Better Fintech Stocks: Upstart vs. Confirm

Upstart Holdings (UPDATE -8.78%) and Verify inventories (AFRM -4.29%) were both once considered disruptive fintech companies. They also had the attention of growth stock lovers.

The upstart drew attention because it challenged credit reporting services by analyzing a wide range of nontraditional factors — including a person’s education, GPA, standardized test scores and work history — to approve loans for customers with limited credit histories.

Affirm’s attention came because it challenged credit card companies with a “buy now, pay later” (BNPL) service that allowed customers to split large purchases into smaller installments. This approach, which approved “microloans” for each purchase, also targeted customers with poor or limited credit histories who could not be approved for traditional credit cards.

Image source: Getty Images.

Both companies attracted a stampede of bulls during the growth stock rally last year. Upstart’s stock closed at a record high of $390 last October, while Affirm’s stock soared to a record high of $168.52 the following month. But as of this writing, Upstart and Affirm shares are trading at around $23 and $17 per share, respectively. Let’s see why both stocks crashed and whether either is worth buying as a turnaround play in this tough market for growth stocks.

Upstarts are being pressured by rising interest rates

Upstart has loans on its website, but these loans are primarily financed by cooperating banks, credit unions and car dealers. It charges these partners fees to access the platform and serve its worthy loan applicants.

This business model works well when interest rates are low, because low interest rates encourage consumers to take out more loans. Lenders also generally have access to more liquidity and face less macro headwinds in a low interest rate environment, so they are willing to approve more of these loans.

But when interest rates rise sharply, as they have in the past year, this business model is not nearly as appealing. Consumers are becoming reluctant to take out loans at higher interest rates, while macro headwinds are causing lenders to take a more cautious approach to approving loans. That’s why Upstart, which had previously tasked its partners with fulfilling all of its loans, finally began temporarily funding some of its loans from its own balance sheet earlier this year.

The upstart’s revenue rose 42% in 2020, driven by its 40% growth in bank-originated loans, then rose 264% to $849 million in 2021 as originated loans rose 338% to 1.3 million. But this year, it expects revenue to fall 1%-3% as rising rates pressure its core business. As growth stalls, operating costs and leverage rise as it funds more of its own loans. It ended the third quarter of 2022 with a debt ratio of 1.7, compared to a ratio of 1.2 the previous year. It also posted a net loss of $53 million in the first nine months of 2022, compared with a net profit of $76 million a year earlier, and analysts expect it to remain unprofitable through at least 2024.

Affirm is being hit by inflation and concerns about subprime

Affirm’s BNPL platform can initially appear resistant to inflation because it helps lower-income customers pay for large purchases in smaller instalments. However, that business model only works if inflation and other macro headwinds do not cause crime to rise.

Only 2.7% of Affirm’s accounts were past due by more than 30 days in the first quarter of fiscal 2023 (which ended Sept. 30), but that percentage could rise sharply if inflation and higher interest rates drive the economy into full-throttle recession. The glaring weakness reinforces the notion that Affirm is essentially a subprime lender financing smaller purchases, and its elevated debt-to-equity ratio of 1.8 doesn’t leave it with much room to raise new money.

On the bright side, Affirm is still growing rapidly. Revenue rose 71% in fiscal 2021, which ended last June, and its total active consumers grew 97% to 7.1 million. Revenue increased another 55% to $1.3 billion in fiscal 2022, while active customers increased 96% to 14 million. For fiscal year 2023, it expects revenues to increase 23-29%.

But Affirm is also deeply unprofitable. The net loss widened from $441 million in fiscal 2021 to $707 million in fiscal 2022, and analysts expect an even bigger loss of $1.01 billion in fiscal 2023. Affirm could potentially increase merchant fees or interest (which are often negotiated on a case-by-case basis case) to stabilize these losses, but doing so would narrow the moat against aggressive BNPL competitors who Block‘s Afterpay and PayPal‘s Pay in 4.

The valuations and the judgment

Upstart and Affirm both trade at about 2 times next year’s sales, suggesting their downside potential may be limited. However, neither stock is likely to rise until the macro headwinds subside. Therefore, I would not rush to buy any of these out-of-favor fintech stocks in this challenging environment.

But if I had to choose one over the other, Upstart looks more appealing than Affirm because it had previously generated stable earnings in a lower interest rate environment. With inflation under control and interest rates falling, the outlook can quickly improve and buy more time to scale up the business. Meanwhile, Affirm hasn’t actually proven that the BNPL business model is sustainable yet — and there’s no guarantee that the outlook will improve even if interest rates cool.