Upstart Holdings, Inc. Q2 FY2022 Earnings Call

Good day, and welcome to the Upstart Q2 2022 Earnings Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Jason Schmidt, Head of Investor Relations. Please go ahead, sir.

Good afternoon, and thank you for joining us on today’s conference call to discuss Upstart’s second quarter 2022 financial results. With us on today’s call 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 second quarter 2022 financial results and published an Investor Relations presentation and credit FAQ. All are available on our Investor Relations website. During the call, we will make forward-looking statements, such as guidance for the third quarter of 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 as of 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. 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. Later this quarter, Upstart will be participating in the Goldman Sachs Communacopia + Technology Conference on September 13 and the Piper Sandler Growth Frontiers Conference on September 14. 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 second quarter 2022 results. I’m Dave Girouard, Co-Founder and CEO of Upstart. Today, we reported a decline in revenues, which is obviously disappointing and unacceptable to us. I want to explain where this decline came from and what we’re doing to address it. It may be natural for you to question whether Upstart’s AI-powered risk models aren’t working as designed, but we’re confident this isn’t the case. In fact, our models continue to improve with respect to accuracy and risk separation, but there’s no getting around the fact that a decline in revenues is a business problem that we need to address. And today we’ll share with you the actions we’re taking to address it. Today, Sanjay and I will discuss a variety of topics, including credit performance, loan funding, lending partners' sentiment, and some of the actions we’re taking right now to make sure Upstart’s future is bright. I also want to share with you the progress we’ve made in many important aspects of our business and how they’re setting the stage once again for Upstart’s growth in the future. I don’t want to spend too much time restating what you’ve already heard about the current economic climate. Given the nature of our product and our borrower, we do, however, have a unique lens into what’s transpired in the last two plus years and what may transpire in the coming months and years. We believe we’re at the end of a unique economic cycle related to the pandemic that included two distinct phases. The first phase was triggered by pandemic-constrained consumer spending and unprecedented government stimulus throughout 2020 and early 2021. These together drove significant improvements in consumer savings levels and liquidity, which in turn led to a dramatic overperformance of credit during this phase. Our platform experienced about a 50% reduction in credit defaults compared to the pre-COVID timeframe. The second phase, toward the end of 2021 and into 2022, began to unwind as stimulus was discontinued, and consumers began to travel, dine out, and spend once again. As expected, default rates returned to pre-COVID levels or in some cases even higher. While virtually all consumers benefited financially from reduced spending during the early stages of the pandemic, this cycle was concentrated in consumers who received government stimulus checks—a demographic that is also more likely to be Upstart borrowers. Our risk models largely captured these effects and performed admirably, though not perfectly throughout. I’ll get to that in a bit. We believe we’re now at the end of the two-phase cycle, and an important question for all of us is, what’s next? Will efforts to slow inflation lead to recession and unemployment? While no one knows the future, we do expect a significant slowing of the economy and a worse-than-normal macro environment for the next year and beyond. We’ll speak to that as well. Our job through all of this is to ensure the future of our platform and to protect Upstart’s ability to pursue our mission for years to come. Alongside our earnings release, we today shared some responses to important questions regarding credit performance on Upstart’s platform. It goes without saying that measuring credit performance is vital, and it’s also non-trivial. Comparing one platform to another can be challenging—different products, different borrowers, different return targets, months on book, prepayments, hardship policies, and more. There’s no simple apples-to-apples comparison. We believe the essential measurement for credit performance is actual dollar returns compared to the lenders or institutional investors' targets at the time of origination, full stop. Today we provided this information for all Upstart cohorts, going back to the beginning of 2018. The bottom line is this: our 70 plus bank and credit union partners, who typically retain loans in the lower risk grades appropriate to their businesses, have seen portfolios consistently meet or exceed expectations since the program began in 2018. However, institutional loan buyers, in comparison to the target of approximately 8% gross return since Q1 2018, have seen 12 quarterly vintages overperform with five expected to underperform. It’s important to highlight that a loan buyer who invested equally across all cohorts since Q1 2018 would have experienced a positive return on all vintages thus far with an overall 9.8% gross annualized return. This compares to a return of less than 3% in the U.S. high yield bond index over that same period. Lastly, we believe it’s not reasonable to expect above-target loan performance irrespective of the economic cycle. It’s fundamentally important to separate the impact of macro conditions from imperfections in a credit model. The essential litmus test for model performance is separation between high and low risk borrowers. As demonstrated in the loss rate by grade and AUC metrics we shared today, our model is positively differentiated in this respect and it continues to improve. In an effort to deliver unparalleled transparency and analytics, we will provide this detailed information to each of our lenders and loan buyers. Today, we’re in a funding-constrained environment, which is the primary cause of our revenue shortfall. I want to share some thoughts on this situation and actions we’re taking to address it. First, as we have said recently, our goal is to operate as a marketplace for credit over the long run. We want loan transactions to take place when they make sense for the borrower and the lender. Certainly, lending is a category that would be expected to experience some volatility over time due to macroeconomic factors. However, in the last few months, lenders and institutional credit investors reacted more quickly and abruptly than we anticipated. Despite the fact that our bank partners have