Upstart Q1 2022 Earnings Review: it's tough to be a lender without a balance sheet
Upstart ( UPST ) reported Q1 2022 results on Monday. The company delivered a strong quarter but lowered its full-year guidance, which caused the stock to collapse by 56% the next day. Rising interest rates and higher risk premiums demanded by Upstart’s lending partners translate into higher rates for borrowers and create a strong headwind for loan origination growth this year.
Don’t get me wrong, I genuinely root for the success of every Fintech company I write about, but Upstart’s results clearly put on display the limitations of a lender without a balance sheet. As Upstart relies on banks, credit unions, and institutional investors, to fund the originated loans, it doesn’t control the rates it quotes to borrowers. Thus, higher rates make Upstart offering less attractive, or even make the riskiest borrowers ineligible for a loan.
SoFi and LendingClub didn’t want to take this risk and got their banking charters. What Upstart does during this economic cycle will define the future trajectory of the company. In the meantime, I will keep my fingers crossed they come out from this year as a stronger company.
If you are new to Upstart, I suggest reading my review of their Q4 2021 and full-year 2021 results, where I break down their business model.
Upstart reported $4.5 billion in originations in Q1 2022, which represents a 162% YoY growth, and an 11% growth sequentially. Sequential growth is especially impressive given the fact that the first quarter of a year is usually a slow period. As can be seen from the chart below, the average loan amount also increased considerably from Q4 2021 to $9,741.
As per the management’s comments during the earnings call, the rising interest rates, as well as increasing risk premiums required by the company’s partners (that actually take loans on their books) are a strong headwind for loan originations. Higher rates result in higher decline rates for the riskiest borrowers, as well as less competitive offerings for the borrowers that the company could finance.
The company did not guide for loan originations, but the revenue guidance (discussed below) indicates that the company does not expect origination growth for the rest of the year.
One unexpected outcome of the quarter was the company stepping in as the lender for a portion of the originated personal loans. Previously, Upstart would pass through all originated personal loans to its banking partners and credit unions, or immediately sell to institutional customers. The exception was the auto-refinancing loans, which the company retained on its balance sheet.
However, in Q1 2022, the company put some of the originated personal loans on its balance sheet. The company added $433 million in loans to its balance sheet during the quarter, increasing loans on its balance sheet from $253 million to $598 million. As per the management comments, 2/3 of these loans were auto-refinancing loans, and 1/3 were personal loans. The reasoning provided by the management was that the institutional clients were not fast enough to adjust to the rapidly rising rates and Upstart had to step in and finance these loans. The management said that in the long-term it doesn’t see the company being a lender, but in the short-term, the company might continue using its balance sheet.
As I wrote in my previous newsletter on Upstart (review of Q4 2021 earnings), the company will hit a limit in personal lending at some point, and thus, expansion into auto lending is crucial for the company. What I didn’t expect is that the company would reach this limit already this year. Upstart’s competitors, such as LendingClub and SoFi, have banking charters (and deposits to finance loans), and thus, will fair better in the environment of rising rates. Thus, success in the auto lending business becomes even more critical for Upstart’s continued growth.
Revenue and Take Rate
The company reported $310 million in revenue for the quarter, which represents a 156% YoY growth, and a 1.7% growth sequentially. Upstart is not keeping loans on its balance sheet (with the exception mentioned above); thus, the company makes money primarily by charging its origination partners various fees.
As can be seen from the chart above, sequential growth in origination did not translate into proportional revenue growth due to a decline in the Take Rate from 7.01% in Q4 2021 to 6.92% in Q1 2022 (which I calculated by dividing Revenue from fees by the Origination volumes).
The company managed to beat its own Q1 2022 guidance for the quarterly revenue of $295-305 million. However, the company’s management lowered revenue guidance for the full year from $1.4 billion to $1.25 billion, as well as guided for $295 - 305 million in revenue in Q2 2022, which means no growth sequentially.
As the company primarily makes money by charging fees for the originated loans, we can conclude that no growth in originations is expected for the rest of the year. On the earnings call, I also didn’t hear anything about Upstart’s plans to start selling auto loans to its partners (which was the plan announced on the previous call). Given the economic uncertainty, we should keep in mind that Upstart’s partners might be especially risk-averse, and thus, the company might need to continue accumulating the auto-refinancing loans on its balance sheet.
The company reported $147.8 million in Contribution Profit for the quarter, which represents a 165% growth compared to Q1 2021, and a 1% decline sequentially. Contribution Profit is calculated by deducting borrower acquisition, verification, and servicing costs from the revenue from fees (you can think of it as the company’s Gross Margin).
