Upstart Holdings, Inc. (UPST) Earnings Call Transcript

Hi, everyone. I'm Trey Brown. I work together with Joe Hall on our U.S. small and mid-cap strategy team within BofA Global Research. We have a few sessions going on concurrently, but Joe and I just wanted to welcome everyone to our 2-day Annual SMID Cap Executive Insights event, which provides opportunities to hear from corporates across the small and mid-cap space, where BofA has great breadth of coverage. Our analysts cover nearly 1,000 small and mid-caps in the U.S. and Joe and I have also been expecting continued leadership from SMID Cap in the back half of this year. So please feel free to reach out if you need the schedule or want to sign up for any additional sessions today or tomorrow. We have nearly 20 companies joining or if we can help sign you up for either our small mid-cap strategy research or our daily compilation of SMID Cap fundamental research. But with that, I'd like to pass it over to Mihir Bhatia, our consumer finance analyst, to introduce Upstart Holdings.

Thanks, Trey. Thanks, everyone, for joining and especially to the Upstart team and Paul. Really appreciate you guys joining us today. Before we get started, one quick disclosure statement that I've been asked to read. So today's discussion may contain forward-looking statements that relate to future results and events, which are based on Upstart's 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. Okay. With that out of the way, the lawyers should be happy, so we can get started. Again, like I said, a lot of you already know Upstart I think I see -- I recognize most of the names of the folks joining, but we'll go through, I think, right at the start, I'll ask Paul to give us a quick overview of the company. But before that, again, I just want to say thank you to Paul and the Upstart team for doing this conference with us today and for the opportunity to host you all today. So thank you, Paul, for joining. And let's get started. So maybe I'll just kick it off with that, Paul. You've been with Upstart right from the start, 14 years now, I think. You recently took over as CEO. Maybe for the benefit of anyone who's newer to the story, just give us a quick 90-second version of what Upstart is today? And then I think the part that investors -- that matters for investors, that excites investors, why does this business compound for 35% over the next few years?

Yes. A really short tagline would be AI for consumer lending. We operate a marketplace business where consumers can go and shop for offers of credit. We do Personal Loans, Auto Loans, HELOCs really, over time, we will offer the entire suite of consumer credit products. And our real strategy from the beginning has been to say, hey, there's a whole bunch of transformative technology innovation happening around how we use models to make better predictions and understand sort of patterns and data. But that innovation has largely not made its way into consumer lending, which is arguably the most important place for it to go because if you think about the history of consumer lending, this is the world's oldest industry, almost everybody borrows at some point in time. And actually, surprisingly, a large number of people, depending on your exact metric of preference, something like 50% or more of people in the U.S. we think are underserved in how they access credit, either it costs too much, they can't get approved, it takes too long. And it's all fundamentally because the ability of the models and the lending companies to understand their risk is too limited. And so what we've done over time is we've built models that can both better understand the risk, which we call better risk separation and automate away a bunch of the process. And as a result, we're able to radically reduce the cost and complexity of credit for everyday Americans who are looking to borrow, and that's just about everybody.

Great. Maybe just on the second part of that question, though, why is this going to be growing at a very high rate for the next few years?

Yes. It's exactly those two things I said. This is -- one, this is an industry that's relevant to almost everybody. The sort of addressable market here is enormous. It's almost kind of laughably large if you try to do any kind of math against it. And then at the same time, usually industries that are that big are really saturated, really well addressed. All the sort of innovations have already gotten plugged in. And that's just not the case in the consumer lending world, which I think for various reasons historically has tended to move slowly in adopting new technologies. And so we really have been, for a number of years here, the first, and we think we have quite a large lead in taking a lot of the innovation happening in AI and applying it to this space. And we think it's one of the best possible applications there is for AI to do good and serve the consumer. And so I think you put those things together, disruptive technology transformation against a huge market that hasn't really fully injected that disruption. And I think naturally, you're going to get a business that has the ability to compound for a very long time.

Got it. And I do want to dig in on that advantage that you all have, but we'll get to that in a few minutes. Before that, I did want to just highlight that you recently took -- while you've been with the company a long time, you just recently took over as CEO in the last few months. And I think when you took over one of the -- over the last few weeks, I think in those readings, you called it the second leg of the race, right, taking over as CEO. So maybe just talk about that a little bit? And specifically, I think one question we get from investors is, well, Paul has been there a while, what's really changing? So maybe talk a little bit about what investors can expect in terms of changes? Like what are you -- what is going to be different under Paul than maybe under Dave?

