Are These Stocks, Down More Than 80%, Worth Buying?

When you see a stock is down 80% or more, it's often a sign that the company is failing or something drastic has changed. But an examination of the businesses of Cloudflare (NET -3.11%), Unity Software (U -2.28%), and Upstart (UPST -1.84%), clearly show they are still humming along. And yet the stocks for these three companies have been decimated.

Their drops were caused by one primary factor: overvaluation. These stocks got way ahead of themselves and were richly valued. With the recent broad market sell-off, valuations have returned to a more normal range, but many investors got caught up in the news of large price losses and dumped these companies out of fear rather than a full evaluation of the company.

Should investors now consider adding these three price-deflated stocks to their portfolios? Let's find out a bit more about them and see if we can find the answers.

1. Cloudflare

Cloudflare is "building a better internet" by allowing its customers to host the source code for their websites in its data centers worldwide. When users try to access the websites of these Cloudflare clients, they are routed to the nearest data center, which speeds up the connection. It also provides cybersecurity solutions to its clients, giving users first-rate protection while maintaining access speed.

This solution has taken off, as Cloudflare saw its large customer count (those spending more than $100,000 annually) grow 63% year over year to 1,537 in the first quarter. Overall, it has more than 154,000 paying customers, and the company estimates its total addressable market will be $135 billion by 2024.

Even though it grew revenue by 54% year over year, Cloudflare is not free-cash-flow (FCF) positive, which makes it a riskier investment. Cloudflare management anticipates the company will be FCF positive again in the second half of this year.

At its peak, Cloudflare stock was valued at more than 100 times sales, but its P/S has now fallen to around 20 times. While that valuation is still considered high, it's not nearly as bad as it was.

Cloudflare still has a huge runway for growth and a plan for accessing it, and with its valuation reduced, investors should consider this stock.

2. Unity Software

The metaverse was all the rage not even a year ago, and Unity Software was at the bull's-eye of that hype. Unity Software is mainly known for its gaming engine, which helps game developers to more easily create and monetize games across multiple platforms. But its digital design prowess also excited investors because of its potential to tap into the growing interest in the metaverse. And though the metaverse hype bubble has been significantly reduced, it does not mean Unity's business has.

In Q1, Unity's revenue rose 36% year over year, with a 27% free cash flow margin. Unity management did give disappointing guidance, with second-quarter revenue only expected to grow 7% at the midpoint. This guidance was due to bad data being fed into its Audience Pinpointer tool, which put the wrong ads in front of a particular audience. Unity is fixing this problem and projects results returning to normal higher growth levels in Q3 and Q4.

Trading at around 11 times sales (the same as Adobe, another visual design giant), shares of Unity are reasonably valued at the moment.

3. Upstart

Upstart is taking on the established lending practice that relies heavily on the Fair Isaac FICO score to determine creditworthiness. With its algorithm, Upstart is showing that it can approve more loans while reducing lender risk. Upstart rates creditworthiness with a letter scale, with its worst rating being an E-. An upstart analysis of loans given out where the recipient had a FICO score above 700 and who received an E- rating from Upstart ended up defaulting about 9.2% on their loans. At the same time, those who received an A+ rating from Upstart but had a FICO credit score of 639 or below only defaulted on 1.2% of loans. The analysis strongly suggests Upstart can better identify credit risks and worthy credit recipients than the typical FICO system.

A chart from Upstart shows annualized default rates on loans. Note: Upstart internal performance data as of March 31, 2022. Includes lending partner originations made from Q1 of 2018 to Q3 of 2021. 2018-Q1 to 2021. Image source: Upstart Holdings.

With Upstart expanding into auto loans, it is taking a larger step into a $751 billion market. This expansion helped drive revenue growth of 156% year over year while also turning a net income profit of $33 million on revenue of $310 million during the first quarter. However, some investors got upset by the larger-than-normal presence of loans on its balance sheet. Upstart is doing this as a research and development opportunity, so it can prove its software before rolling it out to lenders. Other investors are wondering how Upstart's algorithms will hold up in terms of predicting default rates as interest rates rise and a potential recession take hold.

Shares of Upstart are down a whopping 90% from their all-time high and trade for a mere 3.7 times sales. The stock got way too far in front of itself when it was priced at nearly $400, but it's a steal for around $40.

A common problem

All three companies compensate their employees with stock, which is a problem when all the stocks are down more than 80%. Essentially, anyone receiving stock as payment has received a significant pay cut. While Upstart isn't as bad as the other two, stock-based compensation is a significant expense each company must realize.

Data sources: Cloudflare, Unity Software, and Upstart.

This pay cut means employees will quit or demand to be compensated with more stock (which dilutes shareholders) or with cash (which could hurt free cash flow profitability). Either action will not thrill investors, so the companies must be careful with how they proceed.

I believe all three businesses are solid investments, but Upstart is by far the best due to its profitability and low stock-based compensation. Regardless, they have all reached a reasonable valuation (compared to where they previously were) and should be considered worthy investments moving forward.