Inflation is at a 40-year high, and it's placing significant upward pressure on interest rates, hitting the hip pocket of consumers and driving down demand for loans. That's bad news for fintech company Upstart Holdings (UPST 3.90%), which released its preliminary financial results for the second quarter of 2022 on Aug. 9.
The day after Upstart's release, its stock price fell by more than 11% as investors digested news of slowing revenue growth and a murky short-term outlook. The company's bank and credit union partners have been hesitant in taking on risk from unsecured loans amid deteriorating credit conditions.
But there's still a highly attractive story unfolding, which makes the steep decline worth buying for the long run. Here are two reasons why.
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1. Despite concerns, Upstart's lending models are performing as expected
Upstart uses an artificial intelligence-driven algorithm to originate loans for its bank and credit union partners. The company's goal is to deliver loan decision technology that outperforms and is more inclusive than Fair Isaac's decades-old FICO credit scoring system.
Upstart aims to achieve this by analyzing up to 1,600 different data points on a potential borrower, compared to the handful that FICO assesses. In addition, Upstart's algorithm makes an instant decision 73% of the time, eliminating days or even weeks worth of manual assessment, a great cost saver for its bank partners.
A few years ago, Upstart conducted a study that suggested loans originated using its algorithm defaulted 75% fewer times compared to loans assessed the traditional way. But investors have expressed concerns more recently because its models have never been battle-tested in difficult economic times, or a recession.
But according to a presentation released alongside Upstart's second-quarter results, the company's algorithm has only improved in accuracy in 2022 with respect to its ability to separate high- and low-risk loans. The entire industry has seen an uptick in default rates as pandemic stimulus measures tapered off, but they remain in line with Upstart's forecasts.
Additionally, the company points out that groupings of loans issued in 12 of its quarters have overperformed, while five have underperformed. It says it has calibrated its algorithm in preparation for an economy that is significantly worse than the 2014 to 2019 period, so the company appears well prepared.
2. Upstart continues to add banks and car dealerships
Upstart is a loan originator, so it doesn't lend any money itself -- or at least it's not supposed to. The company is currently holding $623 million loans on its balance sheet amid deteriorating credit conditions, which have led to funding constraints from its partners, who usually purchase them. This has understandably spooked investors, but the company says its balance sheet is merely being used as a transitional bridge, not a long-term solution to solving funding issues.
Despite banks and institutions being hesitant to take on risk right now, they're still joining Upstart's network in droves. The company reported a total of 71 bank and credit union partners in the second quarter, a 184% jump compared to the same time last year. Its automotive sales and finance platform is also active in 640 car dealerships, more than triple the 199 it served in the second quarter of 2021.
In the first quarter of 2022, the company told the market it had 11 bank partners that abandoned a minimum FICO score requirement completely thanks to Upstart's algorithm, a number that had grown from seven just three months prior.
It would seem that, despite some short-term funding issues, more banks and credit unions are as willing as ever to try innovative new ways to originate loans through platforms like Upstart. It's entirely possible that if Upstart can prove its mettle during economic turbulence and come out the other side with consistent loan performance, it might see a wave of rapid adoption that could supercharge its growth.
Upstart stock is a buy on the dip
Upstart delivered second-quarter revenue of $228 million, an increase of just 18% compared to the prior-year period and much slower than the triple-digit percentage growth investors are accustomed to with this company. It also saw a 98% reduction in net income to just $1 million in the quarter.
To make matters more challenging, it withdrew its full-year 2022 guidance and revised its third-quarter revenue and net income downwards, so the short term is likely to be bumpy.
But Upstart has flagged a $6 trillion annual opportunity across its two existing lending segments and two more (mortgages and business loans) it could enter in the future. That's not to mention that its secured automotive loan origination business is soaring, with a 734% year-over-year increase in transactions in the second quarter.
Upstart has over $790 million in cash on its balance sheet, plus the $623 million in loans it will likely offload in the near future, so it has plenty of breathing room to weather this difficult period.
There are some signs that inflation has already peaked, which could keep a lid on interest rates going into 2023. That might signal the end of Upstart's recent troubles. If that's the case, investors who buy the stock now could be handsomely rewarded in the long run.
