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This Artificial Intelligence (AI) Stock Is Up 158% Over the Last 6 Months, But It Faces 1 Big Risk Going Into 2025
Upstart Holdings(NASDAQ: UPST) has been on a roller coaster since its initial public offering (IPO) in 2020. The lender, powered by artificial intelligence (AI), aims to democratize borrowing for a wide range of consumers.
However, its business model has faced challenges, navigating peaks and valleys as investor interest in its loans dipped before experiencing a recent resurgence. With the prospect of falling interest rates in the last year, there has been increased interest in hopes that consumer lenders like Upstart can capitalize on this promising opportunity.
However, as the stock surges, risks that could impact Upstart's prospects remain on the horizon for 2025. Here's what investors need to know.
Upstart has faced a rocky road
Upstart Holdings went on a tear shortly after its IPO, as investor optimism over its AI-powered lending model reached a fever pitch. The company looks to take on Fair Isaac's (NYSE: FICO) FICO scoring model, which has been the standard for consumer lending since its introduction in 1989. By leveraging over 1,600 variables across 77 million repayment events, Upstart leverages AI to predict the likelihood of default or prepayment for its loans.
Upstart enjoyed early success and turned several profitable quarters throughout 2021. Its early success led to the launch of a massive $400 million share repurchase program, as management expressed strong optimism about the company's growth trajectory.
However, reality hit in 2022 when the Federal Reserve began raising its benchmark interest rate to fight inflation. Rising interest rates increased borrowing costs across the entire economy, including consumer lenders. Additionally, Upstart's business model faced a crunch when it could not find willing investors for its consumer loans. As a result, many of its investors backed away from these loans until they got more clarity on the future path of interest rates.
The past year has been much more favorable for Upstart Holdings. For one, the Fed stopped raising its benchmark interest rate at the end of 2023 and cut rates for the first time in years last September. In addition, the company has secured numerous investments from lending partners.
In May of 2023, the investment manager Castlelake agreed to purchase up to $4 billion of its loans. Up until that point, Upstart had struggled with tepid investor demand, and this was a great sign that investor appetite for its loans was picking up. The company continues to find investment partners, and in October, alternative asset manager Blue Owl Capital committed to purchasing up to $2 billion of its AI-powered loans.
Upstart and other consumer lenders are well positioned to benefit if interest rates retreat from their recent highs. According to the Federal Reserve Bank of New York, consumer credit card balances are $1.17 trillion. These high balances come when credit card interest rates are some of the highest on record, at around 22.7%.
Upstart faces this risk in 2025
Declining interest rates could strongly incentivize consumers to refinance their debts by converting them into personal loans like those offered by Upstart.
However, there is a risk that interest rate cuts may not be as deep as many market participants had expected. At the last Federal Reserve meeting, Chair Jerome Powell indicated that interest rate cuts may not be as deep as expected as the inflation rate "remains somewhat elevated."
A slower pace of interest rate cuts could pose a risk to Upstart, which is naturally an interest-rate-sensitive business. While the AI-powered lender has secured funds from numerous lending partners, a pickup in consumer interest in its loans would boost revenue growth and help it return to profitability.
A lofty valuation for the consumer lender
Upstart's loans continue to perform, which suggests that the AI-powered business is doing a solid job of differentiating risk compared to traditional credit scores. Not only that, but over 91% of its loans in the most recent quarter were automated, which could go a long way toward helping the company efficiently scale up and meet growing demand.
That said, Upstart is priced around 5.5 times forward sales and 55 times forward earnings, making the stock far from cheap. The stock has run up significantly, and higher-for-longer interest rates could potentially weigh on the expected rebound in consumer demand for its loans.
Given the recent run-up, investors may want to take some profit on their position. However, if you maintain a longer-term outlook and wish to hold on for the long haul, understand the cyclical nature of Upstart's business, as it could continue to experience wide swings up and down.
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Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Upstart. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.
