Upstart Holdings (UPST 6.50%) uses artificial intelligence (AI) to help banks make better lending decisions. The disruptive fintech company wowed investors when it reported several consecutive quarters of triple-digit revenue growth in 2021, and its share price soared more than tenfold in the 10 months following its IPO in late 2020. Then things went south.
Upstart's financial performance has deteriorated amid the challenging economic environment, and its share price has fallen 95%. Put another way, Upstart stock has given back all of its gains and then some, as shares currently trade at a 29% discount to the IPO price.
Is it time to buy?
The bull case for Upstart
Lenders have long relied on FICO scores to assess the creditworthiness of potential borrowers, but those scores are calculated based on limited information. In fact, some of the more sophisticated FICO-based credit models consider no more than 30 data points. As a result, banks often make lending decisions without understanding the true risk, and that inevitably leads to higher loss rates.
Upstart wants to make the system more efficient, so it designed its platform to collect over 1,500 data points per borrower. Its software then leans on AI to measure those data points against past repayment events, correlating the variables with the likelihood of fraud and default. That theoretically allows Upstart to quantify risk more precisely than FICO-based models, and better risk assessment means bigger profits for lenders. Better yet, management has data to back its claim. For loans originated between the first quarter of 2018 and the second quarter of 2022, Upstart's AI models separated high-risk borrowers from low-risk borrowers with five times greater precision than FICO scores. That means Upstart may have a significant competitive advantage in a very large industry.
Upstart currently serves three lending verticals -- personal loans, auto loans, and small business loans -- and origination volume across those three verticals totals over $1.5 trillion each year. As a caveat, investors should be aware that Upstart has paused the development of its small business loans product until economic conditions improve.
The bear case for Upstart
Upstart has faced a number of headwinds over the past year. High inflation has put pressure on borrowers, causing delinquency rates and defaults to rise, and that trend has naturally made banks less willing to extend credit. Meanwhile, in an effort to stamp out high inflation, the Federal Reserve has raised interest rates at their fastest pace since the early 1980s, and the rising cost of borrowing has reduced demand for loans.
Upstart has also dealt with another headwind. The lending industry is naturally cyclical, meaning there are expansionary periods where banks lend money more freely and contractionary periods where banks exercise more caution. Those cycles are generally driven by the economic climate. As discussed above, Upstart has demonstrated its ability to quantify risk more precisely, but that data comes from an expansionary period in the credit cycle. Upstart's AI platform has never been tested during a contractionary period. That makes its software especially risky right now. Why should lenders implement unproven technology during an already difficult lending environment?
Those headwinds have caused Upstart's financial performance to deteriorate significantly. Third-quarter revenue dropped 31% to $157 million, a shocking turnaround from 250% revenue growth in the prior year. The company also reported a net loss of $56 million, an equally stunning reversal from its $29 million profit a year earlier.
On the bright side, economic headwinds are temporary. Inflation has already decelerated for six consecutive months, and the Federal Reserve plans to continue raising interest rates this year to keep that trend in motion. Then, as inflation approaches its long-term target of 2%, the central bank will reverse course and start lowering rates. Fed officials expect that process to begin in 2024.
So, the headwinds that have hammered the lending industry will eventually fade, and that should lead to an expansionary period in the credit cycle. But investors still need to monitor the performance of Upstart-powered loans during the ongoing contractionary period.
The stock is worth the risk (for some investors)
To summarize, Upstart is battling economic headwinds, but the company is also struggling to displace the decades-old credit score system with newfangled technology simply because lenders are hesitant to make changes during an already difficult situation.
That said, Upstart has shown its superiority to FICO-based models during an expansionary period of the credit cycle. If it can demonstrate the same superiority during the ongoing contractionary period, Upstart would likely see the adoption of its platform surge as the economy rebounds.
On that note, the stock currently trades at 1.8 times sales. That valuation would look like a bargain if Upstart manages to meaningfully reaccelerate revenue growth. For that reason, risk-tolerant investors should consider buying a few shares of this growth stock today. But given the uncertainty surrounding the business, keeping the position small (i.e., 2% or 3% of a portfolio) would be a prudent decision.