seen consistently strong credit performance, with portfolios performing at or above plan across quarterly cohorts, several of them have paused or reduced originations due to fear about the future of the economy. To be clear, these lenders and institutional investors have not left Upstart’s platform, but have temporarily paused or reduced their originations. As we shared in our credit performance FAQ today, we believe our models are well calibrated to the current economic environment and in fact include a generous accommodation for a recession over the next 18 months to 24 months. Given funding constraints, we believe the opportunity for lenders to generate strong returns on Upstart is unusually high right now. Yet, the reaction of lenders is often binary in nature, more so than we would have anticipated. As a result, we've concluded that we need to upgrade and improve the funding side of our marketplace by bringing a significant amount of committed capital on board from partners who will invest consistently through cycles. We're currently evaluating a variety of opportunities to do just that. We expect this will take some time to bring to fruition. Furthermore, while we continue to believe that it doesn't make sense for Upstart to become a bank, we've decided that it may make sense to at times leverage our own balance sheet as a transitional bridge to this committed funding. I acknowledge that this is a shift relative to what we planned and communicated earlier this year, but a changing and volatile environment suggests we need to be flexible and responsive in our approach. We're taking this step for a few reasons. First, there's an obvious information asymmetry where we understand better than anyone how our model is performing today and how well it's calibrated for the current economic environment. Secondly, we believe the opportunity to generate outsized profits on our platform is unusually high right now. And third, we can bring a level of stability to our business, which is important to our longer-term goals while we work to put these committed capital structures in place. Sanjay will share more about this in his remarks shortly. I want to also highlight that we're building a business that can survive and thrive under a variety of market conditions to make sure we achieve these ambitious long-term goals. Our fixed costs are low and our gross margins are strong, so we can continue to invest in our roadmap and in our future through a variety of macro environments. We continue to make rapid progress in the newer parts of our business, and we're optimistic that this progress is setting up the next stage of growth for Upstart, which I'm sure you're all looking forward to. First, we continue to add new lenders to our marketplace with a total of 71 banks and credit unions as of today, up from 57 when we last spoke to you in May. Despite the cautionary outlook in the financial services industry, forward-thinking banks and credit unions continue to choose Upstart. We now have 640 dealerships using Upstart Auto Retail software. Just a few weeks ago, industry analysts declared Upstart the nation's fastest growing auto retail software provider in the second quarter. Subaru and VW were the latest OEMs to announce support for Upstart Auto Retail, joining Toyota, Lexus, Mitsubishi, and Kia, as well as top franchise dealers from 37 brands, including Ford, Honda, and BMW. We also expanded our auto retail lending product out to 29 dealerships and saw the first $10 million in retail loan originations in the second quarter. In the last couple of weeks, we merged our machine learning model for automated income verification, originally developed for our personal loan product, into our auto retail lending flow. We expect this improvement to more than double the percentage of applicants for whom we can automatically verify their income. I'm also pleased to announce that we quietly launched our small business loan product at the end of June, well ahead of schedule. We've already seen more than 40 small business loans originated, totaling more than $1 million in principal in just a few weeks. That team is quickly ironing out operational issues with an eye toward rapidly expanding this product in the coming months and years. Lastly, the small dollar loan team launched support for Spanish-speaking applicants, another giant step towards serving those left out of the country's mainstream financial system. Some of you have questioned whether Upstart veered too quickly into lending to riskier borrowers in 2021 in order to grow in our post-IPO phase. But I believe we have done exactly what we set out to do and what we said we would do. Upstart's mission has been to leverage modern technology and data science to improve access to affordable credit. There are tens of millions of Americans who deserve access to reasonably priced credit from our nation's banking system, yet are denied access through no fault of their own. We're unique among our FinTech peers in that we aim to tackle this problem directly. The terms non-prime, near-prime, and subprime are words the industry invented to describe people that our current systems don't understand. The truth is that the vast majority of these Americans are entirely creditworthy. Upstart's mission is to identify those borrowers and provide them with access to affordable credit, and we haven't wavered from that challenge. How does growth fit in? We approach our business as a waterfall of priorities in a way analogous to structured credit. Upstart's highest priority, our A bond if you will, is credit quality. Our goal is to reliably deliver the return the lender or investor expects for a specific allocation of risk. Our B bond, our next highest priority, is unit economics or gross profits. We don't strive for loan transactions that lose money for Upstart and generally speak to avoid them. Finally, whatever is left over goes to platform transaction growth, our residual, so to speak. In truth, growth isn't a specific target for us. It's a plug based on our waterfall of priorities. The reasons for this ordering are clear: without strong credit performance and solid unit economics, growth over the long term would be unsustainable. To close, I want to acknowledge that we've experienced some setbacks in our business. But our fundamental economic engine is strong. Our risk models are better than ever, and I'm confident that we'll be on the growth path again soon. We're taking decisive action to bring committed capital to Upstart, and to those who say that we should focus on the traditionally prime market, I say that there are plenty of others focused on that. Improving access to credit for all Americans is too important to go ignored, and Upstart has the right stuff to get it done. Thank you. And now I would like to turn it over to Sanjay, our Chief Financial Officer, to walk through our Q2 financial results and guidance.

