Upstart: A profitable growth company

While I'm usually a value-based investor, I do have room for a few growth stocks in the portfolio. Growth stocks are riskier but may also grow substantially both in short-term and in the long-term. Lately, I have been investigating Upstart, and here are my thoughts on the company.

This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

This analysis will be a bit different from what you are used to read in my blog. Upstart is a growth company. So instead of using the principles I have learned from my Phil Town workshop, I use the principles I have learned from the GOAT academy. I should also mention that most of the numbers I use in this analysis is from Finbox, which I believe is a great tool to get different numbers from various companies.

Before I start with the analysis, I should mention that I do not currently own shares in Upstart. I came across the company some time ago, as it grew from $120 to $390 in just 2,5 months. It has since dropped to $99, which is the price as I write this. Hence, the stock is definitely very volatile, and you need to be able to stomach that, if you choose to invest in Upstart.

Upstart is an American company that was founded in 2012. They describe themselves as a cloud-based AI lending platform. In short, they connect people that needs a loan with lenders. Traditionally, banks used the FICO requirements to calculate credit scores. These requirements were not only time consuming, but they also resulted in a large share of the population being excluded from taking a loan. Upstart wants to change that by creating an AI model that take other requirements than the FICO ones into account. As a result, consumers should get higher approval rates, lower interest rates and faster payouts, while the banks benefit from access to new consumers, lower fraud and loss rates, and increased automation throughout the lending process. Upstart is mainly generating revenue from fees by receiving a fee from being the middleman between the consumers and banks/institutional investors, as 92 % of the revenue was made this way in Q3 2021. It also means that Upstart only hold very few of these loans themselves. Upstart is building their secret moat through their AI model. An AI model cannot simply be copied as Upstart has a head start with lots of data points. Hence, I do feel like Upstart has a secret moat that will only be stronger moving forward. Upstart started with consumer loans and moved into auto lending in 2020. They did their IPO in 2020 as well.

Their CEO is David Girouard. He is also the co-founder of Upstart, which is something I like, as founders are usually determined in growing the business. He has an MBA from the University of Michigan, and prior to founding Upstart, he held positions in Apple and Google. He has said that the reason he left Google to start Upstart is that the finance industry has been frozen in time for decades, and he sees a great opportunity to use technology and data science to build something impactful and differentiated. He also mentioned that he believes that millennials have no particular affinity to banks, and that the next great financial institutions will have well-defined brands like Nike and Apple, and that is the sort of brand he wants to create with Upstart. He believes that customer experiences are what will grow Upstart in the future, borrowers want a loan with the lowest possible rate as easy as possible and that is what Upstart wants to provide. When asked how he motivate others, he said he hires self-motivated people, and once he shares the opportunity to build a lasting company that will change the world forever, it is easy. Another thing I like about the management is that the other two co-founders, Paul Gu and Anna Counselman are also still part of the company. Hence, I feel very comfortable that the management can grow Upstart moving forward.

I believe that Upstart already has a moat that will grow stronger moving forward. I feel very confident about management as well. Later I will do a discounted cash flow model to calculate a price for Upstart but before I do so, let us just have a look at some key financial metrics.

Down below we see some key financial metrics. 2021 has been a great year for Upstart. They grew their revenue tremendously. The also achieved to grow their gross profit margin, and it now reached 86,2 %, which is a level you don't see in most companies. Furthermore, they also managed to grow their operating margin to a level above 2019. It is also worth noticing that the company became profitable in 2020. All in all, the metrics looks fantastic as they are growing both the top line and bottom line.

Before we continue to the discounted cashflow model, I would like to investigate the risks and potential of Upstart. One risk is that the limited operating history. It is a risk that exist for all growth companies. They have been growing at a rapid pace but only for a short while. Hence, it is difficult to determine of the company can continue their growth moving forward. They need continue to improve their AI model. If they cannot continue to grow their AI model, or in case the model contains errors, they will lose their moat. Without their moat they will lose their competitive advantage, and we could see competitors taking market shares. Depending on few customers. According to their 2020 annual report, Cross River Bank accounted for 63 % of their revenue, while another bank accounted for 18 % of their revenue. If Cross River Bank or the other bank end their relationship with Upstart, it will significantly hurt their business. Macroeconomic factors could affect revenue. The Fed has already announced that they will increase interest rates in 2022. Higher interest rates usually suggest less borrowing, which will hurt a company like Upstart. The pace in which interest rates are rising means that in Q1 in 2022, Upstart had to put some of their loans into their balance sheet.

