Upstart Holdings, Inc. Q2 FY2025 Earnings Call

Good afternoon, and welcome to the Upstart Second Quarter 2025 Earnings Call. As a reminder, this conference call is being recorded. I would now like to turn the call over to Sonya Banerjee, Head of Investor Relations. Sonya, please go ahead.

Thank you. Welcome to the Upstart earnings call for the second quarter of 2025. With me on today's call are Dave Girouard, our Co-Founder and CEO; Paul Gu, our Co-Founder and CTO; and Sanjay Datta, our CFO. During today's call, we will make forward-looking statements, which include statements about our outlook and business strategy. These statements are based on our expectations and beliefs as of today, which are subject to a variety of risks, uncertainties and assumptions and should not be viewed as a guarantee of future performance. Actual results may differ materially as a result of various risk factors that have been described in our SEC filings. We assume no obligation to update any forward-looking statements as a result of new information or future events, except as required by law. Our discussion will include non-GAAP financial measures, which are not a substitute for our GAAP results. Reconciliations of our historical GAAP to non-GAAP results can be found in our earnings materials, which are available on our IR website. With that, Dave, over to you.

Thanks, Sonya. Good afternoon, everyone. Thank you for joining us today. Before I begin, I want to welcome my co-Founder, Paul, to the call today. As most of you know, in May, we hosted our first Investor Day, what we call AI Day. For many investors and analysts who cover Upstart, it was their first exposure to Paul. Unsurprisingly, AI Day generated a lot of interest in how he and his teams are creating the world's leading AI lending platform. After the event, many told us they'd like to see and hear more from Paul, so we asked him to join our quarterly earnings calls. You'll hear from Paul in just a bit. On to the update. On our call a year ago, we provided the first signs that Upstart was returning to growth mode. And today, you can see it in full bloom. The second quarter was exceptional for Upstart. In addition to achieving triple-digit revenue growth, we reached GAAP profitability a quarter sooner than expected. Additionally, our newer businesses, Home and Auto, actually accelerated off the amazing growth you all saw from them in the first quarter. Originations on the Upstart platform in Q2 were $2.8 billion, our highest volume in 3 years. Revenue in Q2 grew 102% year-on-year, helping us deliver positive GAAP net income for the first time since Q2 2022. Our Auto business grew 87% sequentially, while our Home business grew 67% sequentially. While this friendly sibling rivalry tends to go back and forth in terms of growth rate, I can happily say both businesses accelerated meaningfully from their Q1 growth. For the first time ever, more than 10% of our originations came from our newer businesses, including our small dollar loans, which grew 40% sequentially. Our teams couldn't be happier. After a long period of super focused execution, it all just seems to be working right now. Once again, our growth last quarter was not a result of dramatic macro improvements or Fed rate decreases. In fact, the Upstart macro index has been largely stable for several months now. Our growth was primarily on the back of model improvements, which helped to drive conversion rates from 19% in Q1 to 24% in Q2. These wins came first and foremost from Model 22, which we launched in early May. Paul will share more about our model advancements shortly. In addition to our ML team, our growth and operations teams continue to do amazing work to drive down the cost of acquisition and origination. These are technology-driven economic wins that result in a superior product for the consumer and a sustainable advantage for Upstart. As I mentioned earlier, our emerging businesses are growing really quickly. Small dollar loans and Auto each crossed $100 million in quarterly originations in Q2, and we expect Home, the new kid on the block, to follow soon. Our newer products collectively drove almost 20% of new borrowers on the Upstart platform in Q2. For each of these emerging products, we're now reaching the point where credit history is sufficient and volumes are substantial enough for third-party funding. In fact, we have a goal to transition most of the funding for these products off our balance sheet by the end of 2025, though deal timing is always hard to predict. It's worth noting that our Auto Retail product, that is our software installed at car dealerships, has really gained traction and momentum in the last couple of months. This product has always presented unique challenges relative to our others, and it's clearly taken Upstart some time to get it right. Several months ago, we took the decision to narrow the focus of our software on an exceptional financing process, and this focus has paid off in spades. The dealership adoption right now is like nothing we've seen in the past, and the volume of loan requests and closed agreements from our dealer partners is on a steep climb. This is a recent phenomenon, and I expect we'll share more about it as it plays out. In our Home business, we're increasingly confident we're on a path to building the best-in-class HELOC experience. Home is a massive and fragmented category with few players versed in AI and its amazing potential to power superior home lending products. In Q2, we launched instant property verification, with the first applicant completing the entire verification process in under 1 minute. Our system automatically verified their identity and income, assessed the property's value and any existing liens and confirmed ownership and vesting information, all the key steps needed to close the loan. I believe this speed and efficiency in what is normally a slow handcrafted process is without precedent. We continue to strengthen the funding supply on Upstart's platform. Our funding partnerships have been both durable and scalable, allowing us to grow rapidly while delivering the target returns our partners expect. With respect to banks and credit unions, we expect to reach a new all-time high for monthly available funding in Q3, surpassing our prior peak from early 2022. The funding markets continue to improve as the year progresses, particularly since the fears around Liberation Day in early April subsided. In June, we priced and closed our second ABS deal of 2025, delivering significantly improved execution compared to our first, which closed in April. It's worth noting that the more recent transaction had nearly twice the number of investors as the first, including some new names. We feel increasingly confident that these committed funding partnerships can scale with our business as needed and will play an important role as we begin to commercialize our newer products. Before I turn the call over to Paul, I'll share a few final thoughts. Looking over the last couple of years, we've done a lot of work to run our business more efficiently and streamline our cost structure, but we had conviction that investing in much larger Home and Auto opportunities made sense. These categories are ripe for AI disruption and they've expanded Upstart's total addressable market by more than 10 times. Our considerable investments in Home and Auto are really paying off with fast growth, strong credit performance, rapidly improving separation and commercial readiness with 9 lending partnership deals recently signed across one or more of our secured products already. To be clear, our goal is market share leadership in each one of these product categories in the future. As our CMO, Chantal mentioned at AI Day, we're building the always-on everything store for credit, aiming to persistently underwrite 100% of Americans with the best credit products in the world just a click away, and we're off to a great start. Thanks. And now I'd like to turn it over to Paul, my Co-Founder and Upstart's Chief Technical Officer.

