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

All right. We are going to get going with our next fireside. We are very excited to have Paul Gu here, Co-Founder of Upstart, longtime Chief Technology Officer and more recently, assuming the role of CEO. So Paul, thanks for being here.

Yes. Excited to be here.

Before we kick it off, I'm just going to read a quick and then we can get into it. So today's discussion may contain forward-looking statements that relate to future results and events, which are based on upstarts information available as of today and are subject to risks and uncertainties. Actual results may differ materially from these forward-looking statements. The discussion may also include non-GAAP financial measures, which are not a substitute for GAAP results. please refer to the company's filings with the SEC and its IR website for additional information, including GAAP to non-GAAP reconciliations, along with other disclosures. All right. The exciting legalese out of the Paul, let's kick it off.

Thanks for being here. I wanted to start with what feels kind of like the defining strategic message of your first couple of quarters you've been very direct that the core personal loan product is really the superpower of the business, it's the highest margin, most differentiated. -- and that your first priority was simply to do a lot more of it. So how are you doing against that goal so far? And how do you think about the remaining opportunity to continue to deliver growth in that core product?

Yes. I think hopefully, we showed in Q2 that we're well on our way. In Q2, I think we did something like 3.5x as much growth in this core personal loan segment as we did in the prior 3 quarters. combines so a real trajectory change in what's growing in the business and what's not. And yes, like I said, like core personal loans is what we're really, really good at doing. I think we're world-class at being able to do risk separation in this product. And as a result of that, we can identify a lot of really good borrowers that we can underwrite uniquely in the market. Therefore, we have a lot of pricing power in. So this is a high-margin product. We're very differentiated, and we can achieve the combination of high growth, high profitability and good credit performance in the segment. And so naturally, we want to do more of it.

Yes, that makes -- so what does it actually look like to change the strategy internally and get the team focused on core personal loans?

Yes. It's a good question. Really, it is a cross-company effort to grow any particular business. I mean something as -- that we've been doing as long as core personal loans, it's never like any 1 or 2 like really simple obvious things. It's like every team needs to orient its goals around doing this as opposed to something else. And there's always trade-offs and what people focus on. So for us, it's like you're going to think of like the steps of the funnel is like there's targeting and marketing, right? And so there's like these questions of like, okay, you have like a team that's working on building targeting models for different channels like do you want them to like figure out this problem like how do you get like 3% more core personal owned borrowers or do you want them to find something else. And I think we were prioritizing the something else in earlier quarters, and we switched the priority back to this core segment this quarter. And the same is basically true of every team as you go sort of each step down the funnel, and you can just imagine there's a bunch of different teams like each step, there's like the people who then care about, okay, once some eyeballs show up at the website, how do you convert them to applications? How do you convert those into approvals? How do you convert those into what we call rate accepts, how do you get those people through verification the problems of like what kind of verification problems and what kinds of automation problems a core personal user has versus different segments or different types of loan users have are just different. And so we just put more emphasis for every team to focus on this as their #1 thing and you can see step function change in results.

Yes. And just before we move on, just to be clear about the stance on the newer products and the secured products that you've launched, obviously, growing the core personnel. I think it's been very clear that that's the main strategic objective. Have your views changed about in any way about the market opportunity or the growth in some of the newer products over time?

Yes. We definitely made some changes. And I think maybe the meta thing is I really believe in having consolidated focus and really having crisp alignment across the whole company on like what are our top priorities, and you just can't have too many of them. So among other things, one example is we paused on our auto refi product. That's a product that we've been working on for a few years. It was a good product. I think it was something that in some version of the company, we would still be working on. I think it certainly could have had a role and there's all these sort of different advantages that, that product offered. But it wasn't as high-potential, high-growth, high momentum as some of our other product bets, so we've consolidated that one away. And so today, like every single bet that we've got left at the company is one I'm really excited about. I think all of them share the characteristics that they have extremely large addressable markets. They're adjacent to something that the company was already really good at, and they have high momentum that we're capitalizing on and doubling down in.

Got it. Okay. Let's maybe pivot a little bit, talk about the macro backdrop. We, of course, have the upstart macro index, which is kind of your view of macro as it relates to your segment of the consumer. As of September 3, that was relatively stable month-over-month at around 1.5%. It drifted up a little bit year-to-date. So maybe if you could talk a little bit about that metric, how should investors interpret? I know you made some changes to kind of definitions and phraseology around it? And then maybe talk a little bit about what it's telling you today about the state of the consumer and then how that translates to the business.

