Upstart has fallen out of favor with investors, but signs of a turnaround are beginning to emerge.
Artificial intelligence (AI) stocks are all the rage on Wall Street, and it's easy to see why.
Stocks such as Nvidia have soared since ChatGPT's launch about two years ago, creating trillions of dollars in market value for investors. But Wall Street isn't fond of all the AI stocks on the market.
Take Upstart (UPST 5.77%), for example. This AI-based consumer loan company has struggled as of late, and Wall Street is flat-out bearish on the company. Of the 18 analysts covering the stock (tracked by The Wall Street Journal), only one has a buy rating, while eight recommend selling. The stock has an average price target of $23.47, which implies a downside of roughly 40% as of this writing.
But the company's stock price has surged since it reported its second-quarter earnings on August 6, and is expected to rise further. There are two reasons for this.
Image source: Getty Images.
1. Interest rates are expected to fall
Upstart's business, like many other lenders, is highly sensitive to interest rates. In 2021, shortly after the company went public, its business boomed as interest rates were at rock bottom and demand for consumer loans was high during the pandemic. Not only was the company growing fast, with revenue soaring into triple digits, but it also had healthy operating margins in the teens.
But as interest rates rose and fears of a recession spread through the markets and the economy, business slowed and stock prices plummeted.
Now the company has a chance to recover some of its losses: The Federal Reserve will likely start cutting interest rates when it next meets in September, easing pressure on companies like Upstart and helping to revive demand for loans.
It will take time for lower interest rates to stimulate demand, but over the long term, the Fed expects rates to fall to below 3%, from the current 5.25% to 5.50%, which should be a big boost for borrowers.
When interest rates start to fall, stock prices should rise.
2. The technology remains dominant
Though revenue is still declining and losses are widening, Upstart's shares surged following its recent earnings report.
But the conversion rate for interest applications improved to 15% from 9% a year ago, indicating more applicants are getting loans. The company also expects revenue growth to recover in the second half of the year.
Beyond that, Upstart's technology has a lot to offer: The company claims that its AI-based lending model is more accurate than traditional models like FICO scores. For example, as of the second quarter, it saw loan approval rates double those of traditional models and offered APRs 38% lower than competing models.
The company has expanded significantly since the economic boom of 2021. It did not offer mortgage products at the time, but now offers mortgage-backed lines of credit in 30 states and the District of Columbia.
Finally, the firm's Upstart Macro Index points to improving conditions, which should lead to lower default rates and increased loan approvals.
Why Upstart is a good buy
Upstart's struggles aren't due to any fundamental problems with its product — it's simply a cyclical business, and adverse macroeconomic conditions in the form of rising interest rates have dampened demand.
But the Fed's shift in monetary policy is likely to unleash pent-up demand for consumer loans, as well as mortgages in the housing market.
If market conditions improve, Upstart could see the kind of profit investors are hoping for in 2021. The company finished 2021 with $135 million in generally accepted accounting principles (GAAP) net income and $224 million in adjusted net income. If it were to return to those levels, the current stock price (based on adjusted earnings) would trade at a price-to-earnings multiple of 16.
If the company can return to revenue growth and profitability, the stock could move even higher from here.