Thank you, Dave. And thanks to everyone for joining. The environment we're operating in has continued to evolve rapidly since our previous call. Industry data shows a general rise in delinquencies across all segments of unsecured credit, disproportionately impacting the higher risk tiers that constitute a significant component of our borrower base. The impact of this dynamic on the credit performance of Upstart loans can be seen in the supplemental credit performance information that was released today, together with our investor materials. The macro uncertainty and the impact of economic stress on consumer delinquencies have led to a decrease in available funding for loans on our platform, which has become the operating constraint of the business. While today's results are in line with the preliminary numbers we pre-announced on July 7th, I will quickly call out the key financial headlines. On the top line, origination volumes and revenue from fees were both down from last quarter and below our internal expectations, driven primarily by funding constraints in the capital markets. While profitability was also below guidance, we began to systematically improve unit economics in the second half of the quarter and pivoted to optimizing for in-quarter cash flow generation, which will carry over into our third quarter contribution margins. Following our recent share repurchase authorization, we have repurchased approximately 4.4 million shares of Upstart totaling $150 million in repurchases. Additionally, we sold a meaningful amount of the loan assets from our balance sheet in Q2 to fortify our cash position. With these dynamics in mind, here is a more detailed summary of our numbers. Net revenues in Q2 came in at $228 million, up 18% year-over-year. Revenue from fees constituted $258 million of that amount, representing 113% of overall revenue and up 38% year-over-year but down sequentially by 18%. Net interest income was a negative component of net revenue this quarter as we entered into multiple loan sale transactions, some of which incurred a negative fair value impact, and as the valuation marks of our remaining loans continue to be negatively impacted by the rising interest rate environment. The volume of loan transactions across our platform in Q2 was approximately 321,000 loans, up 12% year-over-year and representing over 233,000 new borrowers. Average loan size was up 5% over last quarter, largely owing to auto loans, representing a higher proportion of the mix. Our contribution margin, a non-GAAP metric which we define as revenue from fees minus variable costs for borrower acquisition, verification, and servicing, was flat sequentially at 47%, and 200 basis points ahead of guidance. Without the inclusion of the fledgling auto loan volume, our contribution margin for core personal lending would have risen to 51%. As we optimize our fees and marketing spend for lower near-term volumes, we expect that unit economics will continue to show meaningful sequential improvement. Operating expenses were $260 million in Q2, down 5% sequentially. We reduced our sales and marketing by 21% sequentially as we downsize our marketing campaigns to reflect our constrained funding supply. Engineering and product development grew 14% sequentially and remains our priority area of investment. Although by the end of the quarter, we had slowed down hiring significantly and concentrated most of the remaining hires into key technical roles. Growth in general and administrative spend grew 8% sequentially. Taken together, these components resulted in Q2 GAAP net income of negative $29.9 million. Adjusted EBITDA of $5.5 million contracted 91% Q-on-Q. Adjusted earnings per share for Q2 was $0.01 based on a diluted weighted average share count of 93.3 million. We ended the quarter with $790 million in unrestricted cash, mildly up from $758 million in Q1. Our balance of loans at the end of the quarter was $624 million, of which $484 million represented R&D loans principally in the auto segment, while our balance of core personal loans at $140 million was only marginally down from Q1. We did sell a significant number of the loans that had accumulated on our balance sheet prior to our earnings call in May. Earlier today, we published some key data regarding the credit performance of Upstart loans. Just to recap, a couple of the key points: our models continue to provide around five times the amount of risk separation than a credit score, and the statistical accuracy of our models continues to improve; this has not changed. Most vintages from 2021 will underperform their return targets. This volatility comes on the heels of vintages significantly overperforming targets for 12 consecutive quarters. Despite this latest volatility, an investor who invested equally across all Upstart cohorts would expect a 9.8% unlevered gross annualized return. Notwithstanding the performance of the credit, we must confront the fact that the largely uncommitted nature of our third-party funding has proven inadequate to the task of navigating the market turbulence. We have turned our efforts towards building a more resilient funding model over time. Despite not having suffered any adverse loan performance, some banks are moving to limit their overall exposure to unsecured lending. Investors who’ve earned significant excess returns during the benign cycle of the past few years are now anxious over the state of the economy and wary of the future prospects of less affluent borrowers who have been the most impacted by the termination of the stimulus. Despite significant conservatism in our current underwriting and the prospect of historically high returns, investors have been reluctant to reenter the fray. Consequently, our intention is to significantly increase the fraction of forward-committed capital deployed on our platform through partnerships with investors that are comfortable investing through cycles with an eye toward longer-term outcomes and in exchange for predictable future access to yield. As Dave has said, this will not happen overnight. In the interim, we are prepared to be more proactive with our own balance sheet operations if we deem it necessary to provide a level of stability for the business in this transitional period, as well as to demonstrate our own confidence in the models to the funding markets. Please note that this does not represent a change in permanent strategy, and we continue to maintain the view that it is not in our long-term interest to run a large balance sheet or to become a bank. However, in the context of the current extenuating circumstances, we will be flexible in determining whether a temporary change in tactics around balance sheet usage would be in the best interest of supporting the business through to its next state. Given the volatility of the current funding environment and the difficulty in forecasting the timing of changing macro sentiment, we feel it is prudent to limit our guidance for now to the coming quarter and withdraw prior full-year guidance. With that, for Q3 of 2022, we are expecting revenues of approximately $170 million representing a year-over-year contraction of 26%, contribution margin of approximately 59%, net income of approximately negative $42 million, adjusted net income of approximately negative $9 million, adjusted EBITDA of approximately zero, and a diluted weighted average share count of approximately 85.5 million shares. Our gratitude and admiration once again to all the folks at Upstart who are remaining resilient through the choppy waters that we are currently navigating as a company and who remain as focused and with as much conviction as ever about the purpose and opportunity before us. With that, Dave and I are now happy to open the call to any questions. Operator, back to you.

