If you're an investor looking for turnaround plays, then might I direct your attention toward Unity Software (U -2.31%) and Upstart Holdings (UPST -1.97%). These stocks are down 78% and 93%, respectively, from their all-time highs. And in this article, I'm going to explain why these two can make money for investors who buy today.
Both Unity and Upstart have risks that we'll acknowledge, but by the end, you'll understand why these are growth stocks worth buying on the dip.
Why buy Unity stock?
Unity is one of the world's top-tier platforms for creating and monetizing digital content, including realistic 3D images and video. As I've often said before, I believe it can keep its top-dog status because of its out-of-the-box business model. It offers creative services to small outfits and students for free, almost ensuring they'll use and become accustomed to Unity's platform. But once they start growing, the company can monetize them and generate revenue.
In short, Unity's success is aligned with customer success, and that's a powerful proposition. However, creative solutions is simply step one. Step two is monetization. Unfortunately, Unity's monetization segment flat out broke earlier this year. And that's why the stock is down.
To summarize, faulty data caused Unity's ad platform to lose effectiveness, and the company expects to miss out on $110 million in revenue this year as a result. The algorithm must be retrained from scratch, which is a lengthy process. And that's the risk for Unity investors today. As long as its algorithm performs sub-optimally, Unity's customers could seek out more effective options from competitors.
Unity made things interesting by acquiring a competitor in the app-monetization space, ironSource. IronSource's software is effective, the business is growing, and operations are profitable. Unity could benefit from all three of these things. In other words, I believe Unity is acquiring ironSource at a perfect time to address its biggest problem.
Before Unity's dramatic fall from grace, it was nearly universally cheered by the analyst community. Stifel analyst J. Parker Lane called it the "market leader" on Jan. 18, according to The Fly. And later in January, Wedbush analyst Michael Pachter put it on the firm's list of best investment ideas, mentioning "long-term tailwinds." But now that it's hit a pothole, analysts have hopped off the Unity bus.
All companies encounter setbacks. The great investment opportunities overcome their challenges. Given Unity's position as market leader going into this situation, I have high hopes it can rise to the occasion. In my opinion, the acquisition of ironSource could fast-track its recovery. And that should put Unity stock back on the path to market-beating returns faster than the market anticipates.
Why buy Upstart stock?
When it comes to Upstart, it's trying to serve three separate parties simultaneously. First, it provides banks with artificial-intelligence (AI) software that can automate the loan-approval process and lower defaults. Second, Upstart serves consumers by getting them lower rates and higher chances of approval. Third, Upstart serves institutional investors by providing them with great loan investment opportunities. Keep this last one in mind, because it's why Upstart stock has plummeted.
Regarding the first two parties, Upstart is succeeding. Consider that on July 20, California's Financial Partners Credit Union expanded its existing business relationship with Upstart, as have many other financial institutions this year. Moreover, in the first quarter of 2022, Upstart had 57 bank and credit union partners, up from just 18 in the prior-year period.
New banks keep joining Upstart, and existing banks keep deepening their relationships. To me, this means that Upstart is taking care of party number one. And it also appears to be serving party number two. In the first quarter, more than 2.1 million consumers borrowed money through Upstart, up from just 849,000 in the same quarter of 2021.
This brings us to party number three: institutional investors. Upstart is just the software for originating loans, and many financial institutions aren't interested in holding the loans to earn interest. Rather, they package and sell them to third-party investors. And demand from this group dried up this year, causing Upstart stock to crash.
Some fear that default rates for Upstart's loans are rising, and that's why investor demand is evaporating. Upstart's own data supports this theory, considering defaults are up relative to 2021. However, management points out that default rates are still quite good and in line with earlier years. From management's perspective, the problem is interest rates are up, and with higher interest rates, investors have other, more viable investment options, lowering demand for its loans.
Because investor demand has gone down, loan-origination volume from Upstart and its bank partners is also decreasing. Revenue for the second quarter of 2022 is expected to rise only 18% year over year, down from its previous guidance for approximately 55% growth. And after seven straight quarters of profits, the company is expecting a $31 million to $27 million loss.
Here's the thing: Upstart appears to be doing very well based on what we've seen, but macroeconomic conditions are hurting the business. Given time, good management can compensate for this. And macroeconomic conditions can reverse in time, putting Upstart squarely back in booming-business territory. That said, my belief that Upstart can get back on track is contrarian.
Trading at just 2.7 times trailing sales, valuation risk is very low for Upstart stock. And as more banks sign up and investing behaviors normalize, Upstart's business could continue its growth trajectory and reward those who choose to be contrarian and buy today.
Money where my mouth is
This article isn't full of empty talk. I recently purchased Upstart stock for my retirement portfolio, starting my position with a roughly 2.5% allocation. The company will report second-quarter results on Aug. 8, and any confirmation of my thesis could tempt me to buy more.
The same goes for Unity stock. While I haven't purchased new shares recently, it's one I continue to hold and one I'm considering buying more of soon. It reports financial results on Aug. 9, and again, I'll be looking for signs that what I've shared here in this article is indeed playing out for the business.
