Upstart (UPST 2.76%), a lending platform powered by artificial intelligence (AI), has been on a wild ride since going public a few years ago. The stock climbed from $20 to nearly $400, only to fall as low as $12 earlier this year.
But shares have rallied furiously since hitting that low and are now poised to finish 2023 up more than 100%, beating the broader market. What does that portend for 2024? Will the stock fall back into the pit of despair or continue its ascension?
Here is why investors might like what Upstart has in store for 2024.
Have interest rates peaked?
Upstart uses AI to approve or deny consumer loans. Management believes the algorithms the company uses can better identify the risk of default among applicants than a traditional credit score. The company is confident enough in what it does that it publishes data to show that its models work.
Upstart makes most of its revenue on referral fees it receives from lending partners it works with who take over the loans Upstart initially approves. When someone applies for a loan through Upstart, it analyzes their data and passes them off to one of the partnering banks or credit unions in its referral network.
The crucial takeaway is that Upstart doesn't want to hold these loans on its books long-term, which would pile up on its balance sheet. Its goal is to refer loans to an ever-hungry network of partner lenders, piling up its lucrative referral fees.
But holding the loans longer term is precisely what's been happening over the past 18 months. To slow inflation, the Federal Open Market Committee (FOMC) quickly raised the federal funds rate, causing the market to sell Treasury bonds. When bond prices go down, yields go up. Treasury yields, specifically for the 10-year note, are a benchmark for economic interest rates.
The rapid rise in interest rates hurts Upstart's business in multiple ways. First, the company must charge higher interest rates on its loans to make money. Fewer people borrow when rates are high, so that hurts loan demand. The rise also means banks are less willing to take on loans from someone like Upstart when there are alternatives like Treasury bonds, which are backed by the government (and thus safer) and yield more than they used to.
As rates rose, Upstart began holding loans on its balance sheet until it couldn't anymore and had to let its loan volume plummet. As of the third quarter, it has $972 million in loans on its balance sheet.
You can see that play out below. The federal funds rate increases, the 10-year Treasury yield follows, and Upstart's revenue growth collapses.
UPST revenue (quarterly YoY growth) data by YCharts; YoY = year over year.
Ah, but let's focus on the past few months of this graph, magnified below:
UPST revenue (quarterly YoY growth) data by YCharts.
You can see that the federal funds rate hasn't moved since August, and the 10-year Treasury yield has begun falling. What does this mean? The bond market is thinking, "Hey -- inflation has slowed significantly, and the FOMC stopped hiking the federal funds rate, so it might finally be safe to buy Treasuries again."
In other words, the Treasury yield reflects what the market thinks will happen. It's telegraphing that it believes the FOMC is done raising rates.
Getting back on the horse
To be clear, any company that can collapse like this due to something it can't control is a risky investment. Upstart's magnificent rally in recent months could just be getting started. No excuses, but it's fair to point out that the FOMC's series of rate hikes over the past two years is one of the most aggressive stretches of monetary policy on record.
There is bound to be relief for Upstart's business as that settles and eases. Analysts estimate its revenue growth will flip to nearly 30% next year, and earnings under generally accepted accounting principles (GAAP) will turn positive again.
The company peaked at $1 billion in revenue before developing new loan categories like auto, small business, and home equity lines of credit. That's fallen by 50% over the past four quarters.
If interest rates do ease in 2024, there's a good chance Wall Street could continue pricing in Upstart's upside again. The business has proved too volatile to establish firm numbers for a valuation, and the stock will likely remain volatile if rates get jumpy.
It's probably best to ask yourself whether you believe in Upstart's business model, and if so, buy shares slowly and dollar-cost average into a position while waiting for stable interest rates to spark the company's growth once again.
