UpStart Holdings Inc (UPST)

[eastunder]

UPST earnings call for the period ending September 30, 2023.

https://www.fool.com/earnings/call-transcripts/2023/11/07/upstart-upst-q3-2023-earnings-call-transcript/

Dave Girouard -- Chief Executive Officer

Good afternoon, everyone. Thank you for joining us on our earnings call covering our third quarter 2023 results. I'm Dave Girouard, co-founder and CEO of Upstart. While 2023 continues to be a difficult environment for consumer lending, I can state with confidence that we're making rapid progress in building the world's first and best AI lending platform.

We do this with a focus on our mission and with an optimistic eye toward the transformation of an industry that is inevitable over the next decade and beyond. In the third quarter, rates were at an all-time high in our marketplace, higher than we expected them to be, reflecting both decades high interest rates and significantly elevated risk in the consumer economy. This is not a path we would have chosen and is obviously not constructive to our growth, but it reflects the reality of operating responsibly in this environment. That said, we believe the economic trends continue in the right direction.

Inflation is waning. Interest rates, presumably, are peaking or have peaked. The jobs market remain strong, and many retailers are suggesting that consumer spending is softening. We continue to look for a return to normal for personal savings rates, which are highly correlated with risk and therefore with pricing on our platform.

From a financial perspective, we'd, of course, prefer to be growing quickly, but this is a time when it's wise to be operating in a conservative mode. In that light, we were EBITDA positive for the second straight quarter. Our contribution margins are still near record highs. And finally, we remain confident that our personal loan models are calibrated, and Upstart-powered credit is performing as expected right now.

Not only are we financially superior, we also continue to invest in our AI platform. Last quarter, we launched Model 15.0, the latest version of our core personal loan underwriting model. This new version increased our model accuracy by about 15%, the largest improvement we have seen since we began tracking improvements in 2018 by about a factor of 1.5. Our previous most impactful model launch added personalized timing curves, what we have come to call our loan-month model, for a giant accuracy improvement.

This version improves the accuracy and precision of these personalized timing curves and also adds personalized macro effects for the first time. Last week, we also launched an upgraded version of the Upstart Macro Index to account for seasonal patterns and repayment behaviors. Over the last decade, we've measured a distinct seasonal pattern with respect to loan repayments. The time from January to April represents the best seasonal loan performance in our experience, likely due to borrowers receiving extra cash in the form of state and federal tax refunds.

Performance then generally degrades marginally each month until the early fall and then flattens or modestly improve through the end of the year. With a seasonally adjusted UMI, we'll offer a more accurate lens into changes in the financial health of consumers, and that should result in less volatility in loan pricing and approvals from month to month. Our auto retail platform saw a huge boost recently as we partnered with a major OEM to implement our software in support of the launch of a new vehicle. Our technology powered their consumer reservation, deposit, and customization system for this amazing new vehicle and was implemented quickly at more than 99% of all their dealerships in the U.S.

We see this as a harbinger to a future where consumers can choose exactly the car they want online and have it delivered directly to them with none of the friction and inconvenience many associate with the car-buying experience. We're partnering with leaders in the industry to unlock this future. Separately, we also expanded our roster of car dealerships that have gone live with Upstart Lending from 61 to 69, and we've added support for rooftops in Arkansas, Maryland, and Virginia, expanding our reach to 70% of the U.S. population.

We also signed agreements with two of the largest national nonprime auto lenders to help fund our auto lending solutions. I'm also excited about the progress with our home equity product. As of today, the Upstart HELOC is available to homeowners in Colorado, Michigan, Washington, and Utah, and we expect to be live in Alabama, Kentucky, Tennessee, and Washington, D.C. in the coming weeks.

We have received encouraging feedback from applicants about how fast and easy the process is, even at this nascent stage. Our home equity product helps diversify our business in two critical ways. First, it's a very prime product with annual loss rates expected to be 1% or less. And second, it's a countercyclical to a refinance product because it's an effective way to tap equity in a home during a higher-rate environment, such as we have today.

More than 90% of HELOCs are offered by banks and credit unions today, so it's a good fit with the Upstart platform and our partners. We'll bring some pricing advantage to the HELOC market over time, but there are two predominant advantages we expect to see sooner. The first is speed and ease of access because the banks and credit unions that originate most HELOCs today take more than a month, on average, for the applicant to receive funds. We're aiming for less than five days.

