Upstart Holdings, Inc. Q3 FY2022 Earnings Call

Good day and welcome to the Upstart Third Quarter 2022 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Jason Schmidt, Vice President of Investor Relations. Please go ahead, sir.

Good afternoon and thank you for joining us on today's conference call to discuss Upstart's third 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 third quarter 2022 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 fourth quarter of 2022 related to our business and our plans to extend 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 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 Citi's 2022 FinTech Conference on November 15 and Wedbush's Disruptive Finance Conference, December 2. 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 third quarter 2022 results. I'm Dave Girouard, Co-Founder and CEO of Upstart. Our results in Q3 were certainly not what we wanted them to be, but I also believe they reflect the Upstart team making the right decisions in a very challenging economic environment for the long-term success of the company. Our revenue is down primarily because loan volume in our platform is down and secondarily, because credit markets are extremely cautious and even dislocated. Higher interest rates and significantly elevated risk in the economy means we're approving about 40% fewer applicants than we would have a year ago. And those approved today are seeing offers about 800 basis points higher than they would have a year ago. This accounts for the vast majority of the reduction in volume. Many of our lending partners have reduced their originations, raised their rates or both. This is generally out of an abundance of caution with respect to the economy that their Upstart-powered loan portfolios have met or exceeded expectations since the program began in 2018. But I want to be clear, contraction in lending volume in a time of rising rates and elevated consumer risk is a feature of our platform, not a bug. In fact, it's required in order to generate the returns lenders and investors expect. Whether due to an increase in expected loss rates, caution on the part of lenders or higher yield demanded by credit investors, higher interest rates and reduced volumes means that as unhappy as we are with the numbers, the system is working as intended. We're eyes wide open to the challenges of the current macro economy and determined to make the decisions that will optimize for the long-term success of Upstart. At the simplest level, we're improving our operational efficiency in the near-term so that we can continue to maximize investment in our AI platform for the long term. First and foremost, we're continually calibrating our risk models to the market. Performance of credit is and always will be our highest priority. While we don't make predictions about the future, we've chosen to take a conservative position with respect to the direction of the economy in the coming quarters. In other words, we assume the worst is in front of us. We'll be pleasantly surprised if this turns out not to be the case. Second, we're strengthening our unit economics both by increasing our revenue per loan as well as reducing marketing spend in our most expensive acquisition channels. And third, we're carefully managing our operational and fiscal plans to make sure that we're in a strong corporate footing for as long as this cycle lasts. In recognition of the reduction in loan volume in our platform, we unfortunately eliminated approximately 140 hourly positions within our loan operations team, representing about 7% of our workforce. This was disappointing for sure, but necessary to keep our operational capacity in line with the current environment. No other teams at Upstart were affected. We're also limiting hiring in other functions to a small number of positions that are strategic to our business. With a healthy balance sheet, robust unit economics and strong pricing power, we believe we're well positioned to navigate an extended period of economic uncertainty while continuing to invest strategically in future growth. Despite these challenges, I'm very optimistic about Upstart's future. There's broad recognition among technology leaders and industry pundits that AI is perhaps the most transformational technology of our time, and risk-based industries such as lending are at the forefront of this incredible opportunity. As the leader in AI-enabled lending, we are well positioned to capitalize on these growing trends and believe that market volatility will only strengthen our position and differentiation over time. While we dislike a weakened economy as much as you do, the increase in default rates that accompany this weakness serve to train our AI models faster. While other platforms continue to retreat to serving super-prime consumers, Upstart is rapidly learning how to price and serve mainstream Americans in all market conditions. Beyond my conviction in AI and the impact it can have in lending, my optimism also stems from seeing the rapid progress made by each of our product and machine learning teams. Some of the areas where we're making fast progress include, first, model accuracy. Our AI models have never been more accurate relative to a traditional FICO-based model, and our pace of model development has increased significantly. To