Upstart Holdings, Inc. (NASDAQ:UPST) Q4 2023 Earnings Call Transcript

Upstart Holdings, Inc. (NASDAQ:UPST) Q4 2023 Earnings Call Transcript February 13, 2024

Upstart Holdings, Inc. beats earnings expectations. Reported EPS is $-0.11, expectations were $-0.15. UPST isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good day, and welcome to the Upstart Fourth Quarter 2023 Earnings Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Jason Schmidt, Head of Investor Relations. Please go ahead.

Jason Schmidt: Good afternoon and thank you for joining us on today’s conference call to discuss Upstart’s fourth quarter and full year 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 fourth quarter and full year 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 first quarter of 2024, relating to our business and our plans to expand our platform in the future.

These statements are based on our current expectations and information available as of today and are subject to a variety of risks, uncertainties and assumptions. Actual results may differ materially as a result of various risk factors that have been described in our filings with the SEC. As a result, we caution you against placing undue reliance on these forward-looking statements. We assume no obligation to update any forward-looking statements as a result of new information or future events, except as required by law. In addition, during today’s call, unless otherwise stated, references to our results are provided as a non-GAAP financial measure 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 questions as possible during the call, we request that you limit yourself to one initial question and one follow-up. Later this quarter, Upstart will be participating in the Citi’s 2024 13th Annual FinTech Conference on February 27th; Morgan Stanley Technology, Media & Telecom Conference on March 4th; and The Citizens JMP Technology Conference on March 5th. Now, we’d like to turn it over to Dave Girouard, CEO of Upstart.

Dave Girouard: Good afternoon, everyone. I’m Dave Girouard, Co-Founder and CEO of Upstart. Thanks for joining us on our earnings call covering our fourth quarter and full year 2023 results. Despite the difficult lending environment, we delivered solid results to end the year with revenue up 4% sequentially and our third consecutive quarter of positive adjusted EBITDA. Without question, 2023 was a challenging year for both Upstart and the lending industry and we’re glad to be done with it. With interest rates at their highest in decades, elevated consumer risk throughout multiple bank failures leading to extreme caution and conservatism among lenders and a significant dislocation in capital markets the environment presented one hurdle after another.

Considering the challenges 2023 presented, I’m happy with the decisions we took and the progress we made for the long-term success of Upstart. Looking ahead, we remain cautious about the near-term outlook for our business and we’ll continue to operate responsibly in this environment. But I’m hopeful that you’ll begin to see the benefits of our work as the economy continues to normalize in 2024. The numbers will show that we actually become far more efficient. And even while becoming more efficient, we’ve laid the groundwork to become a more resilient and diversified company that can thrive through a wide range of economic conditions. With regard to efficiency, in Q4, we increased our contribution margin, both percentage-wise and in absolute dollars versus the year ago quarter.

We also finished 2023 with 26% fewer head count than at the end of 2022. Despite this, we hired almost 200 new Upstarters in 2023 as we continue to strengthen our teams and reinforce our priorities. Improved efficiency sets us up well for a return to profitable growth in the future. But 2023 was not all about efficiency, we also focused intensely on building a stronger Upstart for the future. Let me share six areas where we’ve made significant progress recently and why I believe they’ll lead us to a bigger and brighter future. Number one, managing the macro. In the last two years, we experienced an economy unlike any in recent history. In fact, if you look even further to the past, you would be hard-pressed to find an economic cycle similar in form to what we’ve experienced since the beginning of the pandemic.

While most of our innovation historically has been focused on selecting the right borrower at the right price, we learned that disruptions to the macro economy can reduce bank’s desire to lend all together, particularly in unsecured credit where risk is naturally greater. In 2023, we took on this challenge by releasing the Upstart Macro Index, a tool that provides lenders with a clearer picture of the current state of the economy and enables them to make more refined decisions about their lending programs. We also developed Parallel Timing Curve Calibration, which helps calibrate new versions of risk models faster than what was previously possible. While we believe predicting the economy’s future is unrealistic, we do think lenders can be far more data-driven and nuanced in their decision-making.

UMI and PTCC represent a giant first step toward offering a proprietary set of macroeconomic management tools that we expect banks and credit unions will demand for all their lending programs. Such a tool set is vital to Upstart’s mission because it has the potential to make appropriately priced credit readily available to more Americans in all parts of the cycle. Number two, extreme automation. Because so much attention goes to our risk models related to credit decisioning, it’s often less well-appreciated how much progress we’ve made in building a highly automated and efficient credit origination process. Automation and efficiency are a winning combination in any economic climate. In Q4, we once again achieved an all-time high with 89% of our unsecured loans proved through an instant and fully automated process.

