Upstart Holdings, Inc. Q1 FY2023 Earnings Call

Good day, and welcome to the Upstart First Quarter 2023 Earnings. 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.

Good afternoon, and thank you for joining us on today’s conference call to discuss Upstart’s first quarter 2023 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 first quarter 2023 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 second quarter of 2023 related to our business and 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 the result of new information or future events, except as required by law. In addition, during today’s call, unless otherwise stated, references to our results are provided as non-GAAP financial measures and are reconciled to our GAAP results, which can be found in the earnings release and supplemental tables. To ensure that we can address as many analyst’s questions as possible during the call, we request that you please limit yourself to one initial question and one follow-up. Later this quarter, Upstart will be participating in the Barclays Emerging Payments and FinTech Forum on May 17 and the Bank of America Global Technology Conference on June 7. 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 first quarter 2023 results. I’m Dave Girouard, Co-Founder and CEO of Upstart. Despite the headwinds facing our industry in early 2023, I’m pleased with the progress we made against the objectives that I set out for you previously. I’m hopeful that as we move through the year, you’ll come to see Q1 as a transitional quarter for Upstart. While the economic environment remains turbulent, there are many reasons to be optimistic about our future. I assure you we aren’t waiting around for the economy to improve. First, our development teams made significant strides forward in each of our main product areas. Innovation in AI is the primary source of Upstart’s competitive advantage, and we continue to break new ground in this area. I’ll share more about these wins shortly. Second, we accomplished this while taking substantial fixed costs out of our business. Last quarter, I told you that I’m committed to running an operationally and fiscally tight ship. Given our concerted efforts in Q1 to reduce both payroll and operational expenses, I’m confident that Upstart is now a more streamlined and efficient company, setting us up to return to profitable growth soon. I’ll share more about our cost reduction efforts later. Finally, I'm pleased to tell you that we secured multiple long-term funding agreements expected to deliver more than $2 billion to the Upstart platform over the next 12 months. This is a critical first step toward building resiliency and predictability into our business. Together, I believe these efforts put us in a stronger position regardless of which direction the economy turns. Our own analysis, which we launched publicly in March in the form of the Upstart Macro Index, or UMI, suggests that the financial health of the mainstream American consumer deteriorated rapidly through the first nine months of 2022 but has since stabilized, if not improved, for the last several months. The personal savings rate, which may be the most relevant predictor of UMI, bottomed out mid-last year at 2.7% and has increased to 5.1% since then. Since late 2022, loans on our platform have been priced conservatively relative to UMI, so our bank and credit union partners can feel confident that recent vintages are today performing at or above expectations. While banks are certainly treading carefully in the current environment, many lenders and institutional investors appreciate the combination of high yield and short duration that Upstart-powered loans offer. Irrespective of the environment, I push our team very hard to ensure Upstart improves constantly in four critical dimensions. First, best rates for all. We founded Upstart to improve access to credit, so delivering the best rates possible to all consumers will always be our main objective. Given the breadth and diversity of competition, we will never fully achieve this goal, but in fierce pursuit of it, we can become the market leader in a vital segment of our economy. Better rates are unlocked primarily by a more accurate and predictive credit model, one that excels at separating good risk from bad, and AI is the key to this. Our models are currently trained on more than $100 billion of performance data, and now with an average of $90,000 in new loan repayments due each day across all our bank partners, the system is learning and adjusting in near real-time to actual loan performance. We pushed new and improved versions of our AI models into production during the first quarter alone, about one every three days. We’re confident that our AI has never been as sophisticated or accurate as it is today. To deliver the best rates for all, we also need a variety of bank and credit union partners, each with differing priorities, business objectives, and balance sheet issues to solve. Today, we have almost 100 such partners, an order of magnitude more than the 10 we had when we went public in December 2020. Additionally, we need a strong presence and reputation in institutional and capital markets because the limited risk appetite of bank balance sheets will never serve the needs of the entire U.S. credit market. This quarter, we expanded our roster of institutional partners in ways that will help us deliver quality offers to consumers throughout all parts of the cycle. Second, more efficient borrowing and lending. Every quarter we aim to make our platform more efficient for consumers and bank partners. This improvement comes from better AI, which enables more sophisticated risk models, which in turn enable a faster and more efficient experience for consumers and lenders. In the first quarter, we achieved a record level of automation, with 84% of Upstart-powered loans fully automated across all our bank partners. By this, I mean the loans were approved and verified instantly with zero human intervention from rate requests through loan funding. We know of no other lending marketplace with this level of automation. This instant automated process, which, by the way, 70% of consumers access via mobile phone, creates an unparalleled wow moment for the borrower, who is often surprised to find that there are no more steps in the approval process because consumers rightfully value their time. This delightful moment is often more impactful than the specific rate our bank partners offer. Efficiency is obviously