1 Artificial Intelligence (AI) Stock Down 94% You Might Want to Buy Before Interest Rates Fall
The U.S. Federal Reserve could begin to cut interest rates later this year, and that will be a windfall for this AI-powered loan originator.
Upstart Holdings (UPST -1.11%) went public in 2020 priced at $20 per share. In less than 12 months, its stock had soared 2,000% to $401 on the back of the company’s lightning-fast revenue growth and its promising potential.
The company developed an artificial intelligence (AI) algorithm to assess the creditworthiness of potential borrowers on behalf of banks, in a bid to move the industry away from Fair Isaac‘s decades-old FICO credit scoring system. But when interest rates began to soar in 2022, consumer demand for loans collapsed, and investors also grew concerned that Upstart’s algorithm wasn’t yet battle-tested in a challenging economic climate.
As a result, Upstart stock has plunged all the way back down to about $25 as of this writing. However, some of the company’s core metrics have recently returned to growth, and with the U.S. Federal Reserve poised to cut interest rates later this year, here’s why buying the stock now could be a great move.
AI could transform lending
The FICO credit scoring system was introduced in 1989, and Upstart says it’s outdated. It only focuses on five metrics, such as a potential borrower’s existing debt, their repayment history, and the length of their credit history. While these are important things for banks to consider, they aren’t the only measures of a person’s likelihood of repaying their loan, especially in the modern economy.
Thanks to AI, Upstart can rapidly measure 1,600 different data points to gain a better understanding of an applicant’s position. In fact, during the first quarter of 2024, 90% of its loan approvals were fully automated and instant. Parsing that much data would probably take a human assessor days or weeks, so Upstart’s algorithm is a big win for the 100-plus banks and credit unions using it.
Taking a broader view of a person’s creditworthiness by using that much data can also eliminate bias from the decision-making process. Upstart says its algorithm approves 35% more Black borrowers and 46% more Hispanic borrowers than traditional assessment methods, and it does so at much lower interest rates.
Loan demand ticked higher to start 2024
Upstart’s bread and butter is unsecured personal loans, but it also operates in the secured automotive loan segment, and it entered the home equity line of credit (HELOC) market last year.
Between Mar. 2022 and Aug. 2023, the U.S. Federal Reserve hiked the federal funds rate from a historic low of 0.25% all the way up to 5.50% in order to tame a surge in inflation. It led to a collapse in loan demand on Upstart’s platform with the number of approvals falling (year over year) in every single quarter of 2023.
But the Fed has telegraphed its intention to leave rates on hold for now, and it has signaled the next move is likely a cut rather than another hike. Consumers appear to be feeling a little more confident because Upstart saw a 45% year-over-year jump in the number of unsecured personal loans it approved during Q1.
The company’s automotive loan segment remained weak, however, with loan volume falling more than 70% during the quarter. Simply put, consumers aren’t feeling great about making big-ticket purchases right now, especially using financing. Even a hypergrowth carmaker like Tesla has struggled to grow in the early stages of 2024.
Upstart’s revenue turned higher in Q1, but its losses persisted
The increased demand for loans drove Upstart’s revenue 24.2% higher than the year-ago period, to $127.8 million. The full-year outlook remains weak, though, with Wall Street forecasting just $541.1 million in total revenue. While that would represent a small increase of 5.3% from 2023, it would still be 36.2% below its 2021 peak of $848.6 million. However, the 2024 estimate could change quickly if interest rates do come down later this year.
Upstart’s greater challenge is returning to profitability. Despite trimming operating costs 16.8% last quarter, the company still reported a $64.6 million net loss. That was an improvement from the year-ago quarter’s $129.3 million loss, but the company is a long way from returning to sustained profitability.
Perhaps the only way to get there is to wait for economic conditions to improve, which will drive more revenue Upstart’s way. Cutting costs too much can sap the company’s growth potential, which can lead to worse long-term outcomes.
Upstart has $300.5 million in cash on hand plus nearly $1.1 billion in loans on its balance sheet, which are expected to be either repaid or sold on to other lenders, so it’s in a strong financial position.
To be clear, Upstart isn’t a lender, it simply uses its technology to originate loans for banks (which is a very capital-light business model). However, it faced a cash crunch in 2022 when its bank partners pulled back on their activity, so the company decided to use some of its own money to fund loans. CEO David Girouard says that won’t be necessary going forward as the company has around $2.7 billion in capital committed from partners to cover the next 12 months.
Why Upstart stock is a buy now
According to the CME Group‘s FedWatch tool, the Fed could cut interest rates twice in the second half of 2024. That is likely to stoke demand for loans, which will benefit Upstart in the medium term.
But the company also has significant long-term potential. Roughly $3 trillion worth of loans are originated in the U.S. each year across the unsecured, automotive, mortgage, and small business segments. Considering Upstart has only originated $38 billion in loans since it was founded, it has barely scratched the surface of its opportunity.
That said, AI-powered assessment will likely play a growing role in banking because the technology is simply better at analyzing high volumes of data in a short time frame relative to human assessors. Plus, Upstart’s models performed well through a very difficult period starting in 2022, which should give banks confidence in their ability to predict creditworthiness.
Any stock that is highly prone to external factors like interest rates will carry risk, but with Upstart trading 94% below its all-time high, this might be a good time to buy a small position ahead of potential rate cuts in a few months’ time.
