Financial technology company Upstart Holdings (UPST -4.81%) has proven to be one of the most volatile stocks on Wall Street since going public at the end of 2020. Shares have swung between a low of $25 and as high as $401 in the past year alone.
Investors were shocked when Upstart's 2022 first-quarter earnings report revealed a surge in loans on the company's balance sheet, a potentially risky situation in an economy that appears to be slowing.
Since earnings, the stock has fallen roughly 50%; should investors run to the exits? Not so fast; it's time to dispel the two darkest clouds hovering over the stock and illustrate why the volatility is a buying opportunity for long-term investors.
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Loans piling onto the balance sheet
The company uses artificial intelligence (AI) to replace the FICO credit score as the decision maker in consumer lending; its partnering banks handle the loans. Upstart receives a fee for the loans it touches, making it more a technology platform than an actual lender.
Or so investors thought. Upstart revealed that the value of loans on its balance sheet skyrocketed in Q1 2022 to $604 million, up from just $73 million the prior year. This huge increase probably made some investors think nobody wanted Upstart's loans, forcing the company to take them on themselves, but that's inaccurate.
Upstart's loans fall into two categories. The first is loans Upstart intentionally holds for research and development. For example, Upstart just entered the automotive lending category. But banks won't just blindly take Upstart's loans; they want to see a track record of how they perform, how many defaults, etc. So, Upstart holds loans to build that track record, where it can then say, "Hey, Mr. Bank, this is how you can expect these loans to perform, and here is the data to back it up."
The reason the value of loans skyrocketed is simple. Automotive loans are much bigger than unsecured personal loans. The average automotive loan in the U.S. ranges between $20,000 for used cars and $32,000 for new. Bigger-ticket loans mean more dollars on the balance sheet, and investors should expect the value of loans to increase further if the company eventually enters the mortgage industry.
CFO Sanjay Datta noted on the earnings call that almost three-quarters of the loans on the balance sheet were for research and development. The other quarter were loans that Upstart chose to keep because rapidly rising interest rates made those loans difficult to sell for a profit.
It's fair to criticize management for this; Upstart arguably should have been more prepared for a scenario in which interest rates increase rapidly -- surging inflation in the U.S. is no secret.
Datta recently participated in a fireside chat for the Barclays Emerging Fintech and Payments forum. Essentially, he said leadership was surprised by the violent reaction by the market to its decision to support lending with its balance sheet and noted that Upstart would avoid this in the future, except for research and development loans.
But what about a recession?
Investors are justified in worrying about how a recession could impact Upstart. While Upstart isn't a lender per se, it makes money by originating loans; the business will suffer if people stop applying for loans.
Economic sensitivity makes Upstart a cyclical business, and investors will need to focus on the company's long-term fundamentals, like how many lenders it partners with and how it's penetrating new loan categories over time. Revenue and profits should climb higher over time if the business is executing.
It's also possible that a recession could help Upstart build its competitive moat. Competition always follows success, and Upstart will face more threats if it keeps thriving. A common complaint about Upstart's AI seems to be that it's only seen data from a strong economy and may not handle a recession well.
Of course, Upstart could feel some pain in a recession, but wouldn't the addition of data during tough times better train Upstart's AI and make it more robust over the long term?
Here's the bottom line
Upstart slipped up in how it handled the execution of its business in Q1. However, it seems that management is already making adjustments for the future.
A recession would be a short-term challenge for Upstart, but long-term investors should focus on the big picture. Recession data could elevate the effectiveness of its AI models and further separate it from competitors that may pop up in the future.
Meanwhile, the stock trades at a fraction of what it once did, seemingly priced like failure. Investors should keep an open mind and be a bit more optimistic; doing so could be lucrative over the long run.
