Consumers have suffered the most as inflation ripped through the economy over the last 18 months. Not only have they felt the pinch of broad price increases on goods and services, but the U.S. Federal Reserve has embarked on the most aggressive campaign to hike interest rates in history.
That's having a direct impact on demand for credit across the board, from unsecured personal loans all the way up to mortgages. Plus, when interest rates jump, borrowers sometimes struggle to meet the higher payments, which leads to more defaults.
Upstart Holdings (UPST -1.25%) has been impacted by all of the above. It's a loan origination platform that uses artificial intelligence (AI) to deliver better outcomes for both borrowers and lenders, but the macroeconomic environment has thrown a wrench into its ambitions.
The company just reported its financial results for the 2022 full year, and investors sent the stock soaring by 28% on the day to $21.59 per share before pulling back the following day. It's still down a whopping 94% from its all-time high of $401.49, but could this be the start of a longer-term comeback?
Here's the good news
Upstart's mission is clear: The company wants credit to be accessible to everybody based on true risk. For the last 30 years, banks have relied on Fair Isaac's FICO scoring system as the key measure of creditworthiness. But unfortunately, FICO only takes a handful of metrics into account -- the borrower's payment history and outstanding debts make up 65% of their score!
By using artificial intelligence, Upstart's algorithm is instead able to analyze 1,600 data points on a potential borrower to produce a more accurate measure of creditworthiness. The model is able to make an instant decision 82% of the time, with the assessment process fully automated. Parsing so much data would take a human assessor weeks or even months, which truly highlights the power of AI.
There were a couple of very positive takeaways from the company's 2022 results. Remember, Upstart doesn't lend any money itself; it's an originator, so it needs partners to fund the loans approved by its AI model. At the end of 2022, the company had 92 bank and credit union partners on board, and that number was up 119% year over year.
Additionally, Upstart had 778 car dealerships on board across America from 37 different automotive brands, an 89% year-over-year increase. Its AI-driven model funded one-fifth of all car loans across participating dealerships.
The company has continued to build out the Upstart Auto Retail platform. Customers can now buy a car and simultaneously complete financing entirely online, complete with e-signing capabilities for contract documents, which could substantially increase its market penetration.
But Upstart's financials are still on shaky ground
Investors don't like owning shares in a company that isn't growing. After several years of Upstart's revenue soaring at a breakneck pace, its 2022 total of $842 million marked a slight 1% drop from 2021.
It's positive that revenue stabilized at a similar level to 2021 as opposed to substantially contracting, which appeared to be a real possibility given how challenging the economic environment was last year.
Upstart's model originated more than 1.1 million loans in 2022, but that was a 16% drop compared to 2021. Automotive loans, however, were a bright spot. The number of originations jumped 353% to 26,161 -- the segment is still ramping up, so the absolute number was quite small.
But there's one key thing investors are worried about: Upstart is currently holding $1 billion in loans on its balance sheet. Remember, the company is supposed to be an originator, which is a capital-light business model that earns fees with relatively little risk. Management says $492 million of those loans fall under research and development for Upstart's car loan segment, which isn't necessarily of concern.
However, Upstart was effectively forced to take on the rest. Funding conditions dried up last year as banks shunned riskier loans, so the company had to hold on to the loans it couldn't sell. The end of this concerning chapter might be near, though, as on its fourth-quarter earnings call Upstart told investors its balance sheet was near its maximum size and there were no plans to grow it further.
Upstart stock trades near a rock-bottom valuation
Investors are currently valuing Upstart at a market capitalization of $1.7 billion. Based on the company's 2022 revenue of $842 million, that means the stock is trading at a price-to-sales (P/S) ratio of just 2 -- that's a long way from its peak P/S ratio of 13.7 from 2021.
Given Upstart's struggles last year, the decline in its valuation was warranted. But the macroeconomic environment is slowly improving with inflation ticking down over the last seven months. Plus, if its balance sheet doesn't grow any further (as management suggests), that takes a substantial risk off the table, which would be a welcome relief for investors.
Upstart still has its eye on a substantial addressable opportunity. The market for personal loans and automotive loans is worth $942 billion per year, and since the company's originations only totaled $11.2 billion in 2022, it has barely scratched the surface. But add in business loans and mortgages -- areas where Upstart is hinting it might operate in the future -- and the addressable opportunity surges to $5.5 trillion per year.
Upstart isn't going to recover in a straight line, but at its current stock price, it presents an attractive risk-reward proposition, especially for investors with a long-term horizon.
