Upstart Holdings - Way Beyond a FICO Score
If you take a close look at my previous company deep dives on this site, you'll start to notice a theme. That theme is "disruption." For example:
Disruption, in my eyes, is the biggest key to growth a company has. The ability to dive into an already established space, plant a flag and dynamically stand on the battered body of what used to be your competition is the way to the top. For every iPod, there was the CD player that was thrown to the wayside. Every Tesla replaces an Accord or a BMW. Every Bitcoin will soon replace the president in your wallet (probably). Sometimes, the company is so disruptive that you don't even know what it does but you invest in it anyway and then make an ass of yourself on national television:
Well that's where today's subject comes in. For every FICO score now comes a test grade or proof of a degree. Weird, I know, but I'll explain. Let's get into the digital lending disruptor, Upstart Holdings.
Top-Line Numbers
FY 2020 Revenue: $241.44 million (+26.62% YoY)
FY 2020 Net Income: $5.98 million (+1,383.91% YoY)
Q3 2021 Revenue: $228.72 million (+242.41%)
Q3 2021 Net Income: $29.11 million (+201.10% YoY)
Market Capitalization: $16.96 billion
What Is Upstart's Business?
Upstart exists in the world between the lender and the recipient of the loan when a person like you or me applies for one, introducing new variables to establish creditworthiness. How the process currently works is that you apply for a loan with a bank. The bank takes your application and pulls your PII (personally identifiable information) out of the three credit bureaus: Experian, Equifax and TransUnion. The scores produced from these three companies are used to determine your credit worthiness, called a "credit score." This score is rolled together with your FICO score (think the JV version of a credit score), income, current debt-to-income levels and so on, to determine if you qualify for the loan, and what your interest rate could be. Typically, the higher the score, the lower the interest rate because you're a lower risk to the lender.
Upstart looks to supplement those traditional factors with things like educational background and work history, putting all of those variables into their A.I driven model to determine a more holistic view of creditworthiness. This helps both sides of the loan application in this instance: the loan recipient is more likely to get a better interest rate because they can prove their creditworthiness in other ways, while the bank loaning the money can approve more applicants at a less risky rate because they have access to a greater data set. In turn, Upstart charges a fee that the bank will gladly pay because they're making more money. Additionally, Upstart states that their algorithm becomes more effective the longer they are able to stay with a client and analyze their existing data set, meaning the business is very sticky.
This success isn't just theoretical. Since 2014, Upstart clients and banks have seen 75% fewer defaults while increasing approvals 173%. The results are pretty striking. So who came up with the idea to benefit both the banks and those receiving loans?
How Did Upstart Get Started?
That honor belongs to founder and CEO Dave Girouard. Girouard is, as the Upstart website is very quick to tell us, an ex-Google employee who struck out on his own. Back in 2012, Girouard left Google to pursue his passion project based on what he called "a misallocation of capital in our economy." However, the start of life for Upstart is very, very different than the company we know today.
Upstart originally began as a crowdfunding platform for individuals that needed money for their big idea or next great company. Users could start a crowdfunding campaign, similar to a Kickstarter, in order to raise funds to begin their project. They were basically pitching themselves on the platform, with their CV being, well, their literal CV. They pitched themselves on the basis of their education, GPA, past achievements and future goals in order to persuade investors to buy in. However, unlike Kickstarter, investors didn't receive pre-order items or accessibility to new products; they received a percentage of future earnings from the company/idea that eventually comes out of the fundraiser. Upstart comes in by providing both the platform to fundraise, as well as the A.I-driven algorithm that calculated the ideal earnings-to-fundraising percentages for each campaign. This is actually where the name of the company comes from, because their former tagline was "The startup is you."
This idea actually had legs in the early days, backed by several VC firms and even Mark Cuban as it rolled out to a few different college campuses. However, the idea failed to catch fire because the whole idea of the income share agreement (ISA) didn't really work as expected. So rather than pack it in entirely, Girouard took the A.I part of the company that did work and applied it to the loan sector. $160 million of private funding later, including a double dip from Cuban, and you've got one big-time A.I loan processor. On December 15, 2020, the company IPO'd on the Nasdaq at a $1.45 billion market capitalization. Recent company performance now puts CEO Dave Girouard at an estimated net worth of $1.15 billion.
Upstart's Bull Case
Aggressive Expansion into Auto Loans
Upstart has taken to the public markets like a duck to water, skyrocketing over 470% since its IPO nearly one year ago. The crux of their success has been nonstop growth into the credit union and community banking space. The value proposition Upstart provides this industry is that it creates a more successful, cheaper personal installment loan product for the banks and unions, which have historically shied away from the product due to the cost of these loans (and what it costs them when there's a default). As mentioned previously, Upstart is able to increase the delta between the number of applications accepted and the default rates, making personal installment loans suddenly profitable. Well, Upstart is looking to take this logic and apply it to a new stream of loans: car notes.
Earlier this year, Upstart acquired Prodigy, a company specializing in car dealership sales software, allowing them to burst into the second-biggest American loan market (only behind mortgages but you'd better believe that's coming) at a total addressable market of $1.3 trillion. In September, Prodigy became Upstart Auto Retail, integrating financing into the sales tool to provide a one-stop-shop type experience for dealerships. Additionally, Upstart was quietly expanding its availability to dealerships by 45% in the United States, giving them a total coverage of 291 "rooftops" in 33 states. These factors, along with record inflation boosting car prices by as much as 10% in some states, contributed to over $800 million worth of auto loan origination through UAR. And it's not just UAR that's driving auto revenue, as Upstart's flagship platform also offers auto loan refinancing, giving them a backdoor and a front door into the auto loan industry. Pretty smart.
