Bear markets present investors with stocks that trade at a deep discount to previous valuations. But just because something is cheap doesn't necessarily mean you're getting a bargain. Upstart Holdings (UPST 0.81%) is one beaten-down stock that I'm in no rush to buy.
Upstart went public in 2020 and saw its stock price explode as it strung together several profitable quarters in a row. But since peaking at more than $400 per share, the stock has fallen 95% and trades below its initial public offering (IPO) price. This year, the consumer lender has faced challenges that have been significant headwinds to the business. Here's why I'm avoiding the stock for now and what I want to see before buying.
Upstart's mission for fairer lending practices
Upstart is on a mission to improve the economics of the lending industry. The company says countless people are left out of the lending ecosystem because of inherently flawed risk models.
Upstart extends loans to consumers and judges risk based on its home-grown risk-based model that weighs 1,500 data points and runs them through its artificial intelligence program to assess the risk of default and fraud.
Fair Isaac's FICO scoring system considers fewer variables. According to Upstart's management, it can separate high-risk and low-risk borrowers with more precision than FICO.
Upstart partners with banks that help originate loans, and it mainly makes money on referral fees paid by its banking partners for every loan made through its website. These banks will hold some of the loans on their books and sell the remainder to institutional investors. Last year, banks held 16% of loans made through Upstart and sold 80% to investors.
Here's what is causing Upstart's struggles in 2022
The business model was working great last year, and Upstart saw revenue rise every quarter since going public in December 2020 into the first quarter of this year. It was also profitable in every one of those quarters. The company benefited from low interest rates and a stable economy, with few borrowers defaulting. This year, the story has taken a turn against Upstart as inflation and rapidly rising interest rates wreak havoc on credit markets.
Since June 2021, monthly inflation has risen at an annual rate of 5% or more. Many hoped this would be temporary, but it proved to be stickier than initially thought. To stomp out inflation, the Federal Reserve is using its primary tool: interest rates.
Since March, the central bank has raised its federal funds rate from near-zero to an upper limit of 4%, the fastest pace of increases in decades. Rising interest rates have weighed on lending across the entire economy. Companies are finding it harder to issue debt, and investors who might buy that debt seem to be sitting on the sidelines, waiting for the dust to settle.
Target federal funds rate upper limit; data by YCharts.
Demand for loans has plummeted
Many institutional investors have turned away from Upstart-approved loans this year as they face increased costs of capital. These investors might not think these loans are worth the risk because Upstart's model is still relatively untested in a credit cycle downturn, causing problems for the company in the last couple of quarters.
Because investors balked at buying its loans, Upstart held some of those credits on its books in the first quarter to bridge the gap. The company later said it would no longer hold loans, which meant it would have to make fewer loans to keep pace with waning investor demand.
Another problem emerged in the third quarter: a lack of borrower demand for credit. The company had fewer loan applications from borrowers, and saw loan defaults tick up in the quarter. So it has tightened its lending standards in response. The company approved 40% fewer loans than last year. As a result, third-quarter revenue dropped 31%, and its net loss of $56 million came after putting up a profit of $29 million the year before.
Here's what I want to see before considering Upstart stock
Upstart stock is at its cheapest valuation since going public, with its price-to-sales ratio of 2. However, this backward-looking metric might be deceiving if sales continue to decline in the coming quarters.
With default rates slowly increasing, Upstart's lending model faces its biggest challenge yet. Its reliance on selling loans makes it vulnerable to economic conditions. And with the Federal Reserve intent on raising interest rates to stomp out inflation, it will likely face more volatility in the months ahead.
The central bank has made it clear that it wants to get interest rates to a rate that will throttle inflationary pressures. Some experts think this terminal rate is about 5%, while others believe 6% could be on the table. There is hope that the Fed will end its rate hiking cycle; higher rates for longer could trigger a recession, causing defaults to spike.
I want to see interest rates stop rising, inflation slow further, and a more favorable economic backdrop before considering a position in Upstart's stock. Until then, I'll be patiently watching from the sidelines.