be more specific, the increase in Upstart's model accuracy in the last four months is as much as we saw in the prior two years. Second, macro reporting and responsiveness. An important goal for Upstart is to help lenders understand the direction our economy is trending in order to make more informed decisions about their lending programs. To support this goal, we have developed and are beginning to productize the Upstart Macro Index, or UMI. This index is a monthly indication of the state of the economy, specifically with regard to consumer financial health and credit performance. At the simplest level, UMI is designed to estimate the level of default to expect in a time period, holding underwriting models and borrowers constant. What's even more interesting is that we have determined that a handful of common economic variables present in the Dodd-Frank stress test can estimate UMI with a high degree of accuracy. We continue to iterate our methodology with the intention of translating widely available forecast of macro indicators into an expectation for future levels of default. We believe this is the first time that commonly understood and broadly forecasted economic indicators can predict credit performance and are looking forward to sharing more with you as we refine this tool. Our goal is to be the fastest platform to respond to macro changes and to provide the most relevant and up-to-date information to our lenders, and UMI is a big step in that direction. Third, automation. In the third quarter, we saw a record 75% of loans fully automated. This came from a variety of efforts, including an experiment to help applicants enter information more accurately that led to an absolute 1.8% lift in instant approvals. Fourth, auto refinance. This quarter saw three significant improvements to our auto refi product. We launched a new model to more accurately identify loan payoff amounts. We fine-tuned our income verification models. And finally, we improved the process of reviewing registration cards. These upgrades collectively led to a 20% improvement to our auto refi conversion funnel. Fifth, auto retail. In Q3, we shipped our largest software release of the year, including a new build and price feature, which allows consumers to build, configure and price autos that the dealer doesn't yet have on the lot. Our software is in more than 700 dealers now. We've also turned on retail lending with three more dealer groups and are now in four states, representing 25% of the U.S. auto market by population. And more than one in three auto loan applications were automatically verified, about double the prior quarter. Sixth, small-dollar loans. This team shipped too many improvements to name, but in Q3, we saw more than 9,000 small-dollar loans on our platform, almost 4x the prior quarter. And all these loans were to borrowers who otherwise would have been declined. Smaller and shorter-term loans are critical to reach more consumers and to help our AI models learn as quickly as possible. So we're very excited about this progress. And seventh, small business loans. I told you last quarter that we had reached our first $1 million in SMB loans. Well now, we're close to $10 million in loans originated, and the team is rapidly shipping improvements as we look to refine that product. While the financial impact of these upgrades to our products is muted in the current environment, we're confident that they'll set us up for a giant leap forward once the economy and credit markets normalize. Finally, while there's no shortage of caution among banks and credit unions, I'm also happy to report that we deployed a record 17 new lenders onto our platform in Q3, including Alliant Credit Union, which is a top 10 credit union by asset size. This compares to 17 lenders launched in all of 2021. While these lenders are starting up cautiously, it's encouraging that we're planting seeds for funding capacity in our future. As of today, we have 83 lenders under contract on the Upstart platform. Before I wrap up, I want to say again, we're not pleased with the results we shared with you today. But when interest rates are rising and the economy is in flux, lenders and credit investors naturally become cautious. Despite this caution, our lenders will tell you that the performance of the Upstart-powered credit has met or exceeded expectations over time. We don't like volatility any more than you do, but we won't allow it to set us off course from our long-term goal to reinvent how credit works. Our goal is to become the destination with the best rates and the best process for all forms of credit for everyone. This can't and won't be done by a single bank, but it can be done by a vast network of banks, credit unions and credit investors powered by a modern cloud-based AI platform. Great companies separate themselves from merely good ones during the hardest of times. They are clear-eyed about how the environment has changed. They make smart and fast decisions in order to ride out the turbulence, but they also retain an optimistic focus on the horizon as they continue to invest in the future. You have my full commitment to ensure Upstart is exactly that type of company. Thank you. And I would like to turn it over to Sanjay, our Chief Financial Officer, to walk through our Q3 financial results and guidance.

