Upstart Holdings, Inc. Q4 FY2021 Earnings Call

Good day, and welcome to the Upstart Q4 FY 2021 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jason Schmidt, VP of Investor Relations. Please go ahead, sir.

Good afternoon, and thank you for joining us on today's conference call to discuss Upstart's fourth quarter and full year 2021 financial results. With us today are Dave Girouard, Upstart's Chief Executive Officer; and Sanjay Datta, our Chief Financial Officer. Before we begin, I want to remind you that shortly after the market closed today, Upstart issued a press release announcing its fourth quarter and full year 2021 financial results and published an Investor Relations presentation. Both are available on our Investor Relations website ir.upstart.com. During the call, we will make forward-looking statements, such as guidance for the first quarter and full year 2022 related to our business and our plans to expand our platform in the future. These statements are based on our current expectations and information available to us today and are subject to a variety of risks, uncertainties, and assumptions. Actual results may differ materially as a result of various risk factors that have been described in our filings with the SEC. As a result, we caution you against placing undue reliance on these forward-looking statements, as we assume no obligation to update any forward-looking statements as a result of new information or future events, except as required by law. In addition, during today's call, unless otherwise stated, references to our results are provided as non-GAAP financial measures and are reconciled to our GAAP results, which can be found in the earnings release and supplemental tables. To ensure that we address as many analyst questions as possible during the call, we request that you please limit yourself to one initial question and one follow-up. Later this quarter, Upstart will be participating in Jefferies Payments & FinTech Summit on March 1, JMP's Securities Technology Conference on March 8, and Morgan Stanley's Technology, Media and Telco Conference on March 9. Now, I'd like to turn it over to Dave Girouard, CEO of Upstart.

