Motley Fool Hidden Gems Investing - While Wall St. Was Sleeping...

Episode Date: April 18, 2022

The ongoing drama surrounding Elon Musk and Twitter distracted investors from relevant news involving one of the most important companies in America. (0:20) Jason Moser discusses: - His headline from Amazon CEO Andy Jassy's annual shareholder letter - Why AWS isn't getting spun off - Amazon doubling their fulfillment capacity in just 2 years - The company's approach to MLPs (Minimum Loveable Products) (13:59) Jason is joined by Matt Frankel to take a closer look at lending platform Upstart Holdings, which is down nearly 80% from its 52-week high. Got a question about stocks, industries, or trends? Call our voicemail: [phone] Stocks discussed: AMZN, UPST, SQ Host: Chris Hill Guests: Jason Moser, Matt Frankel Producer: Ricky Mulvey Engineers: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

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to something more important. Details next. Motley Fool Money starts now. I'm Chris Hill, and I'm joined by Motley Fool Senior Analyst, Jason Moser. Thanks for being here. Hey, thanks for having me. So for the past week, the dominant story in the investing world has been Elon Musk and Twitter. And I understand why it's been the dominant story, but it has sucked almost all of the oxygen out of the room and things are being overlooked. And one of them is the fact that the CEO of one of the most important companies in America, published his annual shareholder letter. The company is Amazon. The CEO is Andy Jassy. First time Amazon has an annual shareholder letter published by someone other than Jeff Bezos.

There are a few things I wanted to get to in the letter and the interview that Jassy did after it was published, but let's just start here. You read the letter, what was your headline? To me, the headline really simply is, hey, folks, rest easy. We got the right guy for this job. I mean, anytime you replace a longstanding CEO and a founder CEO at that, I mean, there are going to be big questions as to whether you got the right person for the job. And I think just judging by this letter and judging by the interviews I've seen with Mr. Jassy through the months leading up to the letter. Just to me, it feels like they've got the right person for this job. It's really funny too, if you are watching an interview with Andy Jassy,

if you just close your eyes and just listen and don't look, I swear, you think you're listening to Jeff Bezos talk. I mean, they are very similar, not only in how they speak, I mean, the actual tone, the intonations, the pauses, I mean, other than maybe that big laugh, right? I think that's quintessential Bezos. But it's really funny. I thought about that, and I closed my eyes, and I was listening to this interview. I thought, man, he really sounds like Jeff Bezos. And I'm sure there's probably a little bit of nurture there, and they've worked so closely together for so long. But yeah, generally speaking, I think they just got the right person for this job. It's funny you say that about Bezos, because I was thinking the same thing. If you just take

away the laugh and read a transcript, if you're just thinking of how would Bezos answer the questions in an interview, that sort of thing. I pulled a trick out of your bag and did a search in Jassy's letter for the word customer. Bezos famously saying, we want to be the most customer-centric company in the world. The word customer appears more than 50 times. Jassy made his bones as the head of AWS, so it's really no surprise that AWS is very front and center in this shareholder letter. But between the letter and this interview he did with Andrew Ross Sorkin on CNBC, I think one of the things Jassy did was simultaneously speak to the importance of AWS while quietly putting to rest any questions of whether they would spin it

off. I have to say, as a shareholder, I like the fact that he views ... Whenever we talk about spinoffs, it's almost always accompanied by the phrase unlocking value. Jassy's approach is, anytime you're thinking about spinning off, you have to answer the question, why would we do this? And to paraphrase what he said, there's no compelling reason. Yeah, yeah. I mean, well, I think he's right. I mean, generally speaking, I do love in the letter, he takes that moment to really nerd out on the AWS side, which is just, it's really neat to see because, I mean, like you said, that's how he made his bones.

I mean, he's been intimately involved with that side of the business really since he's been there. I mean, that's what he's been responsible for. I just thought it was neat to read through. You can sense his excitement when he gets to talk about that stuff. I think that's really neat because AWS is going to be a pivotal part of this company's future. If there were a compelling reason, if you felt like AWS was suffering under that Amazon umbrella, and you felt like there would be value to unlock by giving it its own path. That's understandable. When you see spinoffs, oftentimes it's maybe two parts of the business that aren't as complimentary as maybe they once

were. I would argue in this case, AWS is extremely complimentary to virtually everything that Amazon does because AWS essentially helps run the internet. It's not hyperbole at all to me to say that if Amazon closed its doors tomorrow, half the world would stop turning. It is that important of a business. When you have a crown jewel like AWS, you got to come up with a compelling reason to unload it, to spin it off. I think he will be very protective of that side of the business and nurture it and give it all the resources it needs. That's the beauty of Amazon's businesses. They're generating all the capital and resources they need to keep iterating and growing and that's exciting. A couple of things real quick. First,