Thanks, Dave. Our aim at Upstart is to win by having objectively the best rates and process for borrowers, and technology, specifically AI, is how we do that. To that end, I want to highlight several areas of recent progress. First, we've continued investing in our core AI advantage. Model 22 made use of neural networks at every level of the model architecture, whereas prior models only made use of neural networks in the base layer. That may sound like a subtlety, but it increased our separation accuracy advantage over our benchmark textbook credit model by 17 percentage points to 171.2%. Equivalently, it decreased the inaccuracy remaining to be solved to 87.5%. This is a metric where the starting point is the benchmark textbook credit model I described back at AI Day and 0% would be a model that gets every credit decision perfectly right. As you can see, there is a long way to go, but fortunately, we have a commensurately long roadmap of model improvement ideas to get there. As of the end of Q2, core underwriting had 91 million borrower repayment events to train on, up from 86 million at the end of the prior quarter. To support the larger and more complex models, we invested in further parallelization and caching solutions that cut up to 17 seconds of latency off borrower pricing and saved on model costs. Those time and resource savings can now be reinvested in yet more powerful models. Second, servicing is the newest frontier for us, and realizing loss reductions via best-in-class servicing has been a major focus. Over the past year, including the most recent quarter, we launched numerous improvements and optimizations to how customers can pay, how much they pay, and when they pay. As a result, year-over-year population-adjusted delinquency rates are down 20%, and raw delinquency rates are down 32%. Machine learning is already informing many of these optimizations and will soon allow us to determine the causal impact of servicing actions we take. This will include the assignment of specific agents, hardship programs, or settlement offers to specific borrowers. We also plan to apply machine learning to the problem of individualized recovery prediction for the first time ever, replacing a fixed assumption about an economically significant portion of loans' cash flows with machine learning. Servicing wins directly improve loan loss rates on loans, which in turn improves the pricing and approvability of new loans. Third, we made strong progress in Q2 generalizing our AI technology across product verticals. I want to start by noting that even with accelerating growth in new products, our share of fully automated loans actually kept up this quarter. That will be challenging to keep pace with, but we're encouraged by wins we had across new products. As Dave mentioned, HELOC had its first instant property verification, which involves solving for over a dozen facts or documents that previously required waiting for a manual verification. In Auto refinance, we launched full automation of the remote online notarization process. Both of these wins remove major procedural barriers to model-driven automation, which we've seen relentlessly drive the percentage of loans fully automated up in core personal loans over the past few years. Our growth in auto has been supported by and coincides with strong advances in the generalization of our core underwriting technology. Auto is the first area where instead of directly training an auto model, we start by training a foundational credit model on data from multiple credit categories and then apply fine-tuning to arrive at an auto-specific model. We are now working to add embeddings to the auto retail model, along with generalizing what we call 'APR as a feature' and our macro framework from personal loans. This type of model generalization is powerful because it means all of our loan products can learn from repayment patterns observed across our platform, not just within their individual category. Lastly, I want to touch on generative AI and its applications to our business. I'll start with the table stakes. Like any good tech company, we've realized solid productivity wins from the application of large language models to our internal operations. 60% of our developers are weekly active users of LLM-powered developer tools, and teams all across the company have built over 700 custom GPTs to automate various internal workflows. More interesting are the applications to the end borrower. We've already launched early versions of borrower-impacting generative AI tools around model explainability and customer service. We will continue to build on these with an eye towards eventual agentic management of our consumers' credit needs. As Dave has discussed, one of our key priorities in 2025 is to 10x our leadership in AI. We continue to have a robust pipeline of modeling wins, and I'm incredibly proud of the team and what we've been able to accomplish so far. With that, I'll turn it over to Sanjay.