Good afternoon, everyone. Thank you for joining us on our earnings call, covering our fourth quarter and full year 2021 results. I'm Dave Girouard, Co-Founder, and CEO of Upstart. We're a month and a half into the New Year, and I'm grateful finally to have the opportunity to reconnect with the investor community; some quiet periods just be longer than others. We have seen some epic progress at Upstart in the past few months, and I'm excited to share what we've been up to, the results we've been seeing, and how we're thinking about 2022 and beyond. Let me state upfront that we're in a multi-decade mission to put affordable credit within reach of every American. The price of credit is the price of opportunity and the price of mobility. And we want to ensure that opportunity and mobility are available to all Americans, particularly for those whom the financial system has failed in the past. But like you, we've been watching all that's happening in the world in the last few months: the rise and fall of the Omicron variant, the clear signs of inflation, and the Fed's plan to counter it, and of course, the market rotation out of high-growth technology. But through all of it, our business continues to get stronger, and my confidence in Upstart's future has never been greater. As the rare public technology company with triple-digit growth and profits, we're confident that an economy and market in transition play to our strength. I’d like to start by reflecting on 2021, which was a remarkable year for Upstart. We grew revenue from $233 million in 2020 to $849 million in 2021, while generating net income of $137 million. And with the fourth quarter surge, we're now at more than $1 billion in revenue on an annualized basis. 2021 will be remembered as the year AI lending came to the forefront, kicking off the most impactful transformation of credit in decades. To gain some perspective on what Upstart achieved in 2021, we looked for another company in the public markets with our combination of scale, growth, and profits, but we were unable to find one. Our profits are neither marginal nor ephemeral. We generated more cash in 2021 than we burned in our entire eight-plus years as a private company. Profits matter for a reason. They allowed us to invest significantly in our future by more than doubling our headcount in product, engineering, and machine learning in 2021. This unusual combination of growth and profits in a heavily competitive industry is evidence of a distinct competitive advantage and clear operating leverage. It also suggests that you're witnessing the creation of an industry-defining category, artificial intelligence lending, and the emergence of the category leader, Upstart. In addition to reaching $1 billion in annualized revenue and record profits, Q4 was special for other reasons. It was the first quarter with more than $4 billion in loan transactions on our platform, a record not just for Upstart but potentially for the entire personal lending industry. Our bank and credit union partners originated almost 500,000 loans in the quarter. We also now have 42 banks and credit unions, as well as more than 150 institutional investors funding loans on the Upstart platform, providing deep and diverse sources of liquidity to keep the engine humming and the AI models learning. I'm also pleased to report that we now have seven lenders on the Upstart platform with no minimum FICO score required. But perhaps the most important achievement of the last quarter of 2021 was the incredible work done by our auto team. Through a relentless and determined cross-functional effort, this team put the last essential pieces in place necessary to begin scaling auto lending on the Upstart platform. I'll come back to this topic in a moment. I'd like to note that the Upstart team accomplished all of this during the second year of a global pandemic while operating in an almost entirely remote and distributed fashion. We moved to a digital-first strategy while simultaneously implementing what we call a vertical team working structure. This new approach is unlocking Upstart's ability to execute quickly and efficiently as a multi-product company. What's really exciting is that we're finding talent across the entire U.S. In fact, in Q4, more than two-thirds of our hires were made outside of our California and Ohio footprint. I cannot help but express my amazement for all the Upstart team accomplished in 2021, particularly given the circumstances under which they accomplished it. A sincere thank you to the entire Upstart team and also to the family and friends that support them. Now, I would like to move on to 2022 and how we're thinking about the year ahead. We find ourselves today in the strongest position Upstart has experienced to date, and it's our mission in 2022 to build on the many successes of the last year. At the beginning of each year, I'd like to clarify in my head and with the team the handful of objectives Upstart needs to achieve to make the year an unqualified success. Right at the top of the list for 2022 was achieving meaningful scale with auto lending on our platform. We believe in our core that AI lending isn't a one-category phenomenon but will eventually transform virtually all flavors of credit. I'm happy to tell you that just 1.5 months into the New Year, we've accomplished this goal. In fact, our auto refi funnel performance is now comparable to where our personal loan funnel was in 2019 on a channel-adjusted basis. Based on this progress, we now expect $1.5 billion in auto loan transactions on our platform in 2022. Just as importantly, we now have the confidence to invest the resources necessary to unleash the model and technology improvements in auto lending that made Upstart the category leader in personal lending. As I referenced earlier, this great leap forward was the product of an intense push by our auto team toward the end of Q4. There are many pieces and parts we needed to get right to enable a minimally efficient funnel, and the team worked night and day right up through the holidays to make it happen. It's worth stating that scaling the auto business from here is no simple task; more funnel and model improvements will be necessary, and distribution channels in auto refi aren't nearly as well established as they are in personal lending. But even though channel development will require significant time and effort, the good news is that we're confident we're in a class by ourselves. Upstart has a unique and proprietary auto refinance product with far less competition than we've had in personal lending. In truth, if you don't have a certain level of funnel efficiency in auto refi, you really don't have a product. Today, we're confident that automotive lending is a category we can grow into for years to come. We also continued to make rapid progress in the new product categories that I mentioned in our last earnings call: small dollar lending, small business lending, and mortgage. In each case, we've established a core team and are making real progress toward entering the market. In the case of small dollar and small business lending, we expect to have these products in market during 2022. In the case of mortgage lending, we hope to be in market in 2023. In each case, we anticipate a year or so of development, a year of feeding and testing, and then a year to begin scaling. A home run success for Upstart would amount to a new product in market and ready to scale in each of the next two or three years. Of course, it's very hard to time innovation, much less market adoption, but this is the pace we're aiming for. Overall, the categories we're in today or expect to enter represent an addressable market of more than $6 trillion in annual originations. Upstart is now about the size that Google was when I joined that company in early 2004. So I've seen this movie before and hope to use what I learned there to build Upstart into the most impactful fintech in the world. I have some specific personal goals for Upstart in 2022. First, to transition into a multi-product distributed company that can operate in parallel instead of in serial. Second, to break new ground in terms of quality of execution at the $1 billion-plus scale, with leaders such as Google, Amazon, and Apple as my North Star. And third, to move aggressively to unlock Upstart's addressable market while simultaneously upgrading our ability to pursue it. These challenges will keep our leadership team busy in 2022 and well beyond. Upstart is a unique company, both in terms of our technology and our business model. We don't exactly look like anybody else. And for this reason, we're often misunderstood. So in closing, I'd like to share a few thoughts about Upstart that have struck me in the last few months as useful ways to understand who we are and what we're building. First, Upstart is both a consumer Internet brand as well as a cloud software provider, delivering a deeply proprietary and technical product to our bank and credit union partners. This combination is entirely unique and is central to our competitive position today and in the future. Were it not for the AI models at the core of Upstart, we would have little unique value to offer our bank partners. And were it not for our consumer presence and scale, we would not control our destiny, and our AI models would not be learning as quickly as they are. This combination means we can dramatically strengthen the competitive position of banks who partner with us while simultaneously helping consumers find the very best credit product available for them. Second, choosing not to become a bank was the right decision for Upstart, and it's central to our world view. A very successful bank will serve a particular slice of America incredibly well, with a well-constructed portfolio of products, a trusted brand, durable relationships, and a predictable business model. We believe we can help forward-thinking banks succeed in their mission with better technology. We think of ourselves as a consumer Internet brand focused on personal finance. Unlike a bank, an Internet brand can seek to serve all Americans and eventually everyone in the world. This time with an incredible diversity of offerings from hundreds, if not thousands of partners, each of whom will benefit from leveraging Upstart AI. So in short, our goal is to become a technology partner to all the world's great financial institutions, and through those partnerships, to enable the broadest array of financial products at the best price and with the best experience to everybody. Finally, lending is a cyclical industry and always will be. Though Upstart is not a lender, we are a technology provider to this industry. So we expect our growth in transaction volumes to vary considerably from quarter to quarter. But at the same time, we represent a secular change that we believe is both inevitable and durable. Our core thesis is that over a period of years, AI lending will rapidly gain market share over legacy approaches to credit, and Upstart is in the pole position to benefit from that. In fact, economic volatility, such as we've seen in the last two years, only serves to demonstrate the value of a modern AI-enabled approach to credit origination. Thank you. And now I would like to turn it over to Sanjay, our Chief Financial Officer, to walk through our Q4 and full year 2021 financial results and guidance.