he addressed the fact that they've essentially doubled their fulfillment capacity in the last two years in terms of their fulfillment centers, the hundreds of thousands of people they have hired. We've talked about stocks that basically pulled forward growth. Is there any concern on your part that Amazon has maybe overgrown in terms of its staffing and hiring, or do you think, no, this is what they need to do? I think it's probably more what they need to do. I think you raised some really good points there in regard to growth. They refer to that a couple of points in the letter. Ultimately, talking about the consumer revenue, the North American and international consumer revenue, ultimately realize the equivalent

three years of forecasted growth in about 15 months. To your point on the fulfillment centers, that was another passage that was an eye-catcher. Because he notes, he says, and I quote, this growth also created short-term logistics and cost challenges. We spent Amazon's first 25 years building a very large fulfillment network and then had to double it in the last 24 months to meet customer demand." All along the way, I think as investors, as analysts, we've talked about these investments that Amazon continues to make in fulfillment. You're talking somewhere in the neighborhood of $50 million they have to drop on just one fulfillment center. Were these wise investments, were these investments they needed to be making? Well, it turns out, yes. Now,

it's certainly easy to argue that there was a lot of demand pulled forward, and so maybe they had to go a little bit beyond what they were planning. Maybe they had to accelerate that timeline a little bit. But it's not difficult to imagine a future where that customer demand that they've realized over the last 24 months, it's not difficult to see that demand sticking and growing as the world continues to move online. Clearly, Amazon is a global business making large investments in its international side as well. To me, perhaps there could be some timing issues there, but I think that works itself out over the longer haul, which is obviously how we view investing in these types of businesses. We also got some insight into how

Jassy and his team think about new products. There was a section in the letter where he talked about MLPs, not master limited partnerships, but what they refer to as minimum lovable product, which I love this approach, which is essentially, it doesn't have to be perfect, but it's got to be good enough so that we can iterate off of it. Yeah. It's got to be something, and I'd like that they define there's got to be a threshold there. This is all part of this framework that he laid out there in regard to iterative innovation. I mean, Amazon is known for never sitting still. In laying out that framework and some of the components they noted that helped them in that iterative innovation,

and I'll just read them off because I think they're really helpful. I think there's a lot here for investors, really. It's not just in building a business. I mean, look at this from the perspective of investing in two, but number one, hire the right builders. Number two, organize builders into teams that are as separable and autonomous as possible. Number three, give teams the right tools and permission to move fast. Number four, you need blind faith, but no false hope. No. 5 to your MLP, define a minimum lovable product and be willing to iterate fast. No. 6, adopt a long-term orientation. No. 7, and maybe the most important, brace yourself for failure, because that's a given, it's going to happen. I say it all the time, as investors,

you need to embrace when we make mistakes, you need to embrace that. Because if you can look at that for what it is, No. 1, we're always going to make mistakes as investors, but No. 2, they're the greatest teachers. If you can look at those mistakes as opportunities to learn, it just opens up a whole new world of opportunity. The last thing on Amazon, they're going to report, I believe May 5th is when their earnings report comes out. We will get some insight into how consequential the recent price increase of Amazon Prime is going. we're not going to get a full quarter's worth of data until they report in the summer. How closely are you going to be watching that? Is that a concern at all for you? Where does that

rank on your list of when Amazon comes out with their earnings reports? This is where it ranks in terms of my own interest? I think for me, a time ago, it may have been a bigger concern. One of the lessons I learned along the way in following Costco, and I think that's a business we like and we talk about a lot. But remember, over the last several years, we've entertained this discussion, does Costco have pricing power? Can they raise that membership fee and are people still going to pay it? We've seen through time, the answer is yes, they can raise it incrementally over time. and as long as they continue to offer value that their customers, that their members in turn value,

then they can keep on thoughtfully doing that. I think with Amazon, they continue to offer a lot of value through that Prime membership. I know that there are some criticisms as of late in regard to shipping, and maybe people don't get things on time all the time anymore and two days turns into four. We as consumers have grown very impatient. We want everything now and Amazon is partly to blame for that because they have done such a great job in building that fulfillment network yet. To me, it sounds like these investments that they are making in their Prime relationship are the sensible ones. They're continuing to invest in that same day shipping and making sure that they can get items to us as promised on the timeline,

as promised. I think as long as they continue to make the right investments in that prime relationship and focus in on what people really care about first and foremost, which I think still for the most part is getting your stuff in a timely fashion, then I think they'll be able to continue doing that. It really is difficult. Shipping and logistics and fulfillment, that's difficult work. But they've made a lot of investments along the way to really build out their capability, and I suspect that'll continue. Jason Moser, I appreciate the perspective. Thanks. Hey, thank you. Jason is sticking around, and he'll be joined by his longtime podcast partner in crime, Matt Frankel. If you're a

longtime listener, you know they love to dig into financial companies, and we got a question right up their alley. We got a review on Apple Podcasts from a listener with the screen name Change It Later Now, who writes, I'd like to hear a bit about Upstart Holdings. Seems like it hasn't been mentioned as much after it fell, but I'd like to hear about how rising interest rates in the U.S. will affect them in the future. If you're not familiar with Upstart, it is a lending platform with the ticker symbol UPSC. For a closer look, here's Jason and Matt. Jason Moser. Hey, Matt, great to chat with you again. I hope spring is springing down there in the lovely state of South Carolina.

