You might regret not buying the drop in this AI stock

Assets received (UPST -7.53%) has become one of the most beleaguered stocks on Wall Street. It has made a huge round trip from $20 per share to $400 and back over the past two years. Volatility can stir up investors’ emotions, so it’s essential to assess a company with a clear head.

Upstart is clearly struggling in this rapidly rising interest rate economic scenario, and management has admittedly backtracked on some of its plans for its balance sheet. However, some key clues point to a brighter future for the company. Here’s what you need to know about Upstart’s challenges and why it’s still a compelling long-term investment.

Understanding Upstart Challenges

Upstart is a technology company, but it is sensitive to the dynamics of financial markets. It uses artificial intelligence (AI) instead of a traditional credit score to create loans. Rather than holding the loans as a regular bank would, it wants to immediately sell these loans to investors, removing the risk from its balance sheet. Upstart is building a network of partner banks and credit unions that work with the company or use its software API to generate their loans.

The past two years have been a financial boost for Upstart and go a long way to explaining the company’s problems today. Financial markets were much easier to navigate last year – consumers were showered with stimulus money and interest rates across the economy were very low, making it easier to navigate. ‘Upstart. But a combination of inflation-induced rate hikes and now fearful investors are smashing the bond market.

The speed at which this is happening has made business difficult for Upstart. The company struggled to sell some of its loans because investors were unwilling to buy at a price that was still profitable for Upstart. In other words, the bond market crashed so quickly that Upstart made loans and was underwater before it could sell them.

Instead of taking those losses, Upstart now holds the loans on its balance sheet, which management discussed in its second-quarter earnings call. Additionally, higher rates deprive some potential borrowers of loans, which means lower origination volumes across the board. Upstart is sailing in very rough seas at the moment.

Looking for clues for a better future

Weathering this storm comes down to two crucial factors for Upstart. First, its AI must continue to outperform credit ratings. If not, what is the business for? Fortunately, this seems to be the case, despite the difficult environment:

Image source: Upstart Holdings.

Upstart publishes the above analysis quarterly, showing that its risk ratings separate good borrowers from bad better than a FICO credit score that groups default rates much more closely, regardless of credit score.

Second, Upstart continues to expand its network of partners in its lending program and automotive software. The partner network has grown from 25 to 71 over the past four quarters, while the number of car dealerships using its retail and finance software has grown from 199 to 640. On the contrary, it shows that lenders, who need to accurately analyze risk to stay in business, always trust Upstart’s technology. If that didn’t work, we’d expect partners to drop Upstart, and if that were to happen, then we’d have a significant issue that warranted selling the stock.

A survival game

I don’t think Upstart was perfect by any means – the flip-flop with management’s use of the balance sheet isn’t ideal. However, what ultimately matters in the long run is that the product works and more lenders use it. More partners could most likely mean that growth rebounds significantly when the economic environment improves. Remember, the bond market is going downhill right now, so a lot of this is out of Upstart’s hands.

Upstart’s personal loans fell 31.5% from the prior quarter, but free cash flow held up well, and Upstart still has plenty of cash on the balance sheet:

UPST Free Cash Flow Statement (Quarterly).

Data by Y-Charts.

No one knows how long the economy will be this volatile or when it will rebound. Investors should watch Upstart closely over the coming quarters. Monitor her AI’s performance and if she continues to gain new partners while ensuring that cash losses don’t get out of hand. Upstart could still be a lucrative long-term investment if it can just hold its own in these critical areas.

justin pope has positions in Upstart Holdings, Inc. The Motley Fool has positions and recommends Upstart Holdings, Inc. The Motley Fool has a disclosure policy.

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