Upstart (UPST 0.79%) suffered a 97% decline from its peak in mid-2021 to the end of 2022. Rising interest rates hammered the loan market as consumers became increasingly reluctant to apply for personal and auto loans.
However, so far in 2023, the AI stock has risen by more than 35%, and that has occurred at a time when more banks have taken an interest in its loan evaluator. The question for investors is whether that January recovery means Upstart is finally ready to surge higher again.
Upstart's business model struggles
Upstart derives most of its revenue from its loan-evaluation tool. The company applies AI to evaluate the creditworthiness of prospective borrowers. It collects a fee for performing this evaluation and (at least until recently) does not typically fund loans itself.
Studies by Upstart indicate that the model can approve more loans than the longtime standard in loan evaluation, Fair Isaac Corporation's FICO score, without increasing default risk.
Image source: Upstart Investor Relations.
Nonetheless, unlike the FICO score, Upstart has not yet proven that its model can consistently lower default risks during a downturn. Today, in a rising-rate environment, the economy has begun to put the model to the test.
Furthermore, a record number of banks and auto dealerships use Upstart's platform. Still, 88% of loan volumes come from just two banks, leaving Upstart vulnerable if it loses one or both of these clients.
Other concerns have also appeared, particularly with the move into the auto loan and small-business lending markets. To support its new lending products, the company self-funded numerous loans. Now, these notes have accumulated on Upstart's balance sheet, and so far, management has not followed through on their promise to reduce this loan balance.
How the financials have fared
Additionally, the total addressable markets for automobile and small business loans combined is almost 10 times as large as the personal loan market, according to Transunion.
Still, moving into those markets did not prevent a revenue decline. In the third quarter of 2022, revenue of $157 million fell 31% year over year. That is a dramatic turnabout from the first quarter when revenue surged 156% higher.
Also, amid the revenue decline and rising operating expenses, Upstart reported a third-quarter net loss of $53 million. By comparison, Upstart reported a profit of $29 million in the year-ago quarter.
The silver lining in the decline is that Upstart's price-to-sales (P/S) ratio has fallen from a peak of 48 in Oct. 2021 to just 1.6 as of this writing. But with so many uncertainties remaining, it will need more than a low valuation to bring investors back into the stock.
Can Upstart stage a comeback?
Given the declines in the loan market, Upstart's prospects for a recovery remain uncertain. The good news is that, so far, the model has performed according to expectations. Also, since banks want to minimize defaults in such an uncertain market, Upstart holds tremendous potential to attract business away from FICO.
However, Upstart's most serious threat may be internal. Even amid a move into new loan markets, the company failed to stem revenue declines or reduce the size of its loan portfolio. Moreover, investors should be weary that the company's revenue base is dangerously dependent on two banks.
Upstart stock could drive parabolic gains if it steadily supplants FICO. But until management rights this ship, investors should proceed very cautiously if buying this stock.
