Can Upstart’s business model live up to market expectations?


Expectations are sky-high for the artificial intelligence lending platform Holdings reached (NASDAQ: UPST), which is trading at around 295 times earnings after the stock has plunged about 24% since the company reported third-quarter earnings. Upstart, with its machine learning and 28 billion training data cells, seeks to replace traditional credit underwriting such as Fair, IsaacThe FICO credit rating that the company considers obsolete. The company claims to be able to improve bank default rates by 75%. Investors think the company is on to something big, but I still have questions as to whether this business model can live up to the sky-high expectations set by the market.

Can the Upstart model live up to expectations?

Upstart is a financial technology company that specializes in providing personal loans, but has started to enter the world of auto loans and also wants to apply its technology to small loans and then mortgages. Upstart helps clients get loans in two main ways: it does the marketing itself to find clients, then forwards them to banks and credit unions, or banks can basically integrate Upstart technology into their sites. Web and their branding. Most of the loans are currently referred by Upstart, although the company expects direct branded montages to grow and eventually make up a larger portion of the montages and revenue.

Ideally, Upstart is positioned as a software as a service (SaaS) company, where it supplies the technology to many banks and credit unions that attract customers and finance loans with deposits. Upstart collects a fee for each loan issued through its platform. This is more ideal for them because then Upstart does not have to acquire the customers themselves which requires a lot of marketing and sales expense. But my big question is whether this strategy of partnering with banks and credit unions will be as successful as the market thinks it is.

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For this to work, Upstart will want most of its banking and credit union partners to eventually integrate its technology, stop using traditional credit underwriting that focuses on metrics like FICO, and penetrate their existing customer bases. while opening their credit boxes and their criteria to people they may not have historically served. But so far, many of Upstart’s partners have been small community banks and credit unions. These types of institutions are generally not known to provide many installment loans as these small loans can be expensive to set up and have higher default rates.

Upstart alleviates these problems by providing the technology that can more efficiently generate loans with lower default rates. However, small banks and credit unions are still not particularly good at attracting new customers. The digital landscape has become very competitive. An Experian survey in late 2019 showed that fintech companies were the source of almost half of all personal loans, and many fintech competitors have emerged since then.

The other thing to consider is that small banks and credit unions are generally very conservative. Although four of the Upstart partners have stopped using FICO, it is not a guarantee that all Upstart partners will follow suit as they can use Upstart’s technology and set their own credit settings. Small banks and credit unions may also be less likely to provide these installment loans when interest rates rise, which usually results in more bad debts, and when the financial system does not have as many deposits – almost all financial institutions now have more deposits than they know what to do with.

It’s also not clear to me yet that Upstart will attract all of those new borrowers that the banking system has historically ignored. Upstart CFO Sanjay Datta during the company’s third quarter earnings call said that over the past year, loan application volume has tripled as the company has more ability to serve borrowers across all parts of the “credit spectrum”, but Upstart’s third quarter conversion rate declined. “Lender segments that are relatively newer to our models will initially tend to convert at a lower rate than segments where we have a longer history,” Datta said. “New borrower profiles will tend to have more conservative instant approval rates until we develop a longer history and larger loan volume for our models to train on. “

Growth is no guarantee

Jefferies analyst John Hecht said he believes Upstart can achieve a 40% market share in personal loans by 2025. If you annualize the $ 3.1 billion in fixtures of Upstart loans in the third quarter, that implies annual installments of $ 12.4 billion. According to TransUnion data, there were $ 81 billion in personal loan origination between the second quarter of 2020 and the first quarter of 2021. This assumes a current market share of around 15%. Now, I guess Upstart can continue to develop its origins from here, and the personal loan market is likely to expand, but that still means a lot of things have to go right over the next few years and Upstart will have to. also overcome the challenges explained above. like continuing to drive away fintech competitors.

In addition, Upstart plans to apply its technology to other larger lending markets, including auto lending, low-value lending, and mortgage markets, which all pose their own challenges. CEO Dave Girouard said the interest of his banking and credit union partners in a low dollar loan product – loans for as little as a few hundred dollars paid off in a matter of months – is “off the charts”. Girouard also said the company is designing a low dollar loan product with an interest rate below 36%, which would be extremely impressive as these loans can have interest rates above 600%. The reason for these high rates is that small dollar loans can cost banks the same amount as larger loans, but obviously with smaller volumes and higher default rates.

Upstart is also interested in auto loans, which offer an annual market opportunity of $ 672 billion, and the mortgage market, which presents an annual market opportunity of $ 4.5 trillion. But these loan categories can be competitive and usually don’t have the same high interest rates as installment loans, so I’m not sure banking partners will want to pay Upstart the same fees forever as they consume more noticeably the margin. and the profitability of each loan.

Many mortgages also come with very strict credit requirements if the originator intends to sell them to government sponsored entities, leaving Upstart’s technology less wiggle room. There are still many opportunities outside the qualified mortgage segment. But to reiterate my last point, mortgage interest rates can generate some of the lowest margins in the industry, especially in a low interest rate environment, which is why the banking system grants far fewer mortgages today than it does. ‘it only did a decade ago, so adding another expense to the process may not be ideal.

A good company with a high valuation

What Upstart has done so far is undoubtedly impressive and I think the company is definitely on to something. But the valuation and the stock price have been rising so quickly that I feel like the market has already assumed that a lot will happen, which is not a guarantee yet. Upstart still has a lot of work to do, including getting more of its banking partners to move away from FICO, showing that they can effectively convert FICO-less arrangements and entering new, highly competitive lending segments. I think investors need to ask themselves if Upstart’s business model can meet the high expectations set by the market.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Questioning an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.


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