Upstart Stock Is Up 250% This Year. Here's Why You Shouldn't Buy It.

Here we go again.

Upstart Holdings (UPST -0.78%) stock was the darling of growth investors in early 2020. No great company stays a secret for too long, and one that's posting 1,000% year-over-year revenue growth commands attention and investments.

Upstart soared. And then when its valuation reached beyond the point of absurdity, it came crashing down. But investors haven't learned their lesson yet. As of Tuesday's close, Upstart stock was up almost 250% so far in 2023.

Uh-oh.

Why everybody loves Upstart 

Upstart managed incredible growth when it first went public, and its model remains compelling. Every industry that hasn't changed in decades is ripe for disruption in the age of artificial intelligence (AI), and that's what Upstart is doing for credit evaluation. It uses AI and machine learning, running millions of data points through its system, to assess a borrower's risk of defaulting on a loan. It does this with higher accuracy than traditional scoring models, and approves more loans at the same rate of default. That puts more money in the hands of people who need loans for important purchases and who don't pose a high risk of defaulting, benefiting the borrowers as well as the lenders, who earn more money when they loan responsibly.

The problems for Upstart began even before the Federal Reserve started its interest rate hikes last year to tamp down rising inflation. It's a young and growing company, and it made some mistakes that disappointed investors, notably retaining some of the loans it approved on its balance sheet. Upstart works as a platform for lenders to asses risk, and then it sells loans to institutional investors to fund the loans. Management said it was holding the loans as a trial, but then said it would sell them as it faced shareholder pushback.

The bigger problems became clearer in the current high interest rate environment, where it's not so apparent that Upstart's platform offers big benefits. It's approving fewer loans, because at current interest rates, the risk of default increases. Management maintains that the model is working even now, and while approvals are lower, they still outperform traditional models. Prior loans are still being paid back on schedule and in line with Upstart's predictions.

Valuation matters

Whether Upstart is as great as many investors seem to think, its price wasn't sustainable at previous levels. It hit a high of 465 times trailing-12-month earnings at its previous peak less than a year after its initial public offering, and it's now down almost 90% from that point roughly two years later.

At its lows, the stock seemed attractively priced for investors who believe in its story and potential. Now it looks as if investors are piling on again, even as performance remains underwhelming. First-quarter revenue fell 67% from last year's first quarter, and Upstart posted a net loss of $132 million after a $34 million net profit last year. 

When investors see a stock price climbing, it naturally attracts interest. That tends to send the stock price even higher.

That could be OK. Everyone wants to be in on a hot stock. But when market enthusiasm gets ahead of the actual potential, it's a setup for a fall. 

Management isn't even claiming it's getting out of this mess soon. It has forecast a 41% year-over-year revenue decrease in the second quarter and a $40 million net loss.

The shares now trade at price-to-sales ratio of more than 5. That just doesn't seem reasonable for a stock when the company is posting dramatic sales declines and net losses and has a bleak near-term outlook. There might be cases where even in that situation, the future is so obviously bright that the stock is worth a premium. But as much as I see the potential in Upstart's model, the future is too untested, and therefore risky, to say this framework applies here. 

Make way for a short squeeze

Investor confidence seems to have originated with the disappointing first-quarter report, when management gave an update that it had secured long-term funding from a new partner. That was progress, but I don't see how it outweighs the company's current challenges to push the price up so high.

Even Wall Street doesn't see much of an upside here. On average, analysts anticipate a 68% decline in the shares during the next 12 months.

Skeptical investors betting on a price decline have piled into the stock and a super high 35% of the shares available for public trading have been sold short. That could send this stock into a short squeeze in which investors with negative bets have to buy shares to close out their positions. That might temporarily drive up the shares, but that's not a fundamental reason to buy the stock.

Whatever way you spin it, Upstart, despite its many wonderful qualities, looks like a stock to stay away from right now.