Artificial intelligence online lending platform Upstart


Upstart mentioned in my book

I have discussed Upstart (ticker: UPST) in my books “The Rules of 10 Baggers“,

  • Sections 6-8, p. 339, Discussion on shorting ratio of individual stock

Upstart business

Disrupt lending industry

There’s no question that Upstart’s business model has the potential to disrupt the lending industry. The company provides an AI-powered online lending platform to 83 different partners (banks and credit unions). Upstart’s platform analyzes thousands of profiles and numbers about potential lenders before making a loan decision.

Compared with the model using traditional FICO (ticker: FICO) (about FICO, please refer to my previous article “Fair Isaac, one of the most important listed companies in the US consumer finance industry“), Upstart’s platform has been proven to increase approval rates while reducing default rates. It’s, indeed, a profitable financial mix and the way to make a profit for the company.

How big is its potential market?

Unsecured personal loans are an estimated $146 billion market. And the platform is just beginning to scratch the surface of the auto loan market, a $786 billion market.

Advantages of the business model

Upstart doesn’t take the risk of credit default on all of its borrowers because the banks and credit unions it works with provide most of the funding. The majority of Upstart-backed loans (65% in the first nine months of 2022) are sold to third-party institutional investors; in this way, Upstart transfers the risk of credit default from itself to others.

Of the $30 billion in loans the company has processed in its history, it only has about $700 million on its balance sheet today. This makes Upstart a capital-light business, attractive from an investment standpoint. It’s no wonder the stock has soared through most of its first year on the market: a very scalable model, coupled with a strong macroeconomic backdrop, provides a solid foundation for rapid growth.

Disadvantages of the business model

But investors should be reminded that this business model still requires a booming economic market environment. This is a very disadvantageous point of this business model.

While Upstart doesn’t take most of its loans (and credit risk) on its own books, the business is extremely sensitive to the macroeconomic environment. As things unfold in 2022, the company’s financials and top-line business have taken a hit as the Federal Reserve raises interest rates to curb rampant inflation.

Upstart peers

Upstart’s rivals

Upstart is an alternative to credit bureaus like FICO, Experian (ticker: EXPGY), Equifax (ticker: EFX), and TransUnion (ticker: TRU), see my previous articles “Three major consumer credit rating companies Equifax, Experian, and TransUnion” and “Fair Isaac, one of the most important listed companies in the US consumer finance industry

Core competitive advantage

Since companies use artificial intelligence to determine an individual’s creditworthiness, it’s a seemingly superior approach. Upstart says its algorithm results in a 53% lower default rate than traditional credit scoring methods. In other words, the company’s methodology allows for 173% more loan approvals without increasing the likelihood of the loan portfolio defaulting. At last count, it served more than 80 banks and credit unions and more than 700 auto dealerships.

Of course, these lenders only run credit checks if consumers are interested in borrowing money to make purchases. But that interest has slowed since the end of 2021 and has shrunk completely since the middle of this year. This headwind is a key factor behind Upstart stock’s 96% pullback from its late-2021 high.

Business performance

2021’s performance

2021 has been a very favorable year for the company, with Upstart processing more than 1.3 million loans and generating $849 million in revenue; these figures represent growth of 338% and 264%, respectively, from the previous year.

It is also a kind of lender, acting as a middleman. It has $700 million worth of loans on its balance sheet. Companies must also account for net interest income and adjust the fair value of their loan portfolios.

Q3 2022

In the third quarter of 2022, revenue fell 31% year-over-year to $157 million. Profit swung from a $29.1 million profit in the third quarter of 2021 to a recently ended net loss of $56.2 million. The business helped originate 189,000 loans during the three-month period, down from 321,000 in the second quarter of this year and about half the 363,000 a year earlier.

Upstart’s third-quarter default rate was 70% higher than expected. Funding for Upstart loans from these institutional investors has been tightened as interest rates have risen.

Stock performance

Become a ten bagger within 10 months after the IPO

After its December 2020 IPO, shares soared more than 1,200% over the next 10 months, peaking at $401.49 in October 2021. But since then, its shares have been on a downward spiral that has repeatedly broken bottoms.

It rose from the public offering price of $20 per share to an exciting peak of $401.49 in October 2021, but fell back to nearly $17 per share in December 2022. Shares have fallen 96% in the past 14 months, and the company is now a small cap with a market capitalization of just $1.3 billion.

Why did the stock price crash?

Due to the economic slowdown and the aforementioned disadvantages, the company’s performance in 2022 will change from profit to loss in 2021, and revenue growth will also drop significantly. There is no doubt that this is of course the primary reason for the company’s stock price crash in 2022.

Upstart is highly sensitive to the ebb and flow of the lending market, especially auto loans. Yet the stock’s wild swings from post-IPO bullishness to extreme bearishness may have little to do with its actual credit-scoring business.

For a young public company that is still expanding its business, business has certainly not stabilized. While Upstart booked interest income through most of 2021 when the economy was solid, 2022 was less fruitful. In fact, the Upstart had a loss of $22 million in Q3 2022, resulting in a $56 million loss in net income for the first three quarters of 2022.

Share price comparison with other unicorn peers

There’s nothing particularly unusual about Upstart’s stock price collapse in 2022, as it’s not the only unicorn to go public in the past two years that’s down more than 90%. For example, Affirm (ticker: AFRM), which buy now and pay later (BNPL), has collapsed to the same extent as Upstart in the past year.

It is also worth observing that these well-known unicorns that have fallen by more than 80%, and have been listed in the past two years, their stock price collapse mainly occurred in the first half of 2022. These unicorns, which have fallen by more than 80% in the past two years, will actually not fall much worse than the U.S. stock market in the second half of 2022.

The possible reason is that the current breaking price has approached the reasonable price. Another reason is that these unicorns that have been listed in the past two years, whose decline has slowed down in the second half of 2022, still have certain aspects of competitiveness, which will attract investors to take the opportunity to buy when the stock price is low, supporting them to drop down again and again.

Safer approach

It’s hard for me to recommend that investors consider buying it now, especially since the U.S. could be headed for a recession sometime in 2023. Like average bank, Upstart is a highly sensitive, cyclical business that absolutely thrives in good times but struggles in downturns. Compared with banks, its biggest advantage is that it will not directly bear so much credit risk, which is a more attractive place for investors.

Although the stock is down more than 90% in 2022 and currently trades at 15 times earnings, it’s best to keep Upstart on your watch list for now. If the economy shows signs of improvement over the course of 2023, then its business may recover and the stock will become attractive then.

credit: Upstart

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