Thanks, Dave, and thanks to all for joining us today. As Dave has alluded to, the external environment continues to be a challenging one, particularly for those less affluent borrowers with limited access to credit that are at the core of Upstart's mission. Consumers have simultaneously whittled personal savings rates from pre-pandemic levels of roughly 9% down to 3.3% in Q3, a level not seen since the great financial crisis, and have swapped credit card balances to all-time record highs. Savings rates have dwindled, and credit card balances have inflated to pay for what has been a continuing expansion in real consumption, so far with no corresponding increase in either real wages or labor force participation since the advent of COVID. As a consequence, defaults are on the rise. Industry-wide data shows that less affluent borrowers are leading the way with impairment levels on unsecured personal loans that are about twice as high as they were prior to the onset of COVID. By way of comparison, highly affluent borrowers are now roughly back to being in line with pre-COVID impairment levels, although they continue to be on the rise. The Upstart Macro Index previously referenced by Dave is our internal way of articulating the impact of the external macro environment on loan defaults in our particular borrower portfolio by controlling for underwriting model changes and shifting borrower characteristics over time. The most recent index level of around 1.7 tells us that Q3 environment produced 70% more defaults than we would expect from our borrower base in a long-run normal macro environment. This number is also approximately 20% higher than what we had observed when we last reported earnings in August. As a result of our model's adjustments to these changing macroeconomic conditions, our loans today are being priced at APRs that are significantly higher than those from the beginning of the year, which is one of the principal driving factors behind the overall volume contraction our business is currently experiencing. As David said, this is, in fact, working as intended. On the loan funding side, a brief period of late summer optimism in the ABS market has since receded, and loan funding in general remains challenging. Overall financing costs for our securitization investors are up about 500 basis points since last year. These higher financing costs and the general scarcity of available capital has contributed to the volume pressure on the business. With the preceding context, here now are some of the financial highlights from the past quarter. On the top line, revenue from fees of $179 million was largely in line with our expectations. However, negative fair value adjustments and losses on sale incurred by the loans on our balance sheet brought overall net revenue down to $157 million, short of our guidance and representing a 31% contraction both sequentially and year-over-year. The volume of loan transactions across our platform in Q3 was approximately 188,000 loans, down 48% year-over-year and representing over 125,000 new borrowers. Average loan size was up 14% versus last year. Our contribution margin, a non-GAAP metric, which we define as revenue from fees minus variable costs or borrower acquisition, verification and servicing, came in at 54% in Q3, up from 47% last quarter but still behind our guidance. We have been successful in expanding our margins through higher take rates and more efficient marketing spend, and we expect this to continue in Q4. Operating expenses were $215 million in Q3, down 17% sequentially. We reduced our sales and marketing by 46% sequentially to reflect a weakened conversion funnel, which has declined as a result of our higher offer rates. Engineering and product development grew 16% sequentially, and general administrative spend grew 2% sequentially. Across both areas, hiring has now largely been limited to only a few key strategic positions. Taken together, these components resulted in a Q3 GAAP net income of negative $56.2 million. Adjusted EBITDA was negative $14.4 million, and adjusted earnings per share was negative $0.24 based on a diluted weighted average share count of 81.7 million. We continue to be in a favorable liquidity position with $830 million of total cash and $431 million in net loan equity on our balance sheet. Our gross balance of loan assets at the end of the quarter was $700 million, up $76 million from last quarter. Of that total, loans made for the purposes of R&D represented $451 million, principally within the auto segment, and our balance of core personal loans stood at $249 million. The near-term outlook for our business remains tied to the direction of the macro economy. And while this has historically proven hard to predict, we are currently pricing our loans expecting a further degradation in the environment and in our macro index. The volume assumptions underpinning our revenue and earnings guidance are consistent with this outlook. In order to provide some additional insight into revenue, we are splitting out our top-line guidance between revenue from fees, which reflect our baseline volume and fee expectations; and net interest income, which includes impacts from fair value and gain on sale. With these specifics in mind, for Q4 of 2022, we will expect revenues of between $125 million and $145 million. Within that, we expect revenue from fees of approximately $160 million and net interest income of approximately negative $25 million; contribution margin of approximately 54%; net income of approximately negative $87 million; adjusted net income of approximately negative $40 million; adjusted EBITDA of approximately negative $35 million; and a diluted weighted average share count of approximately 89.3 million shares. As ever, we will take this opportunity to extend our gratitude to all of the employees at Upstart who continue to make daily progress against our underlying business and technology goals in what continues to be a challenging external environment around us all. And with that, Dave and I are now happy to open the call to any questions.