Thanks, Paul, and thanks to all of our participants for sharing some of your time with us today. I'll now spend some time giving context on our numbers. With respect to its impact on financial performance, the credit environment we operate in was largely a non-story in Q2. The emergence from last quarter's tax seasonality played out roughly as expected. The broader macro has been idling in regards to its impact on credit trends, registering as neither a significant headwind nor tailwind over the past 6 months. As Dave alluded to, the strong sequential momentum we achieved in Q2 is largely due to the strength of our model launches during the quarter. In addition, take rates and contribution margins increased in the core personal loan business, although in our aggregate numbers, these dynamics were partially offset by the continued rapid scaling of the newer Home and Auto products, which still have immature unit economics. The combination of these effects allowed us to beat our guidance across both top and bottom lines in Q2 and break through to GAAP profitability a quarter earlier than anticipated. We have been able to comfortably fund the ongoing growth in the core personal loan business through our existing lending relationships and capital structures. The main source of pressure on the balance sheet as it currently stands is from the continued scaling of the new products, and an increasing priority for us this year will be to finalize and implement our third-party capital plan for these new products. With this as context, here are some of the financial highlights from Q2 of 2025. Total revenue for Q2 came in at approximately $257 million, up 102% year-on-year. This overall number included revenue from fees of approximately $241 million, which was up 84% year-on-year and 15% better than guidance. Within this, transactional revenue more than doubled year-on-year, largely reflecting the influence of the aforementioned Model 22. Separately, servicing fee revenue grew by nearly 20% year-on-year as the outstanding book of serviced loans continued to expand. Net interest income represented roughly $17 million of overall revenue, ahead of guidance by $2 million, reflecting the growing volume of new products being incubated on our balance sheet and in particular, the Auto book of loans where our return on investment has meaningfully strengthened. The volume of loan transactions across our platform was approximately 373,000, up 159% from the prior year and 55% sequentially, and representing just over 250,000 new borrowers. Average loan size of approximately $7,570 was 15% lower than the prior quarter as model advancements drove higher approval rates in smaller loan amounts. 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 Q2, up 3 percentage points from the prior quarter and exceeding guidance. This improvement reflects a strengthening take rate in our core borrower segment in addition to the acquisition and operational unit cost efficiencies driven in part by Model 22. GAAP operating expenses were roughly $252 million in Q2, up 16% sequentially from Q1. Expenses that are considered variable relating to borrower acquisition, verification and servicing were up 21% sequentially relative to the 55% increase in volume of loan transactions, supporting the higher contribution margins previously referenced. Fixed expenses were up 13% quarter-over-quarter, largely reflecting a one-time catch-up in the compensation-related accruals, which on the current business trajectory, we expect will normalize in the back half of the year. Q2 GAAP net income was approximately positive $6 million, well ahead of expectations and reflecting outperformance on fee revenue against our tightly managed fixed cost base. Returning to GAAP profitability has been an important objective of ours over the past year, and I am proud that our team has reached this milestone ahead of schedule, while subsisting in the persistently high default environment that still surrounds us today. Now that we are over the line, we will look forward to continuing the positive momentum of our bottom line and to improving our profitability profile as we scale. Adjusted EBITDA was $53 million, also scaling nicely in accordance with our operating leverage. Adjusted earnings per share was $0.36 based on a diluted weighted average share count of 118 million. We ended Q2 with approximately $1.02 billion of loans held directly on our balance sheet, up from $815 million in Q1. This sequential increase is mainly due to the continuing growth of our new products, which have all simultaneously entered the transitional period between R&D and commercialization, a period in which we must ramp deliberately in order to demonstrate credit performance and our ability to deliver meaningful volume before obtaining third-party funding commitments. In this regard, we are in a bridging period with these new products, which is precipitating what we expect to be a temporary expansion of the balance sheet usage that we intend to reverse as these products exit incubation. As Dave mentioned, we have already begun the process of securing external capital to support these initiatives, and we believe these efforts will allow us to transition away from direct balance sheet funding of these in the near term. As we plan for the back half of the year, our macro assumptions remain consistent with our prior view, which is to say a steady environment with the UMI continuing in the 1.4 to 1.5 range, steady interest rate levels and a labor market that remains resilient in the face of unpredictable policy shifts. Inflation will remain a near-term risk. In this environment, we expect to continue to launch model enhancements that will improve conversion rates, our take rates and contribution margins will remain robust, and we will continue to scale and fund the newer products. In this scenario, for Q3 of 2025, we would expect total revenues of approximately $280 million, consisting of revenue from fees of approximately $275 million and total net interest income of approximately positive $5 million. Contribution margin of approximately 58%, GAAP net income of approximately positive $9 million, adjusted net income of approximately $44 million, adjusted EBITDA of approximately $56 million with a basic weighted average share count of approximately 97 million shares and a diluted weighted average share count of approximately 105 million shares. For the full year of 2025, we now expect total revenues of approximately $1.055 billion, consisting of revenue from fees of approximately $990 million and net interest income of approximately positive $65 million, an adjusted EBITDA margin of approximately 20%, and we expect GAAP net income of approximately positive $35 million. These numbers are, of course, the outcome of a lot of hard work and great execution by the various teams across Upstart. So I'll take this opportunity to both thank and congratulate all of those teams. And with that, operator, over to you to kick off the Q&A.