Thank you. We will go first to Simon Clinch with Atlantic Equities.

Hi everyone. Thanks for taking my question. I was wondering, Dave or Sanjay, if you could talk a little bit more about how you actually go about refocusing your institutional buyer investor base to sort of longer-term investors and I guess, how long that might take and a sense of the steps that you need to take to achieve that goal?

Hi there. Sure. This is Dave, I’ll give a quick answer and then Sanjay may want to chime in. So essentially, the nature of our agreements today by and large are at-will agreements with the volume that any particular entity is originating or purchasing being decided on a month-by-month basis. We’re talking about instead about structures where there’s committed funding over a significant period of time, many, many months or even years. And really that’s, in return some form for access to yield over that period of time, in some form of economics that make sense for those entities. We don’t have more specifics just to share other than, certainly, I think a lot of marketplace businesses in many different types of industries take actions to secure their inventory on their platforms one way or another. and we’ve decided this is just necessary for us. And so we’re beginning the steps toward taking that done.

Yes, I’ll just add, Dave, that this is Sanjay. I think that we’ve demonstrated, and we’ll be able to demonstrate certainly as we go through this cycle, pretty attractive long-term yields for anyone who’s willing to hold and invest through cycles, and Dave cited some of those numbers, and we’ve got some of those in the releases we’ve provided. So I think there’s a class of capital provider out there for whom access to that would be attractive. Those arrangements will take a while to put into place. Predominantly, what we have today are capital providers who are vintage-by-vintage, and in some sense may depend on either leverage or liquidity for ABS markets, which creates more volatility. Now that we have some proof points which demonstrate what yield looks like through a cycle, we will use that to enter into negotiations and arrangements with partners that are more akin to wanting predictable stability in terms of access to yield. All we really have to share at this time is that, as Dave said, this isn’t going to happen overnight; they’re pretty complex relationships. But I think we’re all very convicted that this is the direction that will provide stability for our platform to get to the next level of volume.

Okay. All right. That’s useful. And just as a follow-up, Dave, I think in your opening comments, you mentioned your views that we’re heading for significant slowdown in the near-term recession in the next few months. I was just wondering if you could expand on your thoughts there and what you’re seeing that gives you that much bleaker outlook compared to others?

Yes, sure. It’s Dave, I wouldn’t say that it’s my outlook per se. I’m definitely not a macro forecaster, and Upstart does not try to hold within it skills, kind of a crystal ball about the next phases in the economy. What I was trying to state though, is that we try to build in what you would think of as some form of market consensus window where the market thinks the economy’s going to go with a degree of conservatism sufficient for banks and investors, and credit unions, et cetera to feel comfortable on the platform. So, we necessarily take what you might consider a conservative viewpoint on them, only because it’s a good starting point for those who are on the platform with capital at risk. It doesn’t necessarily mean it’s my personal outlook or Upstart’s personal outlook, or really, it’s just trying to reflect a reasonable and a conservative take on where the economy could be in the next couple of years.

Great. Thanks. I’ll jump back in the queue.

And we’ll go next to Mike Ng of Goldman Sachs.

Hey, good afternoon. Thank you very much for the question. I just have two. First, could you talk a little bit more about the fee revenue as a percentage of originations? It was quite strong in the quarter. I was just wondering if there were any specific drivers that led to that increase, whether those are price increases or the loan mix? Then second just on the guidance for the third quarter for $170 million of revenue, could you just talk a little about the mix between fee revenue and net interest income and any notable points around fair value adjustments?

