Upstart's (UPST 2.76%) artificial intelligence-based lending business presents investors with an intriguing opportunity to invest in the future as it takes on traditional lending practices. The fintech got off to a blistering start, with the stock reaching $400 per share within a year of its initial public offering (IPO) in 2020. Since then, the stock price has fallen 94% as the company deals with the effects of rising interest rates, which dampened demand for its product.
The discounted price suggests the stock is a potential buy for those who believe in the business model. But if you're considering buying the fintech today, there are five things you should consider first.
1. Upstart is a disruptor hoping to expand credit to the underserved
Upstart wants its artificial intelligence (AI) lending model to change consumer lending as we know it. The company leverages AI technology to more accurately price risk, and its management believes this model gives more consumers access to loans while providing partner lending institutions with less risk when compared to Fair Isaac's FICO credit scores.
The fintech says that the legacy credit systems, introduced back in the late 1980s, fail to identify risk accurately because of oversimplified rules-based systems that only consider a limited number of variables. Upstart's lending model analyzes 1,500 variables to determine risk and leverages its growing dataset of over 44 million repayment events to approve more loans at lower interest rates and smaller default rates, which it says leads to better returns for its lending partners. It also helps qualified loan applicants who might have otherwise been rejected because of low FICO scores to get approved for loans.
2. 88% of its loans are fully automated
Upstart generally does not hold the loans that it makes. Instead, it sells these loans to its lending partners and gets a fee for the assessment service. One crucial component of Upstart's business is its highly automated lending process, which streamlines the lending process from originating to servicing loans.
By automating most of its loans, Upstart can operate more efficiently and increase its contribution margin, or the net revenue from fees minus borrower acquisition, verification, and servicing costs. Management keeps track of fully automated loans, which represents how many loans are originated end to end, from the initial rate request to the signing of the agreement, largely without human involvement.
Automating the lending process is one reason the company could scale up from 300,000 loans in 2020 to over 1.3 million in 2021. In the third quarter, 88% of its loans were fully automated.
3. Because its business is cyclical, long-term loan performance is still a question mark
The lending business is highly cyclical, which means earnings depend on broader economic and market conditions. Over the last few years, inflation jumped to levels not seen since the 1980s, leading to an aggressive Federal Reserve interest-rate hiking campaign that brought its benchmark Fed Funds Rate from near zero to 5.25%.
Higher interest rates dampened borrower demand as well as demand from Upstart's lending partners. Upstart began making personal loans in 2014 and has operated in a lower interest rate environment for most of its young life. One big question investors have is how well the loans will perform in this elevated-rate environment.
The company struggled to find partners to take its loans until earlier this year, when Castlelake, a global alternative investment manager, agreed to buy $4 billion in Upstart loans. This alleviated some of the pressure from a funding perspective. Still, Upstart continues to face uncertainty around how its consumer loans will perform if there is an economic slowdown (or even a recession) over the next year or so.
4. New market opportunities await the lender
Upstart's original business targeted personal loans, but the company has much more significant market opportunities in its sights. In 2020, the company announced its entry into automotive lending and acquired Prodigy, an automotive commerce software company that expanded its reach to car dealerships across the U.S.
It also recently announced the launch of a home equity line of credit (HELOC) product on its platform -- giving it access to a $1.8 trillion market opportunity.
Image source: Getty Images.
5. Upstart stock is relatively cheap, but headwinds remain
After selling off 94%, Upstart stock is priced at 3.9 times sales. This is well below its all-time-high valuation of 48.4 times sales a few years back when Upstart was growing rapidly and putting up consecutive quarters of net profits.
However, Upstart's growth has slowed significantly. This year, the fintech's transaction volume of $3.4 billion is down 65% from last year, and it has a net loss of $198 million, including $40 million in the third quarter.
Upstart's loan applicant evaluation models have performed well so far, but how they will perform in an economic downturn is still unknown. Consumer credit card debt topped $1 trillion for the first time earlier this year, and bank delinquencies have slowly increased. Given the economic and lending market challenges, Upstart has its work cut out for it in the near term.
