Upstart Holdings (UPST -1.79%) has become one of the more embattled stocks on Wall Street. It's made a humongous round trip from $20 per share to $400 and back again in the past couple of years. Volatility can stir up investor emotions, so assessing a business with a clear head is vital.
Upstart is clearly struggling in this economic scenario of rapidly increasing interest rates, and management has admittedly backtracked on some of its plans for its balance sheet. However, some vital clues point toward a brighter future for the company. Here's what you must know about Upstart's challenges and why it's still a compelling long-term investment.
Understanding Upstart's struggles
Upstart is a technology company, but it's susceptible to the dynamics of the financial markets. It uses artificial intelligence (AI) instead of a traditional credit score to originate loans. Rather than hold the loans like a regular bank might, it wants to immediately sell those loans to investors, removing the risk from its balance sheet. Upstart is building a network of partner banks and credit unions that work with the company or use its software API to originate their loans.
The last two years have been financial whiplash for Upstart and largely explain the company's problems today. The financial markets were much easier to navigate last year -- consumers were flush with stimulus money, and interest rates across the economy were very low, making it easy on Upstart. But a combination of inflation-induced rate increases and now-fearful investors are pulverizing the bond market.
The speed at which this is happening has made business tough on Upstart. The company has struggled to sell some of its originated loans as investors didn't want to buy at a price that was still profitable for Upstart. In other words, the bond market fell apart so fast that Upstart made loans and was underwater on them before they could sell them.
Instead of taking those losses, Upstart is now holding the loans on its balance sheet, which management discussed in its second-quarter earnings call. Additionally, higher rates are pricing some potential borrowers out of loans, meaning lower origination volumes across the board. Upstart is navigating some very rough seas right now.
Looking for clues to a brighter tomorrow
Weathering this storm comes down to two crucial factors for Upstart. First, its AI must continue outperforming credit scores. If it can't, what's the point of the business? Fortunately, this appears to be the case, despite the harsh environment:
Image source: Upstart Holdings.
Upstart publishes the above analysis each quarter, showing that its risk grades do a better job separating good borrowers from bad than a FICO credit score that groups default rates much more closely, regardless of credit score.
Secondly, Upstart is still expanding its partner network in its loan program and automotive software. The partner network has grown from 25 to 71 over the past four quarters, while the number of automotive dealerships using its retail and financing software has grown from 199 to 640. If anything, this shows that lenders, who must accurately analyze risk to stay in business, still trust Upstart's technology. If it wasn't working, we'd expect to see partners dropping Upstart, and if that were to happen, then we'd have a significant problem that would justify selling the stock.
A game of survival
I don't think Upstart has been perfect by any means -- the flip-flopping with management's use of the balance sheet isn't ideal. However, what ultimately matters over the long term is the product works, and more lenders use it. More partners could very likely mean growth rebounds in a huge way when the economic environment improves. Remember, the bond market is going through the wringer right now, so a lot of this is out of Upstart's hands.
Upstart's originated personal loans dropped 31.5% from the previous quarter, yet free cash flow has held up decently well, and Upstart still has plenty of cash on the balance sheet:
Data by YCharts.
Nobody knows how long the economy will be this volatile or when it will bounce back. Investors should keep a close eye on Upstart over the coming quarters. Monitor how well its AI is performing and whether it's still gaining new partners while making sure cash losses don't escalate out of control. Upstart could still be a lucrative long-term investment if it can just hold its ground in these critical areas.