Sure, Michael, this is Sanjay. On the first question regarding take rates, I presume that when you say strength, you’re talking about fee revenue. Yes, I mean, I think it’s as simple as, and I think we’ve signaled this in the past. We’ve typically been optimizing for not in-term cash production but sort of long-term volume in how we price. Our take rates have generally been at a level where, we are able to produce more volume, which leads to model acceleration and learning, and leads to future value in terms of repeat loans. In a situation like we’re in today, where we are funding constrained and we’re much more focused on in-quarter cash generation, we’ve set our fees at a more optimal level, if you will. And that has the effect of creating a more resilient in-quarter P&L. So, I’d say that’s just an artifact of how we’re managing the business through the choppiness that we’re experiencing in the market. The second question really was around the guidance and fair value in particular. Most of our revenue is an expression of transaction volume and fee revenue. There is still some downside in terms of fair value. We disclosed in our investor material the size of the balance sheet we’re holding, which is pretty much on par with last quarter. To the extent there’s more interest rate exposure, if the rates continue to rise, those will necessarily depress asset values and create some fair value exposure, but we’re not making large assumptions one way or the other about macro variables. We’re really just trying to express the direction of transaction volume and the consequence of your revenue.

Great. Thank you for the thoughts, Sanjay. That’s very helpful.

Thank you, Michael.

And we’ll go next to Andrew Boone with JMP Securities.

Hi guys. Thanks so much for taking my questions. As we think about moving more loans onto the balance sheet, can you help us understand the guardrails that you’re thinking about? I understand it’s still early here, but how do we think about just what’s the potential for using the balance sheet? And then as you talked about lenders and just the attractiveness of yields that are available right now, can you talk about how you’re educating your partners to be able to step back in? How can you proactively have them come back? Thanks so much.

Hey, Andrew, this is Dave. On balance sheet usage, I would just say, first of all, we will most certainly be prudent in usage of our cash in any way. As Sanjay said earlier, it is not our intention to become a large balance sheet lender whatsoever. Our long-term strategy hasn’t changed. We aren’t becoming a bank, but certainly we see ourselves in a transitional phase where we are recognizing the need for permanent or more committed capital on the platform. As a bridge to that, we want to have the freedom to do the right things at the right time to get from here to there. It doesn’t really change our overall philosophy, nor do we think it’s great at this time to have sort of a litmus test of not using our balance sheet whatsoever with a lot of cash in our balance sheet. We want to use it to the advantage of the business over the long haul. But for sure, we’re a company that has always been very much capital efficient as a private company. What we raised was very modest compared to others, how we've used it. We’ve been profitable most of our time as a public company. I think we have the genetics of the company that likes to be cash efficient, and we certainly will do nothing to put our operational capacity at risk or our business at risk with our balance sheet irrespective of whether or not we choose to use some of it within the marketplace. Did you have anything to add to that, Sanjay?

Yes, I mean, I guess, Andrew, I’ll just reiterate. It’s still our intention in the long term to be a platform that seeks third-party capital. We don’t want to be in the business of being a balance sheet lender. Now, as you’ve seen, we’re signaling a contraction in our guidance. We recognize that we need less low funding, more committed funding to get us through to that point. What we’re expressing is not so much an intention as flexibility in making that transition. But as Dave said, we’ve always been very, very careful stewards of the capital that are on our balance sheet. We’ve always run a very lean company. This is really more about just making sure we have what’s necessary for the stability of the model in order to make that transition.

Thank you.

We’ll go next to Ramsey El-Assal with Barclays.

Hi, thanks so much for taking my question this evening. Can you give us some color on what you’re seeing most recently in the business quarter to date in July?

Yes, hey, Ramsey, this Sanjay. Are you referring to any particular aspect of the business? Or are you asking about the financials, the volume, the credit performance or so general sort of both?

It was quite general.

Okay. I think the best expression of what we’re seeing to date in the business is reflected in our guidance, if you will. So, I think that we’ve signaled there’s a continuing contraction on the top line, which is evident to anyone. That’s probably the headline for what we’re managing through right now.

Would you characterize that as having gone down, and you’re seeing some stability in performance at this point? Or is it still something where you have relatively limited visibility as trends are sort of unstable and still on the move?

When you say performance trends, are you referring to credit performance or?

I am referring to credit performance but also, I guess, all in addition, perhaps like the demand environment.

I don’t think there’s too much to comment on with respect to the demand environment outside of what we’re signaling with guidance. That’s probably the best reflection we have of it. With respect to credit trends, I would say this, the macro environment remains very fluid obviously. It's something that I think is changing month by month. I’d characterize that as continuing liquidity. With respect to how our model is consuming and predicting the future, I think there’s been significant recalibrations in our model since the beginning of this year. So, when you look at how the loans are performing against how they’re being priced, I think there are pretty big changes starting as recently as January or February. Due to that, the model has recalibrated to where the macro is.

