Upstart : Network, Inc. Second Quarter 2022 Earnings Transcript

Upstart

Q2 '22 Earnings Call

Monday, 8th August 2022

Operator: Good day and welcome to the Upstart Q2 2022 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, sir.

Jason Schmidt: Good afternoon and thank you for joining us on today's conference call to discuss Upstart's second quarter 2022 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 second quarter 2022 financial results and published an investor relations presentation and credit FAQ. All are available on our investor relations website, ir.upstart.com. During the call, we will make forward-looking statements such as guidance for the third quarter of 2022 related 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 result of new information or future events, except as required by law. In addition, during today's call, unless otherwise stated, references to our results are provided as non-GAAP financial measures and or 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 please limit yourself to one initial question and one follow up.

Later this quarter, Upstart will be participating in the Goldman Sachs Communacopia + Technology Conference, September 13th and the Piper Sandler Growth Frontier Conference September 14th. Now we'd like to turn it over to Dave Girouard, CEO of Upstart.

Dave Girouard: Good afternoon, everyone. Thank you for joining us on our earnings call, covering our second quarter 2022 results. I'm Dave Girouard, co-founder and CEO of Upstart.

Today we reported a decline in revenues, which is obviously disappointing and unacceptable to us. I want to explain where this decline came from and what we're doing to address it. It may be natural for you to question whether Upstart's AI powered risk models aren't working as designed, but we're confident this isn't the case - that in fact our models continue to improve with respect to accuracy and risk separation. But there is no getting around the fact that a decline in revenues is a business problem that we need to address - and today we'll share with you the actions we're taking to address it.

Today Sanjay and I will discuss a variety of topics including credit performance, loan funding, lending partner sentiment, and some of the actions we're taking right now to make sure Upstart's future is bright. I also want to share with you the progress we've made in many important aspects of our business and how they're setting the stage once again for growth in Upstart's future.

I don't want to spend too much time restating what you've already heard about the current economic climate. Given the nature of our product and our borrower, we do however have a unique lens into what's transpired in the last two plus years and what may transpire in the coming months and years.

We believe we're at the end of a unique economic cycle related to the pandemic that included two distinct phases. The first phase was triggered by pandemic-constrained consumer spending and unprecedented government stimulus throughout 2020 and early 2021. These together drove

significant improvements in consumer savings levels and liquidity, which in turn led to dramatic over performance of credit during this phase - our platform experienced about a 50 percent reduction in credit defaults compared to the pre-COVID timeframe.

In the second phase, toward the end of 2021 and into 2022, this effect began to unwind as stimulus was discontinued and consumers began to travel, dine out, and spend once again. And as expected, default rates returned to pre-COVID levels or in some cases even higher. While virtually all consumers benefited financially from reduced spending during the early stages of the pandemic, this cycle was concentrated in consumers who received government stimulus checks, a demographic which is also more likely to be Upstart borrowers. Our risk models largely captured these effects and performed admirably - though not perfectly - throughout. But I'll get to that in a bit.

We believe we're now at the end of this two-phased cycle and an important question for all of us is what's next. Will efforts to slow inflation lead to recession and unemployment? While no one knows the future, we do expect a significant slowing of the economy and a "worse than normal" macro for the next year and beyond. We'll speak to that as well.

Our job through all of this is to ensure the future of our platform and to protect Upstart's ability to pursue our mission for years to come.

Alongside our earnings release, we today shared some responses to important questions regarding credit performance on Upstart's platform. It goes without saying that measuring credit performance is vital - and it's also non-trivial. Comparing one platform to another can be challenging: different products, different borrowers, different return targets, months on book, prepayments, hardship policies, and more. There's no simple apples to apples comparison.

We believe the essential measurement for credit performance is actual dollar returns compared to the lender's or institutional investor's target at the time of origination. Full stop. And today, we provided this information for all Upstart cohorts going back to the beginning of 2018.

The bottom line is this: Our 70 plus bank and credit union partners, who typically retain loans in the lower risk grades appropriate to their businesses, have seen, to date, portfolios consistently meet or exceed expectations since the program began in 2018.

And how have our institutional loan buyers done? Against a target of approximately 8% gross return since Q1 2018, institutional buyers have so far seen 12 quarterly vintages overperform, with 5 expected to underperform.

It's important to highlight that a loan buyer who invested equally in all cohorts since Q1 2018 would have experienced a positive return on all vintages thus far, with an overall 9.8% gross annualized return. This compares to a return of less than 3% in the US High Yield Bond Index over that same period.

Lastly, we believe it's not reasonable to expect above-target loan performance irrespective of the economic cycle. So it's fundamentally important to separate the impact of macro conditions from imperfections in a credit model. The essential litmus test for model performance is separation of high and low risk borrowers. As demonstrated in the loss rate by grade and AUC metrics we shared today, our model is positively differentiated in this respect, and it continues to improve. In an effort to deliver unparalleled transparency and analytics, we will provide this detailed information to each of our lenders and loan buyers.

Today, we're in a funding constrained environment, which is the primary cause of our revenue shortfall. I want to share some thoughts on this situation and actions we're taking to address it. First, as we've said recently, our goal is to operate as a marketplace for credit over the long run.

We want loan transactions to take place when they make sense for the borrower and the lender. And certainly, lending is a category which we'd expect to experience some volatility over time due to macroeconomic factors.

Having said that, in the last few months, lenders and institutional credit investors reacted more quickly and abruptly than we anticipated. Despite the fact that our bank partners have seen consistently strong credit performance - meaning portfolios performing at or above plan across quarterly cohorts - several of them have paused or reduced originations due to fear about the future of the economy. To be clear, these lenders and institutional investors have not left Upstart's platform, but have temporarily paused or reduced their originations.

As we shared in our Credit Performance FAQ today, we believe our models are well calibrated to the current economic environment, and in fact include a generous accommodation for a recession over the next 18 to 24 months. And given funding constraints, we believe the opportunity for lenders to generate strong returns on Upstart is unusually high right now. Yet the reaction of lenders is often binary in nature, more so than we would have anticipated.

As a result, we've concluded that we need to upgrade and improve the funding side of our marketplace, bringing a significant amount of committed capital onboard from partners who will invest consistently through cycles. We're currently evaluating a variety of opportunities to do just that, though we expect this will take some time to bring to fruition.

Furthermore, while we continue to believe that it doesn't make sense for Upstart to become a bank, we've decided it may make sense to, at times, leverage our own balance sheet as a transitional bridge to this committed funding. I acknowledge that this is a shift relative to what we planned and communicated earlier this year, but a changing and volatile environment suggests we need to be flexible and responsive in our approach.