Anyone who has even been thinking about purchasing a home or car knows interest rates are rapidly rising this year. As the Federal Reserve hikes its benchmark interest rates, the ripple effects spread out to loans and debt assets across the entire economy. For example, risk-free Treasury bonds now offer higher yields than they did last year, which means that more risky forms of debt -- like mortgages or personal loans -- have to yield their loan owners more to compensate.
Those higher interest rates make loans more expensive for borrowers, which naturally leads to fewer loans being taken out. And that is taking a toll on Upstart (UPST -1.79%), a fintech company that uses an artificial intelligence model to assess the credit risk of potential borrowers, providing an alternative to the FICO score that lenders have used for that purpose for decades.
When fewer people apply for loans, that means less business for Upstart, which one reason why its stock is down this year. But it's off by an astounding 95% from its all-time high and 86% year to date, and the shift in its business environment isn't a complete explanation for why the stock fell quite that far. Last year, it had been pumped up to an unrealistic valuation. When it crashed, it had a long way to fall.
Despite this, I'm still a buyer of Upstart's stock. There's just too much growth potential for this business to leave it for dead, and I think now could be an excellent time for investors to open a position.
A better lending model
Upstart's creditworthiness model is, quite frankly, the future of lending. Across all credit grades (A+ being those it finds offer the lowest risk, and E- being those its model finds carry the highest risk), Upstart does much a better job of gauging default risk than a FICO score.
Image source: Upstart.
Just look at consumers with FICO scores of 700 or greater whom Upstart categorizes as E-. These borrowers default on 10.2% of loans annually, but most lenders wouldn't hesitate to give them the best interest rates. On the flip side, for those with less-than-ideal FICO scores (639 or lower), Upstart can identify solid borrowers through their A+ designation.
With Upstart's model, lenders can approve more loans (particularly to borrowers with low FICO scores) and avoid making higher-risk loans, even to borrowers who would appear safe based on the traditional measure. That means more revenue and lower losses, a win-win for lenders.
This benefit is precisely why Upstart's Net Promoter Score (a measure of customer satisfaction) is greater than 80 -- a world-class score. It's also attracting more lenders to the service. For example, New Jersey-based Atlantic Federal Credit Union recently inked a deal to start utilizing Upstart's tool to approve personal loans.
The model is attractive, but how is the business executing?
A surprise appearance on the balance sheet
With the stock down as much as it is, you might expect that the business would be struggling, but it is holding on quite well considering the interest rate environment.
In the second quarter, revenue rose 18% year over year. However, revenue is projected to fall by about 25% in Q3 as higher interest rates quash demand for loans. Upstart's profitability also disappeared in Q2: It lost $29.9 million compared to the $37.3 million profit it booked in the prior-year period.
Investors were also concerned by the appearance of loans on Upstart's balance sheet. Upstart is supposed to be a low-risk fintech company, and carrying loans on its balance sheet doesn't fit that narrative. However, Upstart is using them for research and development, and taking a short-term profit opportunity.
In particular, it is testing its auto loan product. Upstart wants to show lenders that its service works so that the company can better market it. Upstart CEO Dave Girouard also sees an opportunity: "We believe the opportunity to generate outsized profits on our platform is unusually high right now." Girouard thinks Upstart can make significant profits on the loans it issues right now, and it's taking its shot.
No one understands Upstart's lending model better than itself, so I trust Girouard and his team to make the right calls.
Regardless, the news that it was trying this strategy led many investors to dump the stock, and the company's valuation is now an absurdly low 1.8 times sales. For reference, JP Morgan, a bank that primarily deals with loans, has a price-to-sales ratio of 2.6. A true fintech like PayPal and Upstart competitor Fair Isaac Company trade at 4 and 8 times sales, respectively.
It doesn't make sense for Upstart to trade at a valuation this low. The business may struggle for the next year or two amid a rising interest rate environment. However, its long-term opportunity is massive, with $6 trillion in loans annually.
Upstart will ride this storm out and be well prepared for the subsequent economic recovery. That's why I'm a buyer of this oversold stock.
