Upstart: Get In Before Rates Come Down (NASDAQ:UPST)

Upstart’s (NASDAQ:UPST) shares crashed 20% after the Fintech start-up presented results for the fourth quarter that beat expectations on both the top and bottom lines. The AI start-up’s revenue forecast for Q1’24 was perceived as weak, however, as it came in below consensus estimates. Since Upstart is a rate-sensitive credit play for investors and the Federal Reserve announced that it is going to cut benchmark interest rates in FY 2024, the start-up could be set for accelerating loan demand this year. Key performance metrics are also improving and I believe investors may want to consider buying Upstart before the Federal Reserve starts to lower rates. Shares of Upstart are trading below the 1-year average P/S ratio and have rebound potential, in my opinion.

Previous rating

I rated shares of Upstart a strong buy in November despite revenue pressures and weakening loan demand, which impacted the Fintech’s business negatively. Upstart’s financial profile appears to have further stabilized in the fourth-quarter, however, and I believe investors are overreacting to the Fintech’s revenue outlook for Q1’24. Since the Federal Reserve has stated clearly that it seeks to pivot in terms of its tightening policy in FY 2024, it is only a question of time until Upstart’s operating fundamentals return to positive growth.

Upstart beat earnings for Q4’23

Upstart’s shares tumbled 20% although the Fintech start-up managed to beat bottom and top-line estimates for the fourth-quarter. Upstart’s adjusted earnings were $(0.11) per-share, compared against a consensus of $(0.14) per-share. Revenues beat slightly, coming in $5M ahead of the consensus.

Upstart’s fundamentals are improving

Upstart provides proprietary, cloud-based, AI lending services to its bank partners and in return gets to charge a fee if a consumer is converted and manages to secure a loan. The Fintech is mostly concentrated on personal loans, but demand for loans has suffered greatly in a high-interest world.

Upstart’s fourth-quarter revenues fell 4% year over year to $140.3M, while revenue from fees declined only 2% year over year to $152.8M. The drop in revenues is due to the fact that consumers demand less credit products during high-interest periods. As a result, most of Upstart’s earnings figures also looked dismal in the fourth-quarter, net income was negative $42.4M and adjusted net income came in at $(9.7)M. However, these metrics could improve in the second half of the year, in my opinion, as the Federal Reserve is set to lower interest rates, which could boost loan demand for Upstart’s AI lending platform.

Improving KPIs, Q/Q jump in new loans

While Upstart’s revenues remained under pressure in the fourth-quarter, the company did not experience as much revenue pressure as it did in the previous quarter, which is when revenues dropped 14% Y/Y. The firm did, however, see an improvement in key performance metrics like the percentage of fully automated loans originated and its conversion rate.

Upstart’s credit platform saw a 1 PP increase quarter over quarter in fully automated loans to 89% in Q4’23. Additionally, the conversion rate improved 2 PP from 10% in Q3’23 to 12% in Q4’23.

At the end of the day, Upstart is a rate-sensitive credit bet and the outlook is more positive I believe as investors may believe. Loan demand can be expected to increase when loans become less expensive, which is a scenario that is set to play out in FY 2024 as the Federal Reserve is loosening its tightening policy.

Although loans are still expensive at this stage in the rate cycle, Upstart did see a 14% jump in loans: in the fourth-quarter, the number of loans originated through Upstart’s platform totaled 129,078 which implies a 14% quarter-over-quarter increase, chiefly because of the holiday period that tends to cause an uptick in demand for new personal loans. While Q1’24 should see a bit of a seasonal drop-off in loan originations and revenues, which is reflected in the company’s guidance, I believe that the longer-term interest rate picture only serves to make Upstart attractive as a growth investment.

Outlook for Q1’24

Shares of Upstart sold off 20% after earnings, chiefly because the outlook came in below expectations. The Fintech guided for $125.0M in revenues for Q1’24 while the market expected, on average, a top line of $151.3M. The guidance implies an 11% Q/Q drop in revenues. However, I believe the market overreacted to the revenue outlook as the company’s origination business is set to get a boost once the Federal Reserve starts to lower interest rates… which is widely expected to happen in the second half of the year.

Upstart’s valuation

Upstart is trading at an attractive revenue multiplier after last week’s sell-off. I am using a revenue-based valuation metric to compare Upstart to other Fintech rivals, as Upstart is not yet profitable.

Shares of Upstart are currently trading at 2.95X forward revenues, which is about the same level SoFi’s (SOFI) shares trade at. SoFi is currently crushing it due to exceptionally strong customer acquisition rates and the Fintech achieved positive GAAP profitability for the first time ever in FY 2023… which served to prove all the naysayers wrong that predicted this could not be achieved.

PayPal (PYPL) is trading at the lowest P/S revenue ratio of 1.84X which is due to the fact that the company has to deal with some account problems (it is losing customers), but the Fintech’s enormous free cash flow, in my opinion, is a great reason to load up the truck after the post-earnings price crash.

Upstart is currently expected to grow its revenues 14% this year, while SoFi and PayPal’s consensus expectations imply 15% and 7% top-line growth. However, Upstart is set to benefit the most from a lower-rate market, which would aid its rate-sensitive credit business much more than SoFi’s banking business model or PayPal’s payments processing business. Therefore, Upstart is expected to grow its revenues 31% in FY 2025 compared to 17% growth for SoFi and 8% growth for PayPal.

Upstart could easily be valued, in my opinion, at 4.0X revenues given its stronger longer-term growth prospects in a lower-rate world and re-accelerating top-line growth. This valuation multiplier would also be more in line with Upstart’s 1-year average P/S ratio of 4.1X. Currently, investors get a 26% discount on Upstart’s 1-year average revenue multiplier.

A 4.0X revenue multiplier implies a fair value of $35. This, of course, is a dynamic number that will change depending on the actual trajectory of interest rates and Upstart’s ability to pull off a revenue recovery in a lower-rate world.

Risks with Upstart

Upstart’s biggest risk, as I see it, relates to the Federal Reserve’s plans to lower benchmark interest rates. January’s inflation report has widely changed investors’ expectations with regard to the Federal Reserve’s resolve to lower interest rates quickly. With benchmark interest rates staying higher for longer, potentially positive tailwinds for Upstart’s rate-sensitive credit business may be delayed.

Closing thoughts

Upstart’s financial report for the fourth-quarter was not quite as bad as the market would have you believe: the Fintech saw a much lower decline in its revenue base (4%) compared to the previous quarter (14%), which strongly indicates to me that the Fintech’s AI-powered credit business is further stabilizing. While Upstart generated a big net loss, key performance metrics such as conversions are improving.

With interest rates set to come down in the second half of FY 2024, I believe the odds favor investment in Upstart because its credit business could see a rapid uptick in originations once loans become more affordable. Investors don’t price these tailwinds into the Fintech’s shares at this time, in my opinion, which creates a significant revaluation opportunity for longer-term oriented growth investors. The time to invest in Upstart is before interest rates come down, not after!