Matt Frankel. It is, and our pollen season is coming to an end, which is always good news. you've heard from here, so you know how that is. Well, enough about the weather. We always appreciate listener questions and suggestions, requests for companies to dig into a bit for the show. With that in mind, this week, we're taking a closer look at Upstart. This is a lending tech company. It's a very popular recommendation here in our universe. Now, it's been an underperformer so far. I'm not sure how long that will last though. This is a pretty interesting business, to say the least. And I know it's one that you follow closely, too. So, let's go ahead and begin the conversation with a simple question. What does Upstart do? Yeah, and that's a simple

question, but it's kind of not so simple in a way, because I remember we talked about Upstart when they first went public, and we really didn't get the business model too much. We were like, yeah, subprime lender, it's historically a bad idea to invest in subprime lenders, to be honest with you. But there are a lot more than that. They're a technology company. They develop an artificial intelligence platform that aims to do a better job of predicting loan losses than the traditional methods, specifically the FICO score. So, they provide the system that will underwrite and approve loans and try to give people the credit that they should have. One of their big points is that the vast majority of people have never defaulted on a loan obligation,

but less than half could qualify for lenders' best rates in most circumstances. There's a big disconnect there. Their system aims to solve that. If you look at what they do now, their customers, it sounds like their customers, generally speaking, are lenders. Is that right, banks and just lenders? Or are consumers customers of Upstart as well? Well, yes and yes. Upstart does partner with banks that make loans off of its platform, and that generates fee income for the business. That's where the vast majority of Upstart's revenue comes from, think like 95% of it. But it also does, if you go to upstart.com, you can apply for a loan, and they do hold some loans on their balance sheet and make some of

their money from interest income, but very little compared to the fee income. It's mostly a fee-based model. They mostly partner with banks to do a better job of underwriting loans for their capital. You say, I'm starting to get this picture of SaaS business more or less, but I want to make sure I understand this because you talk about fee income. Is there a subscription side to this business? Do banks pay a monthly subscription fee to Upstart for their services and then they benefit also from that services fee along with that? Or is this really just a services style business? The majority comes from the fees they get for facilitating those loans. In 2021, you could see that the increase in lending volume and the increase in fee income were

really on par with each other. That just shows that their fees depend on how much loan volume is flowing through their network. They're going to be pegged then, obviously, to lending volume. We can talk a little bit more about that in a bit. Before we get there, we always talk about competitive advantages. What is a business' special sauce? What separates them from their competitors? I have a feeling, I know what your answer is going to be here, But what is it that separates Upstart from other companies in this space? Well, there are a ton of personal lenders. We've talked about that many times, that the industry is getting really crowded. Everyone from the legacy banks to new fintechs

have personal loan products. They all use the FICO score to approve loans for the most part. Upstart's the one that doesn't use the FICO score, so they can make better lending decisions and approve people for loans that they otherwise might not have been able to, and even if they could have gotten approved elsewhere, get better interest rates. It's a better underwriting process. It's a win-win for both the customers and for the banks. Making lending decisions based on data. If that sounds familiar, it should. One of the companies this makes me think of immediately is Block, formerly known as Square. But Square is doing such a good job in utilizing the data that they glean from their customers, the small

businesses, in order to be able to make loans to those small businesses. Now, that's small business focus, that's more business focus. Would you say Upstart is, generally speaking, primarily consumer focused? Yeah, they're absolutely consumer focused for now. That's a really good point that you brought that up because they say by the end of 2022, they're going to get into small business lending. For the time being, they're not a competitor with Block or Square Financial Services, as their business division is called. But they will be very shortly. Yeah. The other thing I noticed too in the most recent earnings call, just piggybacking on that small business factoid, I think the following year, maybe 2023,

they have aspirations to get into the mortgage lending business too, don't they? If there's one area where subprime lending could be done better, it's definitely mortgages. There's a market for it. In 2008, 2009, we saw that there was a market for subprime lending. It was just being done very, very poorly. If a company could figure out how to do subprime lending right, there's a huge opportunity there. That's really Upstart's focus. They don't focus on the quote-unquote bad credit borrowers, but they don't focus on the prime borrowers either. They focus on that niche in the middle that's really being underserved by the current system, especially in mortgages. Yeah. One thing I noticed in that