important for the lender as well. Our bank partners' Upstart-powered lending programs are open for business 24 hours a day, seven days a week. In addition to providing the modern all-digital experience their customers expect, banks can tailor their Upstart lending programs to target their business objectives, risk appetite, and balance sheet needs precisely. When it comes to routine transactions like offering a loan, branch hours are inconvenient, few, and intervention is costly, and consumers just want what they want when they want it. Central to this resilience is securing a baseline supply of long-term capital upon which we can depend through the market’s ups and downs. As I mentioned earlier, we’ve secured agreements with multiple strategic partners as of today and will continue to explore additional partnerships. Our primary goal is to have loan funding capital committed at a level that allows us to remain flow positive in typical market cycles. Resilience also comes from a flexible business model with lower fixed costs, proven pricing power, and durable unit economics. We’ve always been a capital-efficient business, raising and spending a fraction of what peer companies spend, but there are always more ways to drive efficiency. Between Q4 and Q1, we took the necessary steps to reduce Upstart's headcount by almost 30%. While clearly a gut-wrenching decision, it will allow us to return to profitability at a significantly lower loan volume and has led us to be more focused and nimble in delivering our product roadmap. We also identified opportunities to reduce our technical infrastructure costs by as much as $10 million annually and sublet some unnecessary office space, both of which will go directly to the bottom line. On the revenue side, we reflected on our take rates, delivering a record contribution margin of 58% in Q1, our prior record was 54% in Q3 of 2020. Our strong and flexible unit economics are a byproduct of the competitive advantage provided by AI. Together, all of these factors position us well to navigate whatever challenges lie ahead while strengthening our position for the inevitable market improvements to come. The last important lever on resiliency is our product offering itself, which I’ll speak to now. Fourth, a broader range of products. Moving beyond our core personal loan product is critical to reaching our potential as a business. Offering a wider range of solutions makes us more relevant to more consumers and also more valuable to our bank and credit union partners. Product and borrower diversification can also provide greater resilience through future market cycles. We continue to make progress in our second significant initiative, the auto lending market. This market has faced what may be the most tumultuous three years in its 100-plus-year history. Despite this, we’ve made rapid progress with our products and couldn’t be more excited about our potential. Since our last earnings call, we announced that both Acura and Mercedes-Benz approved Upstart as a digital retail provider, becoming our eighth and ninth OEM partners. We recently launched a new and improved AI model for our auto retail lending product that builds off our existing auto refinance model. We now consider both of these models calibrated and performing on target. Our footprint of dealers piloting our lending product expanded to 39 since I last updated you, and we expect this rollout to continue throughout the year. We also signed our first external funding agreement for Auto Retail, which is an important milestone for us. Lastly, we’re making rapid improvements to our servicing and collections of auto loans, which accrues directly to model performance. I’m also pleased to let you know that we expect to launch a home equity product later this year. This is a great fit for Upstart for a few reasons. First, 95% of HELOCs are financed by banks and credit unions, so it’s an asset our lending partners know and value. Additionally, HELOCs naturally serve a very prime consumer, namely homeowners. We expect Upstart’s HELOCs to have annual loss rates of less than 1%. Third, home equity products tend to be countercyclical to refinance products. We know this because in Q4 2022, HELOC volumes increased by 32% year-on-year even while mortgage refinances plummeted. Importantly, there’s a lot of opportunity to improve the process of originating HELOCs. The average HELOC today takes 36 days to fund, while we aim for online approval in 10 minutes and funding within five days. Lastly, I have to mention the incredible progress made by our small dollar loan team. By way of context, banks feel pressured by regulators to eradicate overdraft fees and instead to provide affordable relief loans to consumers with short-term cash needs. However, they’ve struggled for years to do this both meaningfully and profitably. Short-term loans have a few hundred dollars to existing customers or even to random walkup consumers at rates within the APR limits for nationally chartered banks have been beyond the reach of the banking industry. We’re building it for them and we believe it has the potential to eradicate more than 70% of payday loans in the next five years. Our small dollar product already has a 90% automation rate, far beyond even our core personal loan product. In Q1, we launched a new AI model for this product that delivered the largest single accuracy improvement measured in our history. We’ve also expanded the offering to include loan terms as short as three months, which have shown over a 37% increase in approval rates. I’m not sure we’ve ever delivered a product with as much impact and alignment with our mission as we’re seeing from the small dollar team. To wrap things up, I want to acknowledge that the financial industry is not out of the woods yet, but even in this challenging economy, I believe Upstart is in a position to grow regularly through our typical run rate of model and technology improvements. When the banking and credit markets eventually normalize, as surely they will, the true strength of our platform will become clear to all. Upstart’s success will continue to be built on excellence and leadership in AI. By this, I mean the speed with which we can develop, deploy, and calibrate new and more accurate AI models. Together with the amazing quality of our team, this is what makes me optimistic about Upstart’s future. Thank you. And I’d like now to turn it over to Sanjay, our Chief Financial Officer, to walk through our Q1 2023 financial results and guidance.