Second, our existing platform unlocks customer acquisition advantages that others can't match. Each month, more than 80,000 homeowners apply for a personal loan on Upstart. Some large fraction of them can and will be better served with a home equity product that offers a lower rate. After all, personal loans and HELOCs are just two different ways to solve the same customer need.

By integrating our personal loan and HELOC application processes, which we expect to do before year end, will take a giant step toward becoming customer-centric rather than product-centric. The trade-offs between price, time, and effort will change over time and will help applicants choose the best product for them. Now let's talk about the funding side. Despite the difficult lending environment, we have seen some great success with credit unions in the last couple of years.

We attribute this to the fact that credit unions are extremely focused on delivering the products that their members want with an intense focus on the quality of experience. They also map well into current and future Upstart products with approximately $29 billion in personal loans, $266 billion in auto loans, and $82 billion in HELOCs funded by credit unions each year. So we're doubling down on credit unions by building features and capabilities that will strengthen our partnerships. In recent weeks and months, we upgraded the Upstart Performance Console to enhance visibility into originations and loan performance trends, improved connectivity to the core systems that power credit unions' financials and operations, deliver features that make it easier for new members to join the credit union, and enhanced our partners' ability to cross-sell other products to existing members.

We're also unlocking loan participation where a loan originated by one credit union can be fractionalized and sold to a network of other credit unions. This significantly improves liquidity in the system and allows us to reach the long tail of small credit unions in an economic and constructive way. On the capital market side, we continue to pursue a large number of committed funding partnerships in order to strengthen the reliability of loan funding on Upstart. With banks retrenching, paying more for deposits and likely facing even more imposing capital requirements, we believe it's important to find alternative sources of funding, even for the primest of loans.

We're in discussions about partnerships and structures that can enable at-scale funding across the entire credit spectrum and are excited to innovate in the space. Lastly, we're investing significantly in servicing and collections, a vital part of our business where improvements can go directly to the bottom line. We recently launched a new version of our funded borrower dashboard, which is the experience borrowers see while in the process of repaying a loan. We also recently launched our first mobile application, which is initially focused on loan repayment.

Servicing and collections is clearly an area where AI can lead to better results, and we believe the surface area upon which we can apply our AI expertise is broad. We've brought some incredible new talent to this aspect of our business and are excited about its potential. To wrap up my remarks today, there are plenty of reasons to remain optimistic about Upstart. First, even with our rates at all-time highs, we continue to grow fee revenue and invest in our teams and core AI.

Second, our models are learning and improving at an unprecedented pace, creating more separation from traditional approaches to lending. Third, the competition to serve mainstream American consumers with responsible lending products has waned considerably, given the challenges in the markets in recent years. And fourth, we believe there's an inevitable period of normalization on both rates and risk levels' return to long-term averages. That will provide Upstart with a tailwind over a multiyear period in the future.

We aren't waiting around for that period, but we'll certainly be ready when it arrives. Speaking of the future, last week, I had the privilege of participating in the U.S. Senate's AI insight forum. It was a very productive bipartisan discussion on how to maximize the benefits of AI while mitigating risks.

I focus my remarks on the lessons we've learned on our journey to use AI responsibly to help establish America as a global leader in AI-enabled lending. Hearing about the challenges other industries are facing deploying AI reinforced to me that lending is one of the most compelling examples of how AI can clearly improve the lives of all Americans. I left more excited than ever about the opportunities ahead of us. Thank you.

And I'd like now to turn it over to Sanjay, our chief financial officer, to walk through our Q3 2023 financial results and guidance. Sanjay?

Sanjay Datta -- Chief Financial Officer

Thanks, Dave, and thanks to all of you for joining us today. We're coming off a quarter of mixed results in Q3 with narrow misses on revenue and margins against success nonetheless in maintaining a positive adjusted EBITDA and sequential growth in fee revenue. We continue to operate in a challenging and fluid macro environment. Real consumption continues to hover at levels which we believe to be unsustainable.

Incomes continue to lag consumption growth despite the positive trend in labor participation as the ongoing decline in government transfers still receding from stimulus era highs offsets any wage gains from the return to work. The residual savings rates in the economy have consequently continued to languish at historically low levels. This consumer reality continues to be reflected in elevated borrower default trends in our Upstart Macro Index, now adjusted for seasonality, which indicates a stable level of loan defaults throughout most of this past year, albeit one which remains remarkably high. Our ability to approve borrowers in this environment has remained the constraint on platform growth for most of the past quarter.

