Can Upstart stand out in its competitive market?
IPO darling Assets received ( UPST -8.06% ) fell 72% from all-time highs amid market uncertainty and a rotation in speculative tech stocks. Can the fintech platform that uses artificial intelligence to assess creditworthiness disrupt the traditional lending industry? Or does it face an uphill battle against established loan companies?
In this music video for “The Rank”, recorded on February 14Motley Fool contributors Matthew Frankel, CFP®, Jason Hall and Tyler Crowe discuss Upstart’s meteoric rise and recent fall, and explore the challenges the company faces in a crowded field.
Matt Frankel: Upstart went public at an IPO price of $20 in December 2020 and it peaked in 2021 above $400. It was a 20-bagger in less than a year after its IPO. He has since descended to earth, perhaps an understatement. Upstart is down about 72% from its highs, and that’s after a recent rally. This one was pretty well hit. Still quite an expensive company, with a market capitalization of around $8.8 billion. Upstart is actually reporting tomorrow, so we’ll get a better look at the state of the business, which I’m really excited to see as the second and third quarters weren’t very comparable to the prior year. The second quarter of 2021, Upstart’s business was going, they were doing loans as much as possible. They pretty much curbed lending in the second quarter of 2020. On paper, that looks like a 1,000% year-over-year gain. But it really wasn’t. The third quarter was like that, but less. Revenue increased 250% year over year. Again, this isn’t an entirely apples-to-apples comparison, but Q4 should be. I want to see where it lands tomorrow.
Upstart’s mission is therefore to democratize access to credit and do a better job of predicting the risk of loan loss than traditional methods, in particular the FICO score. Now there is no doubt. I think the other guys would totally agree with me that the FICO model isn’t perfect. It does not accurately predict the risk of default for each borrower. It does not especially serve the low end, nor the low end of credit. People who may not have established credit in a very long time or people who may have gone bankrupt five years ago and had their credit destroyed for the next seven years because of it. These are the people the traditional method really doesn’t serve, and that’s a pretty big segment of the market. To date, Upstart has used its own methods for underwriting personal loans. For the most part, they are just getting started in the car loan business, but in the personal loan market, they have been hugely successful. The entire personal loan industry accounts for approximately $80 billion a year in loans. Upstart in the third quarter was behind annualized lending volume of about $12 billion. That’s pretty impressive market penetration, especially because they’re just focusing on subprime credit levels. Their business took off. They haven’t really been tested yet, which is my biggest negative about the company, and Jason and I have talked about them on shows before. Upstart was founded in 2009, didn’t really exist during a major recession where borrowers defaulted. It will be tested if this ever happens, if and when. The real possibility here is that this methodology, if it works, which let’s assume it works, will be transposed to other forms of lending. I mentioned auto lending, which is a huge market. Let me share my screen very quickly.
Jason Hall: It’s also a huge subprime market, isn’t it?
Frankel: These are the markets that Upstart plans to target or has already targeted. As mentioned, the personal loan market already. The auto loan market is about seven times larger and has a massive need for subprime disruption. The subprime auto industry is a very predatory credit environment, and it’s not entirely the dealers’ fault. It’s not the fault of the dealerships, but it’s not totally the fault of the car dealerships because there is no right method to take out loans for subprime borrowers. If Upstart can translate its personal lending success into the auto lending industry, that alone could grow its business 5x. Then the long-term potential, you see that the mortgage market right now, if you’re a subprime borrower, it’s really hard to get a mortgage. There are no mortgages other than FHA loans for people with credit scores below 620 right now, FHA loans do exist, but these are expensive, and are government backed and stuff like that. There are many opportunities to translate this into other forms of lending. At the $400 stock price, it was actually a nearly $40 billion business in the mid-30s. Risk-reward didn’t really make sense to me at this point until until we get comparable growth figures. Like I mentioned, I hope to see tomorrow, but at a sub-$10 billion valuation as it is right now, it looks like it’s worth revisiting. Guys, any opinions?
Crow: Without becoming too wobbly, of course, while thinking. I can go in a lot of different directions here, so I’ll keep it as general as possible. Mortgage rate or lending is one of the most competitive industries. A half basis point gain might be billions to people. What does Upstart do that is so unique and so exclusive that no big bank like you said, if there’s money to be made, Goldman go do it. Probably the same can be said for so many other big banks, or even something like what SunTrust changed its name to, whatever.
Frankel: No, it’s BBNT.
Crow: It’s going to be fuel that will spend billions of dollars, and something like that, so what Upstart is doing that’s going to push them back and stop the 300, 400 billion dollar banks from saying no, we’re going to pick up the slack.
Frankel: Sure. Upstart isn’t a lender itself, it provides some kind of cloud-based AI platform that uses about 1,000 different consumer data points to improve it. The great strength of the program right now is that it has over a million consumer data loans to look at so that you can better predict, if you have a college degree, does that affect your risk default, things of that nature. In theory, and this is a big part of the thesis, Upstart’s platform could power some of these big bank lending operations and cut the losses. As you mentioned, Goldman Sachs owns the marketplace platform that already grants personal loans, so instead of using the FICO score to assess borrowers, it could use Upstart’s platform, theoretically reducing its losses and make more loans with less risk of loss and everyone wins. It’s sort of the thesis that bigger and bigger institutions will eventually grab it and bring it in.
Hall: It’s the platform, right? That’s the idea, and in this Tyler, I think to answer your question of not having had one too, I mean, I think that’s just the simple answers, is that, I mean , let’s not ignore rooted players. Why change what worked as long as it was the thing, right? Why increase the risk of trying something that doesn’t work, right? So I think in a way that’s what makes the timing perfect for Upstart because we’ve been in this period of strong economic growth for as long as we’ve had the cycle in its favor to start. That’s why I rated it #7, as attractive as the risk-reward profile has changed because the valuation has dropped so much, but the absolute risk level is the same. Until we go through a full credit cycle, we don’t know how well what he says will work. If it works, I think it works in more ways than just reducing risk, right? As a lender, if you’re a lender, do you want to adopt their platform and pay them, you can’t just reduce the amount of defaults you potentially end up in, but you can find like the good, like the risk profile that works for what you’re trying to do, maybe you just want to grow your loan portfolio and take on a little more risk, right? You could, they say with their algo, you can do that, so it’s really interesting what they’re doing. I’m just not convinced it will be as good until we go through a full credit cycle, and that’s why I scored as low as I did. I don’t want people to think these are value stocks. This is not the case, a valuable security always represents a huge amount of risk that will not work. It could be a very profitable business for another two or three years and grow like crazy and then lenders will stop buying their loans because default rates are much higher than anyone had predicted.
Crow: Well that’s what I was going to ask too it’s been around for a while and obviously we’re in a favorable credit environment but that’s proof in the putting like have we seen can they like , show a defect materially better rate than people in this industry?
Frankel: Yes, they have done their own studies, and in a favorable economic environment, they say it can reduce the risk of default by up to 75% based on their information. This is during good economic times when default rates are at record highs across the board anyway. It really remains to be seen if a financial crisis happens again, how it will translate.
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