Thank you, Dave, and thanks to everyone for joining today. I hope everyone had an accretive Valentine's Day. Quickly running through our results, starting at the top of the P&L. Net revenues in Q4 came in at $305 million, up 252% year-over-year. Revenue from fees constituted $287 million of that amount, representing 94% of overall revenue and up 37% sequentially from last quarter. The majority of our sequential growth came from additional top-of-funnel rate requests, which grew at 29% Q-on-Q. The balance of growth was driven by higher funnel conversion rates, which were up 140 basis points or 6% relative Q-on-Q despite the significant expansion in final traffic. The volume of loan transactions across our platform in Q4 was approximately 495,000 loans, up 301% year-over-year and representing over 400,000 new borrowers. This increase in volume is distinguished by participation across a widening swath of borrower segments. At one end of the spectrum, attracting growing numbers of applicants meeting the traditional definition of prime, where we have historically not competed. At the other end, bringing more hidden prime borrowers into the lendable universe under the national bank rate cap, as partner banks increasingly eliminate hard eligibility criteria, leading our models free to perform their magic. Accordingly, we scaled our marketing program spend in Q4 by 19% Q-on-Q while simultaneously improving loan unit economics. Our contribution margin, a non-GAAP metric, which we define as revenue from fees minus variable costs for borrower acquisition, verification, and servicing, consequently improved through this expansion, rising from 46% in Q3 to 52% in Q4. Our improved contribution margins versus Q3 reflect refinements we've made to our digital and direct mail targeting models, take rate optimizations, improvements to life cycle marketing, which drove a higher proportion of low-cost loans, and shrinking operations unit costs as our automation rate recovered to 70%. Operating expenses in Q4 were $244 million, growing 22% sequentially over the prior quarter. Spend on engineering and product development once again led the way as our priority investment area growing 25% sequentially despite slower hiring than desired. Growth in general and administrative spend registered at 22% sequentially as operating leverage continues to improve. Expenses in sales and marketing and customer operations, as always, grew in proportion to revenue, albeit in Q4 at a rate of increasing economy of scale. Taken together, these components resulted in Q4 GAAP net income of $58.9 million, up 102% Q-on-Q and an adjusted EBITDA of $91 million, up 54% Q-on-Q. Adjusted earnings per share for Q4 was $0.89 based on a diluted weighted average share count of 98.8 million. On the full year scoreboard, we tallied $849 million in net revenue in 2021, which was a 264% growth clip over 2020, a contribution margin of 50%, up 400 basis points from the prior year, and adjusted EBITDA of $232 million, representing a 27% adjusted EBITDA margin versus 13% a year earlier. We ended the year with $1.2 billion in restricted and unrestricted cash, up from $311 million ending the prior year. Of the net increase, approximately $855 million was raised in the capital markets, $266 million was cash earned from operations net of loan transactions, and $170 million was reinvested back into our balance sheet in the form of loans made in support of new R&D programs. Consequently, our balance of loans, notes, and residuals at the end of the year was $261 million, up from $140 million in Q3 and reflecting the accelerated pace of R&D. Most notably, auto lending has been funded since inception entirely from our own balance sheet. This is, as always, a temporary incubation period until we reach the point where the loans can be directed to our bank partners and institutional investors at reasonable scale, which we anticipate will begin to happen next quarter. As we stare down the year ahead of us, we are cognizant of the fluidity in the macro environment. Over the past quarter, we have started to observe what we had long predicted: namely a reversal on the trajectory of default rates. Defaults have been at unnaturally suppressed levels for more than a year. As we have consistently messaged, the fading of stimulus should presumably lead to normalization in default rates. And as of November, we believe we are seeing that normalization. As we, along with our bank partners and investors, have been anticipating this shift and as the loans on our platform have been priced accordingly, we are not expecting any meaningful adverse impact from rising defaults on our volumes or economics. Note that this recent upturn in loan default is not to be confused with the longer-term secular vintage-over-vintage increase in absolute default profile on our platform, which has been alluded to in some public forums. This phenomenon is almost purely a function of a change in borrower mix, as our models expand the frontiers of approvability and pull more applicants into the lendable universe over time. Viewed in this context, rising absolute default rates that are correctly predicted and priced are not above but, in fact, a feature of our platform and a trend we expect to see continue as we successfully progress against our core corporate mission of expanding access to credit. A second macro topic relates to rising interest rates and inflation. Our view is that a moderate increase in rates will not have a meaningful impact on our business for two reasons. An increase in the Fed rate does not translate directly into a higher cost of funding for our bank partners, and to the extent it does, the floating rates on the credit cards that our loans are predominantly refinancing will move in tandem. This means that the savings that our borrower has realized, measured by the spread between our rates and the rates of the credit being refinanced, will remain reasonably constant. Any decrease in loan demand at the margin from borrowers reacting to higher nominal interest rates will be more than offset by the growing demand for credit in the broader economy as stimulus operates, as evidenced by recovering credit card balances. As we look to Q1, we highlight the seasonal contraction we have historically observed between Q4 and Q1, which we have traditionally associated with tax refund season. While such seasonality has been attenuated more recently in the wake of COVID and the associated stimulus, we are expecting a return to the negative sequential pattern here in 2022. With this as context, for Q1 of 2022, we are expecting revenues of $295 million to $305 million, representing a year-over-year growth rate of 148% at the midpoint; contribution margin of approximately 46%; net income of $18 million to $22 million; adjusted net income of $50 million to $52 million; adjusted EBITDA of $56 million to $58 million; and a diluted weighted average share count of approximately 95.9 million shares. For the full year 2022, we expect revenue of approximately $1.4 billion, representing a growth rate of approximately 65% from the prior year; contribution margin of approximately 45%; adjusted EBITDA of approximately 17%; and an auto loan transaction volume of approximately $1.5 billion. It is worth highlighting that the decrease in contribution and EBITDA margins we are guiding for 2022 relative to 2021 is intentional and controllable and largely a function of two levers. One, the speed of the ramp-up in auto lending, which will reduce our overall contribution margin by about 5 percentage points until it attains mature scale in operations and customer acquisition. And two, the objective of growing our technical workforce by around 150% this year, which we view to be the most lucrative reinvestment opportunity for our corporate profits. Obviously, either or both of these investment decisions remain at our discretion and are susceptible to being revisited should any changes in our financial trajectory warrant. Before I turn it over to Q&A, I want to highlight as a final note that we recently announced the authorization from our Board of Directors to repurchase up to $400 million of Upstart shares. With the volatility in the trading of our stock, we have seen what we believe to be attractive buying conditions at various times over the past year, and our profitability puts us in a position to be able to initiate this program and take advantage of those situations on behalf of our shareholders. Our thanks once again to all the talented Upstarters who are helping to build this company. And with that, Dave and I are now happy to open the call to any questions.

