When we initially wrote about Upstart Holdings Inc. (NASDAQ:UPST), we were doubtful of its ability to provide investors with positive returns. Despite the market decline, we watched our fledgling value play continue on its course. We specifically stated that Upstart has gotten “cheaper.” Still, we believe this is just the beginning of its long journey as the market begins to price this as a value stock.
Investors have overvalued the cash on the balance sheet. Still, many financial firms are now trading at or near tangible book value. Upstart remains at 3.7X. That was the correct decision, and staying out worked great. Of all, it is darkness before morning, and things change when existing longs experience nausea during the first trimester of pregnancy. Are we almost there?
The “AI” That Is Struggling
You don’t want to surprise the market with more bad news when your stock declines. However, Upstart (NASDAQ:UPST) did precisely that in early July. The company dramatically reduced its sales projection, a 25% decrease from its previous guidance. It also predicted a loss of roughly $30 million for the quarter, which was more than seven times higher than its worst-case estimate a few weeks earlier.
The loss forecast was driven by management’s quick offloading of debts from its balance sheet. This was an unusual step for a company that had recently loaded up its balance sheet with its own loans. This choice raised questions about whether there was enough demand for these. The reversal, which occurred at a considerable loss, calls into question how (NASDAQ:UPST) management manages its first adverse economic environment. We understand that the AI model will not predict short-term market moves. However, it still appears to be a poor depiction of the overall setup if Upstart pushes loans onto its balance sheet and then unwinds them when it faces a double whammy of higher and higher interest rates.
If there is one consolation prize, neither (NASDAQ:UPST) management nor its AI has received the award for being extremely perplexed. This would be given to analysts who are attempting to forecast earnings. Estimates have fallen across the board in the last three months, but earnings are expected to peak in 2024, then decline in 2025, before rising again in 2026. We believe that (NASDAQ:UPST) will struggle to create significant growth from here, at least in the next 12-18 months, and we would not be surprised to see GAAP losses.
An Alternative Look
For the time being, UPST’s growth model is dormant. It is currently in damage control mode, and the total addressable market slides are unlikely to excite anyone looking at this company. However, what the bond market is thinking is really concerning. UPST’s convertible bonds are set to mature in 2026. The conversion price of these is $285, and no one in their right mind is trading them at that price right now.
They are exchanging it for the return of their money (the par yield is 0.25%). Today, the yield to maturity is 15.43%.A few other aspects of this relationship are intriguing. The first is that there is around $661.25 million owed. Investors believe these bonds are worth less than $375 million at the current price. (NASDAQ:UPST) had existing assets worth more than twice this amount, which was remarkable.
In Q1-2022, total tangible equity (excluding goodwill) was more than $800 million. This is the amount stockholders would have had after repaying the debts (at par). So, to say the least, this complete lack of conviction in the company’s existence is intriguing. Another feature of these bonds is that SEC Rule 144A governs them. That means that small retail investors have no role in price discovery, and professional investors drive everything.
Investors are concerned that UPST’s business model is completely broken at this point and are questioning if the company can survive until 2026. Given the company’s current cash position, that is a significant vote of no confidence.
Verdict on Upstart
If you believe in the company and can trade outside of the SEC’s 144A rule, the convertible bonds make a lot of sense. With a yield to maturity of 15% or above, the company essentially has to survive to provide exceptional returns. The upcoming quarterly reports will be scrutinized to see how UPST handles the current upheaval. Everyone has historically fled to safety during economic downturns. This could be due to investors choosing large-size stocks over small-cap stocks or banks preferring traditional lending models over newer, AI-driven ones. We don’t think the bad news is ended, and we think the stock will eventually trade near tangible book value.
Featured Image: Megapixl © Timonschneider