Yes. The simplest way to think about what UMI is it's just sort of linearly interpretable index of how likely a consumer is to default on sort of unsecured consumer credit relative to pre-COVID levels. So a 1.0 reflects sort of the years right before COVID. So I think this is 2018, 2019, early 2020 type stuff. And the fact that UMI is at 1.5 today is really just -- it's just a way of saying the same exact consumer holding constant all the sort of borrower level characteristics and loan type characteristics is 50% more likely to default than they were pre-COVID. So it's actually a pretty big number. And to your point about the migration this year, we've seen this number drift up 12 points since this spring. And that's quite a lot. I mean, 12 points in our business. It's a pretty significant change. I think if we had been standing still on all of the investments we make into marketing and automation and approval and underwriting risk separation. I mean the business would just be like a fair bit smaller. And of course, it isn't because we have made so much progress and had so much focus on those things. But yes, I think the consumer has been under some amount of pressure this year. I think it's not surprising when you look at the fact that we kind of reversed back into the space of having more inflation than we have wage growth, and that's been true probably for the last 6 months, mapping almost perfectly to the duration of time when UMI has been drifting up. I think you see it in credit card utilization rates. You see it in credit card delinquency rates. So I think if you're looking at sort of whether you're looking at the metrics inside Upstart or outside, I think at this point, it's been pretty clear that the consumer has been or at least the consumer is always sort of a slightly weird word for us because sometimes we care about the opposite thing as companies that want more consumptions to care about. But we would say the American borrower is under more stress today than they were 6 months ago. And I think UMI has done a nice job of picking that up early and clearly.

Yes. And then maybe if you take that conversation more forward-looking and perspective, there's a lot of cross currents out there, gas price shocks, which have been lingering. We've got fading fiscal support from tax refunds. Labor market that is stable, maybe cooling on the margin. I think you've said the business is fine with a stable consumer even if it's not an improving one. how do you think about how the consumer could play out over the next 12 months and then just a range of outcomes for the business.

Yes. Maybe I'll start by saying that one thing I think investors get too focused on is the action of UMI in the short term. And we have said UMI is really, really important in the short term. It's really impactful. That's actually one reason that we somewhat stubbornly refused to give like near-term guidance on results is that we want to be able to take credit seriously as a first priority, and that basically means we want to be fastest and most precise in responding to UMI changes. And if we're going to do that, then, of course, it's really hard to tell you like 1 month from now what exactly we're going to be doing because in some sense, in the very near term, it's somewhat outside our control. But I think investors get a little too focused on this when they think about fully -- if you're here to invest not for like the next 3 months, but you're here for the next 3 years, then like the rate at which you're compounding sort of durable wins in the business across, across marketing and automation and underwriting, suddenly matter a whole lot more than weather like the macro is up or down a few points in any given month. And I think it's really -- that contract becomes really clear when you look at where the business is today versus, say, where it was back in 2021. In 2021, we probably had the most supportive macroeconomic climate you could possibly imagine. You had UMI as well under 1.0. You had stimulus tracks. You had near 0 interest rates. And yet, in spite of the comparison being against that world in today's world of much higher interest rates, much higher UMI, much more consumer stress, we're doing more contribution profits now than we were back then. And how is that possible? It's possible because we've had 3 years of compounding sort of technology wins across the sort of like real durable parts of the business. And so I think in this any kind of medium to long term, like that just ends up mattering much, much more. And so when you talk about like where I think the outlook is 12 months from now. I think the answer on macro is like I have no idea, and I sort of think of it as like really not my job to worry about -- is there going to be like another war in the Middle East or what's going to happen to the Strait of Hormuz and energy prices like I don't know. I have my guess is, but so does everybody in this room, and I don't know that my guess is necessarily are any better than anybody else's. But I think the things that are within my control are about like how fast can I move the sort of technology frontier on lending and I know that as a company, we have a tremendous ability to execute on that. And so compounded over any reasonable time frame, I have a lot of confidence that the business is going to do really well. And so that's kind of like how we've started to think about where we can give confident guidance in the business and where we don't really want to overstretch in sort of what we can tell investors to expect.

Makes sense. I want to hit on one more macro question. and then we'll pivot away. But I wanted to talk about the supply of credit. I think that's one thing that can impact the market, but really supply of credit from other people in the market. I think Upstarts one of the more discipline you just talked about very disciplined culture of wanting to be responsive to what you're seeing in the macro environment. But I also think like funding markets have been less discriminate in providing funding to anyone out there in the market. And so I think when everyone competes in the same channels for the same leads, you run the risk that underwriting could move to least common denominator. How do you think about competitive dynamics in the market that you play in and how to think about new entrants, less disciplined investors, benefiting from a really supportive funding market.