Though we expect this number to vary quarter-to-quarter, the long-term trend has been clear, and it’s a big win for us. We believe process automation is a durable advantage for Upstart that creates an obviously better user experience. Who wouldn’t want to be approved instantly for a loan rather than having to upload documents, schedule phone calls, or wait hours or days for a response from a credit analyst. We believe a fast automated approval is essential to winning over borrowers who have lots of choices and little patience or time, and these tend to be the best borrowers. And it’s not just a better user experience. In Q4, 92% of automatically approved applications converted to a funded loan, while only 27% of those involving manual steps converted.

That’s an astounding difference, more than 3x the conversion rate. Improved conversion from automation mechanically reduces up-funnel costs associated with customer acquisition and data associated with generating the rate offer. Of course, automated loans cost Upstart far less to process in the verification step, contributing directly to our efficiency and allowing us to pass the savings along to our lending partners. We recently began to brand and market our automated approval process to applicants as fast track. Just by planning the benefits of fast track to applicants, we’ve increased our funnel conversion by more than 2%. Number three, strengthening our core. We’ve also focused on strengthening our core personal loan product for periods of higher interest rates and elevated risk, such as we’ve been experiencing in recent quarters.

In the coming months, we expect to release an optional feature that allows borrowers to provide collateral to support their personal loan application. This option will help borrowers access credit at lower rates than would otherwise be possible, particularly at a time when rates and risk are elevated. We’ve also identified a somewhat different opportunity to assist our lending partners in periods of reduced liquidity, when banks tend to prioritize retaining existing customers over acquiring new ones. We’re hard at work at developing tools and techniques to help our bank and credit union partners do just that, strengthening their relationships by better serving existing customers. We expect to share more about this later in 2024. As I mentioned last quarter, we’ve also upgraded our investment in servicing and collections and are hopeful we’ll see dividends from this investment in 2024 and for years to come.

The product team working on our servicing platform grew by more than 60% in Q4. Much of the effort is focused on simply making it easier for borrowers to pay and for servicing agents to handle borrowers issues quickly and efficiently. But we’re increasingly excited about applying our machine learning expertise to this aspect of our product as well to maximize repayment and optimize handling of borrowers who may go or have already gone delinquent. We’ve begun programmatically gathering the data that will unlock the type of efficiency and efficacy gains in servicing that we’ve long seen on the origination side. Number four, upgrading the money supply. In our first 12 years, the lion’s share of our innovation has been focused on AI-enabled credit origination.

In parallel, we’ve also developed capabilities related to efficient customer acquisition that are serving us well. But we’ve directed far less innovation towards the supply side of our business, i.e., the money, and this needs to change. Today and in the coming years, we are increasing our innovation on the money supply and have a healthy head start in this area. Success in this domain means our funding across products will be more scalable, more reliable, and more competitive with respect to cost. We believe this innovation can be unlocked by long-term partnerships that combine novel risk sharing and returns moving structures with direct and proprietary access to our credit origination engine. After the quarter end, we closed an agreement with Ares, a leading global alternative investment manager for them to acquire $300 million of personal loans.

Additionally, we signed an agreement with a lending partner that we expect will originate approximately $500 million in loans over the next 12 months. Number five, products for all environments. We’re building a set of Upstart offerings that are countercyclical to each other with the goal of developing a more balanced portfolio of credit products with less volatility in overall volume. We’re particularly excited about rapid progress in our first home lending product, a HELOC. This product is popular in high rate environments when consumers are reluctant to sell their home or refinance their mortgage. We recently crossed our first $5 million in cumulative HELOC originations and our month-to-month growth is quite encouraging. We’ve now expanded to 11 states plus Washington, D.C. and expect to add a few more states in the coming weeks.

In Q4, our average HELOC time to close was down to nine days. This is amazing progress against our long-term goal of a five-day close and already dramatically better than the industry average of more than five weeks. In Q4, we also launched our first instant approvals for the HELOC product. This means we’re now often able to instantly verify identity, income, and home value without any tedious document upload or waiting. We’re hopeful this will become a meaningful percentage of our originations this quarter. We expect to drive this instant approval percentage up for HELOC, just as we’ve done successfully with unsecured personal loans. Lastly, we successfully integrated our HELOC within our personal loan application. This means personal loan applicants who are homeowners may be offered a home equity option in addition to an unsecured loan.

