4 red flags for the future of Upstart Holdings The Motley Fool | Vette Leader

Ordinary Holdings(UPST 9.62%) The share price fell 12% on Aug. 9 after the online lending company released its second-quarter earnings report. Revenue rose 18% year over year to $228 million, but missed analyst estimates by $7 million. Adjusted net income plunged 98% to $1 million at $0.01 per share, also missing consensus guidance by $0.07.

Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) fell 91% to $5.5 million. On a GAAP (Generally Accepted Accounting Principles) basis, it reported a net loss of $29.9 million, compared to a net income of $37.3 million a year earlier.

Those headlines were disappointing, but they were already partially telegraphed in its July 7th preliminary earnings report. And a deeper dive shows four more red flags.

Image source: Getty Images.

1. Upstart management has a bleak outlook for Q3

For the third quarter, Upstart expects revenue to decline 25% year over year to $170 million, compared to analysts’ expectations of 8% growth. The company also expects Adjusted Net Loss to be approximately $9 million and Adjusted EBITDA to reach breakeven.

Once again, Upstart largely blamed rising interest rates, causing people to take fewer loans through its platform, while prompting its lending partners (banks, credit unions, and auto dealerships) to be more cautious about funding those loans.

2. Upstart questions its own business model

Upstart initially attracted a lot of attention for two reasons. First, it analyzes non-traditional data — including a client’s educational history, area of ​​study, standardized test scores, and work history — with a cloud-based artificial intelligence (AI) platform to approve loans.

Second, Upstart offers a wide range of loans on its website, but typically does not fund these from its own balance sheet. Instead, it acts as an intermediary for its lending partners, who then fund the actual loans and pay Upstart fees to access its platform.

This business model exposes Upstart to less credit risk, but also creates a bottleneck by making it dependent on its lending partners for new loans. To overcome this bottleneck, CEO Dave Girouard abruptly announced during the company’s second-quarter earnings call that the company would begin “using our own balance sheet as a transition bridge to this committed funding.”

It’s a risky move, since Upstart already ended the second quarter with an elevated gearing ratio of 1.5. It still had $790 million in unrestricted cash, but that liquidity could dry up quickly if revenue growth slows and losses mount.

Girouard said that while it “makes no sense for Upstart to become a bank,” it needs to “update and improve the funding side” of its marketplace as interest rates rise. In other words, management is beginning to question the resilience of its own business model.

3. Upstart sees declining loans and conversion rates

Upstart bank partner loans increased 12% year over year to 321,138 in the second quarter, but decreased 31% sequentially from the first quarter. The conversion rate, or percentage of total requests that convert to actual loans, was just 13%, compared to 24% a year ago and 21% in the first quarter of 2022.

These declining engagement rates explain why Upstart is so desperate to fund its own debt. They also suggest that its smaller competitor, Pagaya Technologies (PGJ 2.83%) — which offers comparable white-label AI services to financial institutions rather than acting as a loan brokerage platform — could take a smarter long-term approach.

4. Management initiated pointless buybacks

As Upstart faces a grueling slowdown, suffers bigger losses, and takes on greater credit risk, it’s also buying back more shares. In February, it announced a $400 million buyback plan. No shares were repurchased in the first quarter, but $150 million was repurchased in the second quarter.

These buybacks are arguably a waste, as all of that cash could be used to fund new loans, reduce debt, or simply expand the platform. Upstart repurchased 4.4 million shares (at an average price of about $34), but its weighted average diluted shares outstanding declined only 1% sequentially and actually increased 1% year over year to 94.5 million.

As such, Upstart will likely use these buybacks to offset dilution from its stock-based compensation expense, which rose 86% year over year to $55.4 million in the first half of 2022, rather than actually returning that cash to investors through its Free float reduced.

Upstart deserves to stay in the box

Upstart’s stock might look reasonable at three times this year’s sales, but that price-to-sales multiple is still tied to analysts’ expectations for 12% sales growth this year. Those estimates could be scaled back after Upstart’s disappointing second-quarter report. For now, it deserves to stay in the box until it stabilizes its core business.

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