Thanks, Dave, and thanks to all of you for joining us today. At a headline level, over the past quarter, we’ve observed continuing stability in consumer repayment trends on the borrower side of our platform, counterbalanced by heightened volatility in the banking and institutional funding markets. In U.S. consumer personal finance, a couple of virtuous trends continue to unfold in the aggregate statistics. The percent of adults participating in the workforce is steadily climbing as our population returns to work, and the average personal tax burden for each individual has fallen considerably since last year, together leading to a rising level of real disposable income per adult. On the expenditure side, real consumption per capita continues to moderate and creep back into line with disposable income. Rising disposable income and moderating consumption expenditures are resulting in a personal savings rate that has now risen in each of the past six months, since bottoming out last September. This particular indicator has demonstrated a strong correlation to borrower repayment health since the pandemic, and we are seeing this reflected in our Upstart Macro Index, which peaked last October and is showing signs of early recovery. The ongoing improvement in the consumer fiscal condition together with the recalibration of our own underwriting models is resulting in loan performance that, as of our Q4 vintages, we believe is on track to deliver unlevered gross returns of approximately 11% as a blended average across the banks, credit unions, and institutional buyers on our platform. Conversely, the funding side of the ecosystem remains challenging in the current climate. Increased conservatism among existing lending partners in the wake of the recent bank failures has enhanced our headwinds, even as we have brought additional volume onto the platform through the implementation of new bank partnerships. The banking sector turbulence has also contributed to wider market spreads on high-yield debt after a brief period of moderation in January and February, which is in turn causing institutional investors, who rely on functioning ABS markets, to be increasingly cautious in their deployment of capital. We have managed to more than offset these headwinds by securing multiple longer-term funding agreements, which we expect to deliver more than $2 billion in capital over the coming 12 months. We believe that these deals, as well as others in the pipeline, will provide us with a stronger and more resilient capital supply over the coming quarters. With these items of context, here are some financial highlights from the first quarter of 2023. Revenue from fees was $117 million in Q1, coming in above our guided expectation as a result of some increased funding secured through our longer-term capital arrangements, as well as ongoing take rate optimization. Net interest income was slightly below guidance at negative $14 million, largely a result of unrealized fair value adjustments informed by the economics of a balance sheet transaction that was expected to close after the end of the quarter. Taken together, net revenue for Q1 came in at $103 million, slightly above guidance and representing a 67% contraction year-over-year. The volume of loan transactions across our platform in Q1 was approximately 84,000 loans, down 82% year-over-year, and representing over 53,000 new borrowers. The average loan size of $12,000 was up 22% versus the same period last year. Our contribution margin, a non-GAAP metric, which we define as revenue from fees minus variable costs for borrower acquisition, verification, and servicing as a percentage of revenue from fees, came in at 58% in Q1, up from 47% last year and 3 percentage points above our guided expectation for the quarter. We continued expanding our margins in Q1 through higher rates of