This is an area ripe with opportunity, and we expect to refine and expand this product integration over time. In contrast, high interest rates made 2023 a difficult year for auto lenders. Regardless, we continue to make progress with our auto offering. We used the time to grow and strengthen our relationships with auto dealers, rounding out our retail software with key features most requested by dealers. We also expanded our finance offering with 88 dealerships now offering Upstart auto lending, up from 27 a year ago. And we recently announced that we’re expanding our AI-powered financing capability nationwide. Expecting to reach 90% of US consumers by the end of this quarter. We’re confident that steady focus on the auto vertical will be rewarded once interest rates begin to decline.

Number six, extending Upstarts AI leadership. While the last couple of years have been challenging, I believe they’ve ultimately extended our leadership in the application of AI to lending. Our models learned more than at any time in our history. We’ve navigated extreme changes in macro conditions and build tools and capabilities to manage through such changes in the future. With our small dollar product, which I consider to be at the frontier of AI-enabled lending, we’ve tripled approval rates since August, and this product now represents about 15% of first-time borrowers on the platform. This type of rapid improvement, along with increasing automation and efficiency, gives me confidence that our forward progress in this domain is unparalleled.

To wrap things up, I’m pleased to share that in January, we brought Upstarters together in Austin, Texas. To kick off 2024 with our largest Upstart gathering ever. We spent significant time talking about why our mission is so vitally important and we left with a greater sense of purpose of our work. Upstarters across the country are confident and undeterred by the challenges involved in pioneering AI lending because they appreciate the size of the opportunity before us and the impact that access to affordable credit can have on the lives of all Americans. While many fintechs and even banks retreat from the lending business, we remain strongly committed to it. Americans will always need access to affordable credit. And by continuing to serve borrowers through this difficult time of extending our advantage in training data, model calibration, products and process.

Once the economy inevitably normalizes and lending becomes fashionable again, I believe it will be difficult for others to catch up with us. We’re excited for the new year and optimistic for what it holds for Upstart. Thank you. And I’d now like to turn it over to Sanjay, our Chief Financial Officer, to walk through our Q4 and full year 2023 financial results and guidance. Sanjay?

Sanjay Datta: Thanks Dave and thanks to all of you for joining us today. The hallmark of our economy in the second half of 2023 has been the remarkable unrelenting growth in personal consumption, which continued unabated through the balance of the year. This trend stands in contrast to the flagging level of disposable income, which on a real per capita basis peaked before last summer and has since languished. These contrasting portions of consumption and income over the back half of last year have left personal fiscal health and as precarious a state as they’ve been since the Great Financial Crisis with personal savings rates hovering close to all-time lows. With respect to the corresponding impact on unsecured credit performance, we continue to see clear signs that the rising default rates of lesser prime lower FICO borrowers that has played out over the past two years, is now stable and showing signs of imminent recovery.

However, the same pattern of rising defaults is now in the progress of working its way through higher cycle, higher prime borrower segments as well as primary and more secured products. According to our recent report released by the New York Fed, auto loans and credit cards have now spiked to their highest delinquency rates since the Great Financial Crisis and continue to rise. Within unsecured lending, our view is that the near-term risk in credit has shifted to the primary customer segments and as a result, we are becoming increasingly conservative in our underwriting of these higher cycle borrowers. The funding markets continue to be oversaturated with assets on offer in the secondary markets, largely coming from banks who continue to reduce the size of their balance sheet through asset sales.

Despite these ongoing distractions, institutional loan buyers appear increasingly comfortable with the prospect of a soft economic lending or perhaps even that no lending will be required and there is an increasing anticipation of rate cuts at some point later in 2024. The general outlook on the macro economy seems increasingly consistent with our own long-held view that inflation is on the wane and that significant unemployed risk in this labor market is unlikely. We are optimistic that our ongoing partnership efforts with the institutional funding markets will become increasingly constructive over the course of the coming year, should these macro trends fold. The examples of the partnerships that Dave announced earlier that have closed since the end of last year are hopefully indicators of more good things to come in 2024.

