Upstart's (UPST 5.80%) credit risk evaluation platform is taking the banking industry by storm. Despite the rising popularity of its products, shares of Upstart recently tanked after management reported financial results from the first three months of 2022.
Investors were particularly disturbed by the forward-looking guidance management provided. Management had to change its total revenue outlook for 2022 from the $1.4 billion figure provided in February, down to $1.25 billion.
In response to the guidance revision, analysts at Citi and Goldman Sachs were among many who downgraded the stock. Markets hate uncertainty, so the guidance revision and subsequent downgrades pushed Upstart's stock price down 55% the morning after the company's first-quarter earnings call. Here's why savvy investors aren't even close to panicking yet.
Still growing by leaps and bounds
Upstart had to walk back its guidance a few paces, but it's not like the company's artificial intelligence-fueled risk-assessment services are losing ground. The number of banks and credit unions that pay Upstart to assess individual credit risk jumped 36% since the company reported fourth-quarter earnings in February.
Upstart cut its teeth by originating personal loans, but it's successfully expanding into a larger market for auto loans. At the end of the first quarter, 525 dealerships representing 35 different manufacturers were paying Upstart to assess credit risk. That was more than triple the number of dealerships the company had signed a year earlier.
Upstart has room to keep growing
According to TransUnion, the total addressable market for Upstart's burgeoning auto loan segment is around $751 billion annually. That's a lot bigger than the space for personal loans, which is valued at around $112 billion annually.
The market for originating auto loans is much larger than the personal loan space, but it still pales in comparison to around $4.5 trillion worth of mortgages. Upstart also intends to take a step outside of the consumer credit space and into a market for small business loans, which could be worth around $644 billion annually.
More accurate than FICO
Bearish investors have been quick to point out that the rate of defaults for loans originated by Upstart has been on the rise ever since Americans stopped receiving COVID-19-related stimulus checks. The important thing to keep in mind when looking at rising default rates is that Upstart is still far more accurate than FICO, which is its only big competitor.
At the end of March 2022, the rate of defaults among consumers with an "A" risk grade from Upstart was just 0.7%, even though many of those borrowers have FICO scores below 700 points. Borrowers with scores below 640 who qualify for Upstart's risk grades A and B defaulted at rates of 1.2% and 2% respectively. That's significantly better than the 3.4% rate of default among borrowers with FICO scores above 700 points.
Upstart is trading like a value stock
Following a post-earnings plunge, shares of Upstart have been trading for just 14.7 times forward earnings expectations. That's a valuation appropriate for a business growing earnings by a mid- to high-single-digit percentage each year.
When reporting first-quarter earnings, Upstart lowered its total revenue estimate for 2022 from the $1.4 billion figure provided in February to $1.25 billion. This would still be 47% more revenue than the company recorded in 2021.
Higher interest rates will slightly lower the overall level of demand for consumer credit. Even if Upstart's pace of growth gets cut in half permanently, patient investors will come out miles ahead by scooping up some shares of this heavily discounted stock now and simply holding them for the long run.
Upstart's business is in much better shape than its stock chart suggests, but this doesn't mean there are any guarantees it will continue to succeed. I believe the Federal Reserve will raise interest rates gradually enough to blunt inflation without causing a major catastrophe. That said, this isn't a well-established business with easily predictable cash flows. If you buy Upstart on the dip, make sure it's a relatively small part of a well-diversified portfolio.