Artificial intelligence-powered lending platform Upstart Holdings (UPST 2.76%) has stumbled through 2022. Management can't seem to make up its mind about using its balance sheet to support its loan originations.
The uncertainty mixed with a rapidly tightening lending market has crushed shares, causing a 91% decline from their high. But don't give up just yet. Here is why Upstart could still win big over the long term.
What's going on with Upstart's balance sheet?
Upstart is in the lending business but tries to operate more like a technology company. Its artificial intelligence (AI) approves a borrower for a loan, then either passes it to one of its lending partners or sells it to institutions in the debt markets. In other words, Upstart delivers loans to the real lenders who take the risk.
This model works well in a strong credit market, like in early 2021 when the economy was flush with stimulus money. However, rapidly rising interest rates have put a clamp on things. Now the lenders and loan buyers who take on the risk want higher profit margins for the loans.
Upstart couldn't find takers for some of its loans earlier in the year; it originated some loans with unprofitable pricing because the market changed so fast. Upstart decided to hold a portion of those loans instead of selling them at a loss. Management quickly pivoted after Wall Street sold the stock off, pledging that it would keep loans off its books other than those for research and development purposes.
A positive long-term change on the way
Management has realized that it's hard being at the mercy of buyers to take the loans off their hands. CEO David Girouard noted on the second-quarter call that the company's changing its model, working to establish relationships with loan buyers that will provide consistent funding through both up and down credit market cycles. In other words, Upstart wants committed financing to know its loans have buyers before it delivers them.
This is potentially a big deal for the company over the long term. Theoretically, it could remove some of the volatility from Upstart's business, which you can see in the revenue growth chart below as growth spiked and then plummeted.
UPST Revenue (Quarterly YoY Growth) data by YCharts
Girouard admitted that it would lean on its balance sheet to support loans while it transitioned to this new funding style, and even acknowledged that this flies in the face of what they said just months prior.
The flip-flop is a black eye for management's credibility in the short term, and Wall Street could take some time to regain faith in Upstart's management team. However, the potential benefits from this new funding model could make it worth some patience as the company gets on track.
The long-term potential that's tough to ignore
The important thing for long-term investors is that the product works as advertised. Management has begun sharing a quarterly breakdown outlining how its algorithms perform against a FICO credit score. The data shows that Upstart's better at analyzing risk across the board.
Additionally, Upstart continues picking up new lenders for its network, which has grown to 71, up from 57 three months ago, and 25 a year ago. Lenders seem to buy into the technology, which could remain the narrative as long as Upstart's network keeps growing. There are more than 11,000 banks and credit unions in the U.S. So there's no shortage of potential partners.
The company is also pushing into new types of credit, with automotive lending being its up-and-coming product. Upstart has retail software tied into its lending platform and has tripled its dealer footprint to 640 in just one year. Management has commented on a desire to penetrate other lending areas, ranging from mortgages to small business loans. The opportunity is enormous; it's up to the company's execution to realize its potential.
Upstart has had a tough year, and management's flip-flopping isn't doing much to ease shareholders' minds. Investors should consider Upstart a speculative stock, but the potential reward could make it worth the trouble for long-term investors.