Our first question comes from Peter Christiansen with Citi.

Really great results. Dave, Sanjay, could you discuss the health of the ABS market? Are you seeing any interest in equity tranche investments? Additionally, what are your thoughts on more competitors entering the near prime space, as well as the prime from a loan platform perspective? Are you experiencing any competitive pressure there?

Sanjay here. Great to hear your voice, Pete. Regarding the ABS markets, I believe we have returned to being a regular issuer at the pace we prefer. The bond market is looking positive. As for the residual or equity market you mentioned, I would describe it as opportunistic at this time. There are buyers, but it's not very efficient, and buyers tend to be selective with their deals. Therefore, I wouldn't say that market is as fully back as the bond market is. Overall, it’s a positive market, and we are pleased to be a regular issuer again.

Pete, this is Dave. I'd just say on the competitors, to the extent the funding markets have improved and capital markets have improved somewhat through the year, I think that does tend to bring more competitors into the space. So unsurprisingly, it's a fairly competitive game these days. But again, we're very focused on having the best offers, both at the super prime level and at our core business as well, and also very confident in our ability to grow our market share and keep our strength in those markets as well.

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

I wanted to ask about the increase in the loans on the balance sheet. And Sanjay, you mentioned that those you would start transitioning to external funding in the near term. I just want to kind of zero in on what that means exactly. Should we expect next quarter that amount to begin rolling down, decreasing? Or is it going to take a little more time to line up the external funding category? And I guess what will be the pace of decline there that we should expect over the next few quarters?

Yes, Ramsey. Yes, as I mentioned in the prepared remarks, a lot of the volume on the balance sheet today are from our new products. So our core business, I think, is well funded. Categories like Home and Auto are growing quickly. So it's a bit of a good problem to have, sort of the original use case for the balance sheet, which is R&D and incubation. In terms of timeline to get the flows moving to third-party capital, I think we're looking at a timeline that's sort of roughly between now and the end of the year. And a lot of that is just about new originations and getting that flow to capital sources. I think as we make those deals, obviously, we'll opportunistically use our balance sheet to seed those relationships. So I think as we sort of transition the new flows, you should see our balance sheet start to release as well. But yes, I would give sort of a couple of quarters' timeline on that dynamic.

Okay. I have a quick follow-up. The super prime percentage of loans has decreased slightly from the previous quarter. I'm curious about the reasons behind this change. Is it related to the mix of loans or underwriting decisions? How is this currently trending?

I don't think it's anything in particular because I think we have enormous room to grow in our core as well as in super prime, and both are growing very quickly. So it wouldn't surprise me that it kind of goes back and forth. We have enormous market share opportunity across those product segments. So to me, that's not surprising. We're also really just beginning to build in the depth of funding in the super prime segment. So we do have very competitive funding in super prime, but we need to build the depth there, and that will allow us to scale while keeping prices in a very competitive place. So that's kind of the process going on there. I wouldn't read anything more into it than that.

Our next question comes from Simon Clinch with Rothschild & Company Redburn.

Maybe I could just start with the pretty impressive step-up in contribution margin versus your guidance. And Sanjay, could you perhaps break that down? I mean I presume some of that is due to sort of lesser mix of prime within the mix of loans that you've originated. But also the comment around take rates being higher. Could you just talk to that and elaborate a little bit more, please?

Yes. Sure, Simon. Yes, I guess the overall contribution margin improved. That is in the face of yet sort of growing new products, which have immature unit economics. So you may infer that the contribution margin of our core business grew by even more. And within that, there's both a mix benefit from having slightly more core borrower segment loans versus super prime. Those loans obviously have higher margin than very super prime loans. And then within that core borrower segment, there in of itself, our contribution margins and our take rates improved. And some of that is a result of the model launch we had; an improved model improves conversion rates that decreases acquisition costs like-for-like. And so there's sort of benefits to the unit cost side. And then even our take rates within that core borrower segment in the personal loan business saw some improvement, I think largely a result of the ongoing cost or sort of the take rate optimization that we're always doing, trying to understand elasticities in the different bands and optimizing against them. So that gave us some opportunity to improve our take rates and our contribution margins overall.

