The artificial intelligence (AI) lender Upstart Holdings (UPST 0.55%) has been a wildly divisive stock, with lots of investors fully buying into the company's story and enormous market opportunity, while others are more skeptical.
Upstart has developed algorithmic loan underwriting models that it believes can assess the credit worthiness of borrowers better than traditional underwriting scoring methods such as Fair Isaac's FICO scoring. Upstart currently originates personal and auto loans through a number of lending partners and has ambitions to apply its technology to other loan categories.
Since going public at the end of 2020, the company skyrocketed all the way to $400 per share before coming back down to roughly $35 now. Given all of that price action, let's revisit the bull/bear case for Upstart.
Bull: The long-term opportunity remains
Jennifer Saibil: The problems that came to light in Upstart's 2022 first-quarter report are certainly important to factor into your investment decision, and it's not surprising that Upstart's price has fallen in response.
But much of the original bull thesis remains intact, and management's transparency as well as its quick response to the issues raised demonstrate that it's taking responsibility for its problems and making plans to fix them. Every new company has growing pains at some point, and what you want to see is strong management.
Image source: Getty Images.
Upstart's potential is huge. The company sees a $112 billion opportunity in its core personal loan business alone, plus a $751 billion market for auto loans, along with $4.5 trillion in mortgages, a market it's preparing to enter in 2023. There are several other markets that it expects to enter at some point.
In the 2022 first quarter, revenue increased 156% year over year to $310 million, and net income increased 224% to $35 million. Bank and credit union partners increased from 18 in the 2020 first quarter and 42 in the 2020 fourth quarter to 57 at the end of the 2022 first quarter, and it's adding about a lender each week.
Auto dealerships increased from 162 in the first quarter of 2021 to 525 in this year's first quarter, and Upstart facilitated more than 11,000 auto loan refinances through its platform in the first quarter, or almost double the amount of all of 2021. Upstart's model is working, and more lending partners see the attraction.
As an AI platform, its model is constantly being refined as it adds data points, thereby improving outcomes and making it even more competitive. At the current price, shares trade at only 23 times trailing-12-month earnings, which is cheap for a company posting triple-digit (or even double-digit) sales growth. Market volatility and rising interest rates could hurt Upstart in the short term, but the long-term opportunity is huge, and at this price, it looks like a great time to start a position.
Bear: The company still has a lot to prove
Bram Berkowitz: After the huge sell-off of the stock this year, Upstart's valuation is a lot more attractive. But my main quibble with the company is that there is so much we still don't know and big issues that still need to be resolved.
For instance, Upstart's central claim is that its credit underwriting algorithms can approve just as many loans as traditional banks but with lower default rates. While the company has shown that its credit scoring model has been more effective so far, it has never been through an environment of rapidly rising interest rates like we are experiencing right now. As the Federal Reserve raises rates, the cost of debt will go up, which makes borrowers more likely to default.
NASDAQ: UPST
Key Data Points
As government stimulus has faded, defaults at Upstart in the first quarter quickly went from outperforming modeled expectations to now being in line with them. Furthermore, some of Upstart's more recent securitizations, which include loans to borrowers lower on the credit spectrum, have started to show higher delinquencies than previous vintages and are underperforming modeled expectations.
In a recent Upstart loan securitization, the Kroll Bond Rating Agency issued a report that said it expects loss rates to be more than 3% higher than the asset-backed securities Upstart issued earlier this year. Rising rates also have forced Upstart to price loans higher, which has resulted in less origination volume and leading management to trim its 2022 revenue forecast.
My other big concern is Upstart's funding model. The company is not a bank and therefore does not have any intention of holding loans on its balance sheet. It relies on banks and credit unions that employ its technology to fund those loans with deposits and hold them on their balance sheet. Upstart also sells some loans to whole-loan buyers or to other institutional investors that package the loans into asset-backed securities.
However, with the macroeconomic environment so unsteady amid concerns about a recession and stagflation, investors are wary of personal loans because they can default at higher rates. In the first quarter, Upstart revealed that it had to hold a small portion of loans on its balance sheet that it would normally sell to investors, who have been recalibrating the amount of risk they were willing to take on. Investors are concerned that Upstart might not be able to drum up enough investor demand in this environment to keep funding all of the company's loans, which could have a chilling effect on origination volume.
A risk-reward proposition
Upstart is a true risk-reward proposition. If the company revolutionizes lending and replaces much of what FICO does, then investors could be looking at the proverbial 10 bagger or even more. However, there are risks and uncertainties ahead, such as how credit quality on its loans will hold up, and funding issues in the rising-rate environment. This stock is likely best suited for investors with more appetite for risk, or at most just a small position in your portfolio.
