Upstart Holdings (UPST 2.76%) is a good example of irrational exuberance in action. Throughout 2021 a flurry of excitement surrounding the fintech pushed its share price higher by leaps and bounds. In mid-October the stock peaked at $401.49 per share, representing a 1,907% return since its IPO less than a year earlier. However, despite strong financial results, concerns regarding valuation have since brought the stock crashing back to earth, and shares currently trade 78% below their all-time high.
After that dismal sell-off, is Upstart stock a smart buy? Let's dive in.
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On a mission to modernize the lending industry
Banks often build their lending credit models around Fair Isaac's FICO score, a three-digit number meant to reflect how creditworthy a particular borrower is (or is not). The typical FICO scorecard is based on between 12 and 20 variables, and while banks often incorporate other criteria, many of the most sophisticated credit models consider no more than 30 variables.
Upstart sees that as a problem, arguing that banks often lack sufficient data to quantify risk correctly when making lending decisions. As a result, some creditworthy borrowers are excluded from the system, and many that are approved end up paying too much interest because they have to subsidize the portion of borrowers who will inevitably default. For instance, 80% of Americans have never defaulted on a loan, but only 48% qualify for prime rates.
Upstart aims to make the credit industry more efficient. It provides lenders with a suite of tools for borrower identity verification, bank account verification, and credit decisioning, as well as adverse action notification and loan servicing. More importantly, its platform captures over 1,500 data points per borrower -- far more than traditional credit models -- and it measures those variables against past repayment events to quantify risk.
In that way, each time a borrower makes or misses a payment, Upstart's AI model gets a little smarter. Management believes that network effect is a significant competitive advantage, and it's hard to argue with the results.
How to measure the real-world impact of Upstart's AI models
Internal studies suggest that Upstart's AI-powered platform is quite effective. Compared to traditional credit models, it can reduce defaults by 75% while keeping approval rates constant, or it can boost approvals by 173% while keeping default rates constant. Either way, lenders make more money, which means they can afford to offer lower interest rates to consumers. Of course, internal studies are not the same as real-world results.
Fortunately, investors can glean some insight into the performance of Upstart-powered loans thanks to firms like the Kroll Bond Rating Agency (KBRA). How does that work? A large portion of Upstart-powered loans are actually pooled and sold to investors as asset-back securities. KBRA periodically reviews those securities and publishes the results free of charge. According to a report filed in April 2022, KBRA has lowered its loss projections for all Upstart securities issued between 2018 and 2020, and some issued in 2021. KBRA has not increased its loss projections for any securities. That's good news for shareholders.
However, delinquencies are rising faster in more recent securities. For context, remember that Upstart has not been tested during a down period in the credit cycle. Interest rates have been relatively low for the last decade, and until mid-2021, inflation had been mild for years. But now, with inflation at a 40-year high, borrowers likely have less spare cash, which could lead to increased loss rates.
It's still too early to jump to any conclusions. Right now, shareholders should be pleased with the results of KBRA's analysis, but they should continue to monitor the performance of Upstart-powered loans in the coming quarters and years.
Disrupting a multi-trillion dollar market
Upstart is growing like wildfire. As of Dec. 31, 2021, the company has 38 bank partners on its platform, more than triple what it had a year earlier. Better yet, transaction volume (i.e. the sum of all loans originated on its platform) surged 241% to $11.8 billion in 2021. In turn, revenue skyrocketed 264% to $849 million, and the company generated free cash flow of $153 million, up from $10 million in 2020.
Going forward, Upstart has plenty of room to grow. Its platform is currently used to originate personal and auto loans, two markets that comprise an $820 billion opportunity. For perspective, Upstart's trailing-12-month transaction volume of $11.8 billion means it has captured less than 2% of its current addressable market. But management has even bigger ambitions. The company eventually plans to expand into new verticals of the lending industry, including the $4.6 trillion mortgage origination space and the $644 billion small business loans space.
In short, Upstart is disrupting a multi-trillion dollar industry, and with shares now trading at 10.3 times sales -- near the very bottom of their historical range -- now looks like a good time to buy this growth stock. Of course, there are no guarantees that Upstart ever regains its previous highs, but given its incredible financial performance and massive market opportunity, I think it's worth the risk.