We will take our first question from David Scharf with JMP Securities. Please go ahead.

Great. Thanks for taking my questions today. Dave or I guess for Sanjay as well, I wanted to maybe ask a little bit of a longer-term strategic question as it relates to structure. Obviously, funding environment is going to go through dislocations here or there and ultimately resolve themselves. But I guess in terms of the structure of the business, I know last quarter, you talked about seeking some more kind of longer-term partners. And reflecting on some of your all-digital lending peers, there seem to be a lot of different ways to skin the cat in your industry. LendingClub went out and got a bank charter. Pega's gone for pre-funding securitizations in investment vehicles exclusively. LendingPoint, they've always kind of opted for a 60-40 mix between loan retention and securitization. Obviously, as you noted, the macro environment is going to shift, and ultimately, will emerge on the other side. But in terms of strategically thinking about the types of dislocations that are happening right now, is it different longer-term funding structure something the company evaluates every now and then?

Hi, this is Dave. That's a good question. We constantly think about funding on our platform. However, we fundamentally believe that a marketplace structure, where many lenders make independent decisions over time, will result in the best outcomes. Market-based economies have historically proven to be more efficient than centrally planned ones. Therefore, we do not want to operate as a centrally planned economy, and we don't think becoming a bank aligns with our goals for numerous reasons. That said, we can improve our ability to secure funding on our platform. This can be achieved through strategies like establishing longer-term funding agreements and diversifying our product offerings with secured products such as auto loans and mortgages. It’s something we need to focus on and put more effort into. Overall, we believe that a marketplace with many participants on both sides will ultimately achieve the greatest scale and opportunity. While we face volatility today, we are confident that this approach will lead to the best outcomes for Upstart in the long run.

I appreciate the insights, Dave. As a follow-up, I'd like to delve deeper into funding. As Sanjay mentioned, the ABS markets are quite volatile. However, despite wider spreads, we've seen several non-prime deals completed recently, including Inova, Opportune, and Regional Management. While spreads are still wider, investors are still showing interest in the unsecured personal loan non-prime asset class. Can you provide any further updates based on your discussions with existing bond investors or when you anticipate returning to the market?

Yes, David, this is Sanjay. As you said, it's volatile. We remain in the market. We completed a couple of deals in Q3, and we're going to be back in the market in Q4. Our cadence is generally every sort of two to three months or so, and I think we've been holding to that cadence. So like you said, cost of funds, spreads are all pretty volatile, and they will sort of dictate the economics in any given deal. But there's always deals to be done or at least until now, there's deals to be done. So we're going to continue with that cadence. And we have a stable of investors who are contributing to those securitizations who continue to have interest in contributing the collateral into the securitization as well.

We will take our next question from Ramsey El-Assal with Barclays. Please go ahead.

Hi, thanks for taking my question. I wanted to ask about the on-balance sheet loans. It looks like that number went up about $70 million, $80 million this quarter to around $700 million. I'm just curious in terms of going forward what your plans are there. Do you intend to stabilize that number here? Or will it go up, will it go down? How should we kind of think about that for modeling purposes?

Hey Ramsey, this is Sanjay. Yes, I don't think we've necessarily guided a specific guideline or a number with respect to our balance sheet. I think we gave some sort of high-level parameters last quarter, and I think we obviously operated within that. And I think that, that will continue to be the case. So I think that whether we draw it up or draw it down over the next quarter or so will continue to be an operating decision we sort of discussed and take, but I think it will be within the parameters of what you saw in this last quarter.