On the funding side of our business, the banks continue to manage balance sheets conservatively and seek to unwind existing asset positions in secondary markets. The decline in aggregate deposit base, which started in mid-2022, has now thankfully eased, but anemic savings rates are so far hindering a rebound in liquidity. Correspondingly, the institutional funding markets remain distracted with a bounty of trading opportunities coming from the banking sector. On the other hand, significant amounts of institutional capital has been recently raised for upcoming deployment into credit, and the volume of discussion and negotiation aimed at setting up for 2024 remains encouraging.

With these items as context, here are some financial highlights from the third quarter of 2023. Revenue from fees was $147 million in Q3, slightly below our guidance of $150 million and marginally up from $144 million last quarter. Our underwriting of primer higher-income borrowers has become more conservative over this past quarter as their loss rates accelerate and converge with the broader default trends across the borrower spectrum. This has been a headwind for our volumes and fee revenues over this past quarter versus our contemplated guidance.

Net interest income was negative $12 million in Q3, owing to continued elevated charge-offs in our R&D portfolio, as well as a one-time change in our charge-off process for loans and bankruptcy, that had the effect of pulling some charges forward into Q3. Taken together, net revenue for Q3 came in at $135 million, slightly below guidance and representing a 14% contraction year over year. The volume of loan transactions across our platform in Q3 was approximately 114,000 loans, up roughly 5% sequentially and representing over 70,000 new borrowers. Average loan size of $11,000 was up 9% versus the same period last year and sequentially flat.

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 64% in Q3, up 11 percentage points from 54% last year, but 1 percentage point below our guidance for the quarter. We continue to benefit from high levels of loan processing automation and fraud modeling efficacy, achieving another new high in percentage of loans fully automated at 88%. Operating expenses were $178 million in Q3, down 17% year over year but up 5% sequentially, as increasing sales and marketing spend somewhat offset continued savings in engineering and product. Altogether, Q3 GAAP net loss was $40.3 million, and adjusted EBITDA was positive $2.3 million, both roughly in line with guidance.

Adjusted earnings per share was negative $0.05 based on a diluted weighted average share count of $84.4 million. We ended the quarter with loans on our balance sheet of $776 million before the consolidation of securitized loans, down sequentially from $838 million the prior quarter. Of that balance, loans made for the purposes of R&D, principally auto loans, sat at $447 million of the total. In addition to loans owned directly, we have consolidated an additional $196 million of loans that were sold from our balance sheet into an ABS transaction earlier this quarter from which we retained a total net equity exposure of $43 million.

As described in our prior earnings call, this transaction was somewhat unusual for us and designed to serve as a visible market reset, as well as a public vote of confidence, in our current degree of model calibration. Our corporate liquidity position at the end of Q3 remains strong with $517 million of unrestricted cash on the balance sheet and approximately $425 million in net loan equity at fair value. We continue to watch for signs of moderating consumption, improved savings rates, and reduced credit defaults in our economy as precursors to a broader normalization of consumer fiscal health. Until we see such signals, our operating assumption is that the macro environment will remain constant.

And in such a scenario, our business growth will predominantly come from model upgrades and from improved underwriting accuracy, both of which we consider to be squarely in our set of core technical competencies and ones in which we have demonstrated a strong historical record of delivering growth over the years. With this context in mind, for Q4 of 2023, we expect total revenues of approximately $135 million, consisting of revenue from fees of $150 million and net interest income of approximately negative $15 million, contribution margin of approximately 62%, net income of approximately negative $48 million, adjusted net income of approximately negative $14 million, adjusted EBITDA of approximately zero, and a diluted weighted average share count of approximately 85.6 million shares. That is all for our prepared remarks this afternoon. A shout-out to all of the Upstart teams who have kept their heads down and their results strong over the course of the past year spent in an expecting external environment.

Our business today is a much stronger one in a number of very tangible ways than it was before the onset of this post stimulus hangover. And when the winds eventually settle, your work will be manifest and brightly shine. With that, Dave and I are happy to open up the call to any questions. Operator?

Continued at

https://www.fool.com/earnings/call-transcripts/2023/11/07/upstart-upst-q3-2023-earnings-call-transcript/