Got it, Sanjay. Thank you very much.

Okay.

And we’ll move on to our next question from Pete Christiansen with Citi.

Good afternoon. Thanks for the question. I have two. Dave, as it relates to the relationship with the CFPB, can you just walk through some of the changes have been there? I know that a bunch of nuances, but if you can give your take of how that relationship is moving?

Sure. Thanks, Pete. I’ll take the first question. I’ll let Sanjay handle the second one. We continue to have what we consider to be a great relationship with the CFPB. We’ve had that relationship since the very early days of the company through three different administrations. We have a lot of history with them. We consider it constructive. We’ve always been very transparent and forthright with them. As many know, we had a form of a no-action letter agreement that started way back in 2017 and renewed in 2022. A few months back, we requested to terminate it early, really in the sense that it was mission accomplished; it had done what we had hoped in terms of getting a lot of feedback from the CFPB on how to properly test for fairness in a sort of modern lending model. We’ve built—in the years we built a very sophisticated form of testing that we do on behalf of all our bank partners. We have continued a strong relationship with CFPB, that structure of no-action letters, et cetera, is something the CFPB internally decided they wanted to move away from. I think that’s okay by us, as we said; we felt in the early days of our existence, and before we had really refined how to do fairness testing right, it was very useful. But today, we continue to believe we have state-of-the-art fairness testing. We do this reliably on behalf of all our lending partners, and we do continue to have open communication with the CFPB and expect to do so in the future.

Hey, Pete, this is Sanjay. To your second question, there’s no explicit assumptions we’re making with respect to ABS issuance in our guidance. We continue to issue regularly; obviously, the execution in the market right now is quite volatile. But we don’t have an explicit assumption on what that looks like or dependency on it.

Okay. Thanks, gentlemen. I’ll get back in the queue.

Thanks, Pete.

And we will go next to Arvind Ramnani with Piper Sandler.

Hi, thanks for taking my question. Yes, just a couple of questions. As you’re deciding to use your own balance sheet or use your banking partners for some of your loans, what are some of the trigger points you will use to kind of make that determination?

Hey, Arvind, this is Dave. Let’s just say we don’t have specific trigger points per se. We want to really have this flexibility. I think being able to transition from one state of our funding supply to another is important, and we want to make sure it goes smoothly with some confidence in getting from here to there in a way that’s not disruptive to our partners, to our employees, to anything else. So, we don’t have any definitive trigger points other than we absolutely intend to be cautious and prudent with the use of our cash. We are confident that there are profits available on our platform today, so for that sort of basic reason, it makes sense for us to do so. But it isn’t our goal to build a giant balance sheet and it’s certainly not our intention over time to switch toward that form of a business. We do believe it makes most sense for us to have some flexibility in how we navigate through the unique economic time that we are sitting in today.

Yes, that’s helpful. And is that something that you will communicate to investors as you look to expand the balance sheet? Or is it going to be part of regular scheduled earnings calls?

Hey, Arvind, this is Sanjay. I think it’ll be a component of our regular communications with the market. I don’t foresee anything that’s so extraordinary that would require interim communication, but if there is, we’ll certainly make it. Just as an aside, I don’t know if you’ve seen it, but we are sort of breaking out the balance sheet and the exact components of it in our investor materials now.

Yes, I did see that. And then just one of the things that you talked about certainly was how you continue to see the models better equipped to price loans. I know in prior earnings calls you’ve talked about some banks referring to using Upstart versus a FICO score. But are you using similar validation through your partners that may ease up the funding sources in terms of really validating that your models are better to price loans and to shift volume your way?

Well, Arvind, one of the things that we’ve made clear is that the 70 plus banks and credit unions who tend to originate and hold the primary end of the credit have all done really well through all cycles, performing at or above expectations. So, I don’t think we necessarily need any more than that. Some of them have stated publicly, and we can see it in the data, which we’ve shared. But a lot of the issue out there really is about what may happen in the next year or two years, and everybody has the right to have a different opinion about that and take actions based on that opinion. So that’s part of the challenges, it’s about the future—not about exactly what’s gone on in the last year or two years. And in that sense, that’s why we have said we want to move toward investor relationships that have a long-term approach, a through-cycle approach toward investing, and that will be, in the end, lead to a much stronger platform for Upstart.

Yes, great. Terrific. Thank you very much.

Thank you.

We’ll go for our next question from Vincent Caintic with Stephens.

Thanks for taking my questions. I have two. First question so on the balance sheet usage. So, I appreciate your comments on that. If you could talk about your balance sheet strength, so you’ve got over $900 million in cash, and if you were to leverage that conservatively, maybe you could do $2 billion to $3 billion of loan originations to support the business in the interim. If you could maybe talk about some of the guardrails or how you’re thinking about the balance sheet usage? Relatedly, I think you spoke about in a prior press release about selling some of the loans that were on the balance sheet. If you could talk about how that performed, I see there’s still about $600 million this quarter; how did that go? What was the par value?

