At the end of the first quarter of 2022, management at Upstart (UPST -0.44%) was highlighting its seventh profitable quarter in a row and fourth straight quarter of triple-digit year-over-year revenue growth.
By the end of the second quarter, the Federal Reserve had raised interest rates by 150 basis points. And when Upstart reported its second-quarter results in August, the business had run into a wall. Revenue growth dropped to 18% year over year.
The stock is now down 90% year to date -- a thoroughly demoralizing year for Upstart investors. The sheer drop in its stock price means the market has been questioning whether Upstart will return to its top-dog status in 2023 or remain lackluster.
Let's investigate.
Why the stock could stagnate in 2023
Upstart is an up-and-coming cloud-based lending platform powered by artificial intelligence (AI) and runs a simple business.
It develops AI models that determine whether a person or company is eligible for a loan. Then, Upstart provides these AI models to its banking partners, which originate loans to qualified consumers or businesses. Once a banking partner creates an Upstart-powered loan, it can keep the loan on the books or sell it to institutional investors, or Upstart can fund the loan with its balance sheet.
Although Upstart-powered loans were briskly growing with low-interest rates in 2021, demand plummeted once the Federal Reserve started raising interest rates. For example, in the second quarter of 2022, transaction volume decreased by 28% compared to the first quarter. And in the third quarter of 2022, transaction volume dropped another 44%.
The lesson for investors is that despite Upstart's use of AI, the lending market is cyclical. When the Federal Reserve raises rates, all loans become more expensive, reducing borrower end demand. Virtually all lending businesses will suffer when rates rise too high or too fast.
Additionally, one huge added risk to Upstart is that it trained its AI models in a low-interest-rate environment. And no one knows the current rate hike cycle's effect on its loan defaults, as the AI platform is still experimental and can recommend loans for borrowers with a FICO score lower than many lenders would have ever considered in the past. And many lenders are still determining how such loans will perform in a challenging environment.
The worst part is that everyone is in the dark about how high the central bank will ultimately raise rates and how long it will hold rates at a high level. Some economic experts project that the central bank will increase rates well into 2023. Supposing that is true, investors should expect the stock to remain in the doldrums for at least the next year.
It has a high upside if its AI works
Upstart has data showing its AI-powered loans are far superior to traditional FICO-based loan originations -- one reason the Upstart platform was attractive at lower interest rates. The stock has an extremely high upside if it also becomes a better loan origination option at higher interest rates.
Many people already consider Upstart a leader in applying AI to loans. Yet it has only captured 0.02% of its total addressable market of $5 trillion, leaving it plenty of room to grow.
Image source: Upstart.
Suppose you believe that AI is a transformational technology. In that case, today's lousy loan market provides Upstart with valuable data to train its risk models -- practical knowledge no one else has, and a competitive advantage ensuring its business will be tough to copy.
Today, investors value this unique AI platform at its lowest valuation as a public company. It sells at a price-to-sales (P/S) ratio of 1.44 in a terrible market, well below its high of 44.7 in 2021.
Upstart bulls are counting on it to survive this period of low loan demand and reaccelerate revenue growth, profitability, and free cash flow after the loan market recovers. Should that occur, this company will trade at a far higher valuation in the future.
But it's a precarious investment in the short term
Currently, the company is unprofitable and free-cash-flow negative, and revenue shrank 31% year over year in the third quarter of 2022. In addition, Upstart has approximately a year's worth of cash on hand before it will require more.
Suppose Upstart fails to reestablish revenue growth and free cash flow within a year. In that case, it will likely resort to raising cash via the debt and equity markets, likely on unfavorable terms, and the stock could see more downside.
Most investors would be better off giving this stock a pass until there is more evidence that the company's AI algorithms work in an adverse environment. You also might be better off waiting to see if the company needs to raise capital and reassess it at that time.
