Amid the rise in interest rates, the optimism surrounding Upstart Holdings (UPST -0.58%) gave way to hopelessness. The one-time high-growth company saw massive growth quickly turn negative as profits turned into losses and investors lost faith in the company's management team.
Presumably, Upstart's ultimate goal is to persuade lenders to drop Fair Isaac Corporation's (FICO 0.78%) FICO score in favor of its evaluation tool. But given the state of its stock, it might stand a better chance of saving itself and Fair Isaac by seeking an alliance. Here are three reasons why:
1. The FICO score as we know it is likely doomed
For all of the problems with Upstart as a company, smart investors know it holds potential because its AI-driven model works. In other words, it can approve more loans without increasing default risks. In a rising rate environment, this is valuable to banks that may face more defaults as economic conditions worsen.
| Risk Separation-Upstart vs. FICO | |||||||
|---|---|---|---|---|---|---|---|
| Upstart Risk Grades | |||||||
| FICO Scores | A+ | B | C | D | E- | Average | |
| 700 or more | 0.7% | 2.3% | 4.5% | 6.7% | 10.6% | 3.8% | |
| 680-699 | 0.8% | 2.2% | 4% | 5.9% | 9.9% | 4.7% | |
| 660-679 | 1.1% | 2.3% | 4.2% | 6.1% | 10.2% | 5.8% | |
| 640-659 | 1.2% | 2.7% | 4.2% | 6.3% | 11.3% | 7.1% | |
| 639 or less | 1.7% | 3.3% | 5.1% | 7.6% | 16% | 11.9% | |
| Average | 0.8% | 2.4% | 4.4% | 6.5% | 12.7% | ||
The gap between defaults in the highest and lowest Upstart risk grades is 16 times, while the defaults difference between the lowest and highest credit scores is just 3x. In other words, Upstar's risk grades have efficiently identified risky loans. Source: Upstart IR.
Moreover, Upstart is not the only company to use an alternate loan approval process. SoFi Technologies, a fintech-oriented bank, has developed criteria internally to help evaluate prospective borrowers.
In comparison, FICO has used the same criteria for evaluating loans since its score became the standard in 1989. And even with some data-driven additions such as FICO Score X, the scoring system has changed little since its creation. Given that emerging competitors like Upstart are creating AI-driven approval processes with updated assumptions and new analysis methods, FICO's long-term survival is in question unless it makes changes.
2. FICO's dominance
Still, for all of FICO's problems, its score is a fixture in America's credit system. About 90% of top lenders use the FICO score to evaluate loans. Hence, if it wants to improve the process, it is in a position where it can implement changes throughout the credit system most quickly. And since Upstart's model can approve more loans without increasing risks, that could make Fair Isaac more valuable to banks.
However, Upstart would probably see the most benefit. As of the end of 2022, only 92 banks and credit unions use Upstart's scoring system. Additionally, two of those banks make up 87% of Upstart's business, meaning it has attracted little interest thus far. If FICO uses its system, it will probably gain mainstream acceptance quickly, likely changing the game for Upstart shareholders.
3. FICO probably cannot buy out Upstart
Admittedly, a buyout of Upstart might seem like a better move for Fair Isaac than an alliance. Upstart stock now sells at a 96% discount to that all-time high. Trading at just 1.6 times sales, Upstart's valuation is now near record lows, and its $1.25 billion market cap places it in small-cap territory.
Nonetheless, Fair Isaac claims only $140 million in liquidity and holds more than $1.8 billion in long-term debt. That has left it with a stockholders' deficit of $802 million. Acquiring Upstart would cost the company $1.25 billion, plus a buyout premium. Under those conditions, it might struggle to find funding for such a merger without an extreme level of debt or stock dilution.
Making sense of an Upstart-FICO partnership
Indeed, Fair Isaac allying with Upstart could be mutually beneficial. AI is likely going to play a considerable role in credit scoring, and Upstart's technology could be the asset Fair Isaac needs to address that competitive threat.
However, Fair Isaac's balance sheet does not position it well to make such buyouts. For this reason, investors probably should not hope for a merger. Still, such an alliance would further Upstart's goal of becoming the dominant loan evaluation tool, which could send the AI stock rocketing higher if massive growth were to return.
