Upstart Holdings (UPST -3.65%) has proven hypersensitive to the broader economic environment this year, amid rapidly rising interest rates. The company uses an artificial intelligence (AI)-driven algorithm to help banks originate loans, although Upstart also sells some of the loans to investors. But the worse the economy has performed, the more challenged that business model has become.
Plus, as can be expected, demand for credit among consumers is declining, which has dealt Upstart a double whammy.
Upstart stock is down 95% from its all-time high, and while its financial results for the third quarter were relatively weak, the company has laid a stronger foundation for growth. The question is, are investors too pessimistic at the moment? Let's explore.
More banks and more car dealerships want to use Upstart
At the core of Upstart's business is a firm belief that its algorithm can assess potential borrowers more accurately than traditional methods, including Fair Isaac's decades-old FICO scoring system. Thanks to artificial intelligence, Upstart is able to rapidly analyze 1,600 data points and deliver instant, automated approvals 75% of the time, which is a game changer for consumers and a cost saver for banks.
By diving deeper into a borrower's profile, Upstart is able to generate a more accurate representation of their ability to repay a loan and the appropriate interest rate they should be charged. For that reason, the algorithm approves 43% more Black borrowers and 46% more Hispanic borrowers than traditional assessment methods, and at significantly lower interest rates.
It's the company's mission to use this technology to create a more level playing field for borrowers, and so far, it's succeeding.
But delivering more accurate approvals is also a major win for the lenders funding the loans. Despite Upstart's share collapse, and despite the weak economy, the number of banks and credit unions signing on to join the Upstart ecosystem soared 167% in Q3 to 83.
Additionally, the number of car dealerships using Upstart Auto Retail -- the company's sales and loan-origination platform -- jumped 141% to 702. Upstart is now in so many dealerships that it covers 25% of the U.S. car market (by population).
Upstart's soaring revenue growth hits turbulence
Between 2020 and 2021, Upstart's revenue rose an eye-popping 264%. But 2022 hasn't been quite so strong, and in fact, the company's revenue has contracted two quarters in a row on a year-over-year basis.
Upstart generated just $157 million in revenue during Q3, down 31% from the same period last year. A steep drop in transaction volume was to blame, with the dollar value of approved loans falling about 40% from $3.1 billion to $1.8 billion. It was caused by several factors, including reduced consumers borrowing, investor reluctance to purchase loans, and Upstart's approval rates shrinking as it tries to reduce risk.
Analysts have significantly cut their forecasts for 2022 as a result, and now predict that Upstart's revenue will be little changed for the full year. That isn't a great outcome for investors who are used to the company's soaring growth, but given the headwinds it has faced this year, remaining on level ground might be a good position to start from in 2023.
Upstart was a consistently profitable company in the past, but it's had $86 million in net losses over the past two quarters. That's a direct result of the relatively unexpected drop in quarterly revenue, because it makes it very difficult to control costs without knowing where sales might come in.
Upstart stock might be a long-term buy here
Many of Upstart's problems will likely be solved with an economic recovery. The primary concern among investors is that the algorithm was born in good times and hasn't been battle tested in difficult economic conditions (or a recession), and some cracks have definitely appeared.
Defaults are currently tracking about 25% higher than the company had anticipated, though it's charging higher interest rates to compensate for this risk. Plus, management says this tough environment is accelerating the training of its AI model, and it's leaning into the challenge to come out the other side in a better position. In fact, the model has improved as much in the past four months as it did in the prior two years.
Buying Upstart stock is about the risk-versus-reward equation for investors. The company is valued at $1.8 billion right now, but it has $683 million in cash on its balance sheet. Therefore, the stock trades at a price-to-sales ratio of just 1.3 based on analysts' 2022 revenue estimates and excluding the cash balance. It's as close to a rock-bottom valuation as it gets.
Looking to the long term, Upstart estimates its opportunity could be as large as $5 trillion annually, which includes personal loans, automotive loans, business loans, and mortgages -- the latter market of which it hasn't entered yet. The company has recently dipped its toes in business lending, originating $10 million in loans in Q3, up 10-fold from the prior quarter.
Based on recent consumer price index data, there's a chance that inflation peaked back in June, because it has steadily come down since. If that trend continues, Upstart's business may not only recover but emerge significantly stronger with a more accurate lending model in tow.
It might be worth taking a chance on the stock here, especially given the 95% discount to its all-time high, though be prepared to hold for the long term.