A potentially lucrative investing strategy is to focus on the most disruptive companies. If they truly provide a revolutionary product or service, their revenue can skyrocket, which could lead to higher stock returns. Even with its latest challenges, fintech specialist Upstart Holdings (UPST -1.97%) is in this category.
Could Upstart, whose shares are down 80% over the past 12 months, soar higher in 2023? Let's take a closer look at what investors should know.
An innovative business model
Upstart's cloud-based, artificial intelligence platform parses through more than 1,000 different data points, like education and employment, to determine the creditworthiness of loan applicants. The benefit to expanding beyond traditional metrics is that Upstart's model creates borrowing opportunities for those who might not have as much access to capital for whatever reason under the traditional FICO system.
The system has proven that it works, as Upstart reports that its model can better gauge and separate risk between different sets of borrowers. Plus, the company says that its proprietary platform is designed to get better over time, approving more loans at lower loss rates.
Upstart's innovative credit-approval tool is a clear win-win-win for all parties involved. It's a net positive for its lending partners, which include banks, credit unions, and auto dealerships. By utilizing Upstart's platform, they gain the potential to increase their addressable markets by accepting and approving more loan applications, while essentially performing no added work. This can lead to higher revenue and profits over time.
Borrowers get access to affordable credit options, as I alluded to earlier, that they might not get by going to regular banks. To really highlight this point, Upstart mentioned that in the most recent quarter, it was able to approve a higher number of minority borrowers at lower interest rates than the Fair Isaac FICO model.
And lastly, by enabling all of this, Upstart can grow as its solution powers more loans. As you can see, all three stakeholders are better off.
Facing some challenges
Despite what is certainly a truly game-changing lending platform, Upstart is dealing with some major challenges. To curb inflation that was at 40-year highs, the Federal Reserve has been on an aggressive path of hiking interest rates. This discourages borrowers from taking out loans, and it discourages banks from approving them as well.
What's more, higher interest rates usually translate to higher defaults and delinquencies. In fact, we're seeing big U.S. banks prepare for tough times ahead. In the latest quarter, JPMorgan Chase and Bank of America, for example, set aside a combined $2.5 billion in their loan loss reserves, a signal that the economy could be challenged in the quarters ahead.
Consequently, it's hardly a surprise that a business like Upstart, which is so reliant on buoyant capital market conditions for its own success, would take a hit when macroeconomic conditions quickly tighten. Revenue of $157 million in Q3 was down 31% year over year, with the company posting a net loss of $56 million, compared to net income of $29 million in the year-ago period.
If there are worse times ahead, including a possible recession, shareholders should expect more pain for Upstart. "We're eyes wide open to the challenges of the current macro economy and determined to make the decisions that will optimize for the long-term success of Upstart," founder and Chef Executive Officer Dave Girouard said in November.
What's odd with this statement is that during the first nine months of 2022, the leadership team decided to take some of its excess cash to repurchase $150 million of its own stock. If executives were more cautious, and instead decided to better prepare the company for any unfavorable macroeconomic circumstances, then there's no doubt that the balance sheet would be a bit stronger right now. As of Sept. 30, Upstart had $830 million of cash and restricted cash versus borrowings of $919 million.
Investors who believe that Upstart's troubles are temporary, and that the business will be able to weather any prolonged economic downturn, might consider it a worthy portfolio addition. That's because the hope is that the company can return to its phenomenal growth trajectory in a more robust economy. The issue, however, is that it's really anyone's guess whether this will happen in 2023.
Plus, with the stock currently trading at a historically cheap price-to-sales multiple of 1.5, the upside potential is sizable. It's up to investors to balance the near-term uncertainty risk with the possible long-term reward before they decide to buy Upstart shares this year.