Got it. Okay. And then a quick follow-up for me just on the conversion rate on the rate requests. I think that, as you mentioned, it's a tougher environment. That trended, I think, down 300-plus basis points quarter-over-quarter. Also there, just curious from a modeling perspective, do we keep that sort of stable here? Or is that a metric that we could see deteriorate further? Or is the answer it's just contingent on the environment and how it evolves?

Yes. Thanks, Ramsey. It's a good question. I mean, I think that I would bring it back to the vocabulary of this Upstart Macro Index, which Dave referenced, which, as we said, something we've started disclosing in our investor materials. It essentially is sort of an index to try and capture the external macro's impact on defaults. And the simple way to think about our conversion rate is that index went up about 20% versus last quarter. So that's sort of an expression of the fact that the macro is impacting defaults in our portfolio by that amount. And when that happens, our models recalibrate, APRs go up, and essentially approval rates and acceptance rates both go down. So in terms of how to think about it on the go-forward, it really kind of amounts to what you think about the macro conditions. And if defaults are going to continue to go up or normalize or stabilize or maybe even reverse course at some point, that will really dictate the offers that we're making and hence, the conversion level.

Got it. Thank you very much.

We will take our next question from Peter Christiansen with Citi. Please go ahead. One moment please. Mr. Christiansen, your line is now open.

Thank you. Thanks for the question here. Good evening. I wanted to ask about, again, back to rate requests, the previous question. It looks like they were down considerably sequentially, not even looking at the conversion rate yet, but at the very top of the funnel. Just wondering, are you taking a different go-to-market approach in terms of attracting new borrowers to the platform? And how should we think about that in context to this potential horizon like debt consolidation and those kinds of themes? Just wondering how your go-to-market is changing their top-of-funnel new borrower adds. Thank you.

Hey Pete, this is Sanjay. Go ahead, Dave.

No. Go ahead. Go ahead, Sanjay.

I want to add that a lot of our marketing efforts are influenced by the conversion funnel. Specifically, when loss estimates increase, conversions tend to decrease. We adjust the size of our marketing campaigns and activities based on our unit economics targets. Therefore, when the conversion funnel is less effective, we scale back our marketing efforts accordingly. This process can be seen as a two-step approach: when the conversion funnel improves, we increase our marketing, and conversely, we reduce it when the funnel is weaker.

I think the generic of the question is like, how are you thinking about spend on lead gen generally?

The spending on lead generation is related to how well we perform in our conversion funnel. We will invest up to the point where the additional return on marketing spending is negligible. This means that if our conversion funnel gets better, we will increase our lead generation spending because it will be more cost-effective. We can continue to invest more until we reach a point where the additional cost yields no return, and the opposite is also true. Recently, as our conversion funnel has been affected by higher losses in the portfolio, our target for unit economics has been decreasing.

We will take our next question from Mike Ng with Goldman Sachs. Please go ahead.

Hey, good afternoon. Thank you very much for the question. I just had two. First, I was just wondering if you could tell us what the transaction fee rate as a percentage of funded principal was in the quarter, obviously, ex-servicing fees and how we should think about the opportunity to continue to take pricing going forward. And then secondly, I was wondering if you could talk about how much of the principal in the quarter was self-funded off of the Upstart balance sheet versus just the core model. Thank you very much.

Thanks, Mike. This is Dave. I'll address the first part of your question while Sanjay can cover the second. Firstly, we have managed to increase revenues by raising fees on a per-loan basis. Additionally, as Sanjay mentioned earlier, our acquisition costs per loan can significantly decrease during times like this. As a result, the unit economics for each loan have improved, leading to higher gross profit per loan, despite a lower loan volume. These factors are within our control, which is why our contribution margin has increased during this period. I see this as a form of pricing power that allows us to ensure we are monetizing sufficiently to cover our expenses when necessary. We consider this a very positive aspect of our platform.

We will take our next question from Simon Clinch with Atlantic Equities. Please go ahead.

Hi, thank you for taking my question. I would like to start with the contribution margin. I'm curious about the guidance of 59% for the quarter, as it seems you fell short of that. However, it also appears that you were tracking well above that leading into the quarter. I would like to understand the dynamics affecting contribution margins that are within and outside of your control and how to approach this going forward.

