Up-stop-t

What Upstart Holdings may be telling us about the state of credit markets and their wider ramifications.

As I write this, Twitter is ablaze over Upstart’s quarterly results and the resulting 40% after hours stock plunge. The bugaboo looks to be concerns over lowered guidance and the company having to hold more loans and the subsequent risk on their books. Holding these loans in a rising rate environment has already led them to begin marking the values down.

Essentially what Upstart and a number of other companies have been doing is taking loans, revenue streams, receivables, etc., bundling them…and selling them to banks. Or they themselves even create a special purpose entity (SPE, often a Trust) in which they hold an interest…place the loans, revenue streams, receivables, etc., into this SPE and create a security backed by these assets (ABS) as collateral.

These securities have been in demand. The reason? Yield. With no interest rates in treasuries or yield on mortgage backed securities, income investors have had to find alternate ways of finding yields.

Of course now rates are going higher…and in response treasury yields have shot up. As has inflation, making this a much more tricky market to navigate. As yields rise, existing fixed loan values decrease. At the same time, as inflation rises, credit worthiness falls since borrowers have less income left for repayment. A double whammy if you are sitting on loan portfolios that were generated in a low interest rate, low lending risk environment.

Frankly…we shouldn’t be shocked. Early in 2022 some of these same ABS offerings were pulled by companies like Tesla and Affirm. The reason was a lack of market demand for them. However in light of the Upstart report, what we should be asking ourselves is what this means for companies who have been using them going forward?

Take for instance Tesla.

On the surface, Tesla’s cash position seems very strong with 17.5B in cash.

However a look at it’s Accounts Payables and Accrued Liabilities show that they combine to 17.1B in short term liabilities. When you consider that 1B of that cash is also customer deposits and another 1B is revenues that were received yet still not earned; the cash position may not be quite as robust as some would think. Last quarter the company’s Cost of Revenues was 13B. Total it up and the company needs to be able to generate tens of billions of dollars in cash each quarter to pay its bills.

Of course some would say the company did 18B in sales last quarter alone…cash flow should be fine.

However most people don’t pay for the entire auto up front. Rather they finance it over a period of 5-7 years. Which isn’t an issue if the lender is a disinterested third party like a bank. In the case of Tesla however, Tesla routinely does billions of dollars in financing each year via their financing partners. Currently they show 1.9B in receivables on the balance sheet. What this doesn’t show the amount of loans which they have sold over the years to banks as ABS products (like Upstart mentioned earlier).

In 2021 they reported 1.9B in proceeds from Automotive Asset Backed Loans. In 2020 it was 700M, 2019 857M, 2018 1.4B. In other words, 5B in capital infusions in the past 4 years via the Automotive Asset Backed Loan program. The same loans that they had to pull in March because of a lack of investor demand.

Now these loans are stuck with Tesla and their lending partners. And likely more loans will be stuck. How good are their underwriting standards? Time will tell, but it wouldn’t be a shock if they left standards low to juice auto sales. When you can bundle bad loans with good and trade it for cash…you aren’t holding the risk.

In the meantime, how does Tesla fill the funding gap? Again, time will tell. I suspect much to the chagrin of shareholders that at some point within the next few quarters, a capital raise via an equity offering will likely have to come through the pipeline to keep them in hyper growth.

Tesla isn’t the only company that is facing this issue. If you follow my Twitter you’ll notice a number of recent tweets about Mercado Libre which is a double beneficiary of it’s own fintech platform. It gives customers credit cards, which they then spend on purchases on Mercado Libre generating fee revenue. Mercado Libre then sells the credit card receivables to generate immediate cash (Aggregate gains of 575M, 452M, 359M in the past 3 Fiscal years). Which they then give back to their customers in the form of personal loans such as Buy Now, Pay Later. The customers then use said funds on their site again, generating more fees for Mercado Libre. Mercado Libre then securitizes these loans (currently have over 1B) to borrow against them…and repeats the cycle in it’s quest for South American wallet share.

They currently have 1.5B in cash on the balance sheet along with 500M in unrestricted short term investments 1.7B in loans receivables and 2.5B in credit card receivables. But currently their allowance for bad loans is nearly 30% and rising quickly, so it’s uncertain how much of those loans will actually be collectible.

What is certain is that they have 1B in accounts payable, 2.5B in funds payable to customers, 400M due to the credit card merchants and 1.4B in loans due. If you do the math and assume that all of their loans will be repaid…that leaves them with about 900M in liquidity which would just be enough to cover their wages, taxes, and leases payable for the year.

Domestically, Affirm has 2.5B of these securitization trusts. Unsurprising Affirm was down nearly 12% in the after hours as no doubt investors suspect they like Upstart will be feeling the squeeze from high rates. Everyone’s bought now…but will they pay later? I suppose we will find out next week.

So what does all of this mean?

It means you have a number of growth companies who’ve been beneficiaries of extremely loose financing conditions, who’s liquidity is like to be tested in the coming year. It also means we are going to find out how good lending standards have been in the more opaque corners of the market. Finally it’s a warning that investors need to start paying more attention to the risks on their company’s balance sheets. It’s not enough just to look at Free Cash Flow, Revenue Growth or P/E Ratios. You have to know the risks that are hidden in plain sight.