When it comes to lending money, the fundamentals haven't changed much over the years. Banks typically want to see a steady income, responsible spending habits, and an item of security -- like a house or a car -- before writing loans. Technology has improved the process significantly, and it continues to evolve to provide more information to lenders and more options for consumers.
Upstart Holdings (NASDAQ:UPST) is all-digital lending platform with an artificial intelligence model that measures alternative metrics when assessing a potential borrower. The company uses the technology to help originate loans for lenders, and its business model is already delivering profits. Its valuation, though, has ballooned as enthusiastic investors bet heavily on the stock -- and it could take years for profits to catch up. Is it still worth an investment today?
How it works
Upstart partners with banks that write unsecured loans, to borrowers who might have a moderate to low income and might be used to paying higher interest rates. Some of its offerings include personal loans, wedding loans, credit card consolidation, and car loans. The annual percentage rate (interest) for an Upstart loan is in the 8.27% to 35.99% range, depending on the product.
Total non-housing consumer debt in the U.S. stood at more than $4.1 trillion in Q1, including about $745 billion in ''revolving credit'' (credit cards and other loans consumers can pay down, reuse, and carry balances on). Upstart has a substantial market opportunity that it has only just begun to tap.
Potential borrowers can submit a loan application through a bank that uses Upstart's application programming interface (API). Behind the scenes, the company's artificial intelligence is assessing the proposed loan, looking at more than 1,000 data points to provide a decision instantly (in most cases).
Upstart's algorithm has the ability to assess a borrower based on nontraditional metrics. For example, it accounts for a borrower's education and where they went to school, in addition to their job history, rather than just on income and assets. The company claims its decision process can reduce default rates by 75%. In fact, it boasts 173% more approvals for the same overall loan loss rate.
Priced for perfection
Banks are usually valued methodically, using metrics like tangible book value and earnings per share. Investors have decades' worth of historical earnings and valuations to work with when assessing financial institutions. New technology makes the process a bit different -- investors don't have the same history to study, and disruptive companies can therefore be difficult to value.
At the moment, Upstart is trading like a growth-oriented tech company, and this could be warranted since it's effectively a software business.
Year |
Revenue |
|---|---|
2018 |
$99 million |
2019 |
$164 million |
2020 |
$233 million |
Q1 2021 |
$121 million |
Data source: Company filings.
At Wednesday's prices, Upstart has a market cap over $11 billion, with full-year 2020 net income of $6 million. The company beat that total in this year's first quarter, with a net income of $10.1 million, so you can see how fast it's growing. However, it will likely need to earn significantly more for its current valuation to remain at these lofty levels.
The company expects to earn $500 million in revenue in 2021 -- which would represent 114% in yearly revenue growth -- and based on the Q1 result, this could translate to over $40 million in net income.
For the company to keep up this pace, it will most likely need new catalysts, and it likely has them. Upstart is now offering its platform technology to auto financiers, to capture a piece of the single largest lending segment after housing. Total auto loans in the U.S. grew to $1.37 trillion in 2020, and car shortages have led to higher prices and pent up demand across the board.
The company has trailing 12-month revenue of $290 million, so the stock currently trades at a revenue multiple of roughly 38 times. That's higher than Tesla's! With the growth opportunities Upstart is expecting, the company has the opportunity to grow its way into a less intimidating multiple over the next few years. But if you're buying it today, Upstart must deliver.
Looking forward
Upstart is showing promising growth in originations, with $1.73 billion in Q1, up 102% year over year on 169,750 total loans. This is one of the best metrics to measure the company's performance, as it translates directly to revenue. Since the company's algorithm instantly and automatically approved 71% of those loans, the scalability of this business is potentially enormous.
If the company continues to deliver growth in net income, its stock will likely remain buoyant -- although the risk to the valuation might be to the downside, depending how fast that growth is. The question for investors is whether there is enough upside potential from here to warrant that risk. Upstart is guiding for a similar amount of net income in the second quarter as it delivered in Q1, putting the company on track to generate less than $50 million this year. That might not be enough to sustain its current market cap.
However, for investors with a five-year time horizon (or more), Upstart could present a strong growth opportunity.