This is Sanjay. Yes, that's a great question. So I guess the dynamics on the contribution margin was up from last quarter, 47% to approximately 54%. It was sort of our guidance. Maybe one simple way to think about it is, when we are funding-constrained as a platform, we tend to expand contribution margins. And we do that by expanding take rates. And it makes sense to do that when you're funding-constrained. Now when you're borrower-constrained, you sort of do the opposite. You want to sell for volume, and you can take down your take rates a little bit and expand volume. And I think we probably assumed we'd be funding-constrained for all of this past quarter. In reality, we've sort of bounced back and forth a little bit. We've been at times funding-constrained and at times borrower-constrained. And at those times where we've been borrower-constrained, we've actually acted to reduce contribution margins a little bit. And so I think that we are sort of bouncing around between those two states. And as we go into Q4, to the extent we are funding-constrained in any given period of time, our contribution margins would be above the numbers that we produced and probably closer in line to what we had guided. But to the extent we are borrower-constrained and again, the borrower constraints really come from the fact that our macro index is so high that the approval rates are low, you'll see sort of lower conversion rates more in line with how we looked in Q2 probably. So the outcome is sort of a function of where we are between those two states.

I appreciate that. I was wondering if you could go back to the structure of your funding and the current appetite of your investor base. Could you share how far you've progressed in exploring the idea of shifting towards more long-term investors? Also, it would be great to hear your thoughts on that.

Sorry, could you just repeat the very last part of your question? What is our thinking in terms of what?

About the shift towards funding more longer-term capital-type investors.

I understand. To summarize at a high level, historically, we've been funded about three quarters by institutional sources and a quarter by bank funding. That ratio has changed, and the percentage of bank funding on our platform has increased significantly. Bank funding has proven to be a more stable source of capital, while the institutional side has experienced considerable volatility. Additionally, as we discussed last quarter, there is a desire to engage in more strategic transactions and establish committed partnerships on the institutional side. We're currently involved in several promising discussions, though they are still in the early stages. We believe these partnerships, should they materialize, won't happen quickly; instead, it's about making the right choices for the future of our platform. These opportunities are definitely available, but implementing them may require time as they are important and strategic. There's nothing more concrete to report at the moment, but we are optimistic about the opportunities ahead.

We will go next to James Faucette with Morgan Stanley. Please go ahead.

Thanks, this is Sandy Beatty on for James. Question on the forward flow funding process. How volatile is that month-to-month? So you mentioned some summer optimism. And I'm trying to get a sense of how volatile is that, what factors determine that volatility. Is it cost of capital, opinions about future credit performance? How do those conversations typically go? And is there any insight that you can provide us into that process?

Sure. Hi, this is Sanjay again. I wouldn't describe it as volatile in terms of sudden changes. Instead, I'd say there was a steady decline in funding levels from around March to August. Since then, it has remained relatively stable, with one month showing a significant dip compared to earlier in the year. There haven't been many fluctuations recently. Most of our long-term funding partners have remained consistent in their activities. However, some newer partners who depend more on the ABS markets have been more cautious and are waiting to see how things develop.

Got it. And then just a follow-up on profitability in terms of the quarter and also the guidance. How are you thinking about managing that cost structure going forward? And how should we think about the impact from the recent workforce reductions and how that might reduce pressures or reduce costs on a run rate basis?

Sure. I believe our cost structure components include a contribution margin that we anticipate will remain similar to current levels, around the mid-50s, for the next quarter. The recent reduction in our workforce should positively impact contribution margins as it allows us to better align the onboarding team with our loan processing volumes. Regarding our fixed payroll for the engineering, technology, and administrative teams, we have mostly paused hiring, except for a few key strategic positions essential for sales. Therefore, we expect the fixed operating expenses to remain stable, which we plan to review each quarter. Given our current circumstances, we are comfortable with our operating expense level. However, we remain cautious as the situation can change, and if we see a recovery, we will be well-positioned. Conversely, if conditions worsen, we will reassess our strategy. At this time, there are no plans for further workforce reductions beyond what we have already implemented.

