Upstart Holdings, Inc. (UPST) Earnings Call Transcript & Summary

Okay. Next, we are honored to welcome Sanjay Datta, CFO of Upstart, to the conference. Thank you so much for being here. Really appreciate it.

Thanks, Ram.

So I wanted to ask you guys about what you're seeing in terms of the consumer trends, macro impact on the consumer. You have a pretty differentiated view. And so I was just curious what you're seeing.

Sure, yes. On the consumer, I guess there's 2 million things that we're thinking about right now. One, we're observing directly, one we're watching for. The first one I would broadly say the U.S. consumer is slowly getting its fiscal house back in order. And it was out of order for a while, probably for more than 1.5 years. I think that a lot of the stimulus and what that did to real consumption patterns people got used to an elevated level of consumption post stimulus, even just take out the impact of inflation. If you look at just real consumption per adult in the U.S., it went up quite notably after -- so we all came out of lockdown. And of course, real income did not. Some of that inflation into wages a little bit, but also people left the workforce in meaningful numbers. So if you look at that balance between what people are earning and what they're consuming, it was sort of out of whack for a long time. It caused us to eat through the savings stock that was built up in the economy from the stimulus. I think in my opinion, that's what's at the root of what's causing strife for a lot of banks. A lot of people are talking about the asset side of the balance sheet, but really the deposits in this country have been pretty unstable. And that story coming back into balance now when you see consumption in real terms has moderated. People are going back to the workforce. If you see the percentage of adults in the U.S. that are employed, it's been climbing sort of steadily for 6, 7 months now rightly driven by better participation rates. And this all is, I think, most effectively encapsulated in the savings rates in the economy. I think we're -- at the worst part of this dynamic I'm talking about, we were only saving about 2% of our national income, sort of up to 5% now. And pre-pandemic, we were 8% or 9%. So you can see we're sort of working our way back to prior levels of consumer health, which is good. We're seeing that in the repayment patterns. We're seeing it on the delinquencies, which obviously have been extremely stressed for more than a year now. The second thing we are watching for us, to what degree they're going to be employment stress on the U.S. consumer. And obviously, you're not seeing any version of that yet, at least in mainstream America, some white collar employment stress certainly in financial services and in technology. But the labor market -- the blue collar labor market is still very robust. And the question is, is there going to be economic slowdown that sort of creates employment stress? And I think our rough guess is, if inflation continues to abate, if the Fed sort of eases off the rate hikes as most people think they will, probably only a moderate level of stress on blue collar labor, which until recently has had a shortage of labor. And frankly, a lot of missing immigrants, which have been doing the work historically. So that's what we're watching for. But as of right now, as everyone who's watching the labor market knows, things are still pretty resilient.

That's fascinating. So -- and to paraphrase, right now, actually, the pressure seems to be abating a little bit, but the wildcard or the variable to watch is just the employer markets basically.

Yes, it's the sort of fiscal tightening we've been going through is going to be so severe that it causes slowdown in consumption that trickled down to the employment markets. I guess that would be the bear case. I think within the different scenarios that could play out, we're still pretty cautiously optimistic. Considering the consumer, which has been at the root of our problems for the last 1.5 years, is finally and getting the equation between consumption and income back into balance.

Okay. Let's shift over to talking about some of the numerous verticals that you guys have been hard at work on. I think on the auto side, you signed Acura and Mercedes-Benz recently. You've been growing auto partners at a fast pace. Give us an update on auto. What -- how is that relatively new line trending?

Yes. Auto for us is, call it, sort of a 2-part play. Part one is get as many dealers as we can using our software to sell cars, nothing to do with financing and lending. And that is an effort that has been going well for a while now. We've sort of been publishing our dealer accounts and they've been going up very steadily. The dealer world itself is going through an interesting sort of evolution, similar to a lot of businesses that were impacted by the pandemic, which is in the wake of COVID, a lot of them has scrambled to find digital retailing solutions because nobody was going into dealerships and we thought the world was going online. And now that people are sort of showing up in real life again, they're sort of scrambling to get their on-premise sort of in-store IT stacks, is maybe more of the priority now. So there's been a bit of a shift in what people care about. But then step 2 for us is getting those dealers that are using our software to sell the cars to then adopt our financing solutions. And that's very nascent largely because of where the market is. But we do have a calibrated model that's -- I think that prices are effectively -- as lenders come back into that market as they get a little bit more comfortable with the macro dynamics we're just talking about, I think you'll see pretty rapid adoption of the financing product within our sort of retail software footprint.

And you also launched home equity, HELOC relatively recently. Talk about that strategy and help us understand the sort of value that you're bringing to the table for the end user there. What are you guys doing to help the customer that they're not getting elsewhere?

Yes. The HELOC product, I mean it's pretty well-understood product in the market. It will tend to be a much primer audience than our unsecured loans are. These are homeowners that tend to have pretty strong credit and, obviously, it's asset-backed or secured. So with respect to reducing loss rates by doing better risk modeling, I think the opportunity there is probably not as big, obviously, is in what we do in our core business. But the other area of magic that we like to tout is -- has to do with process automation and the ability to take friction out of the process without incurring any increased fraud or credit default. And yes, the HELOC market today, I think an average HELOC probably takes weeks to close. And we intend to be able to approve it within hours and fund it within days. So to take a process from 4 or 5 weeks to 4 or 5 days is really the goal. We think that will, on the one hand, create a lot of process value for a relatively affluent consumer base. But will also allow us to start training our underwriting models for when we eventually do get into nonqualifying purchase mortgage-type market, where we think there's actually a much bigger opportunity over time.