Okay. That's great. As a follow-up regarding the outlook you've provided and your comments on the current macro environment, could you share what assumptions you are making that contribute to your guidance? I notice that the third quarter is slightly above consensus, while the fourth quarter appears to be unchanged relative to consensus. Given the significant outperformance this quarter, it seems like you might be holding some reserves. I would like to understand that better.

Well, let's see, one part of your question was about macro assumptions. We're typically conservative with respect to the macro. We sort of roughly expect the status quo. So the main way that we measure that, of course, is in UMI, the macro index we have, which is hovering in the 1.5 range, and we sort of plan to a consistent UMI for the rest of the year. So remaining in a relatively high default rate. We plan for no real cuts in interest rates in the market. Obviously, there's a lot of speculation around what that might look like for the rest of the year, but we certainly don't bank on anything in that regard. And we're sort of continuing to rely on a relatively resilient labor market, notwithstanding the noise of the last week or so. I think the labor market continues to be in relatively good shape in terms of how many open jobs there are out there versus how many people are seeking jobs. So that's sort of the totality of the macro assumptions that go into our planning, and I think it's a relatively conservative sort of kind of a status quo, if you will. You also asked a little bit about the shape of the guidance. I would just say that we have relatively direct line of sight into what things are going to drive our Q3 numbers. Those projects are very sort of near term and rounding the corner. And so we feel very confident in being able to guide against them. I think there's a lot of things we're excited about with respect to Q4 and how that's going to go, but I don't think we quite have the line of sight required to guide specifically against them. And so I think that a lot of the near-term uplift you see is just excitement over some of the sort of the projects and the dynamics that we can see much more in front of us.

And our next question comes from Dan Dolev with Mizuho.

Amazing results, as always, very proud of you. My biggest question is the UMI, what could make it go up or down as we move throughout the year? This is the key question.

Great to hear from you. Let's see. UMI, I mean, it is ultimately a reflection of the impact of the macro on credit trends. I think the things we think most about in terms of what could move it, what could make it go down? I think the main thing is improvement in savings rates, improvement in consumption patterns relative to income. I think we've been consistent in saying that the American consumer in aggregate is probably overspending relative to the income levels that we're earning, and that's been true for a while now. And if that balance improves, we would expect that credit trends would improve as well. In the opposite direction, you might imagine things like a reacceleration in inflation or significant unemployment.

And we'll take our next question from Kyle Peterson with Needham.

I would like to begin by discussing the average loan size and the take rate. It appears that there has been a downward trend, particularly in our core personal loan product. Should we expect this trend to continue? Is this a strategic decision, or is it more a response to current market conditions where you see the most favorable risk-reward? I'm trying to understand the distinction between what's based on strategy versus what is driven by market conditions.

Kyle, this is Dave. I think you can consider this a strategic decision, as it reflects the rapid growth of our small dollar product. This product is pushing the boundaries of our credit model and bringing more people onto our platform, significantly contributing to our new user base. Those new users can then be offered additional products like auto refinancing. The growth of this smaller loan product is a key part of our strategy to have every American consistently underwritten on our platform. Providing more ways to onboard users is beneficial for us, as it allows for more cross-selling opportunities. This all fits into our larger plan. While we might see fluctuations, we currently have other products like mortgages and home loans also growing, so eventually these different segments will balance each other out. Overall, the main change is that our product mix is becoming more diverse.

Okay. Okay. That's really helpful. And then I guess on some of these new products, obviously, it seems like a really good opportunities are in like HELOC and Auto. How would, I guess, like you guys compare the competition there versus the core personal loan product? Is it equally as much of a knife fight? Or like is the sledding any easier or tougher? I guess, just kind of how should we think about the economics of these products, especially as they shift to external funding and the ability to scale quickly? Any color there would be really helpful.

Yes. I think, I mean these products are different, and our ability to create a very differentiated product happens in a different way. I would say in the unsecured products, the underwriting itself is a big part of the advantage and the magic that we bring to the market, and that is what's built the company. And the newer products, particularly like Home, Auto refinance, they're actually quite low loss rates, prime-ish products. But the real opportunity for both Home and Auto is to create a very differentiated experience and process that costs a lot less to originate and also just creates a far better consumer experience. So the relative ability to price differentiate isn't as great as it is in unsecured, but the ability to create a very much differentiated experience for the consumer and also a lower cost origination is much larger for those products. So overall, that's what we kind of keep pushing on and sharing. We mentioned automating a lot of the process of getting a home equity line of credit. That's a product that normally would take more than a month on average to get from your local bank or credit union, and we can do it just in a few days or even faster. So that, to me, is important. AI can bring not only pricing things properly, but also just eliminating the friction and reducing the risk in highly automated, very efficient ways.

