The 2 Keys to Upstart’s Success

Financial technology company Upstart Holdings (UPST -2.51%) has become one of the most debated companies on Wall Street.

The stock has made both bulls and bears look good. It appreciated more than 1,200% after its late 2020 initial public offering and has now declined more than 90% from its peak.

Upstart is both a young and volatile company and a business that works in the cyclical consumer lending sector. Push all the fear, doubt, and uncertainty aside. Upstart can still be a long-term winner — as long as these two things keep happening.

1. Remain better than FICO

Upstart is a technology company that uses artificial intelligence to determine creditworthiness for consumer loans. The FICO score has been the measuring stick lenders have used for decades to determine borrower creditworthiness. Upstart claims that credit scores are a broad stroke and people may have low or immature credit, despite being capable of paying back a loan.

Its artificial intelligence digests a cocktail of more than 1,000 user data points to determine borrowers’ capacity to repay a loan independently of their credit scores. Upstart says its technology can approve borrowers at the same rate but see 75% fewer defaults.

It’s a bold claim, but Upstart has backed it up. The company’s Q1 2022 earnings deck included a chart comparing default rates for Upstart’s loans by credit score against its internal grading scale. Upstart showed lower default rates in four of its five tiers.

Let’s hope management updates this chart so investors can see how Upstart’s AI keeps performing throughout a changing economic cycle. However, there’s an even better indicator of whether Upstart’s AI works as advertised.

2. Accumulate lending partners

Upstart doesn’t want to be a lender. Instead, it works with a network of partner banks and credit unions. Upstart wants to originate as many loans as possible by placing its technology in banks or creating loans directly and then selling them off to investors. Upstart isn’t trying to make money on loan interest, which means it isn’t competing with its partner lenders.

It would make sense, then, that more lenders working with Upstart would signal that the technology does work as stated. Upstart has said that its total sales and onboarding process can take between six to 15 months; it’s a big commitment for lenders to make, so success in expanding its referral network could be an excellent sign that lenders trust the AI.

Upstart had just 18 lending partners in Q1 2021, but that had grown to 57 as of the end of March. Of them, 11 lenders have been satisfied enough with the technology to remove the FICO score from their loan application requirements, which could also speak volumes about the platform. The company’s second-quarter earnings report is looming, and investors will see how much its referral network grew over the past few months.

The stock is less risky today

Upstart is working on expanding into different types of loans, but personal loans remain the company’s largest segment by a country mile. A softer economy could mean fewer people taking out loans, and that could slow revenue growth, or even cause the business to shrink.

That’s how a cyclical company works; lending has ups and downs. It’s all about surviving the downturns, and it seems that Upstart can do just that, barring a financial crisis or something similar.

The company had just over $1 billion in cash at the end of March, more than enough to cover all of the loans it’s holding on its balance sheet, even if they all defaulted — an event I’d say is pretty unlikely. Again, investors will want to review updated Q2 results to see how Upstart is navigating the slowing economy.

Obviously, Upstart could keep falling from here, but the large share decline of the recent past means that investors are looking at more potential upside if the business thrives. In other words, there is more upside to compensate you for putting money into a riskier asset.

How cheap has Upstart gotten? Consider that the company’s total market cap is $2.4 billion. That’s half of its value sitting as cash on Upstart’s balance sheet! A reliable company like Coca-Cola has just 4% of its market cap in cash.

Things could be shaky for Upstart in this economy, but the long-term potential could make it a risk worth taking if its AI keeps working and its lender network keeps growing.