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2022 has been a very difficult year for artificial intelligence-powered lenders. start-up (UPST -0.43%)more pain is coming.
The company announced in a regulatory filing this morning that it will furlough 365 employees, or about 20% of its workforce, in the latest restructuring effort to return to profitability. (The startup laid off 140 hourly employees in November.) It will also pause building a small business lending product until conditions improve.
After a big year in 2021 when upstarts hit nearly $400 a share, the Fed’s sharp rate hikes have blown the wind out of the company’s sails. With the stock currently trading below $19, what does this latest restructuring mean for Upstart’s future?
Image Source: Getty Images.
Challenges expected throughout the year
The new reorganization will result in a charge of $15 million and the forfeiture of stock awards will result in a one-time non-cash charge of $3 million. However, the layoffs are expected to save him $57 million in operating expenses over the next three years and his $42 million non-cash savings related to stock-based compensation.
In the short term, I think Upstart will continue to struggle for most of this year. The company is primarily in the business of using a proprietary algorithm to underwrite customers who may not be able to borrow with conventional bank loans or conventional interest rates, and to provide personal loans and auto loans to near-prime consumers. increase.
The company then sells most of the loans to institutional investors and some to banks and credit unions. Loan sales commissions are the company’s main source of income.
As the Federal Reserve hiked interest rates, institutional loan buyers saw higher funding costs associated with the Federal Reserve’s benchmark overnight lending rate and federal funds rate. . This leads them to demand higher returns on his Upstart loan, which creates some problems.
Higher interest rates naturally reduce borrower demand to some extent, as some people will not be able to borrow at higher rates and others will no longer qualify.
Startups can raise the price of loans, but the timing is lagging. First, the Federal Reserve will raise interest rates, then credit card companies will raise annual rates. A private lender (usually refinancing credit card debt) can then follow suit. However, the Fed moved so quickly and aggressively that Upstart may have repriced, but not enough to keep up with funding costs.
Another problem is that many economists expect the US to enter a mild recession this year. High inflation is making the financial health of many Americans worse, especially in near-prime sectors. As such, institutional investors may be concerned about credit quality. As Upstart noted in a filing this morning, “Many lenders and credit investors have significantly reduced or suspended loan originations.”
While most retail lenders have dealt with these headwinds, Upstart faces unique challenges due to its lack of access to cheaper sources of funding such as deposits. Upstart reported a 31% revenue decline from the previous quarter and a loss of $56 million in the third quarter.
Can the company recover?
If the Federal Reserve stops raising rates (which could happen in the first half of this year), Upstart will eventually repricing loans to better meet investor return thresholds. You should be able to.
Investors also want more clarity on the trajectory of the economy, but I expect the market for these personal loans to return to better levels later this year.
Longer term, however, Upstart will have to deal with much of the strategy. The first is the funding model. Because, as we’ve seen since last year, having investors buy all your loans can be a highly cyclical and volatile strategy.
Startups also need to do a better job of showing how well their underwriting models work. I think the company has shown some evidence that it’s outperformed its predecessor models, but I don’t think it’s quite enough yet to really win in the market.
Bram Berkowitz has no positions in any of the mentioned stocks. The Motley Fool holds a position on and recommends Upstart. The Motley Fool’s U.S. headquarters has a disclosure policy.
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