Yes. Mostly, we don't think about competitors that much. And I think that's a privilege we have because of where we're really strong. We talked about this core personal loan superpower. I think we're just so differentiated there that we just don't have the luxury of not having to think too much about competitors or what they're doing. I think in some spaces, there is quite a bit of competition. I think we tend to, all else equal, shy away from those spaces. I think in some of our newer products, of course, being the new guy on the block, we have to think about who's the sort of existing players are and who we think we're going to take market share from over time. But by and large, I would say, in the core business, it's not sort of a first priority. I also want to respond to this sort of maybe at this point about the capital kind of just flowing indiscriminately. I mean I do think, of course, that like happens sometimes, but when I look at the sort of capital markets today, I don't necessarily think that there's something fundamentally broken with how they're providing capital to the space. I actually think that over the course of the last maybe 5, 6 years, like I think a lot of things equilibrated in the sense that you look at what happened in unsecured personal loans, I think most of the players that did high volumes of kind of Internet distribution of large dollar loans to lower FICO score borrowers like stop doing it. Like it was just too hard to do. And I think maybe they were somewhat affected by the relatively better selection we could do in the market and kind of got pushed out. I think there's just a lot less happening there. And so therefore, a lot less capital flowing there. In our case, we've had 100% retention of all of our capital partners in recent years. We've re-upped all of the deals they've gotten longer and larger and generally at better terms. And I think that's happened because the capital recognizes where the good risk-adjusted returns are. And so I think the capital sort of markets are working pretty efficiently. And I think even if you think it's not perfect. I think there's pretty good evidence that over a couple of years, they tend to get pretty efficient just because they can just look at how the credit performs.

You get the numbers back. If that were happening, how would it show up in your business? Will we see -- Yes, it wouldn't show up in UMI -- it's not directly a borrower statistic. Is that just lower conversion rates, people being more aggressive and people not taking the upstart loan on the margin?

Yes. I mean I think it can show up in 1 of 2 places. I think 1 is like there can be more noise around sort of top of funnel marketing. And so if you will put too much money into top of funnel marketing, then it just gets harder to get eyeballs and get attention and borrowers don't really know who's who before they track. And then the other would be if you get lower conversion. But in both these cases, I think it's theoretical. We don't see any evidence of that happening in our business and again, despite the fact that we've seen this higher UMI in our business, I think we still actually held up remarkably well in our ability to originate good loans.

Okay. Let's talk about contribution margins and where they go from here. I think the guidance assumes a pretty meaningful step-up in the back half of the year. We started to see it in Q2, margins improved nicely quarter-over-quarter. In your eyes, what still needs to happen to get to that full year target? And how do you split that between continued acceleration in core personal versus the margin profile of some of the new products stepping up and kind of reaching scale?

Yes. I only think a lot more in terms of contribution profit dollars than the margin number, which I kind of just think of as like it's I don't know, it just is what it is. But of course, like, yes, the contribution profit dollars have to keep going up. It's as simple as that. Like if you look at any reasonable full year model for like how you get to the full year guide, like we have to have more contribution profits. And then we've been pretty clear, again, short list of priorities, everyone really focused. It's just like -- kind of like 2 simple things for us. It's like keep focusing on that core personal loan segment, which is like already very high margin. We would love to just do more of it. And then the second is get the unit economics of the new products, specifically the secured products in a good place, get them from negative to positive. And of course, you get a bunch of leverage from flipping that around. So it's as simple as that -- those 2 things. And if we're right about that, you'll see it in more contribution profit dollars.

Got it. So maybe can you talk about that second point in a little bit more detail. So you saw a nice move in the contribution margin on the secured products. I think you've talked about being breakeven by the end of the year. And I think there's kind of a running list of levers that you've talked about to improve the margins. Can you talk mechanically on how that happens and your visibility into the continued improvements in the back half of the year?

Yes. We have really high visibility, really high confidence in what needs to get done to move the secured products from unprofitable to profitable. I mean, in some sense, it's almost just like the standard playbook for how you build a new business and a new product, which is like thing you have to do is you have to prove people want this thing and that's -- you do that before you worry about how dialed in the margins are. You do that before you try to optimize your operations, you do that before you try to like optimize your take rates? And so that's what we did. And I think it's become exceedingly clear that people really want these products, both in car dealerships and in the case of the HELOC product, the combination of process and rates that we deliver there, we think are best in market -- and so we've got the sort of step 1 done, then we were focused on, okay, we got to start onboarding capital providers because we're very committed to funding these businesses in a really capital-efficient manner, having primarily third-party capital funding and so that was kind of the second step that we had to prove out along with credit performance in these products. And then really, the last thing we worry about is unit economics. And so that's the step we're on now, and we are rapidly improving the margins of these products. We'll get them to breakeven before the end of this year. And then once we do that, then we'll turn our attention back to really scaling these products up.