automation, which attained the peak of 84%, improved marketing efficiency, and increased take rates. Operating expenses were $235 million in Q1, down 15% year-over-year but up 14% sequentially due to one-time restructuring costs incurred as part of our reduction in force, as well as a one-time non-cash charge resulting from the cancellation of a single executive performance-based equity award, which accounted for approximately $40 million of the overall expense base in this past quarter. The majority of the year-over-year reduction was achieved through sales and marketing, which declined by 76% following the trend in volume. We continue to limit hiring to only a handful of key strategic positions. Altogether, Q1 GAAP net loss was $129 million, and adjusted EBITDA was negative $31.1 million, both comfortably above our guided numbers. Adjusted earnings per share was negative $0.47 based on a diluted weighted average share count of 81.9 million. We ended the quarter with loans on our balance sheet at $982 million, down sequentially from $1.01 billion the prior quarter. Of that total, loans made for the purposes of R&D, principally within the auto segment, represented $493 million. Our corporate liquidity position remains strong with $452 million of total cash on the balance sheet and approximately $632 million in net loan equity at fair value. In our remarks from last quarter, we expressed optimism that the consumer trends impacting credit appeared positive to us and that the worst was likely behind us, and this is indeed what we have perceived over the last 90 days. Consumers reducing expenditures indicates to us that they’re overspending less relative to income. Decreasing numbers of job openings in the economy indicate to us that Americans are returning to work. While both of these dynamics could be interpreted as indicators of an economic slowdown, it is clear to us that both have been beneficial for credit. This continues to be our perspective as we look to Q2. We also expressed confidence last quarter that through a combination of margin expansion, workforce reduction, and expenditure control, we could create a path to return to EBITDA break-even at our current lower scale. Indeed, we now anticipate achieving this in the second quarter. While painful, the workforce reduction was carried out with minimal impact to the velocity at which we are developing our newest round of bets in auto lending, small dollar loans, and HELOCs, all areas in which we look forward to sharing more updates in the coming quarters. With these specifics in mind for Q2 of 2023, we expect total revenues of approximately $135 million, consisting of revenue from fees of $130 million and net interest income of approximately $5 million. Contribution margin of approximately 60%, net income of approximately negative $40 million, adjusted net income of approximately negative $7 million, adjusted EBITDA of approximately zero, and a diluted weighted average share count of approximately 83.1 million shares. We are happy to signal a return to sequential growth and cash profitability in the current market environment. Our improving guidance is clearly not derived from obvious improvements to the macro economy just yet. It is flowing from a combination of tenacious execution, operating discipline, margin expansion, and deal-making. As always, a huge note of gratitude to the various Upstart teams who have been heads down and laser focused on getting us through the storm and have remained resolute over the past year in the face of such challenging external circumstances. While there may yet be a few more twists and turns along the way, we are optimistic that we have weathered the worst of it, and barring any reversal in consumer trends, we are back on an ascending flight path. With that, Dave and I are happy to open up the call to any questions.