Contribution Margin, which is calculated by dividing Contribution Profit by Revenue from fees, declined from 52% in Q4 2021 to 47% in Q1 2022. As can be seen from the table below, sequential compression in Contribution Margin was driven by the acquisition, verification, and servicing costs growth outpacing the growth in the revenue from fees.
During the earnings call, the CFO of the company explained that the drop in the Contribution Margin is related to its auto-refinancing lending, which is still producing a negative profit contribution. Auto-refinancing business is new to Upstart, and thus, it does not have the efficiency and the scale.
The company’s management guided for a 45% Contribution Margin in Q2 2022, and 48% for the full year 2022. Given the guidance on revenue, this translates to a Contribution Profit of $132.8 - 137.3 million in Q2 2022, and $600 million for the full year 2022. Simply put, the company is guiding for approximately $150 million in quarterly Contribution Profit with limited sequential growth during the year.
The company reported $275 million in Operating Expenses for the quarter, up 160% YoY, which was almost in line with the revenue growth. As mentioned above, the company is investing in the auto lending business, which is not producing meaningful revenue at the moment.
Looking at the relative expense level (as expressed by the Operating Margin), we can see an elevated level of spending in Q1 2022. Thus, the Operating margin declined to 11.1%, which is lower than in both Q1 2021 and Q4 2021 (13.4% and 21.0% respectively). Referring back to the guidance of the flat revenue for the rest of the year, improvement in the Operating Margin can only come through lower costs.
I would not exclude Upstart from taking proactive actions in controlling the costs given the deteriorating economic conditions all the way to a reduction in staff. Lending is a cyclical business and we are looking at the contraction phase ahead. If originations volumes will continue experiencing headwinds, expect some cost cuts.
The company still has a lot of cash on its balance sheet, but given the most recent use of this cash to fund loan originations, the management might become very focused on preserving it to survive the cycle. Unfortunately, cost-cutting can lead to a deadly spiral for a growth company (no spending on growth, no growth). I am not saying this is the case for Upstart, but the management actions during the period will define whether the company comes stronger or weaker out of this cycle.
Net Income and Adjusted EBITDA
Upstart reported $32.7 million in Net Income and $62.6 million in Adjusted EBITDA for Q1 2022, a considerable improvement from Q1 2021 and a decline from Q4 2021. Except for Q2 2020 (pandemic quarter), the company reported a profitable quarter for more than two years.
The company guided for Net Income of ($4) million to $0 million in Q2 2022, and Adjusted EBITDA of $32 to $34 million. This essentially signals the sequential increase of the operating expenses on a flat (or slightly declining) revenue. As I argued above, the company is dependent on loan origination volumes for generating revenue, and thus, controlling the costs is the only measure that the management has to keep the company profitable for the remainder of the year.
The company also guided for an Adjusted EBITDA Margin of 15% for the full year, or $187.5 million given the revenue guidance of $1.25 billion. Deducting $62.5 million (Adjusted EBITDA in Q1 2022), and $33 million (Adjusted EBITDA guidance midpoint for Q2 2022), we get $92 million in Adjusted EBITDA for the second half of the year.
Things to Watch in 2022
Loan originations for the rest of the year. This quarter clearly indicated that Upstart’s business model strips it of the pricing power (higher risk premiums demanded by the company’s partners are passed through to consumers). Thus, further deteriorating economic conditions, or rising rates with further negatively impact originations, and consequently, the company’s revenues.
Progress with auto lending. Upstart is already the largest personal loan lender in the country. Thus, if they don’t manage to scale the auto lending business, we should forget about double-digit growth going forward. Thus, progress with auto lending (auto refinancing and especially financial via Upstart Auto Retail) is critical. We should also closely monitor if the company starts selling auto refinancing loans to its partners, or keeps accumulating those on its balance sheet.
Use of the Balance Sheet. I believe Upstart scared investors by putting part of the personal loan originations on its balance sheet. This goes against their strategy and their value proposition. Moreover, funding loan originations consumes cash, which the company might need to fund the development of its auto lending business.
Balancing growth and expenses. If originations start declining due to worsening economic conditions, the company might need to start cutting its costs. However, the company needs to continue investing in its new business lines to fuel future growth. Thus, management actions in such situations might either break or make the company.
In summary, as expected, the company delivered a strong quarter; however, prospects for the rest of the year are now even less clear than before. Rising rates and deteriorating economic conditions will be creating headwinds for the company’s revenues. At the same time, the company needs to continue investing in the auto lending business, or the growth going forward will be limited by the size of the personal loan market.
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Disclosure & Disclaimer: despite rocky performance in 2021 and early 2022, I own shares in most of the companies covered in this newsletter, as I am extremely bullish on the transformation in the financial services industry. However, none of the above is financial advice, and you should do your research.