Over the past year, Upstart(NASDAQ: UPST) has dealt with concerns about who would buy its loans. Castlelake, a global alternative investment manager, helped alleviate some of these worries when it promised to buy as much as $4 billion in consumer loans from Upstart in May. This vote of confidence triggered a rally of epic proportions, with the stock gaining almost 400% since its May low of $12, although it has since retreated a bit.
Upstart is a promising company with a bright future, but should investors consider taking some of their profits off the table now? Here's what you should know about the consumer lending market today.
What is going on with Upstart stock?
Upstart got off to an incredible start following its public debut, with the stock rising from $22 per share to more than $400 in late 2021. The company uses artificial intelligence (AI) to upend consumer lending as we know it.
It developed models to price risk and help more consumers access loans. The company aims to improve upon the traditional Fair Isaac(NYSE: FICO) FICO scoring system, which it says shuts worthy people out of the financial system.
In 2014, Upstart began making personal loans and has operated in a low-interest-rate environment for much of its short life. Now, its lending model faces its first test in an atmosphere of high interest rates, which rose over the past year and a half at their fastest pace in decades.
Inflation, as measured by the year-over-year change in the consumer price index, began increasing in early 2021 and prompted the Federal Reserve to begin its current rate-hiking campaign to get inflation back down to its 2% target.
When the prospect of rising interest rates became apparent, Upstart's stock couldn't hold its high valuation. One fear that investors had was how the model would perform amid rising rates.
Last year, the lender struggled to find buyers for its loans. As a result, the company began holding loans on its books early last year, triggering further selling of the stock.
Lending activity also slowed drastically. In 2022, the number of loans Upstart made fell 77%, while the total dollar volume of those loans was down 71%.
Many investors became bearish last year and expressed that pessimism by shorting the stock, trying to profit from a falliing share price. Earlier this year, more than 45% of the stock was sold short. Fears persisted until May, when Castlelake agreed to purchase as much as $4 billion in consumer installment loans from Upstart. This commitment exceeded the company's total loan volume of $3.7 billion in 2022, setting off an epic short squeeze in which pessimistic investors rushed to close out their positions, catapulting the stock higher.
Data source: YCharts.
Other consumer lenders are flashing warning signs
Upstart's funding issues have been alleviated for the time being, but consumer lending markets continue to face headwinds. Two consumer lenders, LendingClub and OneMain Holdings, recently reported earnings that confirmed this.
LendingClub is a competitor to Upstart specializing in consumer installment loans for individuals looking to roll up their debts, like those from credit cards, into one loan. In the second quarter, LendingClub's loan originations decreased by $1.8 billion, or 48%, from last year. Originations were also down 12% from the first quarter, showing waning demand for consumer loans.
OneMain is another consumer lender focusing on nonprime consumers, or those with credit scores of 660 or lower. OneMain performed better than LendingClub, with originations falling 4% from last year. But its net charge-off ratio went from 5.96% last year to 7.6% in the most recent quarter, suggesting that consumer credit quality has deteriorated.
Upstart's lending model faces a big test
Since May, Upstart's price-to-sales (P/S) ratio has gone from 1.57 to 8.88. This is well below its all-time high P/S of 48 in 2021. However, at that point in time, interest rates were near all-time lows, loan demand was high, and fears of a recession were far off.
Data source: YCharts.
Growth in consumer lending this year has been nonexistent, which could impact Upstart in the coming quarters. If the lender doesn't put up strong growth, the stock price could be pressured due to its high valuation.
Not only that, but Upstart's AI-lending models also still face a big test. The Fed recently raised its benchmark interest rate to 5.5%, its highest level in nearly two decades. Although the company's model has performed quite well, it hasn't faced a test in an interest rate environment like the one we've experienced this past year. Also, the resumption of student loan repayments in October could burden consumers, affecting their ability to repay other loans.
Upstart's AI-lending models potentially will open financing to more people, and its future is bright. But its model faces its biggest test yet, with high interest rates and consumer delinquencies slowly ticking up. Given its big run-up, high valuation, and potential headwinds in the coming quarters, now is probably a good time for investors to trim some of their position in the fintech.
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Courtney Carlsen has positions in LendingClub. The Motley Fool has positions in and recommends Upstart. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.