call as well, they were talking about the business and the advantages that it has over others. Management noted that choosing not to become a bank was the right decision for it's essentially central to their worldview. They went in a little bit more in that it gives them really the greatest market opportunity. It gives them this large swath of consumers in need. It gives them the opportunity to focus on those consumers without necessarily sticking themselves with that bank identity. Because once you become a bank, then you're competing with all these other banks. But if they're seen as bank agnostic, essentially, that more or less opens up a much larger market opportunity. Yeah, it makes their addressable

market literally every financial institution in the United States. Yeah, it's a lot of people too. A credit-based economy, this is a valuable service they provide for sure. Let's talk a little bit about leadership here because this is a founder-led business. Insiders own a good stake in the business as well. What's your opinion on leadership in anything that stands out? The leadership makes me glad that they are being a tech company, not a bank, because it's led by a bunch of tech veterans. Dave Girard, the CEO, he was a former Google executive. Anna Councilman is another co-founder that came from Google. Paul Gu is the tech guy of the trio of co-founders. All three are still

involved in the business. All three have substantial ownership stakes. It was three very passionate founders. They left very lucrative careers at places like Google to start this, and it's because they are really passionate about democratizing credit. Well, let's dig a little bit more into that fee-based income and how it's tied to lending activity. Obviously, this is a business that has seen some high highs and it's seen some low lows. It's down around 45% year-to-date. If you look even further out though, it's down about 80% from its 52-week high. This has come down considerably from just where it was here recently, and I feel like probably part of that is going to be tied to that interest rate conversation.

let's talk a little bit about that, because how big of a concern is that for investors? It feels like interest rates are really only headed one way, and for those who haven't been paying attention, that's up. How much of a burden is that going to be for a business like this? Yeah. Interest rates, they have the effect of one, slowing down borrowing demand, and two, of increasing defaults on loans and things get a little less affordable for consumers. We really don't know, though, and this is a big risk factor, this is what you're seeing priced into the stock, we don't know how Upstart's business would perform in a recession, in a rising interest rate environment, because it just hasn't been through one yet. This was founded

around the time of the financial crisis. It was in its infancy the last time that defaults were elevated and things like that. We don't know what it would do in a full credit cycle. Now that it's not just the economy going straight up, if you will. Now there's a big question mark in investors' heads as to what happens if these inflation and interest rates leads to a recession. Big unanswered questions is really the key. It feels like we're getting ready to learn. It feels like we're getting ready to find the answer out here over the course of the next year or so. Now, with that said, this reminds me a bit, I know you're familiar with Ellie Mae, the mortgage lending tech platform. This just reminds me a little bit of Ellie Mae in that

regard. Ellie Mae had a subscription dynamic as well as a service dynamic, but we were always having that big question with Ellie Mae, how is this business going to perform in an interest rate environment where refinances start to take a hit? Will purchase mortgages be able to make up for that loss volume. We never really got to find out because Toma Bravo acquired Ellie Mae a little while back. That was an $11 billion deal, I think. But I see a lot of tones of Ellie Mae in this business, and that's a compliment. I was a big fan of Ellie Mae, as many may know. What's your perspective here on Upstart going forward? Are you a bull, a bear? Are you on the fence? What's your feeling in regard to this as an investment?

I'm generally bullish. I like it a lot better than I did when it was a $400 stock. When you look at the numbers, these are not numbers from a company that's been beaten down like that. This is a business that's done exactly what investors wanted it to do. Revenue is up 250% year-over-year. Lending volume is $12 billion of annualized volume. That's multiplied several times over in the past year alone. Their auto lending business is getting ramped up, which was the big bull thesis, because that's a big market. It's a much bigger market than personal loans. The business is profitable. It continues to be profitable. Margins have improved. You really can't make the case that this business hasn't

done exactly what investors should have wanted it to do. I'm generally bullish, especially now that the stocks come back down to earth. Yeah. Lending is always going to ebb and flow, but it's not going away. I think that you're right. It feels like it's a business where management is doing what they say they are going to do, if you can ignore those external factors. Maybe this is one of those windows of opportunity for investors who are willing to take the longer view. But Matt, I think that will wrap it up for us. Thanks so much for taking the time to join the show today. I know I am always the wiser for it, and I that our listeners feel the same way. Yeah, always glad to be here.

If you've got a question, you can include it in a review on Apple. You can also call the Motley Fool Money hotline, 703-254-1445. Leave us a message with your name, where you're calling from, and your question. Again, that number, 703-254-1445. That's all for today, but coming up tomorrow, a conversation about financial advice on TikTok. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.