The ongoing earnings season has been a rough one for many companies. Right now, Wall Street has zero tolerance for businesses that don't live up to analysts' expectations, especially in forecasting future performance.
One fintech company that has felt the bite of the bear market this week is Upstart Holdings (UPST 0.79%). After management cut full-year guidance and spoke cautiously about the macroeconomic environment, the stock crashed. In the days following its earnings report, Upstart saw its stock value cut in half, and it's now trading down 93% from its 52-week high set in October.
Does that sell-off create a buying opportunity? Let's dive in and see if we can answer the question.
Image source: Getty Images.
The bull case
Banks typically make lending decisions with a relatively small amount of data. Fair Isaac's (FICO 0.41%) FICO score -- the heart of most credit models -- is calculated from just 20 variables regarding the loan applicant. That limited analysis makes the lending system inefficient. Some otherwise creditworthy borrowers end up getting rejected and many approved borrowers get inaccurately evaluated and pay higher interest rates based on their scores or pay more as part of a bank's efforts to subsidize those who will inevitably default.
Upstart has developed a different scoring system that uses big data and artificial intelligence (AI) to help lenders make better decisions. Its platform captures over 1,500 data points per applicant and it measures that information against past repayment events. That more-thorough analysis also creates a flywheel effect on lending accuracy because Upstart's AI gets a little smarter about its decisions each time a borrower makes or misses a payment.
More importantly, Upstart's AI models can quantify risk more precisely than FICO scores. The graphic below compares the annualized default rates of Upstart-powered loans versus traditional underwriting over the last four years. In all cases, Upstart is able to parse large FICO groupings into smaller cohorts with very different default rates. It shows that applicants with better risk grades (but lower FICO scores) can be safer applicants than some low-grade (but higher FICO score) applicants. It also illustrates what Upstart management believes are the flaws in the FICO scoring system.
Image source: Upstart Q1 2022 Presentation.
In the first quarter, Upstart delivered another solid financial performance. Revenue rose 156% to $310 million and earnings under generally accepted accounting principles (GAAP) soared 209% to $0.34 per diluted share. On a less optimistic note, management cut full-year revenue guidance to $1.25 billion (which implies 47% growth) due to the uncertain macroeconomic environment.
However, Upstart still has plenty of room to grow its business. Its AI platform is currently used to originate personal and auto loans -- two verticals collectively valued at $860 billion -- but the company plans to enter the market for small business loans in the next few months, adding $644 billion to its market opportunity.
In short, Upstart will soon be competing in a $1.5 trillion industry, but its AI platform facilitated just $14.6 billion in loans in the last 12 months -- that's less than 1% of its market opportunity.
The bear case
The current macroeconomic environment is central to the bear thesis. To rein in high inflation, the Federal Reserve has already hiked interest rates by three-quarters of a percentage point, but many economists believe the benchmark rate will hit 3% by early 2023. That trend has already pushed the average price of an Upstart loan up 3%, and management believes the price will continue to rise throughout the year.
Inflation is also concerning in its own right. As rising prices continue to eat away at disposable income, more borrowers could miss payments. In turn, any uptick in delinquencies and defaults would make Upstart's lending platform less attractive to banks and its network of institutional investors.
For context, in most cases, Upstart-powered loans are either held by partner banks (i.e., the funding entity) or repurchased by the company for immediate resale to institutional investors. In that way, institutional investors provide an additional source of funding when partner banks are either unable or unwilling to keep loans on their balance sheets. But if delinquencies and defaults rise, that funding may dry up.
In that case, Upstart would have to retain more loans on its own balance sheet. In fact, that happened in the first quarter. The company now has $598 million in loans on its balance sheet, up from $252 million at the end of 2021. That ties up capital and exposes Upstart to credit risk. However, management noted that those loans were primarily originated for research and development purposes to improve its auto lending and personal lending products. That means the increase may be temporary.
The big picture
This trial by fire was inevitable. Upstart's AI models have yet to be tested through an economic downturn, so banks and institutional investors don't know what to expect. If Upstart-powered loans continue to outperform those underwritten with traditional credit models, it would validate Upstart's business and strengthen its competitive position.
So far, things look pretty good. But the inflationary environment could drag on for an extended period of time, putting pressure on Upstart from multiple angles. Banks and institutional investors may demand higher interest rates in exchange for taking on risk, and borrowers may find it harder to repay loans. That's why investors need to monitor management's commentary about loan performance.
So, is Upstart stock a buy? It's risky because the company is operating in uncharted waters, but I plan to buy a few shares. If Upstart survives this trial by fire and emerges stronger, its share price could soar. More importantly, I have plenty of time until retirement and my stake in Upstart will be a small portion of a diversified portfolio, so I'm willing to take that risk.