There are also lots of potential for Upstart moving forward. Expanding into new markets. Upstart started with personal loan originations, which according to Upstart is a $81 billion market. They expanded into auto loan originators, which is a $672 billion market, and it also has higher margins than personal loans. In their latest conference call, they talked about moving into mortgage loan originators. CEO David Girouard said: "If people don't have access to a reasonable priced mortgage today at all, we certainly think there is an opportunity to serve them better". The mortgage loan originators market is, according to Upstart, a $ 4,5 trillion market. They are growing at a rapid pace. In Q3 2020 there were 80.893 loans originated on their platform, in Q3 2021, they facilitated 362.780 loans, which is a growth rate of 348 %. They are also adding more partners, in Q3 2020 they had 10 bank and credit union partners, and in Q3 2021 they have 31 partners. Their business disruption. According to Upstart's website, they have made some comparisons with traditional bank models when it comes to loan approvals. And if you compare the same approval rate, Upstart AI approved loans had 75 % fewer defaults at the same approval rate. And if you turn it around, Upstart had 173 % more approvals at the same loss rate. Hence, Upstart has the potential to reach consumers that would never be approved using the traditional FICO method, and that comes with 67 % of all the loans in Q3 2021 being fully automatically approved. In the next paragraphs I will go through my calculations to find the intrinsic value of Upstart.

I have now investigated the financials, risks, and potential of Upstart. I will now look at the price by doing a discounted cash flow model. To do so I will need some numbers that you can see below. The numbers are the Q1 2022 numbers, which I could find at Finbox. However, the perpetuity growth rate and the discount rate are numbers I have come up with myself. The reason I chose 5 % as perpetuity growth rate is that it is usually a between the historical inflation rate of 2-3% and historical GDP growth of 4-5%. I decided to go with a higher option due to the business Upstart operates in. The chosen discount rate of 12%, it is usually between 9-12%, and I decided to go with the higher one due to current market conditions. Remember that all the numbers made in these calculations are in millions.

I also need to determine how much EBIT, Depreciation & Amortization and Net Working Capital will evolve over the next couple of years. According to Finbox, Upstart is expected to grow their EBIT of 51,1 % on average the next 5 years. However, they lowered their guidance in their latest earnings call. They didn't guide for EBIT growth but guided an EBITDA growth of 15 % in 2022. Their EBITDA growth was lower than their EBIT growth last year but I think it is a good numbers to work with. Hence. I decided to make my calculations based on an EBIT growth of 15 % in 2022 and 2023, while they get back on track in 2024 and 2025 with an EBIT growth of 50 % in each of their two years. I decided to go with a Depreciation & Amortization growth of 20 % in 2022 and 2023, and 60 % in 2024 and 2025. It might sound high but it is well below the historical growth. I decided to keep Net Working Capital at the level it is on today. I haven't found a smart way to share all my spreadsheet here but once I did my calculations, I found that the intrinsic value of Upstart to be $29.

Having investigated Upstart, I find the company very interesting. I think they have a lot of potential because of their business disruption and their great management. However, I'm also quite disappointed with their latest guidance, and have used much more conservative growth moving forward. I really don't like that they needed to put a lot more loans on their own balance sheet. Management do not expect to put this amount of loans on their balance sheet moving forward but see it as a onetime event due to fast rising rates. Nevertheless, it isn't something I like to see. I think that Upstart is facing a lot of short-term challenges and it will be interesting to see how management deals with it. I'm still intrigued by their business model though, and I will consider opening a small speculative position, if the share drops below $14,5, as I would get it 50 % discount to intrinsic value.

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