Hey Vince, this is Sanjay. Just to put some parameters around our balance sheet, that’s correct. We have around $900 million in restricted and unrestricted cash. I would say we have about probably $400 million of loan equity on the balance sheet, and about $600 million of assets. So, maybe $200 million of that is financed. We do not have an intention of getting into large amounts of financed loans; I don’t think it would be anything approaching that. I think it would be much more modest, especially in this environment where it’s not readily available at reasonable prices. I think of our loan balance sheet flexibility as being denoted in values of maybe a couple of $100 million. With respect to loan transactions, I would say the main force of gravity on those is what’s going on with rates in the environment as you’re transacting, and most of the transactions we’ve had have been older vintages, those that have accumulated maybe in Q1 of this year. With rising interest rates, it has led to executing below par, and we indicated that that has created some of the negative fair value pressure in our P&L. It’s really a function of the more seasoned loans that have just been impacted by the industry environment this year.

Okay. Thank you for that. I appreciate it. And one question just following up on guidance; if you could talk about the $170 million in revenues, what’s the cadence of that? Are you seeing an improving performance as we go through the quarter? On the contribution margin, I’m calculating 59%, which is a nice expansion. I’m just wondering what would be driving that? Maybe less marketing expense or more efficiency, if you could just talk about that?

Sure. Yes. I guess in terms of the guidance, we’re not really telegraphing any directionality. I would say things are volatile right now, and that’s more of a level than a trend. With respect to the contribution margins, yes, as we referenced earlier, when we are in a period of contraction like this, we optimize for in-quarter cash generation. Candidly, it’s one of the important economic characteristics of the business; we can weather roughly 50% contraction between the forward guidance and what we did in Q1, and yet we can still guide to breakeven EBITDA. The reason is because we have considerable control over our ability to set fees. We tend to be more elastic and below optimal fee levels in normal times. We can raise them to buffer volume contractions. As you said, when we have less funding availability, our marketing programs tend to keep the more efficient ones and discard the more experimental ones. So, as a result, our take rates go up, our acquisition costs tend to go down, and it creates a margin expansion around the volume contraction. It allows us to be somewhat resilient as a business model.

Okay. Very helpful. Thanks very much.

And we’ll go next to James Faucette with Morgan Stanley.

Thank you very much. And thanks for all the detail in the supplemental information. I’m wondering when we look at your expected returns on the quarter, is that you’re showing that you expect a pretty significant improvement on the cohort from Q1 2022 versus Q3 and Q4, even though the total or the target gross return is similar or even a little bit lower. Can you talk a little bit about the changes that were made for Q1 2022 and that are driving your expected return higher versus what was being done in the second half of last year?

Yes, hey James, this is Sanjay. Sure. The simple version is, you're seeing the model recalibrating to the changing environment. In particular, I think starting by Q3 of 2021, the delinquency trends in the industry started to rise, disproportionately impacting less affluent borrowers. Our models observed that and reacted to it, changing pricing as that is happening. Because that trend sort of happened between Q3 of 2021 and early this year, maybe call it Q1 or Q2 of this year, our model has reacted to that, adjusting and recalibrating. On top of that, we do what you might think of as a manual overlay, estimating what we think the future macro holds because that’s not in the training data for our machines. In addition to the model recalibrating to loss trends, we are making more conservative forward predictions over what the macro will do. We are now at a point where our macro accommodation is fairly conservative in terms of what we’re expecting to happen.

Got it. And then when you talk about looking to add committed capital and expanding that range of partnerships and agreements, what’s your expectation for what that’s going to do on cost of capital? And if there is an impact, what you would need to do around fees, just trying to figure out what you may have to give up in order to achieve that longer, better or stickier capital?

Yes, it’s a great question, James. I would say that, on the one hand, it will notionally certainly make capital on the margin more expensive in good times, but maybe on the margin less expensive in times like now because they’re investing through the full cycle. The other variable is that, as we talked about in some of the other questions, we are quite margin rich. We can trade off economics in good times for economics in the choppier periods in the next economic cycle, such that the investor as a whole, and we’re creating more stability for the platform. We view our margins to be a lever we can use to ensure that the investors are stable and that the platform is stable, and that the borrowers are getting some amount of stability. Improving access to credit is crucial.

Great. Thank you.

We’ll go next to Nat Schindler of Bank of America.

