Artificial intelligence (AI) has been a major market driver for nearly three years already, but interest hasn't abated. AI is changing how people do nearly everything, speeding up processes and making many actions cheaper and easier.
Many popular AI stocks continue to climb, including Nvidia and Palantir Technologies, up 36% and 147% respectively. But there are also smaller stocks that offer incredible opportunities, perhaps even more compelling than the stocks that have already caught market attention.
Consider Upstart Holdings (UPST 0.45%). The AI-based lending platform was a market favorite before its business seemed to implode, and investors have lost interest in it. It's up only 4% year to date, despite an outstanding second-quarter report. But as the business rebounds, Upstart stock could soar a lot higher.
A better way to lend money
Upstart's platform uses AI and machine learning to evaluate credit risk. It uses millions of data points and many different criteria and offers nearly instant approvals -- a modern version of the traditional credit score, which has a limited scope. It says that its model approves more loans without adding risk to the lender, which puts more money to work for lenders and gives borrowers greater financial freedom.
Although it was growing by leaps and bounds when interest rates were at zero, the good times came to an end when interest rates were raised, since it was more challenging to identify good borrowers when default rates were climbing.
Image source: Getty Images.
Although interest rates have started to come down, management says its return to growth is unrelated to the decline. It's leaned into its business over the past few years, rolling out new products, expanding the platform, and improving its algorithms.
There was major progress in the second quarter. Revenue more than doubled from last year, and transaction volume was up 159%. It also returned to positive net income on a generally accepted accounting principles (GAAP) basis a quarter earlier than expected, with $5.4 million in the second quarter.
A huge opportunity
The credit evaluation industry is huge, but it's been dominated by a small number of leaders for several decades. Upstart says that $25 trillion is originated in loans globally among all categories, including personal, home, credit card, and more. It claims that at least $1 trillion goes to whoever originates and services the credit.
Upstart offers a better and cheaper experience for everyone involved along the service line, which is how it has entered this space and captured market share. Since it started, customer acquisition costs have been halved despite sales growing fivefold, it has reduced its workforce by 66%, and it approves loans at 36% lower rates.
As it continues to train its models with more data points, they're improving, offering an even better value proposition. And as it continues to enter new categories, the opportunity expands. Originations from its newest product, a home equity line of credit, increased ninefold from last year in the second quarter.
A better entry point
Upstart stock had risen to astronomical valuations before it plunged, but the price is looking reasonable today. It trades at a forward, 1-year P/E ratio of 25 and a price-to-sales ratio of 7. That gives it room to expand as the market gains more confidence in its chances.
The market found what to worry about in the second quarter update despite the strong performance, including Upstart holding too many loans on its books, the health of its funding pipeline, and an outlook that included a lowering of full-year net interest income. But if you can zoom out and focus on the bigger picture, Upstart could be a lot bigger and more profitable over the next three years.
It's hard to come up with a potential growth rate over the next three years because the business is in flux. Last year at this time, revenue decreased 6% from the year before. But interest rates are likely to keep coming down, and Upstart's improvements make it likely that it will get more business as they do. If it can manage a compound annual growth rate of 30% over the next three years, revenue would more than double, and keeping the price-to-sales ratio constant, so would the stock.
