After its initial public offering in December 2020, Upstart Holdings (UPST -3.61%) saw its stock price soar as investors fell in love with the company’s artificial intelligence-based lending platform. Growth was impressive, and the focus was on how quickly Upstart could gain market share in various massive lending verticals.

But despite its early hot start in the public markets, the fintech stock has come crashing back to Earth thanks to ongoing struggles with the business. Making matters worse is the fact that management made what I believe to be a head-scratching mistake last year. Let’s take a closer look.

A change in fortunes

In 2021, Upstart’s business was firing on all cylinders. Loan volume and revenue increased 338% and 264%, respectively, that year, spurred by a favorable macro backdrop and lending environment. And Upstart was able to post a profit of $135 million. This helps explain why the stock was up nearly 10-fold at one point in 2021.

However, with outsized inflation rearing its ugly head, the central bank was forced to aggressively hike interest rates at a rapid pace. Higher rates discourage borrowers from wanting to take out loans, while also forcing lenders to be a bit more stringent about who they loan money to. As a result, Upstart saw the volume of loans originated on its platform decline 5% in 2022 compared to the prior year. Total revenue was down 1%. And the business posted a net loss of $109 million for the full year. All this caused a massive sell-off for the stock.

During what was a very unfavorable economic time for Upstart, a business that is so predicated on robust credit markets for its success, it’s a huge wonder why the leadership team decided to repurchase $178 million worth of its own stock throughout last year. Even more strange is that when Upstart was thriving in 2021, zero shares were repurchased.

On the fourth-quarter 2021 earnings call, an analyst asked CFO Sanjay Datta why Upstart had authorized a $400 million share repurchase program at that time, especially for a company that was fully in growth mode. Datta replied by saying that because of the stock’s volatility, management wanted to take advantage of the share price being undervalued, in their opinion. He also mentioned that because Upstart was profitable, they thought this was the right move.

Looking back, that was a shortsighted move and poor planning for any sort of adverse economic scenario happening. Upstart is forecasting a net loss of $145 million in just the first three months of 2023, which would be more than the entire loss in 2022.

Be cautious

It’s usually a worthwhile strategy to repurchase stock when a company is sustainably producing positive free cash flow (FCF). This means that after reinvesting in the business to maintain its competitive position and to grow, there is excess cash left over to be used to pay down debt, make acquisitions, pay dividends, or buy back stock. Repuchasing shares has the effect of increasing earnings per share, providing a possible boost to the stock price.

With this in mind, Upstart shareholders should call the management’s capital allocation strategy in 2022 into question, especially at a time when the business hasn’t generated positive FCF on a consistent basis, and when the current macro environment is extremely uncertain with interest rates on their way up. What’s more, for a company that is still so early in its lifecycle, focusing on investing heavily in growth, why would useful cash resources go toward share buybacks?

Another thing to pay attention to is the balance of loans Upstart currently holds on its own balance sheet. As of Dec. 31, 2022, the total was over $1 billion. A year earlier, the balance was $252 million. If borrowers start to default on their loans at a higher rate, Upstart’s losses could soar. And it would wish that it could have that $178 million back, which equals about 42% of the company’s current cash balance.

Upstart should wait until it is a sustainably profitable enterprise, in any economic situation, before choosing to return cash to shareholders. Investors should think twice now before buying the stock.

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