Editor's note: This article has been corrected. Lemonade holds $255 million in liquidity and $89 million in short-term investments, in addition to other investments.
Amid the rise of ChatGPT, the public has taken a greater interest in artificial intelligence (AI). Considering the technology's potential to increase productivity, investors have a chance to earn outsized gains in the sector's leading stocks.
However, AI stocks are not necessarily golden tickets. Poor management or a lack of innovation compared to peers could derail the investment cases for some companies. Knowing this potential for failure, investors might want to approach the following three stocks more cautiously.
This AI company could have problems lurking beneath the surface
Justin Pope (C3.ai): Shares of C3.ai (AI -1.48%) have outperformed the market since the new year, but the fun might not last. Despite its 55% gains since then, shares have begun cooling off, shedding 48% over the past month. A look into the company could explain why.
C3.ai sells AI-powered enterprise software applications. The apps serve purposes ranging from supply chain management to detecting money laundering and appraising residential property. These products sound very helpful at face value, but a closer look could tell a different story.
For starters, the company has lacked continuity throughout its life span. It has changed names several times since its founding in 2009, has seen high turnover at the CFO position, and abruptly pivoted its billing model shortly after going public. Not only does this make it hard to get a read on the company's performance, but it forces investors to ask: Why all the changes?
Additionally, C3.ai doesn't give a clear view of how many customers it has. Its most recent quarterly report states its customer count at 236. However, the fine print in the company's 10-Q filing notes that management counts every division, department, business unit, or group within a customer entity as a customer. The company also counts its customers' end users and third parties under reseller agreements. That seems to stretch the definition of what a customer is to the limit and makes its net addition of 18 customers over the past four quarters seem even less impressive.
AI Revenue (TTM) data by YCharts.
Within that context, it's hard to give C3.ai much benefit of the doubt. It's guiding for low-single-digit revenue growth for the year ending April 30. Additionally, the company was unprofitable yet paid out almost as much share-based compensation as it took in in revenue over the past 12 months. There are more concerns than positives here, so investors had best stay away.
The deck is stacked against Upstart Holdings
Jake Lerch (Upstart Holdings): Investors love everything related to AI right now, while banks -- particularly regional banks -- are being left for dead.
So what are we to make of Upstart Holdings (UPST -1.00%), a company that aims to improve lending through innovative AI? The stock's recent performance offers a clue: Shares of Upstart are nearly 97% below their all-time high, which they achieved in late 2021.
That demonstrates that whatever has gone wrong with Upstart has gone wrong in a big way. Indeed, the company is swimming against the tide in a couple of directions.
First, tighter monetary policy from the Federal Reserve is forcing -- or, at any rate, greatly incentivizing -- lenders to keep higher cash reserves on hand, thus reducing lending activity. Look no further than the regional bank crisis to see what happens when anxious depositors descend on a bank with insufficient reserves.
Second, there is the core issue for Upstart: its business model. The company wants to disrupt the credit rating industry by using its proprietary AI to secure more loans -- at lower rates -- for borrowers.
Yet its product isn't taking off. Upstart's quarterly revenue has collapsed from $310 million to below $143 million in less than a year. Whether that's due to customer dissatisfaction or simply a result of tighter monetary conditions, it bodes poorly for Upstart.
AI might one day change how lenders appraise who's creditworthy or who isn't, but for now, lenders seem quite happy using Fair Isaac Corporation's system. Consider this: Even as monetary policy has tightened, Fair Isaac's stock is up more than 100%. In short, investors might want to pay more attention to Fair Isaac and less to Upstart.
This AI insurance stock is more of a lemon until proven otherwise
Will Healy (Lemonade): Without a doubt, Lemonade (LMND -0.40%) has applied AI to the insurance industry in a transformational way. This technology reduces the need for expensive agents in the sales process. Moreover, it can consider factors such as a person's driving habits or miles driven to better price auto insurance.
Unfortunately for Lemonade's shareholders, the basics of the insurance industry have more profoundly affected its stock than AI has. The insurance stock has fallen 97% from its January 2021 high.
Moreover, after the catastrophic ice storm in Texas in early 2021, its gross loss ratios -- the percentage of revenue from premiums used to pay claims -- rose to staggering levels, and they have not fallen significantly to this day. That factor and the 2022 bear market led to persistent doubts about Lemonade stock.
Indeed, Lemonade has begun to show improvement from its recent bear-market lows. In the first quarter of 2023, gross loss ratios dropped to 87%, down from 89% in the fourth quarter of 2022 and 94% in the third quarter.
However, the Corporate Finance Institute describes an "acceptable" loss ratio as being in the 40% to 60% range. Without a significant catastrophe to explain the persistently high gross loss ratios, Lemonade probably needs to make changes to its business model.
Moreover, the company holds around $255 million in liquidity and $89 million in short-term investments. While Lemonade does have additional securities, it is unclear how quickly it could liquidate those assets if need be. Therefore, unless the company can significantly reduce losses, it seems only a matter of time before the company has to take on debt or issue more shares. In the current market, such conditions will likely keep the stock price depressed even with a heavily discounted 3.6 price-to-sales ratio.
Admittedly, Lemonade has applied AI to insurance in a way that could bring massive returns to the stock if it succeeds. However, accomplishing this also requires that it lower gross loss ratios and become profitable. With Lemonade so far unable to meet those financial metrics, the risks do not appear to outweigh the potential rewards.
