It can be unnerving watching a stock fall nearly 20% in a single day, especially after it had already collapsed to $33 a share from an all-time high of $401 in just the last nine months. And yet, as dire as that price drop sounds for investors, they should know that Upstart Holdings (UPST 2.21%) still has significant long-term potential as a stock. It just has to find a way to navigate this difficult economic environment.
Management for the AI-driven fintech specialist just announced preliminary results for the second quarter of 2022, and it revealed that revenue will fall short of expectations -- even though those forecasts had already been trimmed a few short months ago.
It's bad news. There's no denying it. But, here's why investors should look at this setback as a buying opportunity for Upstart stock, rather than a signal to sell.
The Upstart difference
Upstart is a true disruptor. It's working to deliver an AI-driven loan assessment model to replace Fair Isaac's (FICO 1.99%) decades-old FICO credit scoring system. Upstart management says FICO is no longer the ideal reflection of creditworthiness it was three decades ago when banks first adopted it because the economy has evolved significantly since then. The modern workforce is more educated and it often earns income outside of the traditional 9-to-5 employment model. Upstart assesses over 1,600 data points on a potential borrower to generate a more accurate lending assessment.
Upstart's algorithm can make a decision instantly about 74% of the time, and one study found it reduces default rates by up to 75% compared to traditional credit assessment models. It's a winning proposition for the company's 60 bank and credit union partners.
The company generally doesn't lend any money itself; instead, it originates loans for banks who pay Upstart a fee for doing so. It means Upstart runs a very capital-light business, allowing it to be profitable already, which is rare for a relatively young tech organization. But amid tightening credit conditions in recent months, its balance sheet had to temporarily absorb $597 million in loans as its bank partners' appetite for purchasing them eased. It was also holding the loans longer as part of R&D needed to help it build up its expanding auto loan program.
The commentary in Upstart's preliminary Q2 report suggests those loans have now been sold, but potentially at a loss. This appears to be a key reason the company's revenue took a hit in Q2, but it's a positive that this credit risk is gone.
Upstart management is assessing the damage
In the first quarter, Upstart cut its 2022 full-year revenue forecast from $1.4 billion to $1.25 billion. And since the preliminary second-quarter guidance of $228 million is a steep drop from the $305 million it originally expected, it might even place that $1.25 billion target in jeopardy.
While this was a big disappointment for investors, it's worth noting that the Q2 revenue projection would still represent respectable growth of 17.5% year over year. Of course, it's a far cry from the triple-digit percentage growth Upstart is accustomed to.
On a more positive note, Upstart highlighted that all of its loan vintages between 2018 and 2021 are performing within its models. But since this is the first real economic downturn the company's algorithm has operated in, naturally banks and investors are a little nervous about whether it will perform as well (or better) than traditional credit assessment methods when we come out the other side.
It may take some time before the market knows how well Upstart's more recent loans are performing. Risk-averse investors might want to wait another quarter or two to see how that plays out.
Focus on the long term
Upstart currently operates in two key segments: unsecured loans and automotive loans. Together, these markets are worth $863 billion annually, and since the company has only originated $25 billion in loans since inception, it suggests it's still in the early stages of tapping into this opportunity.
But Upstart has identified business loans and mortgages as the next two segments it could potentially focus on. If it elects to do so, its annual opportunity could balloon to $6 trillion.
Right now, 11 lenders have dropped minimum FICO score requirements in favor of Upstart's algorithm. If the company successfully weathers this difficult period, it will likely attract significantly more bank and credit union partners who are looking for a faster, more accurate alternative to FICO.
If you own the stock already, it might be best not to panic-sell here. If you're looking to buy it, now could be a great time given the stock trades at a 93% discount to its all-time high. After all, the U.S. economy might be close to entering less uncertain times.