Upstart (UPST -1.97%) is one of the more notable disappointments of the 2022 bear market. Amid its dramatic reversal from massive growth to huge declines, its stock lost 97% of its value. The drop in the stock price also brought to light some management missteps and significant vulnerabilities.
Nonetheless, Upstart's potential ability to spark industry transformation may help it draw interest despite the challenges. The question for investors is whether its industry influence outweighs significant issues with this company.
Reason to sell: The handling of rising interest rates
Admittedly, the market has seen an unprecedented rise in interest rates as the federal funds rate rose from the 0% to 0.25% range in March 2020 to the 4.75% to 5% range today. The increased cost of borrowing has dampened demand across the board, and Upstart is not the only company in the lending business to suffer.
Nonetheless, this increase also occurred when Upstart dramatically expanded its lending business. Until 2021, its evaluator only reviewed personal loans, a $162 billion addressable market. But in 2021, Upstart moved into auto loans, a $780 billion market that potentially increases its addressable market fivefold.
It also began to evaluate small business loans, adding another $644 billion in loan volumes to its addressable market. It placed this segment on pause amid the slowdown. However, the company's inability to grow loan volumes amid this expansion is disappointing, even with the massive spike in interest rates.
Reason to sell: Heavy dependence on too few banks
Despite its troubles, the consumer finance stock continues to recruit new lending partners. In 2022, bank and credit union partners in the personal loan segment rose from 42 at the end of 2021 to 92 just one year later. It has also attracted more auto lenders. At the end of 2022, 778 automobile dealerships used its software, up from 410 in the year-ago quarter.
But in spite of these improvements, Upstart remains dependent on two banks. New Jersey-based Cross River Bank originated 51% of Upstart's loans in the fourth quarter, while an unnamed bank claimed 36% of originations. Hence, two banks claim 87% of Upstart's loan volumes, down from 91% in 2021. That leaves Upstart's revenue stream vulnerable to ever larger declines if either bank ends its relationship with the company.
Reason to sell: A compromised business model
Additionally, the rising rates have exposed another weakness in its business model. Upstart marketed itself as a loan evaluator, meaning its mission was to assess creditworthiness, collect a fee for its service, and leave lending to banks.
Still, Upstart's balance sheet shows that it carries more than $1 billion in loans, up from $250 million at the end of 2021 and $78 million in 2020.
The company had carried some loans as it experimented with its artificial intelligence (AI) model. However, when these volumes began to rise early last year, investors sold the stock, and management promised to sell these loans. But with loan volumes continuing to grow, it's called into question whether management will keep Upstart focused on its main purpose.
Reason to buy: Its loan evaluation tool works
That main purpose is a credit to Upstart, as its model appears capable of approving more loans without an increased risk of defaults.
The model was a longtime concern for Upstart bears, since it had not dealt with the stress of a rising-rate environment until recently. But Upstart's comparison with Fair Isaac Corporation's FICO model shows its effectiveness.
For example, borrowers who receive the lowest rating from both FICO (meaning a score of 639 or below) and Upstart (an E rating) default at an 18% rate. But of those with FICO's lowest rating, lenders rated an A+ on Upstart (its highest rating) defaulted only 3.5% of the time. Hence, Upstart's model allows banks to approve more loans without increasing risks, which benefits both banks and borrowers alike.
Image source: Upstart.
Moreover, Upstart continues to upgrade its AI-based models, using more than 1,500 variables to measure creditworthiness and automate the process. Consequently, the Upstart model approves 75% of loans instantly, up from 69% in 2021.
This also compares well to FICO, which came about in 1989 and uses only a few variables. Due to this clear value proposition, it is possible that buying Upstart will eventually turn out to be a genius move.
Should I consider Upstart?
Given its tool's performance, investors should not write off Upstart. With its ability to approve more loans without increasing risks, its model stands a significant chance of transforming its industry. However, with management missteps, rising interest rates hampering growth, and its excessive dependence on two banks, Upstart stock faces significant challenges.
Investors should keep this stock on their watch lists, but until Upstart shows it can overcome some of these problems, they should probably wait to buy shares.
