence of a distinct competitive advantage and clear operating leverage.
Source: CEO Dave Girouard – Upstart Q4 2021 Earnings Call
Upstart operating expenses grew almost 220% year-over-year or 22% sequentially to $244.43 million. Operating Income increased 481% year-over-year to 60.41 million. Operating margin increased from 12% in Q4 2020 to 20% in Q4 2021.
Upstart considers engineering and product development (R&D) a priority investment in which $46.49 million was invested in Q4, which is up 228% year-over-year or 25% sequentially. G&A came in at $42.07 million, which is up 184% or 22% sequentially. Upstart’s S&M increased 23% sequentially and 232% year-over-year to $114.81 million. Customer operations grew at a rate that showed an increasing economy of scale.
Contribution margin is a non-GAAP metric that companies use to measure operating leverage. A higher contribution margin means higher fixed costs in relation to variable costs, which equates to a higher operating leverage. What we want to see as investors is either a rising or high contribution margin because that means rising or high operating leverage. Upstart’s contribution margin rose from 46% in Q3 to 52% in Q4, displaying rising operating leverage.
Upstart Q4 GAAP net income came in at $58.9 million, up 102% sequentially. Adjusted EBITDA came in at $91 million, up 54% sequentially. Fourth quarter non-GAAP earnings per share was $0.89, which beat Wall Street analysts’ estimates by $0.38. Upstart FY’21 net revenues were $849 million, which was up 264% over 2020. Upstart FY’21 contribution margin was 50%, up 400 basis points from 2020, and adjusted EBITDA was $232 million, with a 27% adjusted EBITDA margin versus 13% in 2020.
The Upstart CFO mentioned in the earnings call that the decrease in contribution and EBITDA margins being guided to in Q1 is a result of two factors. The first factor is the ramp up in auto lending, which should reduce the contribution margin by 5% until the auto lending business scales and the second factor is the company has plans to increase hiring in the technical workforce by around 150% in 2022. Upstart retains the ability to ramp up or ramp down these variable costs in response to market conditions at any time.
Upstart Balance Sheet
Upstart ended both the quarter and the year with $1.2 billion in restricted and unrestricted cash on the balance sheet versus $311 million in year-end 2020. Upstart had $695 million in long term debt at the end of 2021.
The company also announced that the board of directors has authorized a repurchase of up to $400 million of Upstart shares.
The same risks that I wrote about in my first article on Upstart still exist today. However, I think the biggest risk the company faces today which I did not write about in that first article is the risk Upstart faces from inflation and rising interest rates. Now that inflation is high and the Fed is due to start raising interest rates, the question is, “Exactly how well will Upstart’s algorithms work over the full credit cycle?” If the Fed pushes interest rates high enough to cause a recession, does that crush Upstart’s customers like a tin can or will the company’s risks models be resilient? As great as the company’s results were in Q4, the wise will remember that the company is still attached to the financial industry and if Upstart’s banking customers crash and burn, things will likely not go so well for Upstart.
Upstart Analyst Price Targets
The above is based on 10 Wall Street analysts offering 12-month price targets for Upstart in the last 3 months. The average price target is $218.80 with a high forecast of $350.00 and a low forecast of $90.00. The average price target represents a 48% increase from the last price of $148.01.
Upstart’s recent earnings results just showed a company that is hitting on all cylinders. However, even though Upstart has little exposure to the actual loans, the company’s banking customers are exposed and if Upstart’s credit risk models fail during the rougher part of the credit cycle as interest rates rise, then things could quickly turn sour for Upstart. I still view Upstart as somewhat of a speculative stock and only people that understand the risks should invest in this company. Upstart is a buy for investors willing to speculate in a high risk-high reward stock. Risk averse investors should avoid this stock.