Upstart (UPST -0.49%) and Lemonade (LMND 1.59%) seek to upend segments of the financial industry by using artificial intelligence (AI) to change how things get done. Upstart developed an AI-driven credit scoring system to improve how loans get approved, while Lemonade wants to disrupt the insurance industry through AI, using the technology to apply risk management to the sales process.
Although both AI stocks offer massive potential if they succeed, they both lost nearly all of their value in the 2022 tech bear market as the risks to their business models got more attention from risk-averse stock traders. In the current economic environment, one of these two stocks holds a better chance of succeeding, and the conditions of each business point to the reasons why.
The state of Upstart
Upstart seeks to upend the credit-scoring industry. More than 90% of lending institutions depend on Fair Isaac's FICO score to measure creditworthiness, and gaining approval for loans often hinges on having a high enough FICO score. However, this scoring system hasn't changed all that much since it became the standard in 1989.
Upstart introduced a new evaluation system that factors in many more variables and uses AI to develop a credit grade that it contends creates a far more accurate picture of a loan applicant's creditworthiness. An Upstart study comparing rating systems shows that its system can approve more loans without increasing the rate of defaults. Increasing the number of loans without increasing the number of defaults could deliver game-changing results for partner banks and other lending institutions, especially in a more challenging economic environment. The new system still needs to prove itself and only 99 lending partners currently use the Upstart platform, and two of those banks account for 70% of the transaction volume.
Upstart reported triple-digit revenue growth and positive net income as recently as the first quarter of 2022. But soon after, its financials deteriorated as rising interest rates dramatically reduced loan demand. In Q1 2023, revenue of $103 million dropped 67% from year-ago levels. Also, with operating expenses far exceeding revenue, the company lost $129 million during the quarter.
Still, bright spots have emerged. In the earnings report for the first quarter of 2023, Upstart reduced the loan amounts it held on its balance sheet by 3%. Those loans have concerned investors as Upstart has marketed itself as a loan evaluator and not a lender. Also, the forecast second-quarter revenue of $135 million is up sequentially from Q1's revenue level, making it more likely the declines will stop.
More importantly, CEO Dave Girouard announced a partnership with investment firm Castlelake where it would buy up to $4 billion in consumer installment loans originated on Upstart. Such developments could significantly improve Upstart's financials and reduce the dependence on the two banks that drive most of the company's revenue. Although risks remain, the prospects for Upstart stock seem to have improved considerably.
Lemonade and the insurance market
Like Upstart, Lemonade has also drawn attention for its AI-driven developments. For one, the insurance industry has long depended on a high-cost salesforce to sell its products. Instead, Lemonade sells most of its insurance policies online using AI, reducing the need for such a salesforce. This technology can also replace humans for tasks such as processing claims, likely helping to lower costs.
Moreover, Lemonade can harness the power of data. This means it can find insights not possible with human analysis. One of the more profound applications of this is its work with automobile insurance. Thanks to AI, Lemonade can price insurance based on how one drives. For example, if an individual drives fewer miles than the average user, Lemonade can reduce that driver's premium.
Unfortunately for Lemonade, applying this technology to build a solid, profitable business has proven elusive so far. In Q1 2023, revenue of $95 million rose 115% year over year. Still, with total expenses far exceeding revenue, the company lost $66 million in Q1, only slightly less than the $75 million loss in the year-ago quarter.
Worse, Lemonade reported a gross loss ratio of 87%, meaning that 87% of gross premium payments went to the payment of claims. The Corporate Finance Institute considers gross loss ratios between 40% and 60% "acceptable," indicating deep flaws in Lemonade's current business model. Notably, though, Lemonade has made strides over the past several years to improve its gross loss ratio: In 2017, that metric was 161%, nearly double what it is today. The company is moving this number in the right direction, but there is still much work to be done.
Company guidance tells an interesting story. For the second quarter, Lemonade predicts $97 million in revenue at the midpoint, implying a 94% revenue growth rate year over year. At an Investor's Day in late 2022, management laid out a best-case scenario plan to turn profitable in 2025. But unless the insurance company can further reduce its gross loss ratio and actually achieve the profitability it aspires to, revenue growth alone may not be enough to impress investors.
Still, Lemonade's AI advancements have likely put the industry on notice. If the company figures out how to implement these improvements while improving its business model, the stock could make massive gains.
Upstart or Lemonade?
Between the two companies, investors should probably go with Upstart. Admittedly, choosing between these stocks will depend on the investor's risk tolerances. Since both are money-losing companies taking on established industry players, risk-averse investors should avoid both stocks. Conversely, AI will likely disrupt both industries, increasing the potential for massive returns in both companies.
However, unlike Lemonade, Upstart earned a profit in the past. Also, the Castlelake partnership increases the company's likelihood of success. That deal gives it a more visible path to profitability and, by extension, stock price growth.
Editor's Note: This article was updated on 5/24/23 to include guidance from Lemonade's 2022 Investor Day about its plans to achieve profitability.