Got it, thanks for taking my questions.

We will take our next question from Vincent Caintic with Stephens. Please go ahead.

Hi, thank you for taking my questions. My first question is about the performance of the Upstart platform compared to targets as shown on Slide 12 of your presentation. Can you provide more details on that? Since there has been an improvement, I'm curious about when you anticipate a return in investor demand or an increase in volume demand, considering that customer pricing has increased by 800 basis points and your investors are experiencing a 500 basis points increase. When do you think we might see clearer signs of improved demand, whether it's from the credit side or from borrowers?

Hi Vincent, this is Sanjay. That's a great question and really a crucial one. The return of confidence and funding in the institutional market requires the convergence of those two metrics. We're following a trend reflected in the Upstart Macro Index, which is a moving target for us. Our models are adjusting as that evolves. Compared to our expectations for convergence from last quarter, we now find ourselves on the lower end of our confidence interval due to rising defaults around the world. The critical issue is when the default trend will stabilize. Once it does, we should see the models converge quickly. Furthermore, the target returns have increased. This includes the performance of all our loans, whether from the bank or the institutional side. If you examine the return targets for institutional loans, that's where the 500 basis point figure originates. Ultimately, it depends on how the macroeconomic environment unfolds and how conservatively we're pricing with our models. We've expressed confidence in our current pricing for loans, but we need the situation to develop further to demonstrate that.

Thank you for your question. I appreciate your follow-up regarding costs. When considering long-term investments in new products versus being conservative in the short term, particularly during periods of low volume, we strive to find the right balance. We are indeed expanding our small business portfolio and growing our auto lending, which is showing some positive momentum. It would be helpful to understand how we manage the need to be careful with expenses while also pursuing long-term opportunities with these products. Thank you again.

Yes, this is Dave. Vincent, we aim to continue investing in our future products as much as possible, even increasing that investment. Our franchise relies on this and it is key to our future growth. We have managed to sustain growth while continuing to invest in our products. Internally, we see improvements in each product, but we won't fully benefit until the economic situation and funding conditions improve. We are preparing for the future, but the positive news is that we haven't reduced our investment in our product line. Once the environment stabilizes, we will quickly see the advantages of our efforts. For instance, we reached a record high for automated loans in Q3, with 75% of loans on our platform requiring no human intervention. However, we won't see the business advantages of this until loan prices decrease and funding becomes more plentiful. Overall, every product is improving rapidly, and our teams are making excellent use of this time, though the returns will take a bit longer to realize.

Okay, that's very helpful. Thanks very much.

We will take our next question from Arvind Ramnani with Piper Sandler. Please go ahead.

Hi, thank you for taking my question. I have a couple of inquiries. First, as you look at the next 12 months, what are some of the downside scenarios? If the macro environment worsens significantly, would you anticipate further deterioration in your business given your strong exposure to macro factors?

Sure. There are certainly downside scenarios that any business must consider when looking toward the future of the economy, and we're no exception. Our business model is relatively straightforward, as we have fixed costs and contribution margins to manage those costs. If the macroeconomic conditions worsen significantly, it could lead to reduced volumes on our platform. At that point, we would need to evaluate our fixed costs and determine if they are sustainable. Our primary goal is to maintain solvency and ensure the company remains on stable footing. We currently have a substantial cash reserve and fairly low fixed costs, which have supported us throughout our history. We are not overly concerned, but we do want to continue investing in our products, and so far we have been able to do that. While there are extreme scenarios that might force us to reduce or pause our investments, we do not foresee that happening at this time. At present, we believe we have enough volume and contribution margin to continue investing positively for the future, which is our intention.

As you consider your current cash burn and anticipated cash burn in various countries, when do you think you might need to raise additional capital, either through equity or debt?

