Artificial intelligence (AI) lending marketplace Upstart (UPST 2.76%) is having a lot of trouble navigating the current economic environment. Demand for loans is way down, partly due to higher interest rates. Upstart's partners originated $1.2 billion of loans in the second quarter, down 64% year over year.

There were some bright spots in Upstart's second-quarter report. For one, the company bounced back from an extremely weak first quarter. Upstart generated revenue of $136 million, up from just $103 million last quarter. The bad news, though, is that there won't be much improvement in the third quarter, as Upstart expects to generate revenue of $140 million.

Shares of Upstart have soared this year as investors bet on the company's turnaround, although some of those gains were undone on Wednesday following the company's lackluster guidance. Still, the stock looks like one to avoid for a few reasons.

Persistent losses

As Upstart's loan volumes and revenue have declined, the company has been forced to slash costs. Sales and marketing spending has been gutted, down 77% year over year in the second quarter. Overall, Upstart reduced its operating expenses by 35%.

Revenue fell at a quicker 40% pace, so the profitability picture didn't improve. Upstart reported a net loss of $28.2 million in the second quarter, only slightly better than its $29.9 million loss in the same period last year.

Free cash flow was positive in the first six months of the year, but only because more than $100 million of stock-based compensation was added back in. Despite Upstart's deteriorating performance, the company nearly doubled its stock-based compensation in the first half of the year.

Upstart was profitable during the pandemic, but that was a unique period in economic history. The company was founded in 2012, so it's only existed in a low-interest-rate world until now. How well Upstart's business model works outside of a low-interest-rate environment is an open question.

A lofty valuation

Prior to the post-earnings plunge, Upstart was valued at about $4.3 billion. Based on the average analyst estimate for 2023 revenue, that puts the price-to-sales ratio at nearly 8.

In 2021, when business was absolutely booming, Upstart managed an operating margin of about 17%. The company earned a net income of $135 million on $849 million of revenue. Based on that number, Upstart trades at about 32x peak pandemic-era earnings.

If Upstart could return to that level of profitability, an argument could be made for buying the stock. But it's hard to know if that's possible now that the economic climate has shifted.

Before the pandemic, Upstart's loans handily outperformed target cash flows, albeit at far lower loan volumes. That outperformance was sustained in the early pandemic as loan volumes soared.

Outperformance turned into severe underperformance for loans made in 2021 and 2022. That makes sense: AI models are only as good as the data they're trained on, and Upstart's models had never seen anything close to the post-pandemic economy. Upstart has made improvements to its models and boosted its loan performance back in line with target cash flows, but this episode made it clear that Upstart's models are not a silver bullet for lenders.

While Upstart may return to profitability down the road, betting that it can get back to pandemic-era levels of profitability requires a leap of faith. With the company struggling to boost loan volumes, the safe bet is to avoid Upstart stock entirely.