The constant problem for emerging fintechs involved in lending is accessing funding capacity as the business grows and the economic cycle weakens. Ordinary Holdings (NASDAQ:UPST) is a prime example of how this cycle is broken a investment thesis with the stock. The fintech is not attractive at any price until the constraints of the business model are resolved.
Regardless of how strong a lending marketplace’s credit metrics are, whether artificial intelligence-based or not, the platform must have a source of funding. Without an internal source to fund loans, a platform like Upstart relies on banking partners to continue funding loans.
The typical move during an economic downturn is to exit primarily from unproven lending platforms. Other lending platforms like competitors Lending Club (LC) and SoFi Technologies (SOFI) have acquired digital banks to collect cheap deposits to fund loans and reduce such restrictions in the future.
In the second quarter of 2022, Upstart reported revenue of $228 million, down from more than $300 million in previous quarters. Worse, the fintech had forecast second-quarter revenue of around $300 million just months before cutting guidance on July 7.
Upstart’s Chief Financial Officer Sanjay Datta confirmed this standard issue the company is facing during its Q2 ’22 earnings call.
Macroeconomic uncertainty and the impact of economic strains on consumer arrears have resulted in a decrease in available financing for loans on our platform, which has become an operational obstacle for the company.
The company converted just 13% of loan applications in the quarter, up from 24% in the previous Q2. Again, these numbers suggest that lending partners are retreating from aggressive lending standards and reducing risk in the face of economic uncertainty, while the whole point of the AI-based lending model was an improved risk model to avoid these volatile lending decision outcomes.
Upstart even ended Q2’22 with 71 bank and credit union partners, down from just 57 in the previous quarter when lending volume was strong. Credit quality has returned to previous loss levels, with larger credit defaults from credit cards, personal loans and auto loans returning to pre-Covid levels.
The company still has better access to credit risk than traditional credit scores like FICO. Unfortunately, this doesn’t matter when Upstart relies on banking partners to fund new loans.
The company projected revenue of just $170 million in Q3 ’22, indicating another large decline in partner lending. Business will have nearly halved since peaking in Q1 ’22 when sales hit $310 million. In addition, the business is now very unprofitable.
Part of the problem is that expected results for loans have been underperforming lately. The model spent most of 2020 and 2021 beating expected results, with defaults over the period 50% below expectations. Average returns are still excellent at 9.8% over the period, but of course credit partners aren’t as aggressive when expected returns drop to a baseline of 5.2%.
New model will be interesting
The stock becomes interesting below $30 with a market cap of just $2.4 billion. The company has a strong balance sheet with nearly $0.9 billion in cash on hand. Upstart has nearly $850 million in debt, mostly offset by $625 million in debt investments on its balance sheet. Net enterprise value is just $1.7 billion.
Investors must understand that Upstart will never trade at valuation premiums similar to those of the past. The market will not trust that the funding problems will not show up in the next cycle.
Additionally, it’s difficult to rate the stock without actually knowing its ultimate sales bottom. The market is forecasting $900 million in revenue over the next few years, making the current EV attractive.
The real key to the stock’s appeal lies in whether Upstart can solve its funding problems. The management team is working on a new plan for committed financing from banking partners while using existing capital to fund loans during periods of reduced funding.
Any scenario that offers funding to Upstart to avoid the current problem would make the stock attractive here. The current business model is flawed and the only acceptable solution to the problem is a source of funding that will not disappear in the next weak economic cycle.
While the market loves the concept that a fintech does not take credit risk, the business model only works if the risk model works. If banking partners are unwilling to fund the loans, Upstart should no doubt step up and leverage available capital or seek a digital banking license to fill the gap. In essence, the company and shareholders should be willing to bet on the AI lending model, or they should not expect banking partners to take that risk.
LendingClub had solved the same problems by acquiring a digital bank. The lending platform saw revenue stall at the same level as Upstart. Still, the company now generates over $300 million in quarterly revenue for the current period because it doesn’t face the same hit in debt financing, with the flexibility to self-fund up to 25% or more of new loans.
Upstart plans to transform the business model into a tied-up capital structure. The stock will be more investable at this point, but as CEO Dave Girouard pointed out on the Q2’22 earnings call, the transition will take time:
As a result, we have concluded that we need to upgrade and improve the funding side of our marketplace, onboarding a significant amount of committed capital from partners who will invest consistently through cycles. We’re currently evaluating different ways to do just that. So we expect this will take some time to materialize. While we continue to believe that becoming a bank does not make sense for Upstart, we have determined that sometimes it can make sense to use our own balance sheet as a bridge to this promised funding.
The key takeaway for investors is that Upstart has historically encountered predictable issues that most fintech lending platforms have faced. The new business model is too opaque to invest here, but the stock becomes more attractive when a more dedicated funding model is in place. At this point, investors cannot properly analyze the investment opportunity based on the terms of the promised financing model. As such, investors should just watch as Upstart marginally develops the new model.