Reached ( UPST -7.34% ), the lender using artificial intelligence in its lending decision-making, delivered strong results for the fourth quarter of 2021, pushing its share price higher last week. But the company also delighted shareholders by announcing that it had authorized a $400 million share buyback program.
The news of the stock buyback came as a bit of a surprise as Upstart only went public at the end of 2020 and has been in growth mode ever since. Typically, companies in growth mode do not buy back shares. They are usually too focused on investing in the business to grow users and gain market share.
Let’s take a look at why Upstart chose to buy back shares and what it could mean for investors.
Volatility and valuation
Upstart’s chief financial officer, Sanjay Datta, attributed the decision to buy back shares to the stock’s recent volatility. Since its IPO, Upstart’s stock has been on a rollercoaster ride. It traded at around $44 per share on its first day as a public company, then hit nearly $400 per share last October. But in recent months, the stock has taken a hit along with most other tech and fintech stocks as inflation rose and the Federal Reserve changed its monetary outlook. The market reset on news that the Fed will raise its benchmark overnight lending rate (the federal funds rate) several times this year and may also reduce its balance sheet at some point.
On Upstart’s recent earnings call, Datta said the buyback plan was tied to the stock’s volatility; the fact that Upstart is already profitable, which is rarely the case for a fast-growing fintech; and management’s belief that the company is undervalued.
But even at current price levels, Upstart shares are trading at about eight times projected sales in 2022 and about 56 times projected earnings. When Upstart was trading near $400 per share, it was trading at about 40 times forward sales and 200 times forward earnings. I wouldn’t exactly call 56 times forward earnings a light valuation, and in no way do I think Upstart belongs near 200 times forward earnings or 40 times forward earnings right now.
Upstart should focus on its core business
While the company plans to increase spending to do things like increase tech hiring, I would rather see the company focus on its core business than buy back stock. Upstart’s entire model is built on the belief that it can better gauge the true quality of borrowers. The company claimed it could produce default rates 75% lower than traditional bank underwriting. Ultimately, Upstart wants banks to use its underwriting models and ditch traditional FICO scoring requirements. The company started with unsecured personal loans, then recently expanded into the auto loan business. Management said it plans to expand into mortgages, small dollar loans and then small business loans.
Over the past few months, Upstart has begun to underwrite personal loans to borrowers on the lower end of the credit spectrum, leading to higher default rates. Management said it was to be expected at first, but banks and credit unions are very conservative. If they feel Upstart’s subscription isn’t working, forget about getting rid of the FICO requirements; they will drop the Upstart platform.
Upstart recently revealed in its annual filing that partner banks only retain 16% of loans funded through the platform, with the rest being sold to institutional investors. The company has added banking partners, and I’m sure banks have retained more loan volume overall than in 2020, but that number still leaves a lot of room for improvement.
Additionally, Upstart has talked in the past about creating a low-cost loan product that charges interest rates of less than 36%. These loans, often known as payday loans, typically carry interest rates between 200% and over 600%, largely because they are so risky. This could be very difficult for Upstart to achieve.
Finally, the economy is entering a completely different environment from that of the past two years. Federal stimulus, low interest rates and high savings rates have resulted in historically low loan loss rates for the banking system over the past two years. That should change as the Fed raises interest rates, stimulus benefits fade, and savings rates decline. Management expects this, but Upstart needs to ensure its technology and underwriting models can hold up well and beat traditional underwriting models in tougher economic conditions.
Is Upstart management overconfident?
What Upstart has done so far is impressive. But I feel like the management is getting a bit ahead of itself. Upstart CEO Dave Girouard on the company’s recent earnings call said:
Upstart is now roughly the size [Alphabet‘s] Google was when I joined that company in early 2004, so I’ve seen that movie before and hope to use what I learned there to make Upstart the most impactful fintech in the world.
There’s nothing wrong with confidence, but with the cyclical headwinds coming, I feel like it’s a little early to Google comparisons and buy back stocks. The company is doing well, but there is still a lot to prove.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.