Thank you. Our first question comes from Simon Clinch with Atlantic Equities. Please go ahead.

Hi, Dave. Hi, Sanjay. Thanks for taking my question and congrats on a pretty good quarter here. I was wondering just if you could give us a little bit more detail around the long-term funding commitments perhaps and how we should think about how that might be applied or flow through for the remainder of the year? Are there any constraints on product categories that it’s focused on, or anything else that we need to know about? Thanks.

Yes. Thanks, Simon. This is Sanjay. Let’s see. I would say Upstart, each agreement is a bit bespoke, so it’s hard to sort of broadly generalize. But maybe a couple of headline thoughts. First of all, I would say these agreements, they more or less flow from the ability we’ve demonstrated over the past couple of quarters to demonstrate enhancements in our margins and to improve our take rates. And because we have expanded margins, the way to think about these agreements is that we’re able to share some modest preferential economics with long-term committed investors. Those preferential economics could take the form of return premiums or a co-investment on the take rate or modest discounting and risk sharing. All investors have a slightly different set of preferences and objectives, so it tends to be a bit different per counterparty. They’re all currently focused on personal loans, so they’re sort of restricted to our core business. Beyond that, they tend to mirror our broader institutional programs. So apart from some preferential economics that essentially flow from our enhanced unit economics, they tend to look very similar to what we would normally do through the capital markets.

Great. That’s really helpful, thank you. And maybe a follow-up question to that. Just on your comments around take rate and the impressive contribution margins that you generated this quarter and anticipate to generate in the next quarter. How should we think about the sustainability of that as you go through perhaps an economic recovery and loan acceleration at some point? Should we expect those contribution margins to decline, and what does that mean in terms of those funding commitments becoming less important in that regard? I’d just like to think about how all that ties together.

Sure, yes. I mean, I guess the punchline is that I think they’re probably sustainable for as long as we want them to be. There are really two underlying factors I would point to. One is the extent to which we are sort of investing for the short term versus the long term, and the other is the general elasticity of the loan demand on the borrower side. Currently, for example, elasticity is quite high, credit is in demand on the borrower side, and that creates pricing ability on our side. But maybe the more important factor is, when we’re solving for the near-term P&L, we are optimizing take rates as much as possible against that elasticity, and we are managing our marketing programs to deliver loans that are profitable in the near term. As the economy evolves, and certainly as it improves, you would see a declining elasticity. So there will be more provision of credit on the supply side, and borrowers will have more choice. The other factor is that we would then start to rebalance how we trade off the short-term for the long-term. By reducing take rates and growing our marketing campaigns, we can generate more volume, harvest more lifetime value of the customer, and gain more insights for our model learning. These may not show up in this quarter’s P&L, but they provide value over time. So when you combine all that, for an improving economy, you might see take rates that may not return to where they were before, but would probably moderate with the economy improving.

Thanks, that’s really helpful. Thank you.

Our next question comes from the line of Ramsey El-Assal with Barclays. Please go ahead.

Hi, this is John Coffey on for Ramsey. I had a question for you on your Slide 18 regarding your conversion rates. So it looks like your conversion rates had declined from about 21% last year to 8%. I was just trying to understand the drivers of this a little bit better. Is most of it just the supply of credit or is it sometimes that potential borrowers are hitting that ceiling for interest rates, or they’re deciding to defer some purchases to later when they’re maybe in a more stable economic condition?

Yes. Hey, John. It doesn’t have much to do with the supply side. I think maybe the single most explanatory variable would be what we call our Upstart Macro Index, or UMI, which is also in our materials. It reflects the fact that the same consumer is defaulting at a rate that is maybe 2 to 3 times higher than they were in mid-2021. Because of that, consumer repayment patterns have changed, and we are pricing loans very differently. We’re including much higher default premiums in the loans. Compounding that, of course, are the higher base interest rates, which are requiring investors to demand higher returns. When you add those two up, our like-for-like price for a loan has gone up quite dramatically, in some cases by 1500 to 2000 basis points. Because of this change in pricing, two things are happening: many fewer borrowers are getting approved, as they are being pushed above the 36% APR threshold; and even those who are still getting approved are facing much higher prices and may be less willing to take the loan. Those two factors combined have resulted in the contracting conversion rate.

