The past few years have been tough operating environments for interest rate-sensitive, cyclical industries. One company that encapsulates this struggle is Upstart Holdings(NASDAQ: UPST), the artificial intelligence (AI) consumer lender.
Upstart stock ran up significantly in the months following its December 2020 initial public offering (IPO). The consumer lender benefited from declining interest rates, a backdrop of fiscal stimulus, and strong consumer metrics, and it became profitable right away. However, the past couple of years have been tough for the lender, as it scrambled to find investors in its loans while consumer demand waned.
With the Federal Reserve lowering its benchmark interest rate by 50 basis points in its September meeting, the interest rate easing cycle is officially underway. With rates retreating from multidecade highs, now might be the time to buy Upstart stock. Here's why.
Upstart's cyclical challenges
Upstart has been using artificial intelligence for years to make loans accessible to more borrowers, many of whom are worthy of personal loans but get shut out of the financial system. The company is set on taking on Fair Isaac's FICO scoring system, which has been the standard in consumer credit since its creation in 1989.
Upstart has trained and refined its in-house lending model for over a decade and is constantly improving it. The model leverages AI to analyze and evaluate risk on over 1,600 variables across 73 million repayment events and has shown promising results when evaluating risk across the credit spectrum.
That said, the company is still relatively young and faces cyclical challenges in the personal lending market. Upstart, specifically, is sensitive to changes in interest rates and the impact those changes have had on consumer borrowing and investor demand for its loans.
This is where Upstart's business model faces significant challenges. Unlike a bank, Upstart generally doesn't hold on to the loans that it makes. Instead, it partners with banks, alternative asset managers, and other types of investors that hold on to the loans and collect interest payments. Through the first half of this year, 84% of Upstart's loans were held by institutional investors or lending partners.
In 2022, investor demand for Upstart's loans dried up amid the Fed's aggressive interest rate hiking cycle. The company struggled to find lending partners for its loans when the future path of interest rates was uncertain. As a result, the company held some loans on its books and was met with strong resistance from investors.
UPST Revenue (TTM) data by YCharts
Things are looking up for the consumer lender
As interest rate hikes slowed down, investors' demand for its loans returned. Last year, the company got a big boost when the alternative investment manager, Castlelake, agreed to purchase up to $4 billion in its loans. The company has continued to secure lending partners for its loans, including numerous credit unions and small banks.
With one piece of the puzzle solved, Upstart's next challenge is restoring consumer demand for its loans. Through the first six months of this year, Upstart's total loan transaction volume was $2.2 billion, slightly above last year but well below 2021, when it had over $4.5 billion in transaction volume through the first six months of that year.
A massive refinancing opportunity awaits
Despite tepid consumer demand for its loans, the declining interest rates could provide a huge tailwind for Upstart and other consumer lenders.
According to the Federal Reserve Bank of New York, consumer credit card balances are now $1.14 trillion. These rising balances come at a time when average credit card interest rates are 22.75%, near the highest they've ever been. If interest rates decline meaningfully, Upstart could see a surge in loans as people refinance and lock in lower interest rates on these balances.
Image source: Getty Images.
Is it time to buy Upstart?
Upstart is a young cyclical company vulnerable to economic and market conditions, making it riskier than blue chip stocks and a bad choice for more conservative, risk-averse investors.
However, the stock is priced at around 6.8 times sales and five times next year's forecast sales. For investors willing to tolerate the volatility, the stock isn't too expensive, and today could be an excellent opportunity to build a small position in the lender ahead of further interest rate cuts over the next couple of years.
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Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Upstart. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.
