Resilience is an important ingredient for success in the business world, and Upstart (NASDAQ: UPST) has it in spades. It's using artificial intelligence (AI) to transform the lending industry, but its methods were called into question in 2022 when credit conditions tightened and crushed the company's momentum.
Investors have sent Upstart stock plunging 95% from its all-time high as a result, but the company is making important moves to secure its future. In the first quarter of 2023, it announced a new funding deal, and it also told investors of plans to expand into a new, major lending market.
Here's why the stock might be a buy now.
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The Upstart difference
Upstart's mission is to make lending faster, fairer, and cheaper for borrowers. The traditional banking system has relied on Fair Isaac's FICO credit scoring system for more than 30 years; Upstart says it's an outdated and inadequate tool for determining creditworthiness.
By using AI, the company can analyze thousands of data points on a potential borrower as opposed to just the handful FICO considers. And because AI can process huge volumes of data quickly, 84% of approvals happen instantly. That's a welcome improvement over the traditional manual assessment process, which can take weeks.
Upstart is a loan originator, so it doesn't actually lend money itself; the company earns fees when its algorithm approves loans for its bank partners. It has approved more than $32 billion to date.
Last year, investors grew concerned that Upstart's AI models weren't battle tested in the kind of difficult economic environment it was facing. Soaring interest rates sent default rates climbing and also led to a collapse in demand from consumers for new loans.
At the very same time, banks weren't committing as much funding to Upstart's originated loans, forcing it to absorb some of the loans onto its own balance sheet. To better prepare for these situations in the future, Upstart announced it had lined up more than $2 billion in funding during Q1. And earlier this week, it also came to a major $4 billion agreement with investment firm Castlelake.
The company has always maintained that its algorithm was performing as intended, and with the dust continuing to settle, it highlighted some key trends in its Q1 report. Upstart says the loans it originates experience 53% fewer defaults at the same approval rate compared to large U.S. banks. Additionally, it approves a whopping 173% more loans at the same default rate, which effectively means those banks are missing a substantial number of opportunities to lend because of their outdated assessment processes.
Banks, credit unions, and car dealerships are backing Upstart
Curiously, while investors were sending Upstart stock crashing last year, banks, credit unions, and car dealers were lining up to adopt the company's AI technology. That momentum continued in Q1, with the company reporting 99 lending partners on board, nearly double the 50 it had a year ago.
The key problem Upstart has now is demand for credit. In this tough economy, consumers simply don't have a high appetite for unsecured personal loans and car loans, which are Upstart's bread-and-butter products. In fact, it originated 82% fewer loans in Q1 than it did at the same time last year.
That led to a decline of 67% in Upstart's revenue. When revenue falls so steeply in such a short period of time, companies struggle to pivot their cost structures fast enough to avoid net losses. Upstart is a prime example: It posted a $129.4 million bottom line loss in Q1, which was a big swing from the $32.7 million profit it generated in Q1 2022.
Here's why Upstart stock is a buy
Upstart estimates roughly $171 billion in personal loans are originated in the U.S. each year, along with $775 billion in car loans. And in Q1, it revealed its intention to enter the home loan market later in 2023, which is worth a whopping $2.7 trillion each year. Not only will that substantially increase Upstart's fee base, but it will also diversify its business so that it has more revenue opportunities in difficult times like the present.
The company has been preparing for this since it was founded. Its AI models train on over 100 billion cells of performance data and 90,000 new customer repayments every day, and it delivered 23 model upgrades in Q1 alone. As it originates more loans, its AI models are fed more data, which leads to further improvements. It's a flywheel that will spin faster and faster as the cycle continues.
Upstart isn't out of the woods yet because it will take time for loan demand to recover, but there's no question the company has positioned itself to succeed when the economy does improve. For that reason, the 95% decline in its stock price presents a very attractive risk-reward proposition for investors.
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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Upstart. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.
