Artificial intelligence (AI) has proven its worth in the corporate world this year for its ability to boost business productivity and unlock convenience for consumers. As a result, investors have rushed to get their hands on AI stocks, and Upstart (UPST 2.76%) is one of them; it has rocketed higher by 148% in 2023.
Upstart uses AI to originate loans for consumers on behalf of its banking partners, but while its stock is having a strong year, it's still trading 92% below its all-time high. Shares suffered a drastic decline in 2022 when the U.S. Federal Reserve started rapidly raising interest rates to fight soaring inflation, and that hurt Upstart's business in more ways than one.
But in the second quarter of 2023 (ended June 30), the company managed to deliver its first quarter-over-quarter revenue increase in more than a year. It might be an early sign that a recovery is in the works. Here's why Upstart stock presents an attractive risk-reward proposition for investors right now.
Disrupting the entrenched lending business isn't easy
Banking processes haven't changed much over the last few decades. While the industry eventually caught on to the digital revolution, it's notoriously slow to adopt new technologies. In fact, when it comes to assessing a potential borrower, banks have relied on Fair Isaac's FICO credit scoring system for over 30 years.
Upstart says FICO isn't suitable for the modern borrower because it considers only five key metrics, including outstanding debts and repayment history. In contrast, Upstart says its AI algorithm can instead analyze 1,600 data points to not only deliver a more accurate decision, but also charge a more appropriate interest rate. Plus, because the process is powered by AI, 87% of Upstart approvals are fully automated.
The company's AI models are trained on over 70 billion pieces of loan performance data, including 88,000 new repayments made each day, so they're constantly learning and improving. According to Upstart's research, it approves 43% more borrowers than traditional lending methods, at interest rates that are 43% lower.
But when interest rates rapidly began to rise last year, investors grew concerned that Upstart's methods weren't battle tested in a tough economic environment. As a result, the company struggled to sell all the loans it was originating, forcing it to absorb some of them onto its own balance sheet. At the very same time, demand for credit from consumers was collapsing, which meant Upstart was doing far less business overall.
Originations did recover somewhat in Q2. The company processed 30% more personal unsecured loans than it had in Q1, though demand was still down 66% year over year (YOY). But on an even more positive note, Upstart signed a new $4 billion funding deal back in May with a pair of investment funds. It will ensure the company won't have to use its own cash to absorb any further loans in the future if investor appetite sours again.
Upstart's revenue ticked higher in Q2
With Upstart unable to sell as many loans in 2022, and with demand from consumers falling, its revenue began to rapidly decline from its peak of $310 million in the first quarter. It continued to slide throughout the year and into the first quarter of 2023.
But many experts believe the Fed might start cutting rates early next year, which means the worst of Upstart's pain might soon be behind it. Plus, the company's lending models have withstood the incredibly challenging environment so far, and in Q2, it said its portfolio was performing above target.
As a result, while Upstart's $136 million in Q2 revenue marked a 40% decline YOY, it was climb of 32% from Q1, which suggests a recovery might be underway.
Why Upstart stock is a buy now
As noted above, Upstart stock has more than doubled in 2023. If the company can string together a couple more quarters of sequential revenue growth, investors might start to believe in a sustained recovery, paving the way for further upside for its stock. The company issued guidance for the third quarter that suggested it could generate revenue of $140 million, which would be enough to maintain the trend.
But the long term is more exciting for Upstart. Though it struggled to draw money out of its funding partners over the past year, new banks, institutions, and car dealerships continued to join the ecosystem. It had 100 lending partners in Q2, an all-time high and an increase from 71 a year ago. That suggests the banking industry sees merit in AI-based lending, even if it's not willing to bet the farm just yet.
Upstart is currently originating personal unsecured loans and automotive loans, which, together, represent a $925 billion annual opportunity. But the company is eyeing small business loans and mortgages. And while it hasn't entered either segment, doing so would take its annual opportunity to a whopping $4 trillion.
According to Wall Street's estimates, it appears to be a foregone conclusion that Upstart's revenue will decline in 2023 relative to 2022. But the Street is predicting a strong rebound next year with growth of 42%, so with the stock currently trading 92% below its all-time high, this might be a great time for investors to buy.
