After going public in December 2020, Upstart Holdings' (UPST 0.96%) stock has been on a roller-coaster ride, skyrocketing more than 13-fold in 10 months before finishing 2021 up only 271% on the year. Upstart's lending platform aims to make credit accessible to more borrowers by using artificial intelligence (AI) to capture details that FICO scores might miss, while supporting volume growth and lowering costs for lenders.
Down about two-thirds from its recent highs, Upstart's stock is trading at levels it hasn't been at since last July, and investors might be wondering if it's a buy today. A lot has been written about the bull case for this exciting fintech, but I want to dive into the bear case.
Here are three downside risks that Upstart shareholders need to know.
Image source: Getty Images.
1. Customer and product concentration
Upstart has a total of 31 bank and credit union partners on its platform, up meaningfully from just 10 a year ago. While expanding its ecosystem is definitely necessary for the company's long-term success, revenue primarily comes from a select few of its partners. In the most recent quarter, a whopping 84% of the $228 million in revenue was derived from just two lenders.
This customer concentration should naturally become more diversified with each passing quarter, but today, Upstart's fortunes depend on the willingness and ability of two partners to lend to its customer base. What happens if they decide that Upstart's fees aren't worth it or that the technology doesn't offer any advantage in underwriting borrowers?
And even though the business is now making progress in the auto lending market, virtually all of Upstart's revenue still comes from one product: personal loans. These are unsecured, so in the event of an economic downturn, borrowers may choose to prioritize other loans (like a mortgage or auto loan) when it comes to making payments, causing defaults for Upstart's partners to rise and hurting the legitimacy of the company's credit-approval algorithm.
2. Big banks are investing in tech
It's true that the current markets that Upstart is in -- personal loans and auto lending -- are huge at $81 billion and $672 billion, respectively. Is it realistic to assume that the company will eventually command a sizable share of these markets or any other lending products it offers? I'm not so sure.
Massive banks like JPMorgan, Bank of America, Wells Fargo, and Citigroup collectively have almost $3.5 trillion in net loans outstanding. Upstart's total loan volume over the past 12 months was tiny by comparison -- just $8.9 billion.
Plus, the big financial institutions have the resources to invest in technology in-house without the help of Upstart's platform. For example, JPMorgan invests $12 billion per year in technology and has 50,000 employees working on digital initiatives. That's more than the entire market capitalization of Upstart.
Upstart has been successful thus far onboarding much smaller lending partners that don't have the resources to invest in technology themselves, but the big banks still control a material share of credit activity in the U.S. And direct competitors like LendingClub and SoFi Technologies are already incorporating technology into their processes. This seriously caps Upstart's true addressable market.
3. Dependent on a robust economy
Although Upstart doesn't originate any loans and therefore doesn't directly take on credit risk, the business is still very exposed to how the broader economy is doing. Unsurprisingly, in robust economic times with solid GDP growth, low unemployment, and low interest rates, demand for credit is elevated. And in recessionary periods, the opposite is true. Problems are exacerbated because what happens in the economy is out of Upstart's control.
During the second quarter of 2020, when pandemic fears and uncertainty were at their peak, Upstart's loan volume and revenue fell 86% and 73%, respectively, compared to the year's first quarter. Lending partners reduced originations to customers in order to lower risk and shore up their balance sheets. Furthermore, because a large (and increasing) portion of Upstart-powered loans are sold to third-party investors, when capital markets dry up, Upstart's ecosystem is disrupted.
The pandemic-led recession was short-lived, but what happens in a prolonged economic downturn? Upstart's AI models will definitely be put to the test. Even so, the volume of loans offered by partners and the amount of funding from institutional investors will be put under pressure, placing Upstart in a difficult situation no matter what.
Become a more informed investor
Upstart certainly has a lot of momentum right now. It also helps the stock that the fintech space is generally adored by investors. But beneath the hypergrowth financial figures, there are serious risks to consider. Generating the bulk of revenue from a small number of customers, competing with the big banks, and a looming recession are major factors to keep in mind.
Understanding the bear case for Upstart will make shareholders much more knowledgeable about the business they own.
