Upstart Q2 2022 Earnings Review: all eyes are on default rates
Upstart “pre-announced” its Q2 2022 results in early July, so the sequential decline in loan origination volume and revenue, as well as a Net Loss for the quarter, did not surprise the investors. Upstart operates in the subprime borrower segment, its credit models have not been tested by a recession, so it is not surprising the company experienced a major drop in demand for its loans, as investors got more cautious given the dark economic outlook. This quarter greatly illustrates a limitation of the marketplace lending model, which I wrote about in my previous review.
Upstart is notorious for operating efficiently, and has sufficient cash balance to survive this cycle….assuming that its credit models hold well in a recession and default rates don’t go through the roof. I have heard an argument that online lenders will not survive a recession over and over again, and I realize that there is some truth to that. Most of the major online lenders (LendingClub, SoFi, Upstart) scaled during the last decade, and have not been tested by a severe recession. I guess, we just have to wait and see how Upstart loans perform in a recession (if one comes). Until then, let’s look at the company’s Q2 2022 results!
If you are new to Upstart, I suggest reading my previous reviews:
👉🏻 Upstart Q4 2021 Earnings: auto loans are great, but growth needs to come from personal loans too
👉🏻 Upstart Q1 2022 Earnings: it's tough to be a lender without a balance sheet
…and if you are new to Popular Fintech, subscribe to receive upcoming reviews:
Upstart reported $3.3 billion in loan originations in Q2 2022, up 17% compared to Q2 2021, and down 28% sequentially. Out of the total origination volume, $3,080 million were personal loans, and $196 million were secured auto loans. Excluding secured auto loans, which were non-material last year, Upstart’s origination volumes grew by 11% YoY. For comparison, LendingClub originated $3.8 billion and SoFi originated $2.5 billion in personal loans in Q2 2022 (and both companies grew originations sequentially).
The company’s management attributed the drop in origination volumes to the lack of funding, as the investors, buying Upstart’s loans, either decreased their appetite or pull out completely due to economic uncertainty and the high likelihood of a recession. The breakdown by funding sources (see below) illustrates that while the funding by banks and credit unions decrease by 15% QoQ, the funding by institutional buyers decreased by over 41% QoQ.
As a way to address (hopefully) temporary lack of appetite from investors, the management committed to finding sources of more permanent capital, as well as reiterated the idea of using the company’s balance sheet to fund a portion of the originated loans (similar to what they did in Q1 2022).
Finding permanent sources of capital is definitely something that will benefit Upstart long-term, but I believe the company’s ability to find such capital will heavily depend on the performance of the loans it originated. Delinquencies are rising (as you can see from the chart below, in-period actual defaults surpassed modeled defaults in Q2 2022) and Upstart’s scoring models were not tested in a recession, so I wouldn’t exclude the possibility of investors just taking a pause for a few quarters to see how loans perform.
On a positive note, Upstart continues investing in developing its auto lending capacity. Thus, the company originated $413 million in secured auto loans in the first two quarters of the year and keeps increasing the number of auto dealerships it serves. As a reminder, in 2021 Upstart acquired Prodigy, a producer of software that allows dealerships to launch digital stores (the solution was later rebranded into Upstart Auto Retail). I will continue arguing, that any bullish scenario for Upstart should include the company successfully entering the auto lending space, which is a much bigger category than personal loans.
Revenue and Take Rate
Upstarted reported total revenue of $228.2 million for the quarter, which represents an 18% growth compared to Q2 2021, and a 26% decrease sequentially. Revenue from fees increased by 38% YoY, and decreased by 18% sequentially, and the company booked a fair value adjustment loss in the second consecutive quarter. Fair value adjustment loss is a result of the loss the company booked on the sale of loans (meaning the market rates rose, while the loans were on the company’s balance sheet; thus, reducing the net present value of repayments).
Q2 2022 was the first quarter of declining revenue in a long time, so the disappointment of investors is understood. As Upstart earns most of its income from the fees, a decrease in origination volume immediately translated into a decrease in revenue. The negative impact was partially offset by the higher take rate the company charged its partners. As per the management’s comments, the company used to offer some of its clients lower fees to build long-term relationships, but now is maximizing its fee-earning potential to the full extent.
The company’s management guided for $170 million in total revenue in Q3 2022, which would imply another sequential decrease of 25%. This guidance suggests that the company expects to originate approximately $2.5 billion in Q3 2022, which would be the lowest volume since Q1 2021.
Upstart reported $120.9 million in Contribution Profit, which represents a 25% increase compared to Q2 2021, and an 18% decline sequentially. Contribution Profit is a measure of the company’s gross profitability and is calculated by deducting borrower acquisition, verification, and servicing costs from the revenue from fees (you can think of it as gross profit).
