The technology sector has taken a beating this year, with the Nasdaq-100 index down 28%. The retreat is being driven by soaring inflation and rising interest rates, which are putting the brakes on the economy and forcing investors to rethink their growth expectations.
This is hurting some companies more than others. Upstart Holdings (UPST 0.79%), for example, uses artificial intelligence (AI) to originate loans for banks on other lenders, and investors have doubts about how well its lending models will hold up as household finances deteriorate. To make matters worse, demand for loans is slumping as the economy sputters.
As a result, Upstart stock has plunged 94% from its all-time high. But the shares may be very attractive at today's prices, with the potential to deliver solid long-term returns for investors who buy now.
Loan demand is slowing, but demand for Upstart is soaring
Upstart's main goal is to displace the standard tools used to size up the risk in consumer lending. Fair Isaac's FICO credit scoring system has been the gold standard for decades, but Upstart says its criteria is too narrow to serve potential borrowers in the modern economy.
Instead, Upstart uses artificial intelligence to determine a person's creditworthiness by assessing up to 1,600 data points. Because AI works much faster than humans, it can deliver instant decisions on about 73% of loan applications. That's a big cost-saver for banks.
In the second quarter of 2022, Upstart's algorithm originated $3.2 billion of loans, which was a modest 17% year-over-year increase. But it represented a 27% decline from the $4.5 billion originated in the first quarter of 2022 -- marking a rather abrupt slowdown.
But there was a silver lining. The number of banks and credit unions adopting Upstart's algorithm continued to soar both year over year and from the first quarter.
Similarly, Upstart continued to add partnerships with car dealers. There are now 37 major brands using the Upstart Auto Retail sales and loan origination software across 640 U.S. dealerships.
Therefore, even though consumer demand for credit is dwindling, Upstart could be setting itself up for a strong rebound when the economy recovers.
But there are challenges
Plenty of investors doubt that Upstart's credit models will hold up during a sustained economic downturn. After all, they were developed during good times and haven't been battle tested.
Loan defaults are rising across the lending industry as pandemic-related U.S. government stimulus programs shut down. Still, Upstart expected this, and it says its models are calibrated for an economy much worse than the slow growth in some years after the financial crisis.
But investors who buy some of the loans Upstart originates have definitely been spooked, and the company stepped in to fund $623 million worth of loans using its own balance sheet. That's a big no-no from a risk perspective as far as the stock market is concerned; however, the company says it intends to sell the majority of these that don't relate to genuine research and development.
In fact, in a recent presentation the company said that its AI-driven approach continues to have an edge over traditional credit scores, and that its accuracy has consistently improved over time -- even during this year's tumultuous second quarter. If that remains the case, any funding issues should be relatively short lived.
Upstart stock is very attractive
After declining 94% from its all-time high of $401.99, Upstart's current share price of about $23.65 gives the company a valuation of $1.9 billion. But here's the thing: It has $757 million in net assets on its balance sheet, including a $790 million cash pile.
If you back out that cash, investors are basically valuing Upstart's actual business at just $1.23 billion, even though it generated over $1 billion in revenue during the past four quarters. Beyond that, Upstart was profitable in 2020, 2021, and in the first half of 2022 despite the challenging economic environment -- and not something you see often from a fintech startup.
Concerns about the company's AI-driven lending models probably won't be resolved for a few more quarters. Investors will also want to see Upstart follow through on plans to sell the loans on its balance sheet.
Proceeding with cautious optimism might be the smart plan here. Upstart stock is so beaten down that it could generate blockbuster long-term returns for investors who buy it now, provided the company's assumptions are correct and its lending models don't crumble even as economy worsens.