Yes. Obviously, Dave and I worked together in close partnership for a long time. We started this business, as you said, 14 years ago. And the thing about this business is that it surprised us in how long it took to build. Well, at first, I think when we started, we thought, oh, we'll just do this. And within a few years, everybody is going to be chasing us on the same race of applying AI to credit and realizing how large the opportunity is. And I think we've just been consistently surprised how slowly it has taken to happen. And I think it's actually for a lot of the reasons that it took us to build -- so long to build the sort of first -- what we call the first leg of the race, which has a lot to do with the fact that consumer credit, maybe credit in general, but certainly consumer credit, obviously, it's highly regulated. It's an industry that has a lot of kind of entrenched ways of doing things. And so think about what does it take if you're going to say, hey, we have this completely new way of understanding credit risk. What do you need to do to actually make that a market reality and do that at scale? Well, it turns out you need a whole bunch of different kinds of very old institutions to buy-in, right? So you need rating agencies to understand the risk of this stuff, so they can rate these things in a sort of risk-appropriate way. That unlocks financing for capital partners. The capital partners themselves, of course, have to buy-in, regulators have to understand it, banks, et cetera. And so you have all of these different kinds of institutions that really sort of form this network around kind of maybe the traditional way of understanding consumer risk. And we came in and said, hey, with this completely different way of doing things, never mind that this person's FICO score may look like this or that. And it took actually a bunch of years to overcome that because then once these people buy-in, then you are able to start making the loans, then the loans themselves take 2, 3, 4 years to prove themselves as actually good performing loans. And guess what the reality is like the first time you build a model, it's not going to be very good. So the first model is going to have a few things that gets wrong and then you're going to have to tune that model and then you have to start that 2- to 4-year clock again. And so it ended up taking us really the better part of a decade to really get the sort of first leg of the race done where we've really built the foundation for the company, which was -- we acquired really valuable proprietary data. We talked about this in terms of rows and columns of data that the company uniquely has where we gathered thousands of columns of data about people's sort of characteristics at time of taking out a loan. And then we had millions of rows of repayment data. And it's that sort of matrix that actually allows you to train the types of models that we've developed. Of course, we had many years where we actually developed proprietary algorithms to understand the pattern of that data. Those two things work together, high volume of data, high complexity of algorithms. You really can't have one without the other. And so that was on the technology side. At the same time, we build up the sort of credibility with institutional capital markets, the rating agencies, the regulators to really believe that this is something that can work and to see the evidence and prove it out. And so those two things took a really long time. And we finally got to this place where we said, okay, it's indisputable at this point that this is just a better way to lend. If you do this, then you get a tremendous accuracy advantage that unlocks either much higher approval rates at the same loss rates or equivalently much lower loss rates at the same approval rates. And so that's something that we kind of think we proved in Phase 1 of the company. Of course, we took the company public. We sort of built an incredible team that's able to operate this business with leverage and scale. And we started taking the same idea and going, hey, we're not just going to do this in Unsecured Personal Loans, which was our first product. We're going to do this in every category of credit that's relevant to the consumer. So we rolled it out across Auto and Home and sort of short-term lending. And so that's where the company sat at the sort of moment of transition, and that's what we called it the leap from the first leg of the race to the second leg of the race. And in the second leg of the race, I think we have exactly the foundation that we need for the company. And now it's about really tactically and strategically applying it to the right places at the right time. And so the very first thing that I prioritized in 2026, I said, well, you look at the state of the business today, you look at the stock price today, one thing that's very clear is that the business is operating with an inordinately high cost of capital implicit in the stock price, where investors and the market just sort of is skeptical that this is a business that can sustainably deliver high rate of profit growth. And we said, well, actually, the market is wrong about that, and we know just the way to fix that. And so instead of saying we're going to invest in every possible thing we could do at once, we streamlined the company priorities down to a very short list, very centered around what we call contribution profit, which is our sort of single best measure of the operating progress of the business. And we delivered exactly that in Q2, and you can sort of see it in our results. We said, well, first thing we're going to show you is that in our core Personal Loans business, we don't have any kind of intensifying competitive threat or sort of declining margins or any kind of structural compression there. Actually, this has just not been our #1 focus for a little bit and now it is. And we did 3.5x the growth of the prior 3 quarters put together in a single quarter. And that drove then a massive increase in our contribution profits. We got to record contribution profits in Q2 that surpassed Q4 of 2021 back when the macro conditions were much more generous in 2021, of course, than now in '26. So you're looking at interest rates for consumer default levels, I mean just sort of night and day mark difference. And we still did record contribution profits in Q2 of '26. And second thing we said was, well, we have a few new products that we're really excited about. And in the last few quarters, we have proven that these products have real borrower demand, they have investor demand. But we haven't really shown that these products are going to be profitable, good businesses for Upstart. And so we said, let's make the #1 priority of these teams to get to contribution profitable in these segments is at Home and Auto. And so in Q2, we expanded their contribution margins by 61 percentage points. They're not all the way there, but they're well on their way to getting towards contribution profitable, and we've said that we're going to be there by the end of this year. So that's been really, really strong. And then I think the last sort of big question has been like, is this going to be a business that just structurally constantly needs like more equity capital in order to like support the balance sheet or make the whole business work? And Q2, I think, was also a really good proof point on that question, which is like we did 23% sequential growth, right, 23% growth in originations in a single quarter, that's like $760 million. It's way higher than the sort of normalized rate of growth that I think most people would be ecstatic about in the business. And we did that while predominantly funding that with third-party funding, our balance sheet loans declined to almost a 2-year low in terms of the percent of total outstanding loans. So really, I think, just a quarter that -- where we were really hyper-focused on proving to the market that this is a business where you can expect all of the sort of underlying businesses have really strong margins because their underlying tech differentiation is very strong for that to be able to grow at a nice rate and for us to do so in a very capital-efficient manner.

