After a challenging year in 2022, Upstart (UPST 2.76%) is finishing 2023 with a bang. The company had a rough go of it as investor demand for its artificial-intelligence-powered consumer loans waned. However, fresh cash came in to fund its loans this year, taking some pressure off the lender on that front.
After attracting new investors to take on its loans, the stock shot up over 500% from its low point in May, reaching as high as $72 per share. After giving up a large chunk of those gains, the stock has bounced back and is up almost 300% from its 52-week low.
Upstart is an intriguing company on the cutting edge of bringing together artificial intelligence (AI) and lending, looking to increase accessibility to loans for all people. However, the company faces persistent headwinds that could continue to weigh on the stock.
Upstart wants to make lending accessible to all
Upstart believes that traditional credit scoring systems, like Fair Isaac's FICO scoring system, shut out worthy people from borrowing. It argues that legacy credit systems fail to identify risk accurately because they rely on a limited set of variables.
To help more consumers access loans, Upstart created AI models to analyze risk to approve more loans at lower interest rates. Its models rely on 1,500 variables and over 44 million repayment events; the company argues that this model better assesses risk.
A critical component of Upstart's business is its highly automated nature. The company can assess and interpret risks thanks to its AI models, and 88% of its loans are fully automated. These loans are automated from end to end, from the initial rate request to the signing of a loan agreement, without any human intervention.
This high degree of automation enables Upstart to scale up and process more loans when demand is highest. For example, in 2020, it processed 300,000 loan applications; by the following year, that amount more than quadrupled to 1.3 million.
Demand for Upstart loans is muted
What has hurt Upstart is the tepid demand for loans. In 2021 and 2022, Upstart made more than 1 million loans worth over $11 billion. However, this year, demand for its loans was lackluster. Through the year's first three quarters, the company's system had approved 307,995 loans worth about $3.4 billion, a decline of 68% and 65%, respectively, from the same period last year.
Upstart's lending activity has suffered due to the economic backdrop. For one, the Federal Reserve raised prevailing interest rates aggressively to battle inflation. This has increased the rates Upstart must charge on loans, leading to lower demand from borrowers.
These higher rates also constrained funding for institutional investors, who in the past bought many of Upstart's loans; these conditions have persisted amid concerns about the macroeconomic picture. The company has done an excellent job forging partnerships with alternative asset investors and other banking institutions to buy its loans, but that hasn't done much to make up for tepid demand from consumers.
Upstart's model could face a big test
Upstart's loans continue to perform well, and the company has done a solid job identifying credit-worthy borrowers that FICO passed over. However, its lending models could face their biggest test yet.
That's because consumers are racking up debt -- a lot of it. According to the New York Federal Reserve, consumer credit card debt surpassed $1 trillion for the first time earlier this year. Growing use of debt could indicate that consumers don't have as much accumulated savings but want to continue spending.
Increasing consumer debt isn't too concerning as long as consumers have the money to pay those bills. However, an uptick in delinquencies or past-due accounts could indicate struggling consumers. According to the Fed, the delinquency rate on credit card loans is almost 3%, the highest level since 2012. The delinquency rate on all consumer loans is 2.5%, up from its pandemic low of 1.5% and around pre-pandemic levels.
Data source: YCharts.
Upstart's models have performed well, but how they perform as we advance is a big question mark. The models are built on a slew of data, but they haven't necessarily faced an environment like the one we're in today. Interest rates have risen rapidly, delinquencies are on the rise, and consumers have resumed repayments of student loans on top of all of this.
Is Upstart a buy?
One potentially positive catalyst could be if the Fed cuts interest rates. This could lower consumer borrowing costs and spur new demand for its loans. According to CME Group's FedWatch Tool, market participants are projecting the Fed will reduce its benchmark interest rate by 1.5% by December of next year.
However, investors shouldn't assume rate cuts will come. The Fed may be more patient than markets expect and wait to see if inflation reaches its 2% target before cutting interest rates. The most recent consumer price index measure showed prices for November were up 3.1% over the past year.
Upstart's long-term potential could be great, but the coming quarters could test the company and its lending models. Also, the stock is up a lot from its 52-week low and is valued at 7.4 times sales at a time when its growth remains muted. Given the stock's big run-up and uncertain outlook over the next couple of quarters, I would avoid Upstart shares in the near term.
