Some companies see their entire business model hinging on one decision or governing body. While this is most often associated with biotech companies that could be a hit or fade away based on a regulatory decision, it's also been the reality for Upstart (UPST -7.89%).
Upstart offers an alternative way to assess creditworthiness rather than a traditional FICO score and uses artificial intelligence (AI) to assess a loan applicant. However, its business model has been turned on its head thanks to the Fed's decisions to hike interest rates. The stock has plummeted more than 90% from its highs, although Upstart has rebounded in the past few months.
So has the Fed decimated Upstart's business to the point of no return? Or is there hope for Upstart's survival?
Upstart's model isn't working as well as it used to
Upstart champions its model over the traditional FICO score because it more accurately pinpoints who is most likely to default on their loans.
Image source: Upstart. Performance as of April 2023.
Those with high creditworthiness as determined by Upstart (which uses a letter grade system) have a more consistent default rate even when FICO scores are different. Someone could have an excellent FICO score (700 or greater) -- and a poor Upstart ranking -- and still qualify for the best loan rates using traditional methods, and that would expose the lenders to more risk.
This better prediction ability is why Upstart has an outstanding net promoter score (NPS) of 82 (a way of scoring how likely a customer is to recommend a product), far exceeding that of most competitors.
However, its product excelled in and was built for a low-interest rate environment. Over the past 12 months, the Fed has hiked interest rates rapidly to slow the economy and get inflation under control. This has significantly reduced demand for car and personal loans, as the cost of borrowing is much greater than it used to be, and Upstart has felt the impact. In its quarterly report from early May, the company relayed that its lending partners originated loans totaling $997 million in the quarter, a 78% drop from the year-ago period.
Furthermore, Upstart's creditworthiness rankings aren't working as well as they used to.
Image source: Upstart. Performance as of March 2022.
If you compare the two tables, it's clear that there has been a substantial uptick in defaults across the board. However, Upstart's A+ tier clients with low FICO scores are the most notable offenders. Upstart informed lenders that traditional methods don't properly assess these consumers and its system worked well in a low-interest rate environment, as A+ clients with FICO scores of 639 or lower only defaulted on 1.2% of their loans. Now, this same category sits at a 4.7% default rate -- a significant increase.
While default rates have increased by about double across the board for Upstart's risk grade (the bottom "average" row in each image above), the FICO scores have only slightly risen at the top end (the right average column) while nearly doubling at the low end. This gives more credence to the FICO method, as it seems more consistent over low- and high-interest rate periods. Still, Upstart's highest tier (A+) only has a 1.3% default rate compared to a FICO score of 700 or greater, which sports a 4.2% default rate.
So is this a nail in the coffin for Upstart? It doesn't appear to be.
New partnerships are still being forged
In May, alternative investment group Castlelake reached a deal to purchase up to $4 billion in loans using Upstart's product. It believes it can receive higher-interest rate products with lower default rates.
Additionally, Mercedes-Benz has provided Upstart's assessment software to dealers across the U.S., which shows a major car company believes Upstart's product provides them with better opportunities to evaluate customers' creditworthiness.
Customer acquisition is still ramping up, and both partnerships will boost Upstart's finances, which it desperately needs. In the first quarter, Upstart helped originate more than 84,000 loans totaling just shy of $1 billion. That's significantly down from 465,000 loans totaling $4.5 billion in Q1 2022. The primary driver of this decrease is higher interest rates creating less demand for loans, but with Upstart's default rate rising, investors have to question if that is coming into play.
I believe Upstart's software can better assess creditworthiness (as evidenced by its new lender relationships). Still, interest rates will likely never tumble to the lows reached during the past few years. This means Upstart's stock may never return to its highs, but that doesn't mean it can't be an excellent investment moving forward.
At just 3.3 times sales, Upstart trades below the price-to-sales valuation given to competitor Fair Isaac (the parent company of the FICO score), which trades at nearly 14 times sales. Because both companies have similar profit margins and are performing the same activity for lenders, these valuation spreads exhibit how the market values a strong and a poorly executing company and show there's a lot of room for the market to boost Upstart's value.
This looks like a potential buying opportunity, but with much uncertainty surrounding Upstart's system, it makes sense for investors to keep their position in the company small. That way, it won't drag an entire portfolio down if it flops.
Upstart has some challenges, but when the Fed cuts interest rates in the future (maybe next year), Upstart could see its business pick up again.