With this environment as context, here are financial highlights from the fourth quarter of 2023. Revenue from fees was $153 million in Q4, slightly above our guidance of $150 million and up from $147 million last year. Net interest income was negative $13 million in Q4. With continued R&D portfolio charge-offs in line with expectations and a downward revision to the outlook of our risk capital co-investments, reflecting the deterioration in the prime borrower loan performance. Taken together, net revenue for Q4 came in at $140 million, above our guidance and up 4% from the prior quarter. The volume of loan transactions across our platform in Q4 was approximately 129,000 loans, up 12% sequentially and representing over 82,000 new borrowers. Average loan size of $10,000 was flat versus the same period last year and down 9% sequentially.

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 63% in Q4, just ahead of guidance and up 10 percentage points from last year. As Dave highlighted, we continue to benefit from high levels of loan processing automation and fraud modeling efficiency, achieving another new high in percentage of loans fully automated at 89%. Operating expenses were $188 million in Q4, down 9% year-over-year but up 5% sequentially. As increasing sales and marketing spend somewhat offset efficiencies in automation and servicing costs. Altogether, Q4 GAAP net loss was $42 million, while adjusted EBITDA was positive $1 million, both just ahead of guidance.

Adjusted earnings per share was negative $0.11 based on a diluted weighted average share count of 85.6 million. We completed the full year with net revenue of $514 million down 39% from 2022, a contribution margin of 63%, up 14 percentage points from the prior year and adjusted EBITDA of negative $17 million, representing a negative 3% adjusted EBITDA margin versus 4% a year earlier. We ended the year with loans on our balance sheet of $977 million before the consolidation of securitized loans, down from $1.01 billion the prior year. Of that balance, loans made for the purpose of R&D, principally auto loans, was $411 million. In addition to loans held directly, we have consolidated $179 million of loans from an ABS transaction in the third quarter, from which we retained a total net equity exposure of $38 million.

We ended the year with $368 million of unrestricted cash on the balance sheet and approximately $590 million in net loan equity at fair value. Some amount of the core personal loans added to our balance sheet in Q4 were aggregated in anticipation of a secondary loan sale that was completed following the close of the quarter totaling $300 million. Despite the promising economic indicators around inflation and employment, we believe we are not yet completely out of the woods from a macro perspective. The excess money in our collective savings accounts plentiful during the stimulus years, has been spent after accounting for the effects of inflation and with historically low savings rates, the cash account balances in the economy continue to contract.

As noted, we believe rising delinquencies are now making their way over to the primary and more affluent segments of the borrower base, which is causing us to increase the conservatism in our loan pricing for those borrowers. Considering the lingering credit risk and keeping in mind traditional seasonal softness in the first quarter of the year, for Q1 of 2024, we expect total revenues of approximately $125 million, consisting of revenue from fees of $133 million and net interest income of approximately negative $8 million. Contribution margin of approximately 61%, net income of approximately negative $75 million, adjusted net income of approximately negative $33 million, adjusted EBITDA of approximately negative $25 million, and a diluted weighted average share count of approximately 87.0 million shares.

Having observed the stabilization and recovery of delinquency trends from lower prime borrowers, we believe to have cost for optimism coming into the new year. And so it has been disappointing to see how the primary borrower segments are now quickly following suit and extending the strain of the current environment. We will, as always, continue to act in the best interest of the credit by quickly reacting to raised prices and lower conversions in these segments. Confident in the belief that this will always lead to the best long-term outcome for our business. If the earlier arc of the less affluent borrowers is any indication, the same cycle amongst primary borrowers will soon normalize. And when it does, we continue to have conviction that we will be very well positioned to capitalize.

Continuing thanks to all of the Upstarters who are persevering through this right. With that, Dave and I are happy to open the call to any questions. Operator?

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Q&A Session

Operator: Thank you. [Operator Instructions] And our first question is going to come from Kyle Peterson from Needham. Please go ahead sir.

Kyle Peterson: Great. Good afternoon. Thanks for taking the questions. Just wanted to start off on funding and what the kind of constraint of growth right now, is the constraint right now on funding, whether it be committed capital or other buyers or this kind of a borrower demand and getting people below that 36% threshold? Just kind of want to see what the different gating factors are right now?

Dave Girouard: Hi Kyle, this is Dave. I think that there’s not an obvious excess of funding or borrowers. It does kind of bounce back a little bit back and forth, because the pricing of loans is so high, the approval rate is relatively low compared to our history. But it’s still a funding constrained environment. So, it’s not definitively leaning one way or the other right now.

