In Dec. 2020, Upstart Holdings (UPST -0.85%) listed on the stock market priced at $20 per share. In less than 12 months, it rocketed to an all-time high of $401.49, delivering a gain of more than 1,900% for investors who backed its initial public offering.
If you've just checked the tape, don't worry, you're not dreaming. Upstart stock has in fact collapsed by 95% and is once again trading at around $20. The retreat can be partially attributed to the decline in the broader technology sector with the Nasdaq-100 index currently trading in a bear market. But Upstart's business is also being challenged by the tougher economic climate.
To understand why, let's take a look at what the company does and how its recent stock-price drop could be a buying opportunity.
Upstart is on a bold mission
The concept of lending can be traced back as far as 4,000 years. Instead of using currency as we know it today, people back then might have transacted in precious metals, grain, or livestock. But the mechanics were very much the same -- the lender assumed risk and expected to earn interest.
Fast-forward to the modern day, consumer loans are mostly facilitated by banks that are complex and tightly regulated to ensure the borrower is treated fairly, and to reduce any potential risk to the broader financial system. Banks tend to rely heavily on Fair Isaac's FICO credit scoring system, which looks at a borrower's payment history and existing debts (among other things) to determine their ability to service a loan.
FICO has been the gold standard for over three decades. That's a long time, given today's pace of innovation, and that's where Upstart has stepped in. The company says FICO is outdated, because it doesn't assess enough metrics to capture the creditworthiness of the modern-day income earner in the digital economy. To solve that, Upstart has developed an artificial intelligence algorithm that can analyze 1,600 data points on a potential borrower and make a decision instantly about 73% of the time.
That's a game changer for banks because fewer manual loan assessments mean lower costs, and the consumer also gets a far better experience. So far, Upstart's algorithm has performed well, but investors are concerned it hasn't been battle tested in a recessionary economic environment. That, combined with a sharp drop in loan demand from consumers, has resulted in the steep sell-off in Upstart stock recently.
The bad and the ugly
Upstart earns revenue by originating loans -- it's not supposed to lend any money itself. But credit conditions have tightened, and the company's bank partners have a smaller appetite for funding Upstart's mostly unsecured loans. Therefore, it has recently been forced to step in and use its own money, to the tune of $624 million as of the second quarter of 2022. Upstart says it fully intends to sell these as soon as practicable, but it's an example of the struggles disruptive innovators can have when the economy weakens.
Consumers also have a lesser appetite to borrow money right now because of higher interest rates, so Upstart saw a 27.7% sequential decline in originations in the second quarter, a steep drop in just three months.
That's having severe knock-on effects. For example, analysts estimate Upstart will generate $897 million in revenue in 2022, which would represent growth of only 5% compared to last year. I say "only" because Upstart grew its top line 264% in 2021, so it's set for a notable slowdown.
One silver lining is that the company is expected to remain profitable, so it's unlikely to require a cash injection any time soon. That's a big positive in this economy, especially since Upstart stock is so heavily beaten down.
Looking at the long term, this period could be a blip on the radar
Banks, consumers, and investors won't remain pessimistic about the economy forever. Eventually things will turn, and Upstart will likely find greater demand for its platform. Despite most of its other metrics shrinking recently, the company is still seeing banks, credit unions, and car dealerships rushing to adopt its algorithm.
In the second quarter, Upstart had 71 bank and credit union partners, up 184% year over year. It also reported that 640 car dealerships were using its Upstart Auto Retail sales and loan origination platform, more than tripling from the prior-year period. Those dealers represent 35 of the largest car manufacturers in the world. An investor might look at these numbers and think Upstart is well positioned for better times ahead, and they might be right.
The company has identified about $6 trillion worth of annual loan origination opportunities, including from two segments it doesn't operate in yet: mortgages and business loans. That points to a long runway for growth -- in fact, the company has barely scratched the surface so far.
The tech sector of 2020 and 2021 was the hottest it has been since the dot-com boom over 20 years ago. At Upstart stock's all-time high of $401.49, it traded at a price-to-sales (P/S) ratio of more than 50. That was nosebleed territory. The company is generating more revenue now, so if the stock were to rise back to that level today, its P/S ratio would be a slightly less crazy 30.
That's still quite high for this bearish environment, but considering Upstart's P/S multiple right now is just 1.8, it's basically at a rock-bottom valuation. There's room for plenty of upside in this stock, even if it reclaims a fraction of its previous gains.