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What do Rising Interest Rates Mean for Challenger Banks like SoFi and Upstart?
Stock Analysis & Ideas

What do Rising Interest Rates Mean for Challenger Banks like SoFi and Upstart?

On Wednesday, the Fed announced a rate hike by 25 basis points, its first since 2018, and signaled that there was a possibility of six more such hikes to fight inflation. According to a Wall Street Journal report, Federal Reserve Chairman Jerome Powell commented that wages were “moving up in ways that are not consistent with 2% inflation over time. We need to use our tools to guide inflation down to 2%. That will be in the context of an extraordinarily strong labor market.”

Rosenblatt Securities analyst Sean Horgan had predicted an environment of rising interest rates in a research report earlier this month. The analyst stated that this could result in challenger banks emphasizing profitability over revenue growth.

Although, what exactly are challenger banks? According to the analyst, they are companies that are challenging traditional banks with their business models. This includes companies that provide digital lending like SoFi Technologies, Upstart Holdings, Robinhood (HOOD), MoneyLion (ML), and other fintech firms.

So, amid rising interest rates, where is this challenger bank group headed in 2022? The analyst gave some context to this in his research report.

For the purpose of this article, we will be concentrating on two stocks that fall in this group, SoFi Technologies, and Upstart Holdings, and will compare them using the TipRanks stock comparison tool.

SoFi Technologies (NASDAQ: SOFI)

Shares of SOFI have not fared well in the last six months, with the stock tanking 43.2%. When it comes to the declines in share price for various stocks in the challenger bank group, analyst Horgan views it as “rising rates led to multiple compression, rather than a deterioration in fundamentals.”

According to the analyst, the path to profitability for challenger banks like SoFi depends on their customer acquisition costs, the range of their products, and customer engagement.

Regarding customer acquisition costs (CAC), SoFi managed to lower its customer acquisition costs by 17% in 2021 as around 33% of its new products were adopted by its existing members in Q4.

The company offers a suite of financial products through its platform, a one-stop-shop app and its key business segments include Lending, a technology platform, and Financial Services.

Horgan also drew a comparison between CAC for incumbent banks like Wells Fargo (WFC) and SoFi using data from Factset, company filings, and his estimates. While Wells Fargo has a CAC of $900 per customer, it earns an average revenue per user (ARPU) of $1,072.

In contrast, SOFI spends only $248 acquiring each customer, but its ARPU is $403.

However, the analyst sounded a note of caution when it came to customer acquisition costs. Horgan expects that for challenger banks like SoFi which has a one-stop-shop app, data privacy changes from large technology platforms like Apple (AAPL) could lead to higher CACs.

How is SoFi positioned amid rising interest rates? According to Horgan, rising interest rates can positively impact net interest income and personal loan originations for challenger banks but can adversely impact retail trading volumes.

For SOFI, in 2021, 75% of its revenues were made up by its lending business and this business could benefit from an increase in interest rates. This business had adjusted net revenues of $208 million, up 30% year-over-year, largely driven by “interest income, and origination and gain on sale revenue.”

As of now, the analyst remains upbeat about the stock with a Buy rating and a price target of $22 on the stock.

The rest of the analysts on the Street, however, are cautiously optimistic with a Moderate Buy consensus rating based on six Buys and six Holds. The average SoFi stock prediction of $16.85 implies approximately 92.1% upside potential to before-market open levels on Thursday.

Upstart Holdings (NASDAQ: UPST)

Upstart Holdings has been not immune to the stock sell-off and has seen its price drop by 64.7% in the past six months. Upstart is a cloud-based artificial intelligence (AI) lending platform that connects consumers to its network of AI-enabled bank partners for loans.

While Rosenblatt analyst Horgan considers Upstart a challenger bank, similar to SoFi, the research house has not rated UPST yet. For the purpose of this article, we will consider Wedbush analyst David Chiaverini’s comments about Upstart.

Earlier this month, analyst David Chiaverini came away reassured from an investor meeting with Upstart’s management as the analyst learned that “a new securitization collateralized by Upstart loans is in the works and is targeted to be completed by late March/early April.”

The analyst had been concerned about the slow securitization for UPST in the first calendar quarter so far. Securitization is the process of converting a batch of loans into marketable securities, and slower securitization activity could signal lower buyer demand for credit. It is important to note here that rising delinquency rates can impact the cash flows from securitization.

For Chiaverini, the highest risk to UPST is that it is largely reliant “on third-party funding to support its high pace of [loan] origination growth.” As a result, according to the analyst, if these funding sources come under pressure such as during a recession, problems could arise for UPST.

With the Fed raising interest rates, there is a possibility of economic growth slowing down.

It is important here to look at how UPST earns its revenues. The company charges referral fees to banks for every loan referred through the Upstart.com website and originated by a bank partner. UPST also charges a platform fee for every loan origination, regardless of its source, and servicing fees for loans as consumers repay them.

As a result, Chiaverini remains sidelined on the stock with a Hold rating and a price target of $110. Another reason for the analyst to remain sidelined on the stock is that UPST “has yet to operate through a true recession which means its underwriting model has yet to be battle-tested.”

Other analysts on the Street, however, are cautiously optimistic with a Moderate Buy consensus rating based on five Buys and two Holds. The average Upstart stock prediction of $195.71 implies approximately 76.5% upside potential to levels seen before market-open on Thursday.

Bottom Line

Interestingly, Wall Street analysts are cautiously optimistic about both SoFi and Upstart. It remains to be seen how the rising interest rates environment pans out for both companies.

Rosenblatt analyst Sean Horgan, over the long term, sees “all digital-first financial services companies converging towards the same goal: becoming a full-service (challenger) bank.”

The analyst has also envisaged a few scenarios for these challenger banks. One of them is merger and acquisition activity and thinks that M&A will “play a larger role within the challenger bank space in 2022.”  Horgan also sees the possibility of large incumbent banks targeting smaller challenger banks that would help expand the legacy bank’s digital offerings.

Another possibility that Horgan foresees is that as large, traditional banks announce the reduction or elimination of overdraft fees, it could result in reducing the “relative attractiveness of challenger banks.”

It is because challenger banks have led by offering overdraft alternative products to attract customers to switch to their platforms to avoid paying this overdraft fee.

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