The next question comes from Mihir Bhatia with Bank of America.

Maybe just starting with the newer products, particularly the Home and Auto. You mentioned you're working on additional funding partners or funding partners to get some of that off the balance sheet. Can you provide a little bit more color on that? Are those going to be more bank partners? Are you thinking securitization? How are you thinking about that?

Mihir, this is Dave. It will involve both banks and credit unions, as they have significant experience and familiarity with these products. HELOCs, in particular, are very popular within that space. Therefore, they likely have a bigger role compared to institutional capital or private credit capital. However, we will consistently seek the most competitive capital combinations to deliver the best products in the market. What sets us apart is our access to depository capital, private credit, and other institutional funding sources, all competing to create the best offerings for consumers. In comparison to unsecured products, I believe that other product lines will increasingly tilt toward depository capital.

Got it. That's helpful. And then just turning maybe I think on the conversion rate improvement, you mentioned the biggest driver was the new product, the new model, which launched in early May, if I heard that correctly. So does that mean you only got the benefit of 2 months? So 3Q conversion rate should be even higher from there? And just if I could also just throw in there, if you could just talk a little bit about the Walmart partnership, any call-outs there?

We aren't really forecasting anything about conversion rates for current quarter. There's always puts and takes on conversion rates. When it goes up, we often end up spending more and pulling it back down intentionally. In other words, turning conversion rate into extra growth. So there's just not a straightforward kind of up and to the right on conversion rates. If you sort of see the chart that we provide in the investor deck, I think it's a great illustration of how conversion rate trades off with volume. And so I'd say that. On Walmart, we continue with that partnership. It's been a great success for us thus far, but we don't have anything new we want to share about it today.

And our next question comes from Reggie Smith with JPMorgan.

Congrats on the quarter. Really strong quarter. I had a follow-up on the conversion rate. I'm not sure if you guys have shared this in the past or if you're comfortable sharing it. But I'd love to hear about, I guess, the 2 elements of conversion rate, the approval rate and then kind of the acceptance rate is how I've been thinking about it. I guess, one, am I thinking about that right? And then two, can you talk about how those ratios have maybe changed versus the prior year? And then as we think about the new model, maybe anecdotally, talk a little bit about the types of people or the profile of the people that may have been rejected before that they're being approved today. Obviously, I don't want to give your secret sauce, but just any color you can give there? And I have one follow-up.

Reggie, your sort of decomposition of conversion rates is correct. It's sort of a product of our approval rates and the subsequent exception rates of the loan. We've never really decomposed it in how we analyze externally, and I don't think we have any off-the-cuff narratives around the relative subtrends there. It may be something that if it's interesting, we can sort of look at exposing over time or in the future, but I don't think that's anything that we have any great soundbites for you as of right now.

This is Paul speaking. Regarding the second part of your question about specific types of borrower characteristics that we may be seeing more of, the short answer is that, as we have mentioned several times, the real strength of our model lies in its ability to uncover numerous subtle relationships within the data. This occurs at various levels of the model architecture, as we explained with Model 22. Unfortunately, there isn't one straightforward answer to your question, such as an increase in high credit score borrowers or low-income borrowers. Instead, it involves selecting borrowers from various segments of the credit landscape and identifying those who are more likely to repay, based on characteristics beyond traditional credit metrics.

That makes sense. Okay. And then if I could, Slide 23 in the deck, you guys give this every quarter. We see, obviously, the numbers are increasing. It looks like the assessed value is greater than the co-invested value up until this point. Maybe help us understand like how should we interpret this slide? And what should we take from it? And then as far as outperformance or underperformance relative to expectations for this piece of your portfolio, where does it show up? And how do we see that flow through? Because it looks like maybe things are better than you even thought when you put these loans on the books. I'm just curious where that shows up.

Reggie, well, as far as what takeaway from this slide, I mean, it does pull together, I think all the various ways in which we are co-investing in risk capital deals. So it hopefully gives you a holistic perspective of what that investment level is at any point. I think in terms of thinking about how to model it, we're sort of in the ramping phase. To the extent that these deals start paying back a couple of years into the deal, you should expect this to sort of ramp probably for a few more quarters, and then it will start to level off as the amounts we're investing in new quarters are roughly offset by the amounts coming back in from prior deals. And so there's sort of a ramp-up and then a sort of a platforming of this amount. And then, of course, this tells you how we're doing on those investments. I think early on, in the early sort of instances of these deals, our goal is to make sure we were preserving capital. And so you want to make sure that the way that we're valuing what these positions are is at least on par with what we invested. I think more recently, we have an intention to start earning returns on these investments. And so you'd expect or hope that the assessed value of these positions starts to grow in relation to the invested capital. But I think the idea of this slide is to give you a picture of how this investment is trending and how the returns are looking. In terms of how it shows up in the P&L, it's probably a much more complicated answer to your question because the reality is it hits on various line items depending on the structure of the deal, and there's a lot of different structures at play here. But I think at a very high level, you can expect that the amounts that we're assessing at current value, if they were to hold, they will make their way back into the P&L largely in the form of fair value improvements or net interest income really. And so while there's a couple of different paths back into our financials, I think that's probably like if you were just to really crudely simplify it, that's how it will show up.