Got it. That's interesting and particularly on 2Q results, one thing that struck us on 2Q results, there's a few I would say, highlights in the results. You mentioned the Unsecured margin improving so much. But what was also interesting was the growth in core Personal Loans. I think you are up 27% sequentially. The growth was probably -- I think it was like faster than the prior 3 quarters combined. Now to be fair, you had called it out in 1Q. But I did want to dig in a little bit on that. Maybe just like bridge for us. How much of it was the model and the funnel improving versus you're just much more focused on driving that product and marketing investments in that product? Some of it was, of course, a little bit easier comp. But like what drove that big improvement in 2Q? And what should we expect for 3Q with core Personal Loans?

Yes. I do think, ultimately, it's all downstream of management focus. And so I think the different categories of why it grew are really not so different in our mind. So as a reminder, the #1 way that our business grows is we invest in better funnel. That can be better models, better user experience, more automation. Those are to us sort of all ways of doing roughly the same thing, which is increasing the percentage of people that convert holding constant the applicant pool. At the same time, of course, the applicant pool is not fixed. We're always putting effort into growing the number of consumers that we have relationships with, the number of consumers that know about Upstart, the number that are coming to us. And if you think about you had always every single quarter, have these trade-offs you're making in like which pockets are you going to focus on. And so I think in the preceding year, we had been a little more focused in some other segments. We have been a little more focused maybe on going kind of broader and in this -- in Q2, we were extremely focused on this core segment because it's a segment that we have such strong margins in, we have such a strong level of differentiation in. And we just wanted to prove and make clear that with a little bit of focus on this, there wasn't any kind of fundamental like change in the size of our advantage or compression in the margins. It was just actually a thing of like if we focus on this, then it's going to grow a lot and that the sort of untapped opportunity here is just very large. And we will -- I think that was disproportionate maybe in Q2, but we certainly will continue to focus on this as a strategy because it's just such a good way for the business to generate contribution profits and contribution profits kind of pay for everything else we want to do.

Right. And I guess maybe if I'll push you a little bit on that, exactly where you ended, right? If you continue to focus on it and it has such a large market, you can drive a lot of contribution margin, which lets you invest in the rest of the business. Why not push even harder on this and really generate the cash flow, if you will, to help you invest in the rest of the business? Like I guess, where is the choice between investing in growth of other products versus investing more of your time in just driving personal loans? Like how do you -- take us through that decision. Like when Paul is there and looks at it, how does he say, well, that's enough for that. Let's we need to feed or water, whatever analogy you want to use, some of the other products too.

