Upstart Holdings Inc. (UPST), an American fintech company focused on revolutionizing the financial services industry, released fourth-quarter earnings that exceeded analyst expectations on February 15 after the closing bell of the market. The company reported earnings per share of 89 cents, compared to analyst expectations of 49 cents per share. Upstart stock surged more than 35% on February 16 as investors rewarded the company for beating analyst estimates for earnings handsomely, unveiling a surprise share buyback program, and issuing upbeat guidance for the first quarter of 2022. Upstart is a profitable business that has seen explosive growth over the last couple of years, and the company is well-positioned to profit from the booming digital lending market. Even on the back of yesterday’s surge in stock price, Upstart stock is still trading well below the 52-week high of $401 reached last October, and growth investors are likely to find this a good opportunity to bet on a fast-growing, profitable tech company at a reasonable price.

Upstart is changing the playing field

Upstart operates a cloud-based AI lending network that provides personal loans in partnership with banks. The company is revolutionizing the credit market with AI models that use and analyze data from all of its bank partners to assess potential borrowers' creditworthiness in more detail than the traditional FICO scoring method. The company has developed an income and default prediction model to analyze a potential borrower's creditworthiness, resulting in decreased loss rates for Upstart-powered banks. Unlike traditional methods that rely solely on income and FICO scores, Upstart’s prediction model analyzes non-traditional criteria such as education, area of study, GPA, and employment history when determining a borrower's ability to repay a loan. The company calculates credit risk using thousands of data points, which is already proven to be a more accurate and reliable measure of risk, resulting in more loan approvals and 75% fewer defaults. Taking into account the better-than-expected success rate of Upstart’s AI prediction model, seven of its bank partners have abandoned FICO scores and are now entirely dependent on Upstart’s models, which goes on to highlight the impact Upstart is already having on the financial services industry.

Exhibit 1: Default rates using Upstart’s model vs. the traditional bank model

Source: Upstart

The company earns most of its revenue from fees for software and services used by its partner banks, and therefore, carries far less credit risk than a traditional bank. For the fourth quarter of 2021, Upstart reported revenue of $305 million, up 252% year-over-year with fees accounting for $287 million of that total. In Q4, bank partners originated just over 495,000 loan transactions with a combined value of $4.1 billion, up 301% year-over-year. The company, in the fourth quarter, served over 400,000 new customers, with automated loan approvals reaching 70% of total volume. The company now has 42 bank and credit union partners, as well as more than 150 institutional investors financing loans.

Exhibit 2: Quarterly automated loans

(Click on image to enlarge)

Source: Upstart

The success the company and its bank partners are seeing as a result of automated loans is already posing a threat to big banks, which has prompted them to either partner with the likes of Upstart or invest in building their own AI models. This is a clear indication that Upstart is well and truly changing the dynamics of the financial services sector in the United States, and there is room for the company to grow in double digits over the next decade.

Expanding into new markets

Upstart initially focused on the personal loans market, which is valued at $96 billion, then in 2021, the company expanded into the automotive finance market by acquiring Prodigy, a car dealership-sales platform, for $89 million. Upstart Auto Retail, a two-in-one sale, and loan origination platform was created using Prodigy's software. The platform is now used by 410 dealers across the United States and has 10 bank partners signed up for auto financing. The expansion is likely to boost Upstart’s market share in the auto segment with over $1.5 billion in transaction volume expected this year.

Exhibit 3: Dealership footprint

Source: Upstart

Upstart's revenue and earnings growth rates have been outstanding, and its foray into the $727 billion car loan business has expanded the company's growth opportunities beyond personal lending. As the auto lending platform grows in size, the company plans to invest in the resources needed to unleash model and technology advancements. In addition, Upstart is looking for innovative ways to expand its consumer base. In 2023, the company is projected to penetrate the $4.6 trillion mortgage industry as well, and this year, Upstart is working to enter the $644 billion small business lending sector.

Commitment toward shareholders

Upstart announced that its Board of Directors has authorized the purchase of up to $400 million in common stock through a share repurchase program. Upstarts CFO, Sanjay Datta, also claimed that this isn't a capital-structure decision, but rather economic opportunism, stating that the stock was undervalued multiple times in the past year and the company's profitability allows it to initiate this program.

Risks to monitor

Despite the noteworthy success of the company, there are risks of investing in Upstart as well. Upstart is not a bank, and its CEO, Dave Girouard, describes the company as "both a consumer Internet brand and a cloud software provider," which is critical to its current competitive position. The company has handled the uncertainties admirably, but Upstart has been able to do so because its AI platform ensures higher approval rates with lower fraud and default rates. Now that banks are introducing similar systems and models and have a huge client base, they can have their own AI platform, but modeling data like education, work function, and GPA to forecast a customer's payment ability will be challenging. However, this does not rule out the possibility of a future replication of Upstart’s concept. To continue to grow, Upstart must continue to position itself as a facilitator of higher-quality services, and failure to do so may result in a deceleration of earnings growth. This is the major risk investors need to monitor.

The AI lending market will continue to grow

The global digital lending market is estimated to reach $26.08 billion by 2028, according to Research & Markets, growing at a compounded annual growth rate of 24% from 2021 to 2028. AI is influencing the credit and finance industry as it has become a game-changing technology for all businesses. By leveraging the emerging technologies, Fintech has evolved at a remarkable pace in recent years. According to Statista, there were 10,755 fintech companies in the Americas as of November 2021. Further, digital payments are expected to be the largest component of the Fintech market, and with approximately 78% of the Millennial population in the United States anticipated to utilize digital banking in 2022, the credit industry also needs to embrace digital solutions.

Takeaway

Upstart is a pioneering AI lending platform that improves access to affordable financing while enabling partner banks to profit from the cutting-edge technology developed by the company. Its platform allows more than two-thirds of Upstart loans to be accepted instantaneously and is fully automated. Despite customer concentration being one of the risks to be considered, the company has shown stellar growth by expanding into new markets and partnering with a higher number of banks and credit unions. Upstart is certainly not cheaply valued in the market, but paying a premium to invest in a fast-growing, profitable tech company that could disrupt the financial services industry is still likely to help early investors enjoy multibagger returns in the future.