Upstart Holdings, Inc.

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.

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 Girard, 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 a 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 are reconciled to our GAAP results, which can be found in the earnings release and supplemental tables. To ensure that we have addressed 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 Communicopia Plus Technology Conference, September 13th, and the Piper Sandler Growth Frontier Conference, September 14th. Now I'd like to turn it over to Dave Girard, CEO of Upstart.

Good afternoon, everyone. Thank you for joining us on our earnings call covering our second quarter 2022 results. I'm Dave Girard, 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's 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 Upstart's growth in the 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 a 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 overperformance of credit during this phase. Our platform experienced about a 50% 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 the two-phase 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 rates 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 five 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 U.S. 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 cycles. 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 have 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 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 have concluded that we need to upgrade and improve the funding side of our marketplace, bringing a significant amount of committed capital on board from partners who invest consistently through cycles. We're currently evaluating a variety of opportunities to do just that, so 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. We're taking this step for a few reasons. First, there's an obvious information asymmetry. where we understand better than anybody how our model is performing today and how well it's calibrated for the current economic environment. Secondly, we believe the opportunity to generate outsized profits on our platform is unusually high right now. And third, we can bring a level of stability to our business that's important to our longer-term goals while we work to put these committed capital structures in place. Sanjay will share some more about this in his remarks shortly. I want to also highlight that we're building a business that can survive and thrive through a variety of market conditions to make sure we achieve these ambitious long-term goals. Our fixed costs are low and our gross margins are strong, so we can continue to invest in our roadmap and in our future through a variety of macro environments. We continue to make rapid progress in the newer parts of our business, and we're optimistic that this progress is setting up the next stage of growth for Upstart. which I'm sure you're all looking forward to. First, we continue to add new lenders to our marketplace with a total of 71 banks and credit unions as of today, up from 57 when we last spoke to you in May. Despite the cautionary outlook in the financial services industry, forward-thinking banks and credit unions continue to choose Upstart. We now have 640 dealerships using Upstart auto retail software. And just a few weeks ago, Industry analyst Automotive Market Data declared that Upstart was the nation's fastest-growing auto retail software provider in the second quarter. Subaru and VW were the latest OEMs that announced support for Upstart Auto Retail, joining Toyota, Lexus, Mitsubishi, and Kia, as well as top franchise dealers from 37 brands, including Ford, Honda, and BMW. We also expanded our auto retail lending product up to 29 dealerships and saw the first $10 million in retail loan originations in the second quarter. In just the last couple of weeks, we merged our machine learning model for automated income verification originally developed for our personal loan product into our auto retail lending flow. We expect this improvement to more than double the percent of applicants for whom we can now automatically verify their income. I'm also pleased to announce that we quietly launched our small business loan product at the end of June, well ahead of schedule. We've already seen some more than 40 small business loans originated, totaling more than a million dollars in principle in just a few weeks. That team is quickly ironing out operational issues with an eye toward rapidly expanding this product in the coming months and years. Lastly, the small dollar loan team launched support for Spanish-speaking applicants. another giant step towards serving those left out of the country's mainstream financial system. Some of you have questioned whether Upstart veered too quickly into lending to riskier borrowers in 2021 in order to grow in our post-IPO phase. But I believe we have done exactly what we set out to do and what we said we would do. Upstart's mission is and has been to leverage modern technology and data science to improve access to affordable credits. There are tens of millions of Americans who deserve access to reasonably priced credit from our nation's banking system, yet are denied access through no fault of their own. We're unique among our FinTech peers in that we aim to tackle this problem directly. The terms non-prime, near-prime, and sub-prime, these are words the industry invented to describe people that our current systems don't understand. The truth is that the vast majority of these Americans are entirely credible. Upstart's mission is to identify those borrowers and provide them with access to affordable credit, and we haven't wavered from that challenge. How does growth fit in? We approach our business as a waterfall of priorities, in a way analogous to structured credit. Upstart's highest priority, our A bond, if you will, is credit quality. Our goal is to reliably deliver the return the lender or investor expects for a specific allocation of risk. Our B bond, or next highest priority, is unit economics or gross profits. We don't strive for loan transactions that lose money for upstart and generally seek to avoid them. And finally, whatever is left over goes to platform transaction growth, our residual, so to speak. In truth, growth isn't a specific target for us. It's a plug based on our waterfall of priorities. The reasons for this ordering are clear. Without strong credit performance and solid youth unit economics, growth over the long term would be unsustainable. To close, I want to acknowledge that we've experienced some setbacks in our business, but our fundamental economic engine is strong. Our risk models are better than ever, and I'm confident that we'll be on the growth path again soon. We're taking decisive action to bring committed capital to Upstart. And to those who say that we should focus on the traditionally prime market, I say that there are plenty of others focused on that. Improving access to credit for all Americans is too important to go ignored, and Upstart has the right staff to get it done. Thank you, and now I'd like to turn it over to Sanjay, our Chief Financial Officer, to walk through our Q2 financial results and guidance. Sanjay?