All right. Great. Thank you. And just for a very short follow-up, I noticed that your loans on your balance sheet actually declined a little bit quarter-over-quarter. Should we think of last quarter, the fourth quarter, as a bit of a high watermark, or is that still too early to say?

Good question, John. I mean, I think we will continue to think of the balance sheet along the lines of the parameters we’ve expressed to the market, which is a certain number we won’t exceed, and that’s probably roughly where we were last quarter. We also mentioned that there is a transaction that did not complete in Q1, but we expect it to complete in Q2, and that will bring our balance sheet down next quarter. From there, we may continue to use the balance sheet as a platform tool, but you’ll probably see us remain around the billion-dollar range and then ebb or flow from there based on whether we’re transacting or accumulating.

Great. Thank you.

Thank you.

Our next question comes from the line of Peter Christiansen with Citi.

Good afternoon. Thanks for the question. I just wanted to dig a little bit into the secured funding, the $2 billion. I just want to understand, are these funds securing minimums from existing partners, or is it incremental from new funding partners, if you could just provide a little bit more color on that and how it compares to the existing run rate, I guess, of business that you have?

Sure. Yes, thanks, Pete. This is Sanjay. A lot of it is coming from partners that are new to the platform that we’ve never worked with before. Some of it is coming from existing partners who had either stepped away from funding during the turbulence of the past few quarters, or they’re re-upping in significant size and committing forward in exchange for the longer-term agreement. I think in almost every case, you can view it as being additive to what we’ve been doing recently and sort of underpinning both the improving guidance we have in our Q2 numbers as well as the qualitative optimism we’re signaling.

That’s helpful. And then I guess in the past, Upstart has made a number of model changes to the AI platform, and you’ve seen subsequent results change as well. I guess in the current status quo environment, how do you think these model changes will influence results in the coming quarters? Thank you.

Hey, Pete, this is Dave. Generally speaking, upgrades to the AI tend to improve automation or boost model accuracy, resulting in overall positive growth. As I mentioned before, we believe we can grow without the economy improving. However, it’s still a challenging environment concerning funding markets, base credit rates, and interest rates. But we believe the reason we’ve been able to grow over time is primarily because the technology and models continue to improve, contributing positively to growth even in a difficult environment like today.

Okay. Thank you. Thank you both.

Thanks, Pete.

Our next question comes from the line of Compass Point. Please go ahead.

I was curious about the mix of bank versus non-bank and the institutional investors on the platform. I’d be curious if there’s a sense of where that mix may have shifted this quarter where that might go going forward.

Hey, Juliana, you’re asking about the mix of banks versus institutional investors.

That’s right, yes.

At a headline level, I would say the events that we went through in March, that particularly impacted the banking sector, had an impact. We continue to bring in new lending partner banks and credit union partners, but existing ones are obviously becoming a little more conservative. I think this has impacted the capital markets less so, so you may have seen a bit of a shift toward the institutional dollars. How that plays out going forward is hard to predict. The banking sector is currently undergoing some turbulence, and that may increase or moderate depending on their experiences over the coming quarters.

That makes sense. And then kind of looking through some of the past disclosures, it seems like two banks are the primary enablers of the loan sales or the marketplace side of the platform. If you add up the volumes of those two banks, it seems to imply that they account for 50% plus or even close to 60% of all of your bank funding side of the platforms. I’m curious what level of concentration there is on the bank side of the funding platform, and have you seen any of those partners pull back in their buying activity recently?

Yes. There are really three banks on our platform that serve as conduits where they originate loans. In some cases, they hold some of them, and in other cases, they end up selling them to institutional partners. So there are three of those banks on our platform, and it’s quite possible to move volumes between them. It’s quite purposeful that we can do that. Generally speaking, the fees and the profits on loans that land on the institutional side are higher than those on the bank side, where they originate and hold on their balance sheet. This creates the structure you’re seeing there, but it’s not really in the sense of revenue concentration; there are many institutional buyers behind those banks. We do have multiple marketplace lending partners on the platform.