And we'll take our next question from James Faucette with Morgan Stanley.

I wanted to just talk about really quickly, you mentioned your CAC and some benefits you're getting there. But you've also always been really CAC efficient during even lean periods and whether it be your organic or your own CRM mind leads. As you expand though, how should we be thinking about how much is purely organic traffic to upstart.com, how much is originated via direct mail, and how much is sourced via third-party marketplaces? And how should we think about the evolution of those types of channels?

James, this is Dave. I believe the long-term trend shows an increase in repeat borrowers, particularly in our core unsecured products, which are increasingly cross-sold to other offerings. These borrowers often come from our existing database or relationships, resulting in minimal customer acquisition costs for a growing portion of our loans. However, we must also consider the pace at which we are growing and bringing in new borrowers. While it’s positive that new borrowers are joining swiftly, they often come with associated costs. We are gradually reducing our dependence on aggregators and similar representatives of our brand, allowing for a stronger direct connection with consumers and broader product offerings. In recent quarters, we have significantly improved our ability to cross-sell. For instance, we successfully refinance auto loans at lower rates for individuals who may have initially sought small personal loans. This cross-selling approach is proving to be more effective than initial customer acquisition. As our Auto and Home categories expand, we are seeing an uptick in cross-selling opportunities. This trend indicates a move towards longer-term relationships with our customers and underscores the long-term value we provide. This confidence enables us to invest more upfront, knowing it will lead to greater margin potential by facilitating additional loans or product offerings in the future. This model has been in development for some time and has contributed to a reduction in acquisition costs per loan over the years.

Got it. I wanted to ask about the portion of the loans that are being handled automatically. I may have missed it this time, but I found it interesting that you mentioned in relation to new products like HELOC and Auto that you're aiming to leverage your improved automation as part of your brand. I can imagine that's really beneficial for cross-selling. What are your current automation levels, and what do you think you can ultimately achieve?

Yes. Thanks. Great question. So we obviously haven't broken out the exact fully automated percentages for the new products at this point. But I think it's safe to say that they're a fair bit less mature than they are in the core personal loan product. And that's not surprising. I think they're both newer products, but also they start out with more challenges. I think ultimately, we believe that those challenges can all be overcome. And I think we shared in the pre-prepared remarks that we made quite a lot of progress in both Auto and the Home categories in this quarter. And in particular, we had our first instances of fully automating several new parts of the home loan process for our HELOC product. And there's still quite a bit more work to be done before those numbers will reach the personal loans level, but I think they are on a very good trajectory towards that. And I think in the long run, that would be our expectation.

And our next question comes from Rob Wildhack with Autonomous Research.

On the fair value adjustment in the quarter, I noticed that was higher or more than a negative than it's been in the past. Can you speak to the drivers there? And then I think along the same line, the aggregate NII guide is down for the rest of the year despite the increase in balance sheet loans. So how you're thinking about fair value marks for the rest of the year?

Fair value does experience some volatility. The rep contour is UMI, and our macro index saw a significant decline in the latter half of 2024. We recognized some gains as fair value marks that continued into the year. In the first quarter and part of the second, you benefited from the decrease in UMI, which has since risen slightly in the early quarters of this year, impacting Q3. By Q4, you'll see advantages from the earlier risk capital deals as they begin to repay. However, there was a lull in Q3 due to the rising UMI, putting some pressure on results. The risk capital deals have not yet started to show benefits. Additionally, depending on the seasoning of your loan book, the fair value of an individual loan tends to be very high at the beginning due to interest accumulation and absence of charge-offs. It typically peaks around month 12 when charge-offs rise, causing fair value to drop. By the end of the loan, as charge-offs taper off, the interest returns to a high state again. This natural cycle of loan valuation shifts from high to low to high. When applied across an entire portfolio, it can introduce seasonal volatility; this phenomenon is also contributing to Q3 results. Overall, fair value is a complex issue, but these are the key factors influencing the trends over recent quarters.

Okay. Bigger picture, it seems that all personal loan originators are experiencing significant growth lately, and even companies like SoFi are clearly moving into near-prime territory with their loan platform, which overlaps with your market. You have also seen considerable growth in core loans. I’m curious about how you perceive adverse selection in such a competitive landscape.

