Shares of artificial intelligence-powered lending platform Upstart (UPST -1.88%) have surged nearly 300% so far this year. The rally looks a lot less impressive if you zoom out a bit -- the stock is still down a whopping 86% from its all-time high.
Still, with the stock almost quadrupling in 2023, it's worth asking whether it makes sense to jump on the bandwagon and follow those investors piling into Upstart. While the stock could be a winner in the long run, Upstart looks risky.
The weakness of AI
Upstart claims that its AI models produce a better assessment of default risk for lenders compared to traditional credit scores. That was certainly true before the pandemic and through 2020. During this time, Upstart's loans outperformed expectations considerably in terms of gross returns.
That outperformance vanished in early 2021 as the economic environment shifted. Upstart's newly issued loans started greatly underperforming expectations, and loan volumes crashed. The company has made improvements to its models, which has helped close the performance gap. But this episode puts on display the inherent weakness in any AI model: The model is only as good as the data it's trained on.
Upstart's AI models had never seen an economic environment like the one we're currently experiencing, marked by historically high inflation and aggressive interest rate hikes. Upstart's models worked until they didn't. The company has incorporated new data and improved those models, but any lender that uses Upstart must be concerned about what will happen to those models the next time an unexpected and unprecedented economic event occurs.
Upstart's loan volumes are still deeply depressed. In the first quarter of 2023, total loan volumes were down 78% year over year, while revenue tumbled 63% to $103 million. Upstart also posted a GAAP net loss of $129 million. The company does expect the second quarter to look a bit better, with solid sequential revenue growth and a smaller net loss. Long-term funding agreements totaling $2 billion will help fund additional loans, but Upstart is still operating at a much smaller scale compared to its peak.
UPST Revenue (Quarterly) data by YCharts
A lofty valuation
While Upstart is attempting to claw its way back, the stock market appears to have gotten ahead of itself. Following the blistering rally this year, Upstart is valued at roughly $4.3 billion. That works out to about 8 times the average analyst estimate for 2023 sales.
It's possible that Upstart's loan volumes and revenue will bounce back strongly from here, but this is not a stock that deserves a premium valuation. The core premise of the business model, that its AI models provide a benefit to lenders, completely fell apart in 2021. Investors paying such a high price for Upstart stock are effectively betting that such a thing won't happen again, but that seems like a leap of faith.
Upstart has already burned investors once. With the company's performance and the stock's performance severely out of step, investors buying into this rally are at risk of getting burned a second time.
