This has certainly been a banner year for artificial intelligence (AI) stocks. As tools like ChatGPT rapidly gain mainstream traction, companies with AI footprints both large and small have benefited from runaway investor optimism and upbeat growth forecasts. 

From tech titans like Microsoft (MSFT) and Google (GOOGL), to specialized chipmakers like Nvidia (NVDA) and Advanced Micro Devices (AMD), to fairly new and smaller upstarts like C3.ai(AI) - there's no shortage of potential investments for those looking to capitalize on the positive momentum in the AI space. 

Outside the tech sector, the AI juggernaut has disrupted the comparatively traditional area of lending, as well. Shares of California-based Upstart (UPST), an online lending platform powered by AI, are up by a staggering 313% so far in 2023.

Despite this breakout price action, Wall Street analysts remain overwhelmingly negative on Upstart stock.

As the AI-powered lender prepares to report quarterly earnings after the close this Tuesday, Aug. 8, here's a closer look at what's behind the sharp gains in UPST so far this year - and whether this rally has the legs to keep running.

About Upstart

Founded in 2012 by Google alums Dave Girouard and Anna Counselman, along with Thiel Fellow Paul Gu, Upstart is an AI-enabled lending platform that uses a variety of traditional and non-traditional data points to assess borrowers' creditworthiness and assist financial institutions in making loan approval decisions. To draw a parallel, Upstart is similar to eBay - but instead of buyers and sellers, it brings lenders and borrowers to one marketplace.

In fact, Upstart is the leading marketplacefor AI-enabled lending, with more than 2.7 million customers, $33 billion in loan originations, and 99 lending partners on its platform.

Upstart stock has been on a rollercoaster ride since it publicly listed at $20 per share in December 2020. The shares zoomed to an all-time closing high of $390 in October 2021, fueled in large part by a favorable interest rate environment that drove heightened borrowing activity among its customer base - only to fall well below its IPO price by late 2022, touching lows south of $12 in response to persistent inflation and a steady rate-hike campaign by the Federal Reserve.

Reasons for the Tearing Rally

More recently, Upstart stock staged a market-beating year-to-date rally off those December 2022 lows. Along with the broad-based enthusiasm that has lifted nearly all AI-adjacent stocks higher at one point or another this year, there are some notable fundamental catalysts behind this rebound.

First is the long-term funding of $2 billion Upstart secured from its lending partners earlier this year. This came as a timely boost after the drop in credit demand due to that searing rise in interest rates over a short period of time. It also reduces balance sheet risk for Upstart, as the company does not have to lend from its own funds. Further, at the end of the first quarter, the company's count of lending partners almost doubled to 99 from 50 in the year-ago period.

Upstart also inked an agreement in May to sell consumer loans worth $4 billion to global alternative investment firm Castlelake LP. This served as a substantial vote of confidence in the company's proprietary creditworthiness assessment methods.

Investors may also be attracted to Upstart's lower default rates when compared to larger, more traditional banks - a group that has been under scrutiny since the first quarter, due to a number of adverse developments that raised serious questions about balance sheet oversight. In its Q1 results, Upstart reported 53% fewer defaults at the same approval rate as large banks. Moreover, Upstart had 173% more loan approvals at the same default rate as large banks.

Although competing with an established player like FICO is no easy task, Upstart has gained an edge both in terms of time spent and data points assessed to provide accurate and timely loans to borrowers in a fully automated format.

And Upstart remains confident that it still has a large market to serve. While the company pegs the size of the personal loan market at $171 billion, the auto loan market is estimated at $775 billion, with the wider home loan market coming in at a whopping $2.7 trillion. 

All in all, the company believes it has a $4 trillion market to capture - and the competitive advantages of AI-based lending, coupled with its market-leading position in the space, leave Upstart well-positioned to benefit.

Analysts Not So Upbeat on Upstart

Regardless, analysts seem unconvinced about the prospect of additional upside for Upstart.

Overall, analysts maintain a “Moderate Sell” rating on Upstart stock, with a mean target price of $23.93 - indicating expected downside of about 56% from current levels. Out of 14 analysts covering the stock, 8 have a “Strong Sell” rating, 1 has a “Moderate Sell” rating, 4 have a “Hold” rating, and only 1 has a rating of “Strong Buy.”

In terms of earnings estimates, analysts are equally unenthusiastic. The consensus calls for an earnings decline of 36.1% in the June quarter, and an even wider 93.9% decline for FY 2023.

Ahead of Tuesday's Q2 report, it's worth pointing out that Upstart reported less-than-stellar results for the first quarter. Revenues dropped by 67% from the prior year to $102.93 million, and the company swung to a diluted loss per share of $0.47, compared to EPS of $0.34 in the year-ago period. That said, both top-line and bottom-line results surpassed the consensus estimates. 

Contribution profit, a key metric for platform companies, also dipped by 54% from the prior year to come in at $67.6 million in the January-March period, with a margin of 58% (compared to 47% in the year-ago period). At the same time, the company's borrowings crossed the $1 billion mark, up from $986.39 million at the beginning of the year, while Upstart's cash balance declined to $386.94 million from $422.41 million on Dec 31, 2022. 

Notably, over the past five quarters (including Q1 2023), Upstart has reported year-over-year revenue declines on three occasions. In terms of earnings, the company has beaten consensus estimates on three instances over the past five quarters, although it reported YoY growth on just one of these occasions (Q1 2022).

Valuation

Due to its unprofitability, it is difficult to compare Upstart with its peers on the basis of some key valuation metrics.

However, in terms of the price-to-sales (p/s) ratio, Upstart seems to be somewhat overvalued. The stock is currently trading at a p/s of 6.69, which is higher than Sofi Technologies (SOFI) (6.01), Affirm Holdings (AFRM) (3.24), and LendingClub (LC) (0.69).

Final Takeaway

Upstart has certainly made a respectable AI-sized dent in the lending space, which has traditionally been dominated by large financial institutions. Its proprietary technology makes it faster and easier to assess lending risk, ensuring timely service to a wider market of borrowers in need.

However, if the company truly wants to win over Wall Street analysts, Upstart will likely need to bolster its fundamental performance - namely, by reversing the decline in revenues and widening losses. As we see gradual green shoots in the economy, and the probability of a recession seems to wane by the day, demand for credit is expected to return - which could help Upstart improve these metrics going forward.

Armed with its recent funding, a sizeable market to address, and well-established credentials in this disruptive space, I remain of the opinion that investors can slowly build positions in Upstart - with the caveat that this stock remains a long-term play, and there may be significant event risk and volatility in the immediate aftermath of this week's earnings.