Yes. Hi guys. A lot of my questions have been asked already. But one thing I wanted to go over, two things. One, you said you're heading into lenders and you have now a cross-cycle vision of your performance. Are we really cross-cycle? Are you modeling that this is the bottom and we’ve turned the corner on kind of the low-end consumer that is contrary to what most of our economists are saying at this point? I want to just understand what you mean and whether or not you think that these delinquencies are going to get worse from here or better. Lastly, I’m a little confused on the back and forth of the balance sheet—no balance sheet, using the balance sheet, not using the balance sheet. One, why this oscillation? And two, how much do you really think that you were ever going to get to on their balance sheet? Originally, you were saying you were going to be only about 5%, and that’s for experimental purposes. I think in Q1 you got up to 15, and you said you would go down from there, and while that was experimental with auto anyways. You’re saying you’re going to go onto the balance sheet again. What’s the kind of level that makes sense? One final question: Who are these investors that you haven’t talked to? Who are you going out to kind of increase your supply? Are they people that don’t do personal loans? Are they people that are new to this market? Who is out there that you are trying to evangelize the product to on the supply side? Thanks.

Hey Nat, it’s Sanjay. I’ll take the first question. Then Dave and I will rotate on the last two. The first question was about, do we really think we’re past the bottom of the cycle? I think in a short word, no. But I’ll just give you an overview on a couple of nuances. First, I do think that what’s happened to date, while in aggregate, there’s a view that it hasn’t been too bad, I think the picture differs in a more nuanced way depending on where you are in the credit spectrum. If you look at the industry data, if you’re an affluent borrower, you’re up mildly; you’re up 30% and you’re still below pre-COVID numbers. If you’re on the less affluent side of the spectrum, you’re up much more than that and you’re well past where you were pre-COVID. The timing of all this is a little bit different. I think that the less affluent side of the spectrum peaked a little bit sooner and has come up a little bit sooner. The second component is we’ve largely cut up to, and we’re making significant conservative assumptions about the future. We expect further degradation in loss trends. However, compared to mid-2021 when everything was rosy and everyone still had a lot of stimulus, and delinquencies were still like 50% of long-term normal, we are projecting it and preparing for it. There is still a world in which these vintages underperform going forward, but it would require a very significant economic setback in our view. As for the back and forth on balance sheet usage, let me say, Dave, do you want to chime in on that?

Yes, sure. Nat, I just say as a company I founded—co-founded 10-plus years ago, being nimble, thoughtful, and responsive has made us successful. We see ourselves as a marketplace business that brings lenders and investors together with consumers on the other side. However, we came to the conclusion that having a sort of litmus test, that thou shalt not use the balance sheet at all, doesn’t make sense, especially when you see reactions to the supply side happen in ways that are contrary to facts to us. Meaning credit is generally performing well, yet for various reasons outside of our control, lenders or investors take certain decisions. So we believe it’s proven to use our balance sheet wisely. We don’t intend to become a large balance sheet lender, but we want to do the right things for the business and not have an ironclad witness test that limits the balance sheet's usage in the marketplace. Regarding what kind of level we think makes sense, we have not defined a specific trigger. We want flexibility. It’s about taking what opportunities present themselves and navigating through a unique economic time.

In terms of who we are going out to, we’re engaging with a variety of investors. Some are entirely new to the personal lending space, while others are existing institutional lenders and credit unions who are now focusing on utilizing their resources on more stable opportunities. We’re working to better communicate the benefits of partnering with Upstart for access to credit that improves the lives of many who find it difficult to get financing otherwise.

Got it. Thank you.

We will go next to David Chiaverini with Wedbush Securities.

Hi, thanks for taking the questions. The first question is on take rate. It makes sense to increase the take rate in this environment. I was curious how high should we expect the take rate to go over the next couple of quarters?

Yes, hi, David, it’s Sanjay. I think we’re putting this as given the guidance we’ve put out for Q3; you might imagine that we’re doing all we can to ensure that our P&L remains resilient.

Got it. And then somewhat similar question on originations for the third quarter. Zooming out back to the second quarter, are you able to share what the June origination number was and how that compares to July?

Yes, we’re not breaking out specific months, David. I would just say that the trend right now is volatile, so there’s no real directionality in our numbers with respect to June versus July.

Got it. And then quickly on the buyback. Can you talk about your appetite from here?

Sure. As you know, we have board authorization to go up to $400 million, of which we’ve used $150 million. It’s sort of an ongoing equation between where the price is versus what we think is fair value and, of course, what other sources and uses of cash we might have. We’re always looking for opportunities, whether it’s buying back the stock or reducing dilution or looking at some of the convertibles in the market. We think can have lucrative returns right now, so we’re monitoring that on an ongoing basis.

Thanks very much.

Thank you, David. And now I will turn the call over to Dave Girouard for any additional or closing remarks.

Thanks all for being with us today. Sanjay and I just want to make clear we’re not happy with our results. We’re not a company that likes to have a declining revenue from one quarter to the next, but we feel we’re doing the right things to make the company as strong and as powerful as it can be in the future. We are as committed as ever to the mission of improving access to credit for those who deserve it. We’re making steps to make the company stronger and better, and we do anticipate we’ll be back on a growth track. We appreciate all of you sticking with us through this, and we’re going to get back to work at making Upstart the great company that it is. Ladies and gentlemen, this concludes today’s call. Thank you for your participation. You may now disconnect.