Kyle Peterson: Got it. That’s helpful. And then just a follow-up on core personal loans, health and balance sheet at the – sequentially, it ticked up quite a bit. I guess, adjusting for that, the loan sale looks like it did continue to glide down. But I guess, excluding some noise in the loan sales and some of the timing issues. Should we expect the core personal loans on the balance sheet to continue to run down at least outside of the committed capital and risk sharing agreements? Or could that bounce around a bit?

Sanjay Datta: Hey Kyle, this is Sanjay. Yes, I think one of the things we referenced is that one of the reasons we aggregated a bit more than usual in the prior quarter on our balance sheet was in anticipation of the balance sheet deal that we did that closed subsequent to the end of the quarter, we’ve disclosed it as a subsequent event, but it’s a transaction that Dave referenced. That was a $300 million transaction.

Kyle Peterson: Okay, that’s helpful. Thanks, guys.

Sanjay Datta: Thanks, Kyle.

Operator: And our next question is going to come from David Scharf from Citizens JMP Securities. Please go ahead.

David Scharf: Yes. Good afternoon and thanks for taking my questions. Sanjay or Dave, I’m wondering, in light of your commentary about sort of delinquencies stabilizing more among kind of the lower-tier borrowers and kind of seeing more deterioration among prime. Can you remind us sort of what the borrower FICO mix is that you’re targeting? I mean I know from securitization docs very often had sort of an average FICO and sort of that 57 — I’m sorry, 670 to 690 range. But can you define for us a little better sort of how you’re viewing the core target borrower base right now, sort of how you’re defining near prime?

Sanjay Datta: Hey David, it’s Sanjay here. So, I think that historically, we’ve said and I think we continue to believe that FICO is not necessarily a great metric with which to understand our portfolio because it tends to be pretty broadly distributed across our grade mix. Now, I think if you think about borrowers in general, let’s call it, less affluent borrowers have become riskier over the last 18 months, we’ve certainly — in increasing their loss estimates, kicked a lot of them out of the approval box, and so there’s a less — so much lower incidence of them as there have been historically. And those borrowers are beginning to recover in the repayment trends and now it’s the more affluent borrowers that I think we’re describing as starting to maybe follow suit.

And so I think that’s a dynamic that you’ll see. As we react to those trends through pricing, you’ll see those mix shifts happen in our portfolio. But I think it’s a bit hard to take a broad sort of FICO aggregate of our platform because; A, they’re pretty broadly distributed across grades; and B, there — the loss rates themselves are pretty different by funding channel, whether it’s a bank or a credit union. Those are — that’s collateral that does not tend to show up in the securitization data, whereas if you’re looking at the institutional world, it tends to be sort of higher loss rate and higher returns. So, I think all of that makes it hard to describe our platform through a traditional lens, but hopefully, if you just think about just sort of high-level loss rates, you’ll see higher loss rate borrowers begin to recover from prior trends and lower loss rate borrowers begin to deteriorate.

David Scharf: Got it. It’s helpful color. And maybe just as a follow-up, focusing more near-term on the Q1 guide. Would you characterize the origination outlook in the fee revenue guidance is sort of the normal seasonality that we typically see in Q1 tax refund season with non-prime borrowers usually paying down balances? Or is there any kind of further tightening of credit that we should read into that?

Sanjay Datta: Sure. Yes, David. I think there’s probably two components to call out, and one of them certainly is what you’re describing, which is I think, usually in Q1, you run into a bit of a slump in borrower demand as you get into tax refund season, and we’re certainly anticipating that. I think that you could probably assume is what we’ve seen on average in prior years. And then the second one is what we described which is that, in fact, we are reacting to rising loss or sort of default trends in the primer borrower base by increasing loss estimates and reducing conversions a bit. But those two things combined probably make up the gap or the bridge to our Q1 guide.

David Scharf: Great, very helpful. Thanks so much.

Sanjay Datta: Thanks, David.

Operator: And our next question is going to come from Ramsey El-Assal from Barclays. Please go ahead.

Ramsey El-Assal: Hi, gentlemen. Thank you for taking my question this evening. I was wondering if you could comment on the on-balance sheet loans and that amount and whether we should — given more committed capital that you’re securing whether we should expect that maybe next year to come down from the levels that we’re seeing now or whether this is sort of where it’s going to live for a while?