Upstart (UPST 0.79%) -- a company that uses artificial intelligence systems to determine would-be borrowers' creditworthiness -- has caught the attention of Wall Street and the mainstream financial media in 2021. As a result, the stock price has surged more than 1,000% since its December 2020 IPO, raising questions about how much bigger this company can get.
But investors considering buying in on Upstart now should remember that this is still a young business, and its stock has the potential to grow another 1,000% over the next decade. The company has just started de-risking itself, making it safer for investors to get a piece of the action.
Let's go into more detail about why Upstart is still worth buying today.
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Upstart's formula could replace FICO
For decades, the chief way banks and others have determined creditworthiness is by looking at a person's FICO score -- a metric created by Fair Isaac Corp. (FICO 0.41%) back in 1989. There are a host of variations based on that model now, but still, those scores have certain weaknesses -- primarily because there are plenty of people who have poor credit histories or no credit history at all, but who would nonetheless be good credit risks. Fully 80% of Americans have never defaulted on a loan payment, yet fewer than half of Americans have prime credit -- meaning that as much as 30% of the populace are potentially good people to lend money to, but might get rejected by banks making their decisions solely by looking at credit scores.
Upstart looks at a much bigger picture -- everything from employment history to how applicants interact with the loan application -- and takes all of this data into account, determining each consumer's creditworthiness with impressive accuracy. An internal study by Upstart showed that all other things being equal, Upstart's evaluations led to 75% fewer defaults than when relying on traditional models.
Even better, the more loan decisions it makes, the more accurate Upstart's AI should get. Each borrower it recommends lending to will either pay off their loan or default. If they default, the model will learn that customers with similar traits might also be less likely to pay off loans. That steady aggregation of new data could help it adjust its decision-making and decrease its default rate as time goes on.
With Upstart, the process to get a loan is becoming much easier. The company approves an average of 27% more loans than banks do using their traditional model, while applicants get on average a 16% lower interest rate. The decision process is also quick for the customer: Upstart's AI has gotten so good that it has been able to automatically approve 71% of its applications with minimal fraud risk. Among its accepted loan applications in 2020's fourth quarter, only 0.4% later proved to be fraudulent.
Innovation is leading to success
Reinventing the loan approval process has resulted in strong financial success for Upstart. The company gave its thumbs-up to 24% of the loan applications it saw in Q2 2021, reaching a transaction volume of 287,000 loans. And loan volume increased by 69% from the first quarter.
Related to the increase in loan volume, Upstart's Q2 revenue grew by 1,000% year over year, and by 60% sequentially, to $194 million. Its contribution profit -- a metric similar to gross margin -- was 50% of total revenue in Q2, up from 46% in Q1 2021.
Despite being a small company in terms of revenue, Upstart is profitable. Its net income for Q2 was $37 million, an improvement from its net loss of $6 million in the prior-year quarter. The company also produced free cash flow of $134 million in the first half of 2021 -- representing a free cash flow margin of 44%.
It won't be surprising to see this strong growth continue. In addition to the network effects it benefits from, lending is an enormous market. Management sees a market opportunity of $635 billion in auto loan origination and an $84 billion opportunity in personal loans. It's just beginning to tap into the vehicle loan market with its recently launched Upstart Auto Retail product -- an outgrowth of the company's April acquisition of Prodigy, a provider of cloud-based software for auto sales.
Lenders are flocking to Upstart
Lenders are moving to Upstart's platform fast -- four banks have partnered with it since its Q2 report. Its customer concentration was high at the beginning of 2021, with one lender accounting for 67% of its loan volume in 2020. That client only represented 60% of Upstart's loan volume in the first half, however. With the addition of these new banks since it reported Q2 earnings, its concentration figure will likely continue to decline.
The stock is trading at 133 times free cash flow and 64 times sales. However, Upstart has been doing everything right so far in 2021: It has decreased its client concentration, expanded into a big new market, and rapidly grown its business. Yet it still has plenty of room for explosive growth over the next 10 years, and investors still have the opportunity to benefit from its game-changing technology.