Thank you. We'll take our first question from Simon Clinch with Atlantic Equities.

Hi. Greeting from the UK. So first of all, congratulations on a very strong quarter. And I'm really interested in the economics of the auto business. I was wondering if you could perhaps walk us through sort of how the revenue model is going to work and how it perhaps differs or will differ in terms of the P&L impact as we roll it through from loan assumptions.

Yes. Hi, Simon, great to hear from you. So auto economics, I think, I would say we're not yet at the point where we're ready to give a precise view on the unit economics. For the simple reason that almost all of the loans to date have been staying on our balance sheet, so currently, we're earning net interest income off of those loans, which is obviously not our core model. At some point, those loans will start to make their way to banks and investors. As I said in the prior remarks, we anticipate that happening over the next quarter or so. And when that happens, we'll begin to pivot to a fee model that's more akin to our core business model, but that's still in front of us. And then on the cost side, consumer acquisition and operations are still things that are, I would call them, subscale. So we have targets for where we want them to get to, but not actual results yet. So taken all together, we don't have precise guidance for you. I guess, what I would say as a general statement is that the overall take rate that we earn over the life of an auto loan, we anticipate at scale to be in the same ballpark to what we earn on personal loans. I suspect less of it will be upfront on transaction and maybe more earned ratably over the life of the loan. But that's what we expect to grow into as we scale. But as I said, we're sort of not yet in that model where we can give you actual guidance yet.

Okay, great. I want to follow up on that regarding your rooftop expansion. Can you share the pace of your expansion and what your expectations are for this year? Also, what potential bottlenecks or challenges are you facing in rapidly increasing that?

Hey, Simon, this is Dave. Yes. I mean, it's not a specific number we're giving guidance on. I would say, generally, if you looked at the numbers, and you can see them in the investment deck, we did see acceleration in the fourth quarter, which is nice. We actually rebranded from Prodigy to Upstart Auto Retail in the third quarter. So it was nice to see that didn't cause any disruption. In fact, it was an acceleration in Q4. I think, generally, the biggest challenge for auto retail at the moment is the supply chain that car manufacturers and the auto industry overall are seeing, meaning it can be challenging to sell software to a dealership that helps them sell more cars when they don't have enough cars to sell in the first place. But despite that and the headwind that we're selling into, as you can see, we are expanding pretty rapidly. So our expectation is we'll see rapid acceleration of that over the year. Certainly, as supply chains sort of repair themselves and inventory levels on car dealerships, etc., begin to return to normal, we think that will be a tailwind that will just further accelerate. So we're really pleased with the progress, and we think we would expect to continue to accelerate adoption across rooftops through this year.

Okay, great. Well, thanks. Thanks, David. I’ll jump back in the queue. Thanks.

Thanks, Simon. Next question.

Thank you. Next, we'll take from Pete Christiansen with Citi.

Good evening, everyone. Thank you for the question. Impressive results. Dave, last quarter you mentioned expanding your credit targets in both prime and towards the lower end. How do you see your performance improving on the prime end where the cost of capital gives you a competitive advantage? Are you making progress in that area? Also, where do you see Upstart's competitive advantage?

Thank you for the question, Pete. We are making significant progress in the primary market, an area where we historically had limited presence. Our success has depended on partnering with banks that have deposit funding, which offers competitive costs for borrowers. The key to winning in any market segment lies in the combination of available funding costs and the quality of our model. As we delve deeper into the primary segment, funding costs become increasingly important, but our ability to enhance our model with a more efficient process—such as avoiding document requests and providing instant approvals—has also contributed to our success. Additionally, traditional marketing often lacks sufficient targeting, which necessitates being competitive across a wider credit spectrum. This broad approach enables us to engage in extensive marketing efforts. We're observing strong advancements in digital channels, which are not as targeted as others, and being competitive in the prime market is advantageous as it allows us to leverage these marketing channels effectively.

That's helpful. I'm considering your rate requests, which I find impressive, showing a 30% increase sequentially. It appears you are attracting more attention. Can you provide some details about the marketing strategies you’ve implemented to draw more users to the Upstart platform? Where are you noticing more success? Is this still primarily in the affiliate marketing channel, or are you observing more growth in direct marketing?

