When investing in stocks, you must be ready for volatility; it's just the cost of doing business. But some stocks can stress you out more than others, and artificial intelligence-based lending company Upstart Holdings (UPST 2.68%) could be the most volatile stock on Wall Street.
Shares have been a big winner in 2023, surging 400% since January, heading into the company's second-quarter earnings. Unfortunately, the market didn't like what it saw, and the stock plunged roughly 40% in just one week.
So is Upstart truly a redemption story worth buying the dip on? Or are the lights out at this party? Here is what you need to know.
It's unfortunate, but it's the truth
Upstart's business is relatively simple: It uses AI-powered algorithms to determine whether someone qualifies for a loan (mostly personal loans at this time). If approved, the company will offer the loan and then refer it to a lender in its network of partner banks and credit unions, or sell the loan to institutional investors. Ideally, Upstart makes most of its money on the referral fees it gets for essentially drumming up business for its partner lenders.
NASDAQ: UPST
Key Data Points
But rising interest rates and economic worries have severely tightened the credit markets over the past year. Lenders became more conservative and afraid to lend as aggressively, making it harder for Upstart to offload approved loans.
In other words, Upstart is very sensitive to big-picture economic conditions that impact how willing banks are to lend money.
Investors had hoped that issue was solved last quarter when Upstart announced it had acquired some funding commitments, but Q2 results and poor Q3 guidance show that it's still a significant problem for the company. It's not that Upstart can't grow again, but there's a real chance the business is somewhat paralyzed until broader economic conditions improve for lenders.
What are the risks moving forward?
Lending is essentially a confidence matter, and that's where Upstart has work to do. The chart below shows the expected return on Upstart's loans by quarter, and the shaded area indicates whether those loans performed above or below expectations. You can see how Upstart's loans underperformed for the past two years, likely turning loan buyers away.
Upstart must show that its loans can consistently meet (or beat) expectations. If not, the company might continue having trouble offloading its approved loans.
Image source: Upstart Holdings Q2 earnings presentation.
The company's balance sheet seems stuck holding loans until then, which creates more risk for the company and investors. While balance sheet loans declined from $982 million last quarter to $838 million, it remains near management's proclaimed $1 billion ceiling. It doesn't leave much room for error, especially considering the company may continue struggling to offload future loans.
Should investors buy the dip?
Investors should take a long-term view of Upstart if they want to own shares. The stock will be tough to value if a shaky lending environment creates fluctuating operating results. The company earned $2.37 per share in 2021, but is expected to lose money this year.
Consider a dollar-cost average strategy if you believe in the company moving forward. Investors should monitor the company's quarterly loan vintages (the above chart) to see that loans perform at least as well as expected. That could indicate how willing loan buyers and lenders will be to take on Upstart's loans in the future.
Lending is a multi-trillion dollar industry in the U.S. alone, so the potential upside makes Upstart a continually intriguing investment idea. It will come down to how well the company can navigate these tricky waters and get back on its feet over the coming quarters and years ahead.
