Upstart Holdings (UPST 1.21%), the artificial intelligence (AI)-based lending platform, saw its shares skyrocket in the 10 months after its initial public offering, peaking at a market cap of more than $30 billion in October 2021. That positive sentiment has completely reversed, and the stock is down about 85% this year.
It might be tempting to buy discounted shares in Upstart today. But if you're considering this, it's best to keep some important factors in mind, particularly as many market participants fear that a recession might be on the horizon. Let's take a closer look at what this could mean for Upstart's business.
Thriving in a rosy economic environment
2021 was a banner year for Upstart. Revenue jumped 264%, and net income surged an astronomical 2,164%. What's more, the company was able to originate 1.3 million loans worth a total of $11.8 billion during the 12-month period. These figures were up substantially from 2020's numbers, which helps explain the stock's meteoric rise.
A low-interest-rate environment is a boon for Upstart. Demand for loans from consumers is elevated because the cost to borrow funds is attractive. And loss rates are kept under control because these borrowers can actually afford the interest on their loans.
A study by Upstart found that large U.S. banks could use its lending platform to lower loss rates by 75%, while keeping approval rates constant. And in another study specified by the Consumer Financial Protection Bureau, it was found that Upstart's AI model was able to approve 27% more borrowers than traditional lending standards.
Further supporting Upstart's business model in this situation is a robust capital-markets landscape. Because Upstart's network of lenders often sell their loans to third-party institutional investors that are searching for a yield, when the economy is firing on all cylinders and credit is cheap, it incentivizes banks to continue lending aggressively. And this translates into more fees for Upstart.
The business recently entered the $751 billion annual market for auto loans and has plans to penetrate the gargantuan mortgage market, worth $4.5 trillion. These strategic initiatives can certainly please shareholders when times are good and the focus is intensely on expansion. But this perspective might no longer be valid.
But questionable in a recession
In a recessionary environment, a situation where interest rates rise, credit markets tighten up, and consumer demand to borrow money declines, the opposite of the previous scenario is likely to unfold. Throw in raging inflation that's at a 40-year high, and the possibility of higher defaults goes up. And interest from institutional investors that helps grease the wheels and keep the money flowing drops off.
Furthermore, banks and credit unions, of which 57 are Upstart partners, are sure to perform worse in a recession than they have in recent years. The lending business is notoriously cyclical, and it's not hard to understand why. Banks usually set money aside in the expectation of elevated defaults, called provisions for credit losses, a move that raises costs and lowers profits in that particular reporting period. An economic slowdown isn't lucrative for enterprises in the money business.
Now, to be fair, Upstart's AI model has performed better at assessing credit risk than the traditional model from Fair Isaac Corporation (FICO 0.05%), otherwise known as FICO. The true merits of Upstart's data-driven platform, however, could very well be put to the test in the near term.
In fact, management recently lowered its forecast for the second quarter, with official results to be announced on Aug. 8 after the market closes. Senior managers now expect revenue to be $228 million, down from the prior estimate of $300 million at the midpoint. This would equate to a year-over-year sales increase of only 18%, significantly lower than the growth of more than 1,000% registered in Q2 2021. Soaring inflation and the threat of a recession have also forced management to lower the profit forecast to a net loss of between $27 million and $29 million, which would be the first loss since Q2 2020.
It's also worth noting that Upstart was founded in 2012 and hasn't faced a true recession outside of the brief pandemic-caused downturn in 2020. While the stock has no doubt gotten hammered, trading at a price-to-sales multiple of just over 2, the cheapest the shares have sold for in the company's young public history, I think the current economic environment is a real risk.
The potential long-term upside might be huge for Upstart, but it's best for investors to proceed with caution.