I would say it was generally very broad-based. We saw improvements across every channel and these were quite significant. Affiliate channels continue to grow, and as I mentioned, digital has been very successful. In the fourth quarter, we achieved unprecedented performance in direct mail, which has always been an important channel for us. There was also very fast growth in organic users, including a notable increase in repeat borrowers, as we are ramping up our life cycle marketing efforts. So, I don't think it was due to any single channel; it really was very broad-based, and we believe there's a lot of potential for growth in all these channels moving forward.

Great. Thank you. Great job.

Thanks, Pete. Next question.

We'll move on to Arvind Ramnani with Piper Sandler.

Hey – hi, thanks and thanks for posting another terrific quarter. Just a couple of questions on my end. Can you talk about some of the pricing dynamics with your partners? And given some of the normalization of consumer credit and sort of the impact you're going to see on the business?

Sure. We have set prices for our bank partners that they absorb. However, the return targets they expect from their loan portfolios and programs are determined by them. If they decide they need a higher return for any risk category, they can adjust that at any time, which will lead to higher prices for consumers. The over 40 banks and credit unions on our platform can make their own decisions based on these dynamics. They balance factors like profitability, risk, and volume to optimize their programs for their specific business needs. In summary, our bank pricing is not influenced by interest rates, but the prices consumers see on our platform are affected by the choices made by our bank partners in the market.

Terrific. And are you able to give us any color on sort of your kind of take rate, overall take rate as the year progressed? Just trying to figure out, like, has it been trending upwards or has it been kind of flat through the year?

Yes. Hey, Arvind, this is Sanjay. So take rates, I don't think there's maybe sort of one generalization we can say about the trend. They do go up and down as a function of other things. Mix is one example of things that will change the overall take rate on the platform. More generally, I guess I would say this like when our models get better, it can result in one of two things. On the one hand, rates can get lowered for the borrowers, and then volume increases. So that's sort of one outcome. And then there's another possibility, which is that the lower rates to borrowers are offset by higher take rates. And so our value manifests through a higher take rate. And which one of those to it is in any particular segment, sort of depends on how elastic the demand for our loan is. So if small changes in APRs can result in large changes in volume, then that's a great outcome for us. In some segments, our rates are getting to the point where they're already so much lower than the market that lowering them further doesn't really change the borrower's propensity to take the lump, and then so more of our value capture ends up materializing its take rate. And so depending on which segments are growing because each one has sort of a different elasticity profile, some can sort of result in value as their models improve through the volume, and others through take rate. It's a bit hard to sort of generalize the trend overall in the platform now.

Terrific. And if I could squeeze one last in. Certainly, on the EBITDA compression, you provided some color in your prepared remarks on ramp-up in auto and hiring in tech. But if you think of like first for 12 months from now, what do you think may drive kind of upside? I mean, certainly, you have to invest in auto and you're going to have to hire tech folks. But is there any levers you have in place that can drive some upside in EBITDA margins?

Yes, absolutely. If you consider the auto business, it will go through a cycle similar to that of the personal loan sector. In the beginning, you are developing acquisition strategies that aren't fully scaled, and your operations aren't optimized. In the early days of our personal loans, we experienced lower profitability. However, as that business grew, it began to positively impact our bottom line. We believe the auto sector will follow a similar trajectory, potentially at a quicker pace because we are familiar with the process. Currently, as we begin to achieve significant volume, our customer acquisition costs are less efficient than in personal lending, and our operational costs are also not as streamlined. However, these will improve over time. As our models enhance and the conversion rates increase, we expect the developments seen in our personal loan business to also occur in the auto business. Thus, while in 2022 it may slightly dilute our contribution margins, we anticipate that at scale and maturity, it will achieve a profitability profile comparable to our core business today. We are essentially incubating new businesses. As Dave noted, there is a timeline of 6 to 12 months for new business development, which will undergo an investment cycle. As more of our portfolio matures and turns into profitable segments, we believe the overall model's profitability will naturally trend towards a higher equilibrium than we see currently.

Terrific. Thank you very much. I’ll just hop back in the queue.

Thanks, Arvind. Next question?

Thank you. We'll take our next question from Ramsey El-Assal with Barclays.

Hi. Thanks so much for taking my question this evening. I was wondering if you could share your early thoughts on the distribution strategy for the new products you'll be rolling out. Obviously, Prodigy really helps with auto. But should we also expect to see Credit Karma or other large distribution partners sort of playing a role in auto and also in these other new categories?

Hey, Ramsey, this is Dave. I think each of the products are very different in the nature of the channel development, I think, we'll be pretty unique to them. So we will certainly use the relationships and the expertise we have. For example, small business, there's no doubt that, in our view, direct mail will be important to that. And we have what we would consider to be pretty exceptional skills in direct mail. There are some affiliate-type partners or aggregators in small business, probably not at the scale that some of them are in personal lending. And likewise, in auto, auto clearly, direct mail is a great channel. It's already proving to be the first channel that's really taking off for us in auto. And there are some aggregators, but again, not as much a single point scale as we see elsewhere. So they're all different. But I think in almost every case, the channels that we have some footprint in today in personal lending will be meaningful probably with different weightings, if you will. And I think we'll see a lot more diversity. And probably as important as anything is as we add subsequent channels, being able to cross-sell is going to be really important to us as well, and that becomes quite accretive to us. So it's a different sort of again, varies a lot by product. We love the partners that we have and would love to work with them on more products as we bring them to market and definitely anticipate doing that.

