Upstart Q2 2022 Results

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1. Upstart Demand

Upstart revised its Q2 2022 guidance lower from $300 million to $228 million on July 7th. Analysts were looking for $235.3 million in Q2 sales. It posted $228.2 million in sales, slightly ahead of its lowered guide but 3.1% below consensus analyst estimates.

Partners originated $914 million in the quarter vs. $1.77 billion originated by institutional investors. This partner origination made up 35% of its funding, representing the highest mark to date. That rise needs to continue. It was a little above 20% during parts of 2020 and 2021 for context. Volume retained by partners is more durable, profitable and visible for Upstart across credit cycles vs. relying on often fickle capital markers to fund. That relative durability showed up this quarter as partner volume fell 15% sequentially while institutional volume fell by over 40%.

More Context on Demand:

• Falling conversion rate is via supply constraints forcing Upstart to turn down some borrowers. Frustrating, I know. Borrower demand remains robust -- funding is the current bottleneck. Much more on this later.

• While Upstart continues to lean on capital markets for funding, it is intimately connected to these relatively volatile sources of funding. This explains the violent shifts in YoY growth rates across quarters. Upstart is not a lender -- but its business is still quite correlated to credit cycles.

• Q3 2021 was when Upstart had to address a fraud incident with manual controls. This weighted on % of loans fully automated.

• Upstart Auto Retail crossed $10 million in originated volume. It's still very small.

• The small business loan product is now live ahead of schedule. This didn't have a material impact on results.

2. Upstart Profitability

As part of the disappointing July pre-announcement, Upstart actually raised its contribution margin guidance from 45% to 47% as its take rate rises to combat volume declines. This was a small, positive sign of continued pricing power.

Conversely, it lowered its GAAP net income guide to a loss of $29 million. It lost $29.9 million, missing expectations by around 4%.

More Context on Margins:

• Personal lending contribution margin was 51%. Compression here is via the new auto business.

• Sales and marketing spend fell 21% YoY as it pulls back on promotional activity while funding remains timid.

• It has also reduced hiring to critical areas... so it's still hiring.

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3. Balance Sheet

For the second time in two quarters, Upstart has pivoted on its willingness to use the balance sheet to fund loans. Along those lines, it is actively seeking out “longer term oriented” institutional investors to provide “more resilient” funding. The fast money hedge funds it was unfortunately relying on pulled back more aggressively that it anticipated amid volatile macro. This change is how it’s addressing the issue. It will take time for this longer term funding to be in place, and so Upstart will actively use its balance sheet in select spots to ensure “the transition goes smoothly.” This newer funding will likely cost Upstart more to utilize in times of strength -- but will be significantly cheaper than what it has access to today in times of chaos. I'll take that trade any day of the week.

While its partner roster rapidly grows, some of these bank and credit union partners are pulling back on their unsecured lending businesses for the year. As a result, Upstart sees a unique opportunity to generate 8%+ returns on these loans while creating a larger sample size of its performance to make partners more comfortable.

As of this quarter, 77.6% of the loans on its balance sheet are for R&D purposes -- the rest are for this transitional phase. More recently (after the quarter ended so not reflected in these results), it sold off a sizeable chunk of loans on its balance sheet, but the trend for the rest of the year should be higher. It does not want to be a bank. It will not liberally use its balance sheet. But it wanted the flexibility to do so in times of turmoil like we’re experiencing now.

As an aside, leadership team probably should have been seeking out longer term funding from the beginning. This -- to me -- is where the problem of having a management team entirely from Google (not financial institutions) is shining through. They're wonderful with shipping product upgrades and building utility into the credit system. But they're not experienced lenders -- which, believe it or not, hurts them. Their idea of how the credit cycle would impact their growth was disconnected from reality (partially due to the severity of the cycle, but still). Now it's learning the hard way.

Somewhat controversially for a company at this phase, it continues to buyback shares. It has spent $150 million on share repurchases with another $250 million left on the program. While some hate this move, I'm not one of those people. Why? It has $790 million in unrestricted cash which continues to sequentially rise.

4. Guidance

Upstart removed its full year guide. To that I say: "What took you so long?"

For Q3 2022 Upstart expects:

• $170 million in revenue. This was 30% below consensus, but is related to fair value adjustments for the loans on its balance sheet. That will be a contra-revenue item next quarter and fee revenue will be higher.

• $0 in EBITDA. Analysts wanted $22.1 million.

• A loss of $0.10 per share vs. expectations of making $0.20.

5. Credit Performance Slides

Upstart risk quantification continues to greatly outperform FICO score bands and that has steadily improved even into August 2022:

Upstart’s default forecasts unfortunately ticked up slightly vs. the last forecast:

The good news is that Upstart's problems are not specific to the company. The bad news is that these industry-related problems are not yet going away. Delinquencies once again ticked back up this quarter across all of its products:

Finally, despite all of the incessant noise and fear among investors, it still sees worst case scenario investor loan returns over 4% for its newest vintage:

6. Conference Call Notes from Co-Founder/CEO Dave Girouard

On Credit Performance

• Upstart's partner retained loans have consistently outperformed since inception in 2018. That has not changed.

• Gross returns for institutions since inception have been a robust 8% -- although it has been FAR from smooth.

• 12 institutional vintages are outperforming while 5 underperform.

• Upstart did not update us on the number of partners who had dropped FICO minimums. Without any information, I am forced to assume that trend is negative.

On Auto:

• Upstart's Auto Refi product is saving borrowers $4,800 on average.

• 19 lending partners have now signed up for auto lending.

On the Consumer Financial Protection Bureau (CFPB):

The end of the no-action letter was because CFPB has decided to end this no-action letter program altogether. The relationship remains intimate between Upstart and the important regulatory body.

7. Notes from CFO Sanjay Datta

On the guide, priorities and expectations:

The theme of Sanjay's talk was how much pessimism and conservatism has been built into its loan return and financial forecasts. It's modeling a macroeconomic environment that is significantly worse than what it actually expects to play out. As long as things don't become even more hectic (hard to envision that happening), this should turn out to be the kitchen sink quarter.

Upstart has pivoted to prioritizing cash flow for now. That's why it expects to continue generating cash flow despite its volumes being greatly cut next quarter.

8. My Take

Following the pre-announcement, this was actually a bit better than I was fearing. 2022 continues to be a tough year for this company with all eyes on what things will look like when the credit cycle turns. That will not happen today for its borrower cohort, and so I have no interest in adding to (or trimming) my position. The clear highlight was the continued rapid partner growth while the clear lowlight was the change in funding philosophy. I'm somewhat fine with it using the balance sheet today as a transition, but would be far from fine if this became a long term theme. I do not want this to be a bank.

Management needs to do a better job of holding public market hands with less surprise than it has. Based on its commentary surrounding how it modeled Q3 2022, I think it has done just that. Down, but not out.