Be careful when considering this ultra-popular Fintech stock

Upstart Holdings (UPDATE -1.62%)the artificial intelligence (AI)-based lending platform, saw its shares skyrocket in the 10 months following its initial public offering, peaking at over $30 billion in October 2021. The positive sentiment has completely reversed, and the stock is down around 85% this year.

It can be tempting to buy discounted shares in Upstart today. However, if you are considering this, it is best to keep some important factors in mind, especially since many market participants fear that a recession may be on the horizon. Let’s take a closer look at what this could mean for Upstart’s business.

Thrives in a rosy financial environment

2021 was a banner year for Upstart. Revenue increased by 264%, and net income increased by an astronomical 2,164%. Moreover, the company was able to make 1.3 million loans worth a total of $11.8 billion during the 12-month period. These figures were significantly up from the 2020s figures, which helps to explain the population’s meteoric rise.

A low interest rate environment is a boon for Upstart. Demand for loans from consumers is high because the cost of borrowing funds is attractive. And loss rates are kept under control because these borrowers can actually afford the interest rates on their loans.

A study by Upstart found that major US banks could use their lending platform to lower loss rates by 75% while keeping approval rates constant. And in another study specified by the Consumer Financial Protection Bureau, Upstart’s AI model was found to be able to approve 27% more borrowers than traditional lending standards.

Further supporting Upstart’s business model in this situation is a robust capital markets landscape. Because Upstart’s network of lenders often sell their loans to third-party institutional investors looking for returns, when the economy is firing on all cylinders and credit is cheap, it encourages banks to continue lending aggressively. And this means more fees for Upstart.

The business recently entered $751 billion annually the car loan market and plans to enter the giant $4.5 trillion mortgage market. These strategic initiatives can certainly please shareholders when times are good and the focus is intense on expansion. But this perspective may no longer be valid.

But doubtful in a recession

In a recessionary environment, a situation where interest rates rise, credit markets tighten and consumer demand to borrow money declines, the opposite of the previous scenario is likely to play out. Throw in furiously inflation it is at a 40-year high, and the possibility of higher defaults is rising. And interest from institutional investors, who help grease the wheels and keep the money flowing, is waning.

Furthermore, banks and credit unions, 57 of which are Upstart partners, are guaranteed to perform worse in a recession than they have in recent years. The lending business is notoriously cyclical, and it is not difficult to understand why. Banks typically set aside money in anticipation of elevated defaults, called provisions for credit losses, a move that increases costs and reduces profits in the current reporting period. An economic downturn is not lucrative for companies in the money industry.

Now, to be fair, Upstart’s AI model has performed better at assessing credit risk than the traditional model from Fair Isaac Corporation (FICO 4.25%), otherwise known as FICO. However, the true benefits of Upstart’s data-driven platform may well be put to the test in the near term.

In fact, management recently lowered its forecast for the second quarter, with official results to be released on August 8 after the market closes. Senior executives now expect revenue to be $228 million, down from the previous estimate of $300 million at the midpoint. This would equate to a year-over-year sales increase of just 18%, significantly lower than the more than 1,000% growth recorded in Q2 2021. High inflation and the threat of a recession have also forced management to lower its earnings forecast to a net loss of between $27 million and $29 million, which would be the first loss since Q2 2020.

It’s also worth noting that Upstart was founded in 2012 and hasn’t faced a real recession outside of the brief pandemic-induced downturn in 2020. While the stock has arguably been hammered, it’s trading at a price-to-sale multiple of just over 2, the cheapest the shares have sold for in the company’s young public history, I think the current economic environment is a real risk.

The potential long-term upside could be huge for Upstart, but it’s best for investors to proceed with caution.