I appreciate your insights, especially considering it's early in the process. I wanted to ask about the share repurchase authorization. It's not common to see a company in such a strong growth phase engage in this kind of capital allocation. How should we understand this decision? Does it indicate that you believe the share price is undervalued and want to communicate that to the market? Or does it suggest a reduced likelihood of pursuing other capital allocation strategies, such as mergers and acquisitions?

Thank you for the question, Ramsey. We still have plenty on our agenda, and we're experiencing rapid growth along with significant hiring. This decision isn’t about capital structuring; it reflects economic opportunism. Two unique factors are at play here. First, the volatility of our stock has been evident over the past year, which we believe has led to it being undervalued based on our insights into the business and our growth prospects. Second, we are profitable, allowing us to leverage this conviction for the benefit of our shareholders. While we will remain attentive to stock volatility, our actions stem from this context rather than a primary focus on returning capital to shareholders. It's more about seizing opportunities presented by stock volatility alongside our existing business model profitability.

Great. That’s super helpful. Thanks so much.

Thank you, Ramsey.

Thank you. Next, we'll move on to Andrew Boone with JMP Securities.

Hi, guys. Thanks for taking my questions. I wanted to go first to default rates. So Sanjay, I think you talked about it being a feature, not a bug. But can you just give us a little bit more detail? Can you provide any incremental just pieces of data that give us more confidence there, talk about cohorts or anything else to just give us a little bit more confidence?

Thank you, Andrew. I was trying to highlight a difference between two often conflated concepts. One is that with each new vintage from our platforms, the delinquency default rate increases, which is evident in our securitizations. However, I want to emphasize that this isn't necessarily negative. It's occurring because we're broadening our approval criteria for borrowers over time. Initially, we were conservative with limited data, but as we gather more data and adjust our risk parameters, it's natural for average delinquencies to rise mathematically. As long as we accurately predict and price the loans, we believe this is actually a positive development. In fact, I see this as a significant representation of our success in creating corporate value as a platform. We're expanding our approval range while starting from a more cautious standpoint. On another note, when we look at delinquency rates by vintage, it's true that each vintage has a higher delinquency than the one before it, but every individual data point is still lower than our original expectations. This observation applies consistently across all vintages, and we believe it's influenced by economic stimulus. We've consistently communicated our expectation for these rates to revert eventually to where we initially predicted. Since October or November, we've noticed each vintage trend is now returning to our anticipated levels. This situation appears to be a more localized phenomenon rather than a long-term trend. As we transition, it’s essential to avoid assuming that this temporary abnormality is the new norm, so the upcoming normalization shouldn't come as a surprise. This shift we've observed since late October or November isn't part of a continual increase in the default profile, which is often discussed publicly, making clarification worthwhile.

Great. That's helpful. And then my second question is just on the $1.5 billion auto goal. Can you just help us understand the potential upside as well as downside like where would that be higher? And why might that be lower as we think about that goal for 2022? Thank you.

Sure. Well, look, obviously, it's early in the year, and we have sort of achieved lift-off, if you will, with auto. So that's why we feel comfortable presenting that number. But we have a long way to go, and it certainly depends on us continuing to make progress through the year. So there are certainly scenarios where it could be better than that and some where we would be less than that. And that's our best view as to what we have sitting here in February. But just like in the personal loan world, for us, it comes down to our models improving as quickly as possible us for moving friction, us getting better at finding distribution channels and acquisition channels, getting better at cross-selling. So there's probably seven or eight key inputs to that formula of how good does that business look come December. And certainly, it is one of the most central areas of focus for the company in 2022. And I guess, we're just sharing that, we have enough confidence to put a real number out there, a meaningful number, and we're going to go to work and take that business as far as we can this year. But we're optimistic and we're just really excited because there's a certain threshold you cross where it becomes real and viable, and there was a time when we really needed 50%, 100% improvements to the funnel in order to really have this thing start to scale. And now we've done that, and we can sort of get to the place where we can get much smaller wins one at a time to really grow from here. And that feels like what personal loans felt like just a couple of years ago. In fact, one of the points we made is that our auto funnel today looks much like what the personal loan funnel looked like in 2019. And that obviously was the beginning of a lot of growth. So that's what gives us some confidence in that market.

No. Thank you, guys.

Thank you.

Thank you. And next, we move on to Mike Ng with Goldman Sachs.

Hey. Good afternoon. Thanks for the question. I just have two. First, I was just wondering if I could follow up on the margin commentary. Could we expect Upstart to get back to 2021 margins in 2023, or what does that visibility look like? And when you talk about hiring the technical workforce, could you just provide a little bit more color on what the key areas of investment there are? Is that simply a doubling of this engineering and product expense? And then second, I was wondering if you could just comment on whether you're seeing any changes in institutional investor loan demand? And could you just remind us how reliant you guys are on the securitization markets? And have you seen any changes there? Thank you.

