Upstart Q4 2021 Earnings Review: auto loans are great, but growth needs to come from personal loans too

Earlier this week Upstart ( UPST 0.00%↑ ) held its Q4 2021 and Full Year 2021 earnings call (you can read a short profile of Upstart here). I am pretty sure many Upstart investors felt uneasy before the event after seeing LendingClub, Paypal, and Affirm stock prices collapse after their earnings calls (despite all three companies delivering strong quarters). Nevertheless, Upstart delivered another stellar quarter and gave a 2022 guidance that exceeded even the most optimistic estimates, and the stock price skyrocketed in the after-hours trading.

The earnings call proved one more time that Upstart is an exceptional FinTech company. Thus, they delivered triple-digit growth in loan originations and revenue, the company is highly profitable, and the business produces so much cash that they announced a $400 million share buyback program. Standing ovation to the team at Upstart, and let’s look into their numbers to see if they can continue to positively surprise their shareholders this year.

Source: Upstart Network, Inc. Fourth Quarter 2021 Earnings Presentation

How Upstart makes money

Upstart is a consumer lender, but with its own flavor. Thus, the company drives potential borrowers to its website, identifies the customers, collects loan applications, and scores the customer using its AI technology…but most of the loans are underwritten by the company’s partners, which are banks, and credit unions. As the result, Upstart earns money through various fees it charges its partners, rather than through taking credit risk and earning interest income. The value proposition of Upstart is that it does a better job at finding and scoring potential borrowers, allowing its partners to deploy their capital and earn interest income.

In its Registration Statement, which the company filed before going public in December 2020, Upstart indicated that they charge “a referral fee of 3% to 4% of the loan principal amount”. In addition, they charge their partners “a platform fee of approximately 2% of loan value”. And finally, they charge “the holder of the loan (either a bank or institutional investor) an ongoing 0.5% to 1% annualized servicing fee based on the outstanding principal over the lifetime of the loan”.

They keep a small proportion of the originated loans on their balance sheet and earn interest income. However, this is a minor part of their revenues, and the loans are held on their balance sheet only temporarily.

As described above, Upstart is responsible for finding potential borrowers, identifying them, and collecting loan applications. They are also responsible for servicing loans, meaning collecting loan repayments, collecting delayed payments, rescheduling, etc. Thus, “Sales and marketing”, and “Customer operations” are two sizeable positions in their costs structure, and contributed 47% and 17% to the total 2021 cost base respectively. One can expect these two expense items to be driven by the volume of loans the company originates and services.

The remaining two positions are “Engineering and product development” (“payroll and other personnel-related expenses, including stock-based compensation expense, for the engineering and product development teams”), and “General, administrative, other” expenses (“payroll and other personnel-related expenses, including stock-based compensation expense, for legal and compliance, finance and accounting, human resources and facilities teams, as well as depreciation and amortization of property, equipment and software, professional services fees, facilities and travel expenses”).

Origination Volumes

As for any lender, loan origination is the key metric. Thus, Upstart reported $4.1 billion in loan originations in Q4, 2021, and $11.8 billion in loan originations for the full 2021 (the company uses the term “Transaction volumes”, as they don’t underwrite the loans). Quarterly origination volume grew 228% compared to Q4, 2020, and 292% compared to Q4, 2019, while annual origination volume grew 241% compared to 2020, and 331% compared to 2019.

The company estimates the market size for personal loans at $96 billion in annual originations; thus, they already control ~11% of the total market, which might make it difficult to grow at similar growth rates going forward. Thus, the company started expanding into auto loans, which they estimate to be a $727 billion opportunity, as well as indicated their intention to offer small-dollar lending, SME lending, and mortgages. Upstart’s management indicated that the company has a sufficient partner base to fund growth in originations (and keeps adding new partners), so the key to the growth will be their ability to find borrowers and originate loans.

The company did not provide guidance on their total origination volumes in 2022, but gave a guidance of $1.5 billion in auto loans. During the earnings call, the company’s management sounded confident that their auto loans product has reached sufficient maturity for scaling. Development of auto loan lending is definitely the right direction for scaling the business, but this will still have a relatively small contribution in 2022 (i.e. $1.5 billion in originations is 13% of total originations that the company did in 2021, so I expect auto loans to constitute less than 10% of total originations in 2022).

Revenue and Fee Margin

Upstart reported $304.8 million in revenue in Q4 2021, which represented 251% growth from Q4 2020, and 387% from Q4 2019. Revenue for full-year 2021 stood at $848.6 million, which represented 263% growth compared to 2020, and 416% growth compared to 2019.

As described above, Upstart earns most of its revenue by charging its banking and credit union partners the referral and platform fees. The fees are calculated from the origination volume in a given period, and thus, will continue developing in line with origination. The impact of this dependency was clearly seen during the early pandemic days in Q2 2020. Thus, origination volumes dropped to just $164 million (from $1.2 billion in the previous quarter), and the company’s revenue followed.

The company does not report separately a metric of the gross fee rate, so I calculated one myself by dividing Revenue from fees by Origination Volumes (you can call it Fee Margin, or Take Rake). As can be seen from the chart above, the Fee Margin ranged from 6.7 to 7.0% of loan originations during 2021. During the earnings call, the company’s management indicated that they expect similar rates for auto loans, but the fee might be spread out over the lifetime of the loan (while for personal loans, the fee is received upon origination). Thus, a ballpark estimate would be that the company will earn $80-100 million in revenue from auto loans on the expected $1.5 billion in auto loan originations in 2022.

