Anything associated with artificial intelligence (AI) has been a hot commodity to own this year, especially since May. It's not uncommon to see stocks that have doubled or tripled, but one culprit has gone up 5 times in value since May. Upstart (UPST 2.76%) is up more than 450% since May 1 and has seldom looked weak over the past three months.
But is it too late to buy Upstart stock right now? Let's find out.
Upstart's model is an improvement over a FICO score
Upstart is a leader in alternative loan approval methods. Instead of using a standard FICO score as the only data point to assess a borrower's creditworthiness, it pulls from other factors like education, employment history, and banking transactions. To do all this work, Upstart utilizes AI, which helps make an unbiased opinion on the chances of a borrower defaulting on their loan.
This product can help lenders expand their clientele base while minimizing defaults. In fact, Upstart promises 53% fewer defaults while approving the same amount of loans.
That's a win-win for customers, as it can boost revenue while reducing losses.
Currently, Upstart's products are limited to personal and auto lending. But in the company's May earnings presentation, it listed mortgages and small business loans as part of its addressable market, indicating Upstart will likely expand into these markets at some time.
But how was Upstart's stock able to go up so quickly in the past three months?
There are massive tailwinds on the horizon
Before its run-up, Upstart was significantly down from its all-time high. The stock entered the year down an astounding 97% from its all-time high, but internal problems didn't cause its decline.
As the Federal Reserve raised interest rates, the demand for products like personal and auto loans declined. With decreased loan demand, Upstart's business fizzled. In the first quarter, Upstart's approval volume fell from more than 465,000 loans to just under 85,000. When that volume disappears, it's tough for a business to operate, as it built its infrastructure and staff to handle much larger workloads.
UPST Revenue (Quarterly) data by YCharts
As a result, Upstart's profitability dwindled, with its net income declining from a $59 million profit to a $129 million loss. But selling off Upstart was an incredibly short-sighted move by investors.
Long-term investors know this slowdown was only temporary, as demand for these loans will return. First, the Federal Reserve will eventually start reducing interest rates, boosting the demand for loans, thus increasing Upstart's business. Second, car and personal loans often have terms of about five years. Once loans from the low-interest years of 2020 and 2021 are repaid, consumers will likely need another, so there should be another wave of business in 2025 or 2026.
Both of these catalysts are still on the horizon, but what really set off Upstart stock was interest in AI.
The stock still isn't that expensive even after its rise
Because Upstart is rooted in AI, it immediately became a trendy investment. Throw in an absurdly low stock valuation, and you have a recipe for a stock that can rocket higher.
To illustrate this, look at Upstart's valuation compared to its closest competitor, Fair Isaac, the originator of the FICO score.
UPST PS Ratio data by YCharts
Because Fair Isaac and Upstart have similar products and gross margins, they should trade around similar valuations. When Upstart entered the year at 1.1 times sales with Fair Issac around 10, there was a severe mismatch in valuations.
Now, Upstart has risen to around 9 times its sales, making it more reasonably valued.
But is it too late to buy Upstart stock? Absolutely not!
As mentioned above, Upstart is trading at 9 times sales, which is reasonable. However, it currently has drastically reduced sales thanks to high interest rates and low loan demand. When interest rates fall and loan demand picks up, Upstart should see a wave of new business, boosting its sales and dropping its valuation from current levels.
While expecting another fivefold return isn't wise, I think investors can still take a position in Upstart's stock and be fine. However, they need to hold the stock for at least three to five years to get the full effect of owning the business when loans are in high demand.
