Upstart (NASDAQ:UPST) is a new firm going after the mortgage origination market. It completed its initial public offering (IPO) at $20 in December. Since then, UPST stock has rallied more than 1,300%.
Those drawn to the name likely think Upstart is going to remake the mortgage industry. It had better, given the now more than $20 billion market capitalization for this firm. Success is already priced in and then some. Unfortunately for folks late to the party, UPST stock has become a full-on bubble. And it won’t take much for it to burst.
Before getting to the negatives, though, why has Upstart succeeded so far?
What Is Upstart’s Edge?
Upstart aims to integrate artificial intelligence (AI) technology into the lending marketplace. The firm believes that by using big data it can more accurately analyze credit risk. This, in turn, is supposed to save banks money by reducing future loan losses.
Upstart has a bit of a first-mover advantage here in using AI in this way. As a result, lenders have been willing to buy loans from Upstart, and the company keeps the origination fee for putting it together. At least until competition arrives in the industry, Upstart has the ability to generate substantial business activity and market share.
UPST Stock Valuation Is Beyond Absurd
Traders are bidding up UPST stock as if it is a high-margin software business when, in reality, this is a company that originates loans. Its competitors historically trade at rock-bottom valuations. Consider mortgage originators (and failed meme stocks) Rocket Companies (NYSE:RKT) and UWM Holdings (NYSE:UWMC), which both trade at less than 10 times forward earnings.
Yet, add a splash of AI to the mix and Upstart is supposedly the best thing since sliced bread. UPST stock is trading at 50 times sales, more than 400 times trailing earnings and more than 200 times forward earnings. This isn’t even an extremely optimistic valuation; it’s a full-on unhinged. There’s virtually no example of buying shares of a bank, financial firm or mortgage company at a 400 P/E or 50 times sales in the past that hasn’t ended in catastrophe.
Bulls may try to argue that Upstart isn’t a financial stock, it’s a software business. It’s not really, though. People pay stratospheric multiples for software companies because they have subscription business models with recurring revenue. Upstart has little of the sort. Once a transaction closes, Upstart gets paid and then needs to find another deal. If banks develop their own AI, or buy loans from rivals, Upstart’s revenue quickly disappears. There’s no long-term lock-in like a subscription software operation.
Even if you think banks can’t figure this business out, what’s to stop SoFi (NASDAQ:SOFI), Square (NYSE:SQ) or another fintech platform from building the same product and charging a lower fee, thus cutting Upstart out altogether?
Upstart’s Model Is Far From Proven
Upstart was founded in 2012. This means the company hasn’t yet endured a prolonged economic downturn. Indeed, the company openly states: “Our AI models have not yet been extensively tested during down-cycle economic conditions. If our AI models do not accurately reflect a borrower’s credit risk in such economic conditions, the performance of Upstart-powered loans may be worse than anticipated.”
Every few years, some new Wall Street darling comes along claiming to have reinvented risk management. Anyone remember LendingClub (NYSE:LC) and how its social borrowing model was going to put banks out of business? LC stock is down 80% since its post-IPO high in late 2014. Not surprisingly, its loans failed to hold up in even modestly stressful economic conditions.
Another issue is that it’s far from certain that the market is large enough to justify Upstart’s current valuation. Upstart’s value-add is most visible in loans to people with relatively low credit scores that are better credit risks than they first appear. Think of people with non-traditional employment situations or extenuating situations that caused an unusual series of adverse credit events in the past.
At first, Upstart should be able to find a lot of people that are hidden good-quality borrowers. Once the low-hanging fruit is picked, however, how will Upstart continue to grow? Credit scores are reliable most of the time. They are the industry standard because they’ve proven their worth over the decades. By contrast, investors should be very skeptical of a new-fangled AI model that hasn’t survived a long recession yet. Especially when we have so many previous fintech companies that failed while trying to disrupt this market.
UPST Stock Verdict
Banks have their problems. Their customer service is hit or miss. Their fees are over the top. Their tech and mobile apps leave a lot to be desired. There is room to innovate and improve the banking experience, for sure. There is one thing, however, that banks are great at: lending. It seems improbable bordering on preposterous to think banks are going to sit idly by and let a random startup beat them at their specialty.
Has Upstart cracked the lending code? Probably not. More likely, Upstart is making a lot of dodgy loans to subprime borrowers. Everything smells like roses during an easy-money period when the government is giving out free cash. Once the economy hits a rough patch, however, look out below.
With UPST stock selling at preposterous valuation ratios, a correction is virtually assured even if the business keeps operating normally. And when the company does miss earnings or hint at mounting credit quality concerns, shares should implode.
On the date of publication, Ian Bezek did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.