Artificial intelligence (AI) stocks have been all the rage on Wall Street, and it's easy to see why.
Stocks like Nvidia have surged since the launch of ChatGPT nearly two years ago, creating trillions of dollars in market value for investors. However, Wall Street isn't so fond of every AI stock on the market.
Take Upstart (UPST -5.62%), for example. The AI-based consumer loan provider has struggled recently, and Wall Street looks downright bearish on it. Of the 18 analysts covering the stock (as tracked by The Wall Street Journal), just one rates it a buy, and eight recommend selling. The average price target on the stock is $23.47, implying about 40% downside from its value as of this writing.
However, the stock has been surging since its second-quarter earnings report went out on Aug. 6, and the stock looks poised for more gains. Here are two reasons why.
Image source: Getty Images.
1. Interest rates are set to come down
Upstart's business is highly sensitive to interest rates, much like most lending companies. In 2021, shortly after the company went public, business was soaring as interest rates were at rock bottom, and demand for consumer loans during the pandemic was high. Not only was the company growing rapidly with revenue jumping triple digits, but its operating margins were also strong, in the teens.
However, as interest rates rose and fears of a recession swept the market and the economy, the business froze, and the stock plunged.
Now, the company has an opportunity to reverse some of those losses. The Federal Reserve is highly likely to begin lowering interest rates at its next meeting in September, easing pressure on companies like Upstart and stoking demand for loans again.
It will take time for falling interest rates to juice demand, but the Fed sees interest rates falling to less than 3% over the long term, down from 5.25% to 5.50% currently, which should give a significant boost to borrowers.
The stock should move higher as rates start to come down.
2. Its technology is still an advantage
Upstart stock soared on its recent earnings report, even as revenue is still falling and losses mount.
However, conversion on rate requests improved from 9% in the year-ago quarter to 15%, showing more applicants are getting loans. It also expects revenue growth to return in the second half of the year.
Beyond that, Upstart's technology still holds a lot of promise. The company claims its AI-based lending model is more accurate than traditional models like the FICO score. For example, as of the second quarter, loan approval rates were twice as high as traditional models, and it was able to achieve a 38% lower APR than competing models.
The company has also expanded significantly since the boom in 2021. At the time, it did not offer a home loan product, and it now offers a home equity line of credit in 30 states and the District of Columbia.
Finally, its own Upstart macro index shows conditions improving, which will lower default rates and support increased loan approvals.
Why Upstart is a buy
Upstart's struggles aren't due to fundamental problems with its product. The business is just highly cyclical, and poor macroeconomic conditions in the form of higher interest rates have suppressed demand.
However, the reversal of the Fed's monetary policy is likely to unleash pent-up demand for consumer loans, much like it's expected to do the same for mortgages in the housing market.
In better market conditions, Upstart has the potential to deliver the kind of profits investors saw back in 2021, when it finished the year with a generally accepted accounting principles (GAAP) net income of $135 million and adjusted net income of $224 million. A return to those levels would give the company a price-to-earnings ratio of 16 at the current stock price (based on adjusted earnings).
Once the company returns to revenue growth and profitability, the stock has the potential to move a lot higher from here.