Got it. And I’m curious, when you think about funding concentration with any partners, are there any partners that account for 10% or more of your overall funding or 15% or more of your overall funding? Or is it more diversified than that?

Hey, Juliana, yes, it’s – I think what you’ll see in our revenue concentration disclosures when the financials come out is that those concentrations are going down. In terms of source capital dependency, I don’t think anything is far greater than the ballpark you just mentioned.

Got it. Thank you very much. And I’ll jump back into the queue.

Thank you.

Your next question comes from the line of James Faucette with Morgan Stanley. Please go ahead.

Hey, thank you very much, and thanks for the details today. I wanted to revisit the secured funding, and I think you made the comment that there were some preferential terms that you were able to offer to them. I guess there are a couple of questions associated with that going forward. What would be the right level of mix or targeted mix for that group? And it sounds like you plan to add more to that. Secondly, how much should we expect that you may have to harmonize at least some of those terms into other sources of capital?

Hey, James, this is Dave. Good question. First of all, one of the comments I made in my earlier remarks was that we would like to have, in any particular month, capital committed such that we can be cash flow positive as a business. So a baseline of capital that we feel very good about being solid will be there and that would dramatically reduce cyclicality. That’s our goal. I generally think we are benefiting from the fact that we have very strong margins, and we can share a bit of that with preferred partners, who are making a longer-term commitment to us. I think that’s a structure we would want for the long haul. It makes sense that if they’re committing to us, we make a special commitment to them. There will also continue to be plenty of at-will participants participating in the marketplace month-to-month, and we don’t expect that to go away. We think it’s a good thing, but we want a significant fraction of the funding to be more long-term committed in exchange for a little preference for doing that. Lastly, as Sanjay said earlier, this is all currently related to personal loans today. I think we will push for this kind of structure on other products as well, like HELOC products, which will likely have less need for it because they will tend to be more normal familiar products and ones that lenders lean toward even in more difficult times. That’s our thinking.

Yes. I appreciate all that, David. And then how are you feeling about the state of your cost base now on a run rate basis? I know that here in the June quarter, you’re expecting to roughly be adjusted EBITDA breakeven now that those programs have been fully implemented. But should we take that to mean that you feel like you’re at the right cost base and that the first quarter would have been roughly the bottom from a revenue generation perspective, and that you can grow at least for the remainder of this calendar year on a sequential basis? Or are there incremental actions that may need to be taken? I’m just trying to think through how you’re seeing the business and its evolution from this point.

Hey, James, this is Sanjay. Yes, I think we’re in very good shape. From a personnel perspective, we did what we needed to do in Q1, and we’re past it. I think our workforce numbers are in good shape now, and borrowing any dramatic reversal in the business or economy, we’ll continue to grow from here. There’s still more work to be done on the OpEx side. As Dave mentioned, we need programs to reduce costs; we’re large consumers of compute power, and our machine learning models require many resources for training, and we want to become more efficient in that area. Our engineering footprint, the resources we consume can be improved also. I think there will be ongoing initiatives, but by and large, I believe you’re right. We are at a good place now. We can tighten up a bit more, but we anticipate a nice path for growth from here onward, and as we’ve demonstrated before, our cost base will scale very efficiently with the top line and provide nice margin materialization as we grow.

That’s great. Thank you for that, Sanjay.

Thank you.

Our next question comes from the line of Reggie Smith with JPMorgan.

Good evening, gentlemen. Congrats on the quarter and on securing the $2 billion in funding. My question, I know in the past, you’ve been asked about becoming a bank and not wanting to do that, which I can totally appreciate. My question relates back to the funding as well. Would you consider a warehouse-type funding mechanism? And does any of your $2 billion structured in that way where you pay a fixed rate and hold more loans on your balance sheet? Or is it purely arms-length outside of balance sheet financing?

Yes, Reggie. That’s generally what we would term forward flow commitment—loans that are purchased monthly by a third party. So that’s what that is. It’s not on our balance sheet, and there’s no warehousing on our side. They can leverage that on their side if they choose to, but that’s separate from anything going on with us. So let me see. What was the other part of the question?

