Upstart Holdings, Inc. (UPST, Financial) stock crashed 23% in after-hours trading on Nov. 7 following the company's third-quarter earnings report and ended Nov. 8 down more than 27%. Historically, Upstart stock has been prone to wild swings during the earnings season, and the market response to Q3 earnings does not come as a surprise given the lackluster guidance for the fourth quarter. A closer evaluation of Upstart's third-quarter earnings, the disappointing guidance for the upcoming quarter, and the company's long-term outlook suggests Mr. Market is short-sighted about what the future holds for the company. The current weakness in Upstart stock, therefore, presents a good opportunity for long-term-oriented investors who are ready to stomach the substantial volatility associated with UPST stock.
The weak quarter masks notable improvements
Upstart Holdings had a weak third quarter, with the company missing analyst estimates for both revenue and earnings. The company reported revenue of $134.56 million for the quarter, a year-over-year decline of just over 14%. Upstart also reported a loss of 5 cents per share against expectations for a loss per share of 1 cent. As discussed in the next segment of this analysis, many of Upstart's challenges stem from macroeconomic woes over which the company has little control. Upstart's revenues have declined in each of the last five quarters, highlighting how the company has failed to overcome the challenges posed by difficult industry conditions.
YoY decline in revenue
| Reporting period | YoY decline in revenue |
| Q3 2023 | 14.4% |
| Q2 2023 | 39.2% |
| Q1 2023 | 64.6% |
| Q4 2022 | 50.4% |
| Q3 2022 | 29.9% |
Source: Company filings
Amid this challenging environment where the company is struggling to grow, Upstart Holdings has made notable progress in improving its operational efficiency. In the third quarter, Upstart reported an adjusted EBITDA of $2.3 million, marking the second consecutive quarter of EBITDA profitability. What stands out is Upstart has achieved this feat on the back of declining revenue. In Q3, operating expenses declined by 17% YoY as the company cut back on engineering and product-related expenditures to align its cost base with the declining revenue.
Another notable development was the improvement in contribution profit margin, which is a non-GAAP metric used to calculate the gross profitability of loan disbursements. In the third quarter, the contribution profit margin reached 64%, substantially above the 54% contribution margin reported in the third quarter of 2022. This improvement indicates the growing efficiency of the company in approving loans. With Upstart's AI model now being trained with an increasing amount of repayment data and borrower data, the company is likely to be able to keep borrower acquisition costs low in the long term. This, in return, will help contribution profit margins.
In the third quarter, 88% of loans were fully automated, which was a new record for the company. The lower volume of loans approved on the platform certainly played a part in boosting the percentage of fully automated loans, but in general, Upstart has been successful in automating the borrower approval process in the last few quarters. When macroeconomic conditions turn favorable in the next phase of the business cycle, Upstart stands to benefit from this as more bank partners would feel comfortable partnering with Upstart to penetrate new markets.
Investors should also pay attention to how Upstart is continuing to attract new funding partners even amid challenging market conditions. A couple of years ago when interest rates were still low and lending activity was booming, Upstart had approximately 40 bank partners. Today, the company works with more than 100 banks and credit unions. This substantial growth in partnerships has failed to convert into revenue growth as these new partners are being cautious about approving new loans amid high interest rates, but in the future, Upstart will be able to handle much higher loan volumes than it did during its peak in 2021.
In summary, Upstart had a weak third quarter but a closer look at the business reveals a few areas where the company is performing well. For now, Upstart's goal is to survive the difficult market conditions and position the company to thrive in the long run, and it seems reasonable to conclude that Upstart is making progress on this front. However, Mr. Market remains oblivious to this progress.
Understanding the growth obstacles
Upstart Holdings runs an AI-enabled marketplace that acts as a matchmaker between borrowers and lenders. In return, the company charges fees from its lending partners, aka banks. Upstart's in-house algorithm, which has been trained with billions of data points, is expected to rival traditional lending score systems in the future. In fact, according to the company management, Upstart's model is already performing better than FICO in predicting credit outcomes, enabling its bank partners to disburse new loans at attractive rates to customer cohorts that were previously not serviced by financial services companies.
The Fed's fight against inflation has resulted in elevated interest rates across the board, and Upstart has become a victim of higher rates. The company's bank partners have become extremely cautious about approving new loans, and Upstart is currently finding it difficult to match the demand for credit on its platform due to a lack of funding. In the third quarter, bank partners originated 34% fewer loans compared to the corresponding period last year, making it difficult for Upstart to grow fee revenue.
The long-term outlook is promising
Upstart's objective is to offer a more inclusive banking experience to Americans while providing the best rates for both banks and borrowers. According to company filings, Upstart's proprietary models train on over 120 billion cells of performance data with an average of 85,000 repayment data added every business day. According to the findings of Upstart's Annual Access to Credit report, the company's algorithm approves 44% more applicants compared to a traditional credit score model. Even more interestingly, the Upstart model does this at an APR that is 36% lower than the traditional model. Even amid rising interest rates, Upstart has been able to maintain better default rates compared to traditional models, which speaks volumes of the robustness of the AI algorithms used by the company. In the long run, Upstart's technological superiority is likely to help the company attract more borrowers, more funding partners, and more investors.
Upstart started as a lending platform focused on personal loans, which, according to TransUnion data, is a market valued at $160 billion. Today, the company is expanding into several other end markets that are bigger compared to the personal loan market. According to TransUnion data cited by Upstart in its earnings presentation, the auto loan market is valued at $731 billion and the mortgage market is valued at $1.8 trillion. The small business market, which is another new market Upstart is keen on penetrating, is valued at $895 billion. The company is well-positioned to mimic its success in the personal loan market in these new market segments, which should boost revenue growth in the long run.
Today, this promising outlook is overshadowed by short-term macroeconomic challenges. As investors, however, it is imperative to focus on the long-term outlook for a company when making investment decisions.
Takeaway
Upstart Holdings is a misunderstood business. The company may take a while to get back to the peak demand enjoyed in 2021, but when economic conditions turn favorable, Upstart will be in a strong position to easily exceed the peak loan volumes it handled two years ago. As a young business, Upstart is focused on penetrating new market opportunities. The company, during this downturn in business, remains laser-focused on improving its operational efficiency while onboarding new bank partners to cater to the expected surge in demand for credit in the next expansion phase of the business cycle. The current weakness in the stock price offers investors a good opportunity to consider investing in Upstart before the U.S. economy enters a growth phase.
