Is Upstart Stock a Buy?

Upstart (UPST 2.76%) investors have experienced a wild ride since its IPO in late 2020. A run-up to nearly $400 per share by mid-2021 led to a massive decline that took it below $12 per share as recently as early May.

Since that time, the stock has nearly tripled, likely on the market's rising interest in artificial intelligence (AI). The question for investors is whether a significant upside remains for the fintech stock or if its troubles make it a stock to avoid.

The case for Upstart stock

Admittedly, a look at the stock's history might imply it's a buy at current levels. Yes, Upstart has experienced a massive surge over the last month. But as of the time of this writing, the stock is down 91% from its all-time high, possibly pointing to a considerable upside.

More importantly, it utilizes AI to improve loan evaluation. The current standard for credit checks, Fair Isaac Corporation's FICO score, has not experienced a major overhaul since its introduction in 1989. Moreover, it makes its determinations based on relatively few variables.

In contrast, Upstart has become an example of AI in finance as it uses over 1,500 variables in its model to determine creditworthiness. According to internal studies, it can increase approval rates by 173% without increasing risks or reduce defaults by 53% at the current approval rate. Additionally, a record 84% of loan approvals are instant and fully automated, showing its model's efficiency.

Currently, it offers this service for personal, business, and auto loans, a combined total addressable market of approximately $1.6 trillion. Soon, it plans to provide its service to evaluate home equity lines of credit, taking it into the $2.7 trillion housing market.

For now, it claims 99 lending partners, up from 50 in the year-ago quarter. And 39 auto dealerships now offer loans powered by Upstart. Furthermore, its business received a huge boost when Castlelake agreed to purchase up to $4 billion worth of consumer installment loans originated on Upstart's platform.

Considering Upstart's rising availability and ability to reduce risk, it might appeal to banks looking to reduce defaults in this rising-rate environment.

Why investors might avoid Upstart

Unfortunately for Upstart, the rising rates seem to have had a net negative effect on the company. In the first quarter of 2023, revenue of $103 million fell 67% versus year-ago levels. It also failed to cover $235 million in operating costs, leading to a $129 million loss. This is in stark contrast to Q1 2022, when Upstart's revenue had risen 156% year over year, and it turned a profit.

Moreover, Upstart intended to act as a loan evaluator, collecting fees for investigating credit. Nonetheless, it holds just under $1 billion in loans on its books. While that is down slightly from the fourth quarter, the loans indicate that it has had to become the bank in some cases to demonstrate its model can work in the rising-rate environment.

Convincing banks to adopt its model is an ongoing struggle. While it claims 99 lending partners, 42% of its loan volume comes from Cross River Bank and 28% from one other lending partner. Worse, Cross River Bank recently received a cease and desist order from the FDIC for "unsafe and unsound" lending practices.

That scrutiny could bode poorly for Upstart if Cross River follows in the footsteps of Silicon Valley Bank or First Republic Bank. But even if Cross River avoids serious penalties, its troubles highlight Upstart's need to diversify its revenue base rapidly.

Should investors buy?

When evaluating Upstart's potential versus its troubles, investors should begin to add shares, but only if one has a significant appetite for risk. The company's potential to reduce defaults is huge in an environment where banks need to find more loan opportunities while reducing default risks. And its performance in better times shows it can be a fast-growth, profitable company under the right conditions.

However, the massive amount of loans on its books and dependence on Cross River Bank show it has much to prove to the banking sector. Until more banks begin to turn to Upstart, the stock could struggle to move higher.