Would so you consider warehouse, or is that also something that you would not pursue?

Yes. We’ve had modest warehouse capacity for many years. When loans are on our balance sheet, to some extent, we have financing, and it’s a more efficient use of our equity capital. But that’s still under the umbrella of the total financing, and as Sanjay said, we aim to keep no more than $1 billion on our balance sheet. Some of it may be warehoused, but it’s not a primary funding mechanism as our balance sheet ultimately is not.

The loans on our balance sheet, when we say we have $1 billion of assets in the balance sheet, less than half of that is our actual loan equity. The rest is financing, but we still consider that to be our balance sheet. What we’re focused on with the long-term arrangements is third parties being the risk engine, and they can finance as it suits them.

I appreciate that. The crux of the question was whether you would consider being more balance sheet intensive. But it sounds like you’re comfortable with the billion, and that’s kind of where you want to remain for the foreseeable future. My second question—guidance very strong numbers. In particular, the interest—net interest and kind of fair value, I guess that implies sharp sequential improvement there. I was curious what was driving that and if you could talk about the performance you’re seeing with your loans that are held on balance sheet in terms of loss rates and things of that nature.

Yes, sure. Reggie, this is Sanjay. As for the guidance, Q1 was the anomaly. Normally, you’d expect your balance sheet to generate modest positive income. We tend to hold our loans at fair value, so we mark-to-market; we don’t use CECL accounting. When interest rates are rising, which they have significantly in the last year, it affects valuations. Q1 did not have adverse interest rate movements, but we booked unrealized fair value marks that reflected a balance sheet transaction not completing in Q1, which we expected to close early in Q2. Therefore, I think you could consider Q2 and beyond as normal conditions without large transactions expected, resulting in a more stable interest income outlook. The performance of our balance sheet reflects underlying vintages that you see on the broader platform.

Got it. And if I could sneak one more in, on the take rate—you talked about stronger economics. Is there a way to parse the impact of stronger pricing or origination fees that are paid by borrowers versus what your partners are paying you? Was there any change there when you talk about better pricing?

I don’t think there’s anything more to parse other than that fees borne primarily by borrowers getting loans funded through institutions tend to flex up at times like this. That’s what you’re seeing. Base yield requirements are rising, loss expectations are increasing, and also fees are going up—none of which we love, but it’s the reality we are dealing with, and we would be very happy if all of this were to reverse over the next year, should we be so fortunate.

No, I got it. That was clear. I’m sorry. I’ve got a couple of calls going on, so I didn’t catch that part—that it was primarily borrowed fees.

No worries.

Our last question comes from the line of Simon Clinch with Atlantic Equities.

Hi guys, I’ve got to jump back into the queue. Thanks for taking my question again. I was just curious, going back to the pace of your new model rollouts or updates through the quarter, was pretty staggering. As someone who doesn’t really know much about these things, I was wondering if you could talk us through perhaps the risks and challenges associated with that kind of pace of rollout and how to think about that in terms of the benefits moving forward because, previously, we hadn’t needed that many rollouts to create significant benefits for you guys.

Yes. Simon, it’s a good question. It’s important to state that we have different models in production for each product we have. So there are four products: two auto products, a personal loan product, and a small dollar product, each having related but different models to push into production. There are also models focused on automation more than pricing issues like fraud. I don’t know the exact number of distinctive AI models we have, but it’s quite a few. These teams are working in parallel. This isn’t a single model being updated or retrained every three days, but there’s a lot of them, and each one generally makes our product line better. The pace has improved significantly from our earlier effort where we might have done one a month.

That sounds more sensible. Thank you.

Thanks, Simon.

This concludes today’s question-and-answer session. I will turn the call back for any additional or closing remarks.

Just want to thank everybody for listening today. As we’ve said, we’re happy with what we’ve achieved in the first quarter. We’re optimistic about 2023, so thanks for sticking with us.

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