Yes, this is Sanjay. To address your first question about whether we might revert to our current margin structure in 2023, it's a bit challenging to predict how far out we can see regarding our upcoming investments. However, I believe there is no fundamental reason our business shouldn't return to its existing profile over time and potentially even exceed it. The pace at which we incubate and invest in new businesses will significantly influence this. This year, we are particularly focused on the auto sector, which I expect will start positively impacting our bottom line by 2023 rather than reducing our margins. While it might have a different margin profile regarding cash flow timing, it should remain within a similar range. As we venture into new markets, such as small business lending, small dollar lending, and potentially home or mortgage lending in 2023, each will carry unique margin profiles and require varying investment cycles. Overall, this strategy represents a portfolio investment approach. We've learned how to lead these new businesses to profitability based on our experience with our core operations. Therefore, I believe our success in incubating new ventures and reaching profitability will improve over time, allowing us to meet or possibly exceed our current profitability as we scale multiple businesses. Regarding our goals for technical hiring in the coming year, we aim to recruit a diverse range of talent, including computer scientists, data scientists, machine learning engineers, and product managers. These roles are crucial for refining our models, expanding into new areas, and strengthening our core business. They are working on transforming our platform from a single product to a multiproduct format and restructuring our code base into a suite of microservices. They are also building out various consoles to support small dollar, business, and mortgage lending initiatives. While this effort is broad, we believe there is a direct correlation between the technical work being done and our business's bottom line, as this work is fundamental to the value we provide. Lastly, regarding our reliance on institutional investors and the securitization markets, I view this somewhat differently. The overall supply chain of money is crucial to us, involving banks using their balance sheets to fund originated loans and excess volume being financed by institutional investors. Our reliance comes into play when we surpass the balance sheet capacity of our banking footprint, relying on loan buyers as forward flow buyers, who absorb much of the capacity we generate. The securitization markets are more indirect for us since the loan buyers themselves securitize the loans. We play a role in facilitating the deals that investors contribute to but do not engage directly with securitization. Each investor's liquidity needs from these markets can vary; however, I believe a significant number are content to purchase loans and earn yields without needing immediate liquidity from the ABS market. Consequently, our reliance on securitization markets is less directly relevant.

Great. Thanks for all the color, Sanjay. Very helpful.

Okay. Thank you.

Thank you. Next, we'll move on to James Faucette with Morgan Stanley.

Thanks very much. I wanted to ask a related question: as we've seen the normalization of the lending markets and borrowing markets, etc. Can you talk a little bit about what your sense of your bank partners, etc. are right now to continue to increase the size of their loan books and what you think, generally speaking, is the appetite to do so this year?

Sure, James. I don't think we're seeing any specific trend at the moment. We're still in the early stages, as we're onboarding new lenders to the platform, most of whom are in growth mode. Some may be at what they consider their peak or optimal run rate. Last year, there was an unprecedented demand for loans due to a surplus of deposits and a shortage of loans in the banking sector, which has calmed down. There appears to be a growing belief that this situation is improving, which might affect demand. However, it's difficult to determine any clear trend right now. Our main focus is on increasing bank capacity, which should enhance the consumer experience on the platform, and we feel optimistic about this aspect for the year. In summary, we are still in the early stages and do not foresee a decline in bank demand on our platform; rather, we expect it to continue growing.

Good. My other question is about the performance of your underwriting in the normalizing market. What are you using as a benchmark, and how quickly can you make adjustments when necessary? We often receive inquiries about how Upstart loans compare to other underwriting methods, especially in a changing environment.

Yes, what sets us apart is that we have two distinct functions that operate independently. The machine learning team focuses solely on model accuracy, aiming to avoid underestimating or overestimating defaults or prepayments. Their primary goal is to enhance model accuracy continuously. On the other hand, the business side is responsible for onboarding more banks and investors, essentially fueling the operation. These banks determine the returns they require based on market conditions and their alternatives for deploying their assets. If banks seek higher returns on loans facilitated through the Upstart platform, they can opt for that. This creates a marketplace dynamic where decisions about return, risk, and volume are made by our bank partners. The essential role of Upstart is to ensure our risk models are as accurate as possible, adapting swiftly to shifts in the economy. This task becomes more challenging during rapid changes, as was evident two years ago with the onset of COVID and in the recent months as stimulus measures have decreased and we return to a more typical environment. Ultimately, what consumers experience in terms of pricing results from the interplay of these factors.

That’s really great color. Thanks a lot.

You bet.

Thank you. And next, we move on to John Hecht with Jefferies.

Good afternoon. Thank you for taking my questions. My first inquiry is regarding the auto segment. Can you provide insights on origination activity so far, how many loans are currently on your balance sheet, the expected distribution of the $1.5 billion throughout the year, and the mix between indirect and refinancing loans?

Hey, John, this is Sanjay. I'll address the first question. Auto loans on our balance sheet constitute a significant portion, being the largest category of new loans we are currently researching and developing. Regarding the $1.5 billion over time, we’re not specifying the split between refinancing and retail, except to note that refinancing is already operational, while the retail program is still in early development. We can't project what that final split will be by the end of the year, but it is likely to be more evident in the first half. The initial surge we’re experiencing gives us confidence in our projections, primarily due to the strong pipeline supporting the refinancing business. As for the timeline, we’re not providing near-term numbers, but we believe we’re on a run rate that offers us a reasonable level of confidence for growth as the year progresses.

Thanks, Dave. Last quarter, you mentioned that different segments of the market are crowded at various times of the year. Based on your models, you managed to identify opportunities in other areas. As we start 2022 and you have set your goals, are there specific opportunities we should be aware of that could lead to shifts in your focus throughout the year?