Ridiculous Growth
So we usually see companies of this size and age in this type of space grow pretty quickly for the first few years before coming slamming back down to earth like one of SpaceX's engines failed. But the growth we're seeing from Upstart in the last 24 months is...different. Q3 revenue grew 250% year over year. If you like that, you're going to LOVE their Q2 revenue growth of over 1,000%. While unsustainable (we'll discuss that later), it's a great sign that their expansion plan is indeed working. And it's working to the tune of constant revenue guidance increases. On each of the three earnings calls this year, leadership at Upstart has increased their revenue guidance, breaking through the $500 million, $600 million and $750 million barriers. That's...not normal.
It could get crazier when they begin to roll out their micro-loan product, which was announced in their most recent earnings call. Small dollar loans can usually see sky high interest rates, so Upstart’s confidence they can produce loans of this size at a 36% interest rate could garner fascinating results.
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They're Profitable!
That is super weird. FinTech companies are borderline wizards at making profits disappear into "expansion" and the marketing part of their EBITDA expenses, but Upstart actually turns a profit. This is excellent news for the future stability of the company if they're able to apply the same profitability model to their future expansion and go full "Scrooge McDuck room full of gold coins."
Upstart's Bear Case
Lofty Expectations and Down Markets
Yeah, told you we'd get to it. So the growth listed above, while incredibly impressive, is totally unsustainable. Manheim, the leader in American used-car auctions, has noted that their super tight inventory in 2021 has likely bottomed out, and we're back on the upswing. This is cause for concern for the growth of the auto loan unit of Upstart, as the company would need to increase the volume of loans fulfilled to maintain the same revenue. Assuming that the 10% used-car hyperinflation comes back down to earth at 2%, Upstart would need to make up that 8% gap they all of a sudden have on their income statement. That's a daunting task, but not unrealistic for the rate the company is expanding.
Additionally, I mentioned revenue guidance increases earlier. While this is excellent to see in any company, it's caused our favorite finance bad guys, the over-caffeinated analysts from Wharton and Stanford, to jump all over 2022 estimates. Currently, consensus sees a $1.1 billion full year revenue estimate, which implies a 40% upside from their expected $800 million revenue guidance for full year 2020. I will note, however, that information from Upstart’s PR team indicates that many analysts have not seemed to factor in the auto loan segment in 2022 estimates.
The Valuation is Bananas
"Bananas" is the most advertiser-friendly term I could think of for a section title, but now that the SEO monster has skipped this part of the article, I can confidently say that the valuation is batshit bonkers. Currently trading at a market capitalization of $16 billion, its price to earnings ratio sits at a nauseating 252, and it doesn't get better when you look ahead and see a 166 FP/E. Jesus Christ. Additionally, the company would have to essentially triple its earnings per share in order to justify the previously stated analyst expectations (again with the caveat of the lack of auto segment inclusion), which seems to be setting the company up for short-term failure.
Upstart's Loss is Their Competition's Gain
While Upstart's Q3 earnings report beat consensus analyst estimates, management did indicate a general slowdown for Q4 into the new year. This didn't exactly thrill investors, who pulled out of the stock after earnings and it tanked. But who did this benefit? The competition, namely LendingClub.
LendingClub is a similarly digital loan originator, but rather than start the loan on their platform and fulfill via the bank, LendingClub starts and ends the loan in the bank, then keeps a percentage in recurring revenue for themselves for each fulfillment. Despite being a smaller company, LendingClub actually completed the same volume of loan origination in each of the last two quarters, as well as turning in higher net income in Q4 of last year. and comparable gross revenue so far in 2021. A key difference is the overall expenses of the firm, as LendingClub pulls a David Copperfield and makes their money *poof* disappear.
LendingClub could also benefit from the analyst expectations game. LendingClub has had an...interesting, let's call it, couple of years leading up to 2021, and the share price has reflected it. Bottoming out at around $5 in late 2020, the turnaround story has been pretty staggering, leading to an 8x share price increase in the last 13 months. If Upstart slips, LendingClub could be right there to pick up the slack.
The Bottom Line
Upstart's business model, through all of its evolution, has resulted in a pretty solid and disruptive company. The lending space seemed ripe for disruption, and companies like Upstart (and LendingClub) are there to jump in and change the game. Upstart's aggressive expansion into the auto industry could be a phenomenal growth driver, but I'd also like to see them get into other loan areas like mortgage and HELOC, though I'm sure these are on the long-term road map. Assuming the company can continue their hot growth streak for at least the next couple of years, this company seems attractive from a long-term hold standpoint. What frightens me is the analyst expectations, which look to weigh heavy on the company in the next few quarters. I would stay on the sidelines as the company presumably struggles to meet the Street's expectations before it catapults into another stratosphere, assuming more reasonable expectations are placed on Upstart in the future.
Short-term: Neutral
Long-term: Long
The following article is for entertainment purposes only, and should not be interpreted as investment advice. The article represents the opinion of the author, so please do your own research. For individual situations, please contact an investment and/or tax professional. The author does not have a financial stake in Upstart.