We certainly think about it. I would say, first of all, it's one of the reasons we really focus on making sure our cost of capital is competitive across the spectrum or anywhere we want to participate or else you are at risk of adverse selection. So at the conceptual level, we just have to make sure that the fuel, the dollars funding the loans are as good or close to as good as anywhere, and then you have much less concern about that. Also, I mean, the nature of our models that have gotten sophisticated enough to handle issues of like how does the price of the loan affect the performance of the loan. If you recall back last fall, we introduced what we call APR as a feature, which was quite an innovation on our side, which helps us make sure the price of the loan is considered when you're measuring the risk in the loan. And that was a giant leap forward back in model 18. So we kind of feel from a technical perspective and also from a business perspective, we are both aware of and responding to potential for adverse selection. So a very competitive market is not new to us and something we feel pretty good about.

Sorry, if I could just sneak one more in on that, Dave. How do you compete with deposit funding from somebody like SoFi or LendingClub in terms of cost of capital?

Well, about, I would say, 25-ish percent of our loans are funded by deposits. So it's just that they're not our deposits; they're from credit unions or bank partners. So that's an important way. And that's, of course, for the primest of our loans. So that's deposits compared to deposit. We're just doing it in a distributed manner as opposed to it being Upstart Bank or something. The other thing I think is important, which is happening quickly is I think non-depository capital is getting more competitive at the primary end of the spectrum just because there are sources of funding that have all sorts of different blends of risk and reward appetite. And through the worlds of private credit, insurance, et cetera, there is non-depository capital that may not be exactly as inexpensive as depository capital, but getting closer and closer. So I think that difference, which historically was quite large, is actually beginning to blend much more these days.

And our next question comes from Kyle Joseph with Stephens.

A lot of them have been addressed, but just thinking about the product mix, obviously, you guys talked about the benefits of AI to the personal loans. And then obviously, you're seeing good growth in Home and Auto, but factoring in the law of large numbers, just kind of how you see the mix going forward and any implications in terms of margins and/or customer acquisition costs?

Well, let me just speak to the mix to the extent we can, and maybe Sanjay can comment on what it might mean for margins. Look, we, of course, feel like there is enormous growth potential in all our product areas, including in our core personal loan product where we have very, very well-established margins and automation, et cetera. And then these newer categories are generally much larger categories, but we're much earlier into penetrating them. So we think we have a very attractive, like very large addressable market. We're very early into it. And almost inevitably over time, I think the secured products, meaning Home and Auto, are going to grow as a fraction. And could they become much larger than unsecured over time, it's quite possible. I don't know that we know that. I think unsecured as a category, even though it's smaller, is growing. It's quite popular with consumers. So I guess that's a long-winded way of saying, look, we're in single-digit market share in unsecured, which we have enormous advantages and strengths and just at the cusp of really beginning to move in Home and Auto. So the potential for very, very rapid growth over a long period of time in all those categories is pretty significant.

Yes. I would just like to add regarding margins that the profile for these new businesses is still developing to some degree. However, all these markets exhibit a similar pattern to our current core market, which is the unsecured sector. In this sector, there are well-served borrower segments where competition drives prices down and margins are narrow, leading to competition based on process and distribution. Additionally, there are always parts of the market that are underserved or lack access, presenting significant opportunities for volume and margin creation. This remains true in both the auto and HELOC markets. The secured loans are likely to have larger loan amounts, possibly lower percentage take rates, yet generate comparable dollar revenue and profit per loan as our unsecured business. However, we do not have the precise details as this aspect is still unfolding as these categories grow for us.

And we'll take our next question from John Hecht with Jefferies.

Like Kyle, most of my questions have been asked. I guess I'm curious as to kind of your sense of what interest rate reductions would do. I assume the Auto refi business would pick up, and the HELOC business, I imagine as well. But in the core products, do you pass on rate changes to the customers? Do some of your partnership agreements with the private credit, do those contemplate changes in interest rates? Just to kind of get a sense if we go into your rate cycle, what to think.

A reduction in rates would directly impact our core business, although not immediately due to some delays. If overall economic rates drop, financing rates will also decrease, which will in turn lower the return on assets for our unlevered loans. This should lead to reduced rates for our borrowers and improvements in conversion. Our agreements with committed partners are designed to account for these changes, so a reduction in rates would be clearly beneficial, as it would eventually lead to lower rates for borrowers.

All right. Thanks, everybody, for joining. Q2 was a great quarter for Upstart, no doubt. For those of us on the inside who saw kind of the radical makeover we've been going through in the last couple of years, it wasn't a surprise, but it was very rewarding. So thanks again. We're very excited for what we'll do the rest of this year, and we'll see you all in November. Thanks.

And ladies and gentlemen, this concludes today's call. Thank you for your participation. You may now disconnect.