The company guided for $295-305 million in revenue in Q1 2022, as well as $1.4 billion for the full year 2022. This would result in 143-151% YoY growth for the quarter, and 65% YoY growth compared to 2021.

Contribution and Operating Margins

In order to measure the marginal profitability of its origination, the company uses two metrics “Contribution Margin” and “Operating Margin”. Contribution Margin is a non-GAAP metric, which is calculated by dividing Contribution profit (“revenue from fees, net, less certain costs that we consider to be variable and closely correlated to our fee revenue”) by Revenue from fees. Reconciliation from the latest quarterly presentation (see Slide 22) illustrates the calculation:

Reconciliation might be hard to understand, as they exclude part of the marketing and operations costs, which are costs that are not directly related to fee revenue generation. However, in a nutshell, one could think about “Contribution margin” as % of fee revenue that is left after deducting marketing and operations expenses, which are heavily dependent on origination volumes.

Upstart reported $149.5 million in Contribution Profit in Q4 2021, and $397.9 million in Contribution Profit for the full year 2021. This represents 261% YoY growth for the quarter, and 279% YoY growth for the full year 2021.

As can be seen from the chart above, Upstart operated within 46-52% Contribution Margin in 2021, and the guidance for the Contribution Margin in 2022 is 45% (46% for Q1 2022). Management explained a slightly lower expected Contribution Margin in 2022 as a more normalized level rather than deterioration in profitability (they budgeted 2021 expenses on a much lower revenue forecast). In addition, given the expected 65% YoY growth in revenue (as per the revenue guidance), a 45% Contribution Margin means that the company does not expect its marketing or operations costs to skyrocket in 2022.

Operating Margin, in turn, is calculated as Income from Operations (Total revenue less Expenses) divided by the Revenue from fees, and indicates % of the revenue that is left after deducting all expenses (including marketing, operations, development, administrative, etc).

Upstart reported $60.4 million in Income from Operations for Q4 2021, $140.9 million for the full year 2021, which represented 481% YoY growth for the quarter, and 1,097% for the full year.

It is clear, that Upstart has reached the scale of originations, where it can consistently generate Income (rather than Loss) from Operations, meaning the revenue sufficiently cover operating expenses. As can be seen from the chart below, the company turned to a double-digit operating margin already in Q3 2020; however, the margin ranged considerably during the year. The company did not provide guidance for either Operating Income or Operating margin.

Net Income and Net Adjusted Income

Upstart reported Net Income (GAAP) of $58.9 million for Q4 2021 ($0.61 per share) and $135.4 million for the full year 2021 ($1.43 per share), which represents 5,639% YoY growth for the quarter, and 2,164% growth for the full year.

Like many other technology companies, the company reports Adjusted Net Income (non-GAAP), which excludes such non-cash items as the stock-based compensation and amortization of acquisitions. Thus, Upstart’s Adjusted Net Income was $87.0 million for Q4 2021 ($0.89 per share), and $224.1 million for the full year 2021 ($2.37 per share).

The company did not provide guidance for Net Income and Adjusted Net Income for the full year, but the guidance for Q1 2022 is $18-22 million in Net Income, and $50-52 in Adjusted Net Income.

They also guided for an Adjusted EBITDA margin (Adjusted EBITDA / Total revenue) of 17% (27% in 2021), implying Adjusted EBITDA of $238 million in 2022 ($231.9 million in 2021). Adjusted EBITDA guidance can be used as a proxy for Adjusted Net Income, as the difference between the two is minor (amortization, provision for taxes and expenses related to warrants).

Things to Watch in 2022

• 2021 was a stellar year for Upstart, and management’s guidance suggests a strong Q1 2022. However, what happens past Q1 2022 is less clear.

• First, management guided for 65% YoY growth in revenue. Such revenue growth will not come from auto loans alone, as the guidance for auto loan origination in 2022 is just $1.5 billion, which should result in an extra $80-100 million in revenue (given past Fee Margin levels).

• Thus, management has to deliver most of the revenue growth from personal loans. Given the guidance of $1.4 billion in revenue (and estimated contribution of $80-100 million from auto loans), the company needs to deliver extra $450-470 million in revenue from personal loans. This would require roughly $6.5-7.5 billion in extra originations compared to 2021. If they can pull this off, this will be another stellar year.

• The company did not provide Net Income guidance for the full year 2022, but the guidance on Adjusted EBITDA margin suggests moderate growth in Adjusted EBITDA and thus, Net Income. At the same time, they guided for 45% Contribution Margin, which is similar to 2021. My guess would be that they plan to invest heavily in engineering and product development to develop new products (such as small-dollar, SME loans and mortgages).

• Finally, the company announced a $400 million share buyback program stating that they looked for potential acquisitions… and decided that buying back Upstart shares is the best acquisition at the moment. This is not something you would expect from a high growth FinTech company, so not sure what to make out of it yet (and I believe I am not the only confused investor).

Source: Quarterly and annual reports of the company

Disclosure & Disclaimer: despite rocky performance in 2021 and early 2022, I have open positions 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.