We don't see any need to do that, Arvind. And honestly, our cash burn today is quite small even in the very constricted position we're in. I mean, I think our volumes are pretty dramatically lower than they were, yet our cash burn is fairly minimal. So we don't see a scenario where we have to raise cash. As Sanjay said, we have over $800 million in cash as well as loan assets on the balance sheet. So that's just not something we anticipate at this time.

That's perfect. Thank you. Go ahead.

I wanted to quickly outline some rough numbers regarding our fixed monthly expenses related to payroll and operating expenses, which are approximately $30 million. Even in a scenario where we originate no new business, we still generate a servicing revenue stream of around $15 million. Therefore, we have a $15 million gap each month that we need to cover with our contribution margin. This represents a downside scenario for us. As you noted, we have about $800 million in cash on our balance sheet, which provides us with a substantial runway, as Dave mentioned.

Right. Right. I guess you can be quite patient in that case. Yes, that's pretty much the questions I had.

We will take our next question from David Chiaverini with Wedbush Securities. Please go ahead.

Hi, thank you for the opportunity to ask questions. I’m looking at Slide 11 regarding the losses during the period compared to expectations. Could you explain what this indicates? Does it mean that the losses from defaults in this period are 25% higher than your projections? Additionally, in relation to Slide 10 where the UMI is at 1.7, should we anticipate the figure on Page 11 rising towards 70%? Could you elaborate on that?

Hi David, this is Sanjay. Those are great questions. Let me begin with Slide 11. This slide shows the current losses for all outstanding loans during a specific calendar period. It's not based on a specific cohort but rather includes all vintages active in Q3 of 2022, indicating that the losses were 25% higher than what was anticipated when the loans were originated. Many of these vintages were previously performing at or below target in earlier quarters. The increase in losses is tied to the macro impact reflected on Slide 10. Although the macro index is at 1.7, it doesn't mean we are 70% above our model. On the other hand, we are currently pricing loans with a macro index equivalent to 2.0. If the macro index remains at 1.7 while we price new loans at 2.0, those new loans should outperform and result in lower losses, approximately 17% to 20% less. We quickly adjust our model to reflect where the UMI is headed, allowing us to incorporate these trends into our loan pricing. Regarding your initial question about expectations for Slide 11 going forward, many existing loans are already priced based on current economic conditions. As the economy worsens, those losses will rise. However, new loans entering the population will be priced with higher UMIs, leading to a balance between the two factors.

Very helpful, thanks for that. And then my second question relates to promotional activity in the third quarter related to gift cards. Was this new? And are you able to say how much that contributed to originations in the third quarter? And what level should we expect in the fourth quarter, if that's going to continue?

Sure. This is Sanjay again. Taking a step back, I believe the best way to understand the situation is that in Q3, we experienced fluctuations between a funding-constrained environment and a borrower-constrained environment. Essentially, the availability of funding or the lack of it was competing with the loss trends in the economy and our capacity to approve loans. There was a period in Q3 where we were borrower-constrained, which led us to implement a marketing campaign offering incentives to boost our origination numbers slightly. The overall impact on the numbers was minimal, both for that month and for the entire quarter. It was not significant, but please continue.

Sorry, Sanjay, I was going to say, I mean, what you're seeing there is we are pretty constantly trying to find the lowest-cost source of borrowers. And in that case, I believe it was really incenting people that were already on our platform that essentially had no other acquisition costs associated with them. But what we're generally doing in all periods is trying to acquire users at the lowest possible cost. And gift cards to promote someone who has no other associated costs with them, meaning from digital or from direct mail or from a partnership, etc., can be a very good way to do that.

And there are no further questions at this time. Mr. Girouard, I will turn the conference back to you for any additional or closing remarks.

Thank you all for your time. We truly appreciate your support. This is a tough period, especially regarding our mission and the business path we've chosen. However, we have confidence in our direction and are committed to it. It's crucial that we make the right decisions now, particularly concerning credit performance and maintaining fiscal responsibility. We firmly believe that the investments we are making today will place us in a much stronger position, leading to growth once again soon. Thank you all for joining us today.

This concludes today's call. Thank you for your participation, and you may now disconnect.