And I know it's early days, but how about the kind of good market strategy there? How do you get to that consumer? Do you go through partners? Is it due to website? Or how do you...

It will be very similar to what we do today, some combination of partners and lead-gen brokers, but also using direct marketing, and frankly, cross-sell. So we now have a pretty big database of consumers. And it's a pretty easy way for us to sort of reach out to an existing sort of potential customer base for this new product.

Shifting over to the most recent quarter, the market seem to really like your message, shares traded up quite a bit the day you printed it. I think a big part of that was the announcement that you secured a couple of billion dollars of new funding. And you mentioned that they carry kind of preferential economics. I want to explore a couple of threads there. But first is on tax, for us, what is preferential economics sort of mean? How are these -- how is this funding structured from a pricing duration standpoint?

Yes. I'd say different agreements take different forms, but the 2 broad categories I'd point to. One is, if you're committing funding forward, you expect maybe a premium on your return versus wherever the market is at. So you could imagine a bit of a spread. We have a core program where the funding is -- you might think of that as a spot market, sort of at will funding and it delivers a certain yield, net yield to the investors. And for folks who have committed capital in those markets, you could expect a premium on the return. The other area is for us to put a bit of skin in the game almost as a co-investment or loss sharing or something like that. And so those are 2 examples or 2 maybe general forms of what a committed investor might receive in exchange for a durable commitment.

And where does that show up? And I understand there's different structures this can take, but where does that show up in the P&L? Where does someone looking at the financial statements see the impact of those arrangements?

Yes. Well, some of it may be passed on to the borrower in a market like today where there's a lot of inelasticity, there's not a lot of options, borrowers can absorb that. Some of it may show up over time as reduced take rates, if some of that return premium is being subsidized from our own take rates. We've shown that we have a lot of flexibility in moving our take rates over time, so we could share some of that with a committed investor. Some of it may show up as interest income, either positive or negative, if we are sharing a basis in the performance.

Okay. And then even more recently, on Monday, you announced that there was a private lender that was going to buy $4 billion of personal loans from you guys. Just to clarify, is this deal separate from $1 billion that we just discussed? And I guess, is it also separate from the $350 million that you already indicated you expected to come off the balance sheet in Q2? And maybe I'm hoping that some questions, but I'm...

Numbers to triangulate. First of all, just to clarify, we didn't make that announcement. The counter-party made the announcement, counter-party, Castlelake. The numbers are related but not the same. What we announced in our earnings call, really had to do with our pipeline of sort of long-term agreed funding over the next 12 months. So we're just looking at the next 12 months and what's in the pipeline can be spent over those 12 months. So that was the $2 billion number. Now Castlelake announced that they intend to spend a total of $4 billion with us. That was not time to limited. Some of that $4 billion is in our $2 billion. But I guess, the meta point is many of our agreements span longer than 12 months. And there's money beyond the 12-month pipeline that we were talking about. But we're only talking publicly about what we can see in the next 12 months. So Castlelake was referring to the full term of the deal we have with them. We've included the 12 months of that deal in our $2 billion number, but they're obviously talking about what may lay beyond that. And the $350 million that you're referring to was a subsequent event that we disclosed in our quarter release, which is essentially a balance sheet transaction. So we had a balance sheet of loans. And we announced that shortly after the end of the quarter, we had gone through a transaction whereby we had -- so that is part of one of the long-term agreements. It was, in fact, I think then disclosed by Castlelake that they were the counter-party that did the transaction with us. So it was a part of that $4 billion deal that they announced.

I see. I mean take a step back and maybe talk a little bit about the evolution of your funding strategy as we move forward. I mean you're finding incremental sources of funds. How should we think about that mix and those partners and really what your strategy is over the next 2, 3 years type of thing?

Yes. I guess I would say, historically, we've had 2 sources of capital. One source has been the banks that use our technology to lend. They are the originating bank and the lender of record, and they generally use their own balance sheet as the capital source and they tend to lend to primary segments. And then there's a broader institutional world, if you could think of as credit funds or hedge funds, they've historically, with us, been what I would call a spot market. It's at-will capital. Every month they can decide to come in or not. I think that worked really well in the pre-pandemic world where there is a lot of fluid capital. I think our learning over the last sort of 2 years has been that there needs to be a third source of capital, which is more durable. And the advantage of that is it won't contract when times are tough the next time of the recycle. The trade-off is, as I said, they will get some preferential economics. And I think with the strength of margin flexibility that we've demonstrated, I think, in general, we're saying we're happy to share some of that or use some of that in the service of having a more resilient capital base. Now what are the mixes of those 3 sources over time going forward? I don't know exactly. But I think in rough terms, we've said, look, I would like maybe on the go forward, once we're back at the scale we were previously, I don't know, anywhere from 1/3 to 1/2 of our capital base, I could imagine is being locked up in longer-term committed agreements. And then, of course, the banks will also play a big role, given the relatively inexpensive cost of capital that they have with from their deposits. And then I think there will always be an important role to play in the spot market in the sort of -- in the trading money that's coming in going because they establish a really good sort of price discovery on our market. They will help establish what the right yields are at any given time. And that's the premiums -- or that's the rate above which you can imagine premiums being earned for longer, more durable sort of capital sources.

This is just one of the questions that I've always sort of been curious about. Do the funding partners specifically want to be involved in certain types of loans or some focused on personal loans? Or the same lenders that might fund the personal loans also willing to go into auto or into other categories? Or is it very much having to match a loan type to a lender?