The contribution margin decreased from 51.6% in Q2 2021 to 46.8% in Q2 2022. Margin compression was primarily driven by the increase in the borrower verification and servicing costs, as marketing costs (borrower acquisition) remained at the same level relative to the income. Upstart is servicing a much larger portfolio than a year ago, so the growth in the servicing costs is natural.
The management guided for a 59% contribution margin in Q3 2022, which, given the revenue guidance, implies a contribution profit of $100 million. My understanding is that such a major improvement in the contribution major will be a result of the lower marketing spend (borrower acquisition cost) relative to the revenue. Additionally, the company might decide to reduce its staff in operations (reducing borrower verification and servicing costs), as the origination volumes decrease sharply.
The company reported $260.3 million in operating expenses, which lead to an operating loss of $32.1 million (the company’s first quarterly operating loss since Q2 2020). Operating expenses increased 65% YoY, as the company scaled its organization to accommodate increasing origination volume. As you can see from the breakdown below, the company continued hiring in Q2 2022, but scaled down sales and marketing expenses.
As mentioned above, the company guided for a considerable improvement in its contribution margin, which means they have to scale down sales and marketing, as well as customer operations costs considerably. If my math is correct, then the company plans to cut down the expenses by around $50 million compared to Q2 2022.
There were no discussions of potential layoffs during the earnings call, so my understanding is that the savings will come from lower marketing spending and minor optimization of operations expenses. However, I wouldn’t take more drastic cost optimization measures off the table, as the outlook for originations (and thus, revenue) doesn’t look great.
Net Income (Loss) and Adjusted EBITDA
Upstart reported a Net Loss of $29.9 million for the quarter, down from a Net Income of $37.3 million a year ago. The company reported an Adjusted EBITDA of $5.5 million, down from an Adjusted EBITDA of $59.5 million in Q2 2021. The company calculates the Adjusted EBITDA by adjusting GAAP Net Income (Loss) by stock-based compensation and related taxes, depreciation and amortization, as well as one-time expenses.
The company’s management guided for a Net Loss of $42 million, and an Adjusted EBITDA of $0 in Q3 2022, indicating further deterioration of the company’s profitability. The company withdrew its full-year guidance, but it is unreasonable to expect any major improvement in Q4 2022.
Upstart finished the quarter with $790 million in unrestricted cash. I also have confidence in the ability of the company’s management to scale down the operating expenses and get back to break-even or minor profitability once they understand the revenue outlook (the company was profitable even before the pandemic induced the origination volume growth).
Therefore, I believe that in the short term it is all about the default rates, and if Upstart’s credit scoring models will hold in a recession. Upstart operates in the subprime borrower segment, they scaled heavily during times of the unprecedented amount of governmental stimulus, and their models were never tested in a recession. In a bear scenario, Upstart’s loans will implode during a recession, which would mean the end of the company. In a bull scenario, Upstart’s loans will perform greatly and the company will come out of a recession even stronger. I’d guess the reality will be somewhere in between.
Things to Watch in 2022
Default rates. Upstart’s credit scoring models are going through their first major economic stress test. The stimulus money dried out, and Upstart’s borrowers started defaulting on their obligations. I believe there is no way to know for sure if Upstart’s models will hold in a recession, so it is not surprising that investors scaled down on funding and take a “wait and see” approach.
Origination volumes. While the management is looking for permanent funding sources to fund originations, I will be watching for the “normalized” origination volumes in a funding-constrained environment. It is possible to make money in subprime lending, the question is about the scale. In my view, origination volumes in the coming quarters might suggest what is the size of the opportunity for Upstart.
Cost optimization. Looks like Upstart will be returning to late 2020 / early 2021 in terms of the origination volumes and revenue. The company’s operating expenses were much lower back then, which ensured profitability even at smaller origination volumes. The management has already guided for cuts in marketing costs, but I would expect that further measures will be needed.
Auto lending. Assuming that the company survives through this down cycle (the company has a ton of cash to cover operating losses, and hopefully, the default rates don’t go through the roof), scaling auto lending will be of even bigger importance than before. This cycle clearly illustrates that the potential for subprime personal loans is highly limited, so the company needs to find new areas of growth.
In summary, it was a really disappointing quarter for Upstart, and I believe it proves, once again, that scaling lending rapidly is a dangerous endeavor. Upstart went through a period of rapid growth, and now we are, most likely, looking at a period of stagnation ahead. Of course, all eyes are on the default rates, and let’s keep our fingers crossed that Upstart’s models hold well through this economic cycle.
Thanks for reading Popular Fintech! Subscribe for free to receive new updates:
Source: Investor Relations
Disclosure & Disclaimer: despite rocky performance in 2021 and the first half of 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 own research.