Fintech company Upstart Holdings (UPST -5.56%) is on a mission to improve the lending industry. Its platform collects far more data about prospective borrowers than traditional credit models, and it leans on artificial intelligence (AI) to make sense of that information. That theoretically allows Upstart to quantify the risk more precisely, meaning lenders should see less fraud and fewer defaults.
However, tough macroeconomic conditions led management to lower full-year guidance when the company reported first-quarter results, and the stock price fell by more than 50% in response. Last week, management again lowered guidance when the company posted its preliminary second-quarter results, sparking another sell-off. Upstart stock is now 93% off its high.
Is it time to buy?
The effect of high inflation and rising interest rates
In its preliminary Q2 report, Upstart cited two headwinds that will likely cause worse-than-expected financial results. First, marketplace funding is constrained. A large portion of Upstart loans are sold to institutional investors as asset-backed securities. That additional liquidity allows Upstart to originate more loans (and grow more quickly) than would otherwise be possible when bank partners are either unable or unwilling to keep certain loans on their balance sheets.
When management says the marketplace is funding constrained, that means bank partners and institutional investors are less willing to fund Upstart loans in the current macroeconomic environment. High inflation and rising interest rates will put pressure on consumers, making defaults more likely. It makes sense for lenders and institutional investors to be cautious right now, especially since Upstart's AI models have yet to be tested during a significant down period in the credit cycle.
The second headwind relates to Upstart's balance sheet. In addition to funding from banks and institutional investors, Upstart held $600 million in loans on its own balance sheet at the end of Q1, up from $250 million in the prior quarter. In other words, the company funded a number of loans with its own cash, which spooked investors and exposed Upstart to significant credit risk.
Fortunately, Upstart converted those loans to cash during Q2. Unfortunately, management says that negatively affected revenue due to the quickly increasing rate environment. That means Upstart probably sold those loans at a loss to make them more attractive to institutional investors.
Here's the bottom line: Previously, the midpoint of Q2 guidance called for $300 million in revenue and a net loss of $2 million. The company is now estimating $228 million in revenue and a net loss of $29 million at the midpoint. That implies revenue growth of roughly 18%, representing a sharp deceleration from the quadruple-digit revenue growth Upstart delivered in Q1 2021.
On the bright side
Upstart has certainly been hit hard by high inflation and rising rates, but there was some good news in the preliminary Q2 report. CEO Dave Girouard said the company oriented itself toward "continued positive free cash flow even at lower origination volumes." That means Upstart should generate sufficient cash to grow its business during this difficult environment.
Additionally, CFO Sanjay Datta noted that Upstart-powered loans have performed very well since the program's inception in 2018 and that the average return for lenders "consistently met or exceeded expectations." Better yet, Datta believes Upstart's AI models will produce returns in excess of 10% in the current macroeconomic environment.
Over the past four years, Upstart's AI has consistently quantified risk more accurately than Fair Isaac's FICO-based underwriting. For instance, borrowers with a FICO score of 680 to 699 had an annualized default rate of 4.1% during that period, but Upstart's AI-powered platform separated that single cohort into several distinct groups with default rates ranging from 0.7% to 8.3%. With that information, banks and other lenders can make better decisions that ultimately result in greater profitability.
Upstart is a risky stock to own
Going forward, Upstart needs to demonstrate that its AI models can continue to outperform FICO-based systems in a down credit cycle, meaning an environment in which defaults are more likely. That is the single most important variable affecting its future, and investors should monitor the performance of Upstart-powered loans more closely than any other metric. That can be done by reading earnings transcripts and browsing the quarterly shareholder letter.
On that note, if the company fails to demonstrate the superiority of its technology, things will only get worse from here. But if Upstart emerges triumphant from this trial by fire, shareholders could see monster returns. The company currently puts its addressable market at $863 billion, but that figure could eventually exceed $6 trillion as Upstart expands into new verticals like mortgage origination and small business lending.
That puts the company in front of a massive market opportunity, and with shares trading at a reasonable 2.5 times sales, I think it's OK for risk-tolerant investors to buy this stock. But I recommend making it a small percentage of your portfolio -- no more than 2% or 3% -- for now.
