The artificial intelligence-assisted lender Upstart (UPST -3.95%) was a darling during the tech boom in 2021. The stock price rose from $44 when it went public to close to $400 per share, trading at an astronomical valuation.
However, the rising interest rate environment has been devastating to high-flying tech stocks, and what went up has now mostly come down. With such a meteoric rise, Upstart has been hit hard, and shares have come crashing down to roughly $17 per share.
While Upstart may look cheap, I'm still not buying. Here's why.
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Upstart has a severely disrupted business model
I don't know if you can say the business model is fully broken yet, but it has been severely disrupted, and I'm not sure if it will ever be the same again.
Upstart uses proprietary algorithm models to underwrite loans. The company believes it can better assess credit quality than traditional underwriting models. The goal is for Upstart to identify borrowers lower on the credit spectrum who are creditworthy, so they can give these borrowers better interest rates while identifying new customers for financial institutions.
Upstart loans are either funded by and retained by the balance sheets of banks and credit unions, or sold to investors. But even in extremely benign credit conditions in 2021, only 16% of Upstart loans were funded by and retained by financial institutions. The rest were sold to whole-loan buyers or securitized.
As rates have soared, the cost of funds for investors who purchase Upstart loans has soared as well, which has led these investors to request higher returns. This means Upstart needs to raise the interest rates it charges consumers. But because the Fed has been raising rates so aggressively, it has been hard for lenders to raise interest rates enough to keep up with higher funding costs. Furthermore, credit quality among Upstart loans has deteriorated.
All this has led the capital markets to dry up. Upstart can't find investors to buy its loans and has had to slow originations. It has also had to temporarily bring lots of loans onto its balance sheet rather than immediately sell them to institutional investors. This is not how its model is supposed to operate, and it leaves the company more exposed to potential losses if the borrowers end up defaulting. In 2022, Upstart reported more than $109 million in losses and subsequently significantly trimmed its guidance.
Can Upstart rebound?
Like many companies, Upstart has been caught up in one of the more difficult macro environments, especially for its business model. If and when the Fed stops hiking interest rates, the capital markets should open back up. But I don't think it's going to be like it was in 2021, and I do wonder what the pricing will be like for Upstart loans and securitization notes, and ultimately if Upstart can still make as much as it did.
That's because even if the securitization markets get more fluid again, consumers could still be headed into a recession, the unemployment market could rise, and consumers face added expenses moving forward like the resumption of student loan payments. This could lead to higher loan losses, especially among Upstart's largely near-prime customer base.
Upstart has also discussed the idea of locking in funding in advance to try to lessen the volatility of the capital markets moving forward, but this will likely cut into the profits Upstart makes from originations as well.
Also, this banking crisis has not helped Upstart. Banks are expected to tighten credit quality in order to preserve liquidity, and the last thing I expect them to do is to load up on unsecured personal loans, especially on those lower down the credit spectrum.
Upstart's model would be much more attractive if many of its loans could be funded and retained by banks and credit unions, but I don't expect this group to be too interested in Upstart loans for the foreseeable future, given what's going on in the banking sector.
Is Upstart even really that cheap?
I believe Upstart has numerous obstacles ahead. Even when the securitization markets open, consumers could still be heading into a tough economy.
Furthermore, I would expect banks and credit unions to stay away from Upstart loans, and I do not believe Upstart has proven that its algorithms are outperforming on credit quality enough to make a real difference.
Additionally, even with the stock down more than 82% over the last year, the fintech company still trades at more than 27 times projected 2024 earnings and 234% to its tangible book value. Things can of course change, but that is not a cheap valuation, and I view Upstart's outlook and business model to be much less attractive and effective than it was.