Well, I'd say, in the personal lending category, we're pushing really across almost all parts of the credit spectrum, as I think we said in the last earnings call. And I think that will continue. We are definitely bringing on more banks that really trend toward the primary end of the spectrum and will make us more competitive there, and we would anticipate that will keep going. At the same time, the core mission of the company is to make affordable credit available to everybody, and that means kind of continues to expand the perimeter of people that we can bring within the sort of national bank level. So that effort is continuing as well, including the small dollar product, which is really going to help us move that part of the market even faster, I think. As well as the Spanish product, which is still nascent for us, but I think is showing promise as way to just bring more people in the fold. So it's really hard to say where that will go on balance. The personal lending product, we're really in a strong position today and can continue to push on all parts of that market. And then, of course, the newer products, I think the great thing that we're excited about is we are really comfortable now we have kind of crossed the chasm, if you will, on auto. We feel confident when building that product. And the important thing about that is, the second one, at least in our view, is much harder than the ones that come after that. So proving that our models and our technologies and our skills and our teams can kind of adapt to a second very different product just gives us that much more confidence as we get into small dollars, small business. And eventually, a lot of people want to hear about the mortgage market. We just think that we're building the skills and the confidence you've got to move to the subsequent products. Also building credibility with bank partners, with capital markets, investors, etc., that are necessary to make progress in those categories as well.

Great. Thanks very much.

Thank you. And we will take Nat Schindler with Bank of America.

Thank you for taking my questions. I have two quick inquiries. First, could you explain why contribution margins are projected to decline from the Q4 levels? It appears they are expected to drop from 52% to 46%, and then to 45% for the full year. I would appreciate any details on this.

Hey, Nat, it's Sanjay. It's primarily due to two factors. First, during significant revenue surges like we experienced in Q4, we often exceed our contribution margin expectations because we base our spending on projected revenues for that quarter. Thus, the Q4 figure may be somewhat inflated. More importantly, as we move into Q1 and 2022, our auto business is beginning to scale up, which currently has a much lower contribution margin. This is due to three main reasons. First, while we are putting auto loans on the balance sheet, there is no fee revenue generated during this time. Contribution margin relies on fee revenue, and right now, as we originate these loans, we are only receiving interest income, leading to a lack of fee revenue for some time. Additionally, once we start seeing fee revenues, they may be earned differently over the life of the loan compared to personal loans, which generate revenue based on transactions. The revenue profile will therefore differ. Furthermore, the unit costs to originate auto loans are not yet at scale compared to personal lending. While our customer acquisition costs for personal loans are efficient, in auto lending, they are still being developed, and we are enhancing our processes. As Dave mentioned, we're not yet performing at the level of efficiency we reached in 2019. Our operational costs are also not at scale yet, as we have been preparing to rapidly grow this business, ensuring we have a safety margin. When we reach scale in personal lending, our operations will be more efficient and finely tuned. Consequently, as our auto volume increases, it will negatively impact the overall contribution margin. Roughly speaking, we anticipate that while the personal loan business could maintain a contribution margin close to 50%, the scaling of auto lending could reduce the full year figures by about 5%.

Makes sense. Regarding a different topic about auto, there has been significant appreciation in the used car market over the past 18 months. It appears to be the highest appreciating category I've observed in the last year. This has resulted in substantial gains on auto loans, as the risk associated with these loans has diminished. Essentially, if a car is repossessed, it can be sold for more than the loan balance. What will happen if this trend normalizes? There is a belief that stimulus contributed to this price increase. If that stimulus is removed and price appreciation declines, how will that impact auto loans over the next year or 18 months compared to the last 18?

Well, I don't think the recent trend of used cars increasing in value is sustainable. Many of us were advised to spend as little as possible on a used car because they typically depreciate. We are currently in a unique situation, and this is not reflected in our model, which does not assume that used car prices will continue to rise. It’s safe to say that our projections do not account for the unusual market conditions relating to auto pricing for either new or used cars. Therefore, we do not expect this situation to have a significant impact on us.

If there's any mean reversion though and prices actually go down to go back to renormalize, not that this will happen. But if it does happen, does that make the loan more risky? And just if the price goes up faster, is the loans less risky, if the price comes back fast, shouldn't the loans be much riskier?

Yes. Hey, Nat. Another way to express it is that we’re in a new normal situation regarding defaults in general lending, but we’re not fooling ourselves into thinking this is the new standard, and we’re not pricing our loans based on that assumption. In other words, the auto loans we are currently issuing might be performing better than expected because we are not incorporating assumptions that match the current reality. What’s happening now is that values are being inflated. If things do return to normal, our returns would likely revert to what you would anticipate in a typical market. Therefore, we aren’t factoring the current situation into our pricing strategy.

Okay. Great. Thanks, guys.

Thanks, Nat.

Thank you. That does conclude today's question-and-answer session. I'd like to turn the conference back over to Dave Girouard for any additional or closing remarks.

All right. Just going to wrap it up. Thanks, everybody. We're really happy with how 2021 turned out. And obviously, we're feeling pretty bullish and optimistic about 2022. So thanks for listening today. Thanks for all who have stuck with us through all this market turmoil, and we're looking forward to a great year. And we will be in touch with you all very soon.

Thank you. That does conclude today's teleconference. We do appreciate your participation. You may now disconnect.