With its potential to disrupt the lending industry, Upstart (UPST 1.95%) was firing on all cylinders in 2021 as the U.S. economy was on solid footing and borrower appetite was high. Then things changed last year, thanks to stubbornly high inflation and rising interest rates. Upstart has been feeling the pain of decreasing demand for its platform.
After being down a whopping 91% in 2022, investors might view the company's shares as seriously undervalued today. But here's why I'm in no hurry to buy Upstart stock.
Visible cracks in the business model
Shareholders should be familiar with Upstart's business model. The company has developed a proprietary artificial intelligence (AI)-driven platform that utilizes more than 1,500 different data points to make credit-approval decisions. This is far more exhaustive when compared to the traditional Fair Isaac FICO model, which uses five variables to come up with a credit score. Upstart's system has proven to increase automation while, at the same time, producing higher approval rates and lower loss rates.
While Upstart does originate, fund, and keep a small portion of the loans on its own balance sheet, most are handled by the company's partners, which include 83 various banks and credit unions. At first glance, this appears to be a sound strategy. Upstart minimizes its credit risk and simply collects fees to provide its service and tech to entities that are equipped to fund loans to borrowers.
In 2021, a year characterized by a strong economy and low interest rates, Upstart's business was booming. Total loans and dollar volume jumped significantly year over year. Revenue and profit surged 264% and 2,164% compared to 2020. And the company was just starting to tap into the auto lending market. The stock was up a jaw-dropping 850% at one point.
But in the past year, things took a turn for the worse. Total loan volume was nearly cut in half between the Q3 2021 and Q3 2022, with sales dropping 31% and the business swinging to a net loss of $56 million in the most recent three-month period. This helps explain the stock's monumental crash in 2022.
The takeaway is that Upstart's business is seriously hampered by a weakening economy. Inflation has been at record highs for over a year now, and this unfavorable situation has forced the Federal Reserve to implement aggressive rate hikes. The end result is lower demand from borrowers to take out loans and an economy that's likely headed for a recession (that is, if we haven't already been in one).
Avoid the stock for now
Based on the discussion above, it shouldn't come as a surprise that I advise readers to hold off on purchasing shares right now. Even though the stock currently trades at a price-to-sales ratio of 1.1, which is about the cheapest it has been since Upstart had its initial public offering in December 2020, investors would be wise to wait.
There is a ton of uncertainty right now, given the macroeconomic environment. And I don't believe that anyone, no matter how much of an "expert" they claim to be, has any idea what will happen with the economy and markets in 2023. Inflation could be on its way down for good, and the central bank might be able to slow down or completely stop raising interest rates. Or we could be in a period of prolonged elevated inflation, and the Fed will have no choice but to keep borrowing costs high, thus pumping the brakes even more on the economy.
For a business that is so dependent on operating in a robust and buoyant economic backdrop for its financial success, Upstart is fully dealing with this uncertainty right now, as its worsening financials demonstrate. And investors just don't need to take on the risk of owning the stock, no matter how cheap it looks today. Put Upstart on your watch list and monitor what happens with the economy before thinking about adding it to your portfolio.
