The expectations of the artificial intelligence credit platform have gone through the roof Upstart stocks (NASDAQ: UPST), which trades at roughly 295 times earnings after the stock slumped around 24% since the company announced third-quarter earnings. With its machine learning and 28 billion cells of training data, Upstart is trying to replace traditional credit underwriting, such as: Fine, Isaac‘s FICO credit rating the company believes to be out of date. The company claims it could improve bank loan default rates by 75%. Investors believe the company is into something big, but I still have questions about whether this business model can live up to the sky-high expectations of the market.
Can the Upstart model live up to expectations?
Upstart is a financial technology company specializing in the personal loan sector but has started entering the auto loan world and plans to apply its technology to small dollar loans and then to mortgages as well. Upstart helps customers get credit in two ways: it does the marketing itself to find customers and then distributes them to banks and credit unions, or banks can essentially embed Upstart’s technology into their websites and branding. Most of the credit is currently being drawn from Upstart, although the company expects direct line lending to increase in branding and eventually to account for a larger chunk of lending and revenue.
Ideally, Upstart positions itself as a Software-as-a-Service (SaaS) company, where it provides many banks and credit unions with the technology that customers get and deposits to finance the loans. Upstart charges a fee for every loan made through its platform. This is more ideal for them, as Upstart then does not have to acquire customers itself, which requires high marketing and sales costs. My big question, however, is whether this strategy of partnering with banks and credit unions will be as successful as the market thinks.
For this to work, Upstart would like most of its banking and credit unions at some point to integrate its technology, stop traditional credit underwriting that focuses on metrics like FICO, and permeate their existing customer bases as they open their credit boxes and criteria for those open that they may not have served historically. But many of Upstart’s previous partners are small community banks and credit unions. These type of institutions are usually not known for providing many installment loans because these smaller loans can be expensive to obtain and have higher default rates.
Upstart mitigates these vulnerabilities by providing the technology that can make loans with lower default rates more efficient. However, small banks and credit unions are still not very good at attracting new customers. The digital landscape has become very competitive. A survey by Experian in late 2019 found that nearly half of all personal loans were made by fintech companies, and many fintech competitors have sprung up since then.
The other thing to consider is that small banks and credit unions are usually very conservative. Although four of Upstart’s partners have stopped using FICO, this is no guarantee that all Upstart partners will follow suit as they can use Upstart’s technology and set their own credit parameters. Small banks and credit unions may also not make these installment loans as frequently as interest rates rise, which usually leads to more bad debts and the financial system not as filled with deposits – right now, almost all financial institutions have more deposits than they know what they should start with it.
I also don’t realize yet that Upstart will bring in all of these new borrowers that the banking system has historically ignored. Upstart CFO Sanjay Datta said on the company’s conference call in the third quarter that loan application volume tripled in the past year as the company has more capacity to service borrowers across the “loan spectrum,” but the conversion rate from Upstart in the third quarter declined. “Borrower segments that are relatively newer to our models will tend to convert at a lower rate initially than those segments for which we have a longer history,” said Datta. “Newer borrower profiles will tend to have more conservative immediate approval rates until we develop a longer history and larger loan volume for our models to train on.”
Growth is not a guarantee
Jefferies analyst John Hecht said he believes Upstart can achieve 40% market share in the personal credit space by 2025. If you extrapolate Upstart’s third-quarter lending of $ 3.1 billion for the year, that translates to $ 12.4 billion in annual lending. According to TransUnion data, US $ 81 billion in personal loans were extended between the second quarter of 2020 and the first quarter of 2021. That assumes a current market share of around 15%. Well, I’m assuming that Upstart can continue to build credit from here and the personal credit market is likely to get bigger, but that still means that a lot still needs to happen in the next few years and Upstart also needs to overcome the challenges outlined above and continue to fend off fintech competitors.
Upstart also plans to apply its technology to other major credit markets, including auto loans, small dollar loans, and the mortgage markets, each with their own unique challenges. CEO Dave Girouard said his banking and credit union partners’ interest in a small dollar loan product – loans for as little as a few hundred dollars paid back over a few months – was “off the charts”. Girouard also said the company is developing a small dollar loan product with an interest rate below 36%, which would be extremely impressive as these loans can have interest rates in excess of 600%. The reason for these high interest rates is that small dollar loans to banks can cost a similar amount to larger loans, but obviously with smaller volumes and higher default rates.
Upstart is also interested in auto loans, which have an annual market opportunity of $ 672 billion, and the mortgage market, which has an annual market opportunity of $ 4.5 trillion. But these credit categories can be competitive and usually don’t come with the same high interest rates as installment loans, so I’m not sure whether banking partners want to pay the same fees to Upstart forever because they eat into the margin more clearly and Profitability of every loan.
Many mortgages also have very strict credit requirements attached if the originator intends to sell them to the government sponsored facilities, leaving less wiggle room for Upstart’s technology. Outside of the qualified mortgage segment, there are still many options. But to reiterate my final point, mortgage rates can achieve some of the lowest margins in the industry, especially in a low-interest environment, which is why the banking system is far fewer mortgages today than it was a decade ago and the fee for the process may not be ideal.
A good company with a high rating
What Upstart has done so far is undoubtedly impressive and I think the company certainly has something on the trail. But the valuation and stock price have risen so fast that I have a feeling the market has already assumed a lot is going to happen, which is not yet a guarantee. Upstart has a long way to go, including getting more banking partners to abandon FICO, demonstrating that they can effectively convert originations without FICO, and tapping into new segments of credit that are very competitive. I think investors need to wonder if Upstart’s business model can meet the high expectations of the market.
This article represents the opinion of the author who may disagree with the “official” referral position of a premium advisory service from the Motley Fool. We are colorful! Questioning an investment thesis – even one of our own – helps us all reflect critically about investing and make decisions that will help us get smarter, happier, and richer.