Yes. It's an evergreen debate at Upstart. We probably could go even harder in core Personal Loans. And I think that would start to come at a pretty significant expense to our new product-type growth and our ability to invest there. And so ultimately, we're like, well, you don't want to -- you don't want to just solve for the very long term. Maybe if you just solve for the very long term and you don't worry about anything in the short term, then you just have -- you're just going to invest a ton and it's going to take a long time to show profitability. And if you only invest in the very short term, then I think you're just never going to reach your potential as a business. And so to me, like you have to land somewhere in between and you have to do it in a way that's mindful of what your implied cost of capital is and how much sort of credibility with investors in markets, and we hope to earn more and more of that over time. And I think certainly, there are businesses that have earned the right to invest more aggressively and invest for a longer duration, and we hope to be there one day. But I think I'm just cognizant of the fact that today, the reality of our implied cost of capital is very high. And so I always say like, well, there are these really great investments. Maybe this will pay off in 5 years or something. And that's really nice. And if you do the math on that and you put it in a model, it says that your IRR on that is really good. But then I look at the stock price and I'm like, well, the sort of -- what I think the implied IRR on the stock price is like even higher than that. And so those are, I think, some of the questions that go through my head in terms of thinking about how far out we should be investing. And we want to be really smart, really rational capital allocators in how we think about those decisions. And I do think we're landing in a place that's a good in between where we are, I think, going to do a really nice job of continuing to grow our profitability as a business, and at the same time, we are keeping open sort of the entire addressable market of this business over our relevant lifetime. And I'm not super old, but I also like not going to wait around for the rest of my life for us to achieve the full market opportunity here. And so I think that's kind of the balance we're trying to strike.

I think one thing that really impressed or struck a lot of investors in 2Q is the sharp improvement in contribution margin for some of the secured products. I think you mentioned it earlier, also 61 percentage points of improvement, right, there in contribution margin. Can you talk a little bit about that? Like what clicked? Why is this suddenly seeing this hockey stick almost, if you will, growth in contribution margin? Is it just a matter of these products are now at scale and have found their product market fit, if you will? And what should we expect from here beyond 4Q where you're getting to breakeven? Like what do the contribution margins of this product look like at scale?

Yes. So both Home and Auto in the preceding quarters had really achieved kind of what I think of as the first steps in building out a new product, which is like proving that borrowers want this thing, proving that investors want this thing, a real marketplace that works. And so it was time for these products to prove the next thing, which is that these are things that can actually make money and be good businesses for us. And so we really kind of fairly sharply turned the focus of these teams over the last few months to be your new #1 goal is to get to contribution profitable. We don't care how much you grow the business. Your new #1 goal is no longer proving demand. It is now sort of proving unit economics. And so that just reshuffles the sort of order of things that you're going to be doing. There are a bunch -- and of course, a bunch of things help both. But if you think about like what has to happen for these businesses to be -- to have good unit economics, well, you've got to do some optimization of costs. These really matter in secured products, if you look at HELOC. HELOC has pretty significant cost when it comes to verifying an applicant for a loan, much more than personal loans levels of automation are much lower. And the just number of things that you could possibly automate is just so much more when you have to deal with liens and all of that. And so a lot more focus on the kind of cost side of it. And then also a lot more focus on optimizing our take rates, which in new products tend to be totally unoptimized where the starting point is just like you just pick some kind of slightly arbitrary flat fee and just charge it equally on everything. And really, if you compare that to what we do in, say, Personal Loans, the big difference in Personal Loans, we have intelligence when it comes to knowing like which offers we are adding a lot of value to the consumer in, which ones we're only adding a little bit of value, trying to like take -- set our take rates in proportion to how much value we're creating. And there's a very similar thing going on now in some of these businesses where if you take Auto as an example, there's just a huge amount of variation in the dealership. Some deals, were like uniquely the only offer, the only way you're going to buy this car is with an Upstart loan because no one else can understand that risk right. And then there are other deals where it's like it's a fiercely competitive free market. And in that case, it just doesn't make sense to try to like take the same amount of economics in each case. So we're just starting to get smart to that and optimize around our take rates. And so those will continue to be dimensions that we optimize along. And I've said a few times that, that is going to be both a fast story and a slow one in the sense that I think there's going to be this very fast ramp to contribution profitable, just because we're very focused on it. It's our #1 priority. And then it's not like we're going to be done. Like if you look at our Personal Loan margins, they continue to expand for years and years after that product was mature. And that should just come as a function of how much value we create. That's ultimately what I care about doing in this business is I want consumers to get a delightful product, something that saves them a ton of money compared to the next best option. And I want us to make more money as we save people more money. So I don't want to try to take too much all at once upfront. And I think that can be a pretty bad trap for these sorts of businesses where you say, well, I'm your best offer, so I'm just going to take every last dollar on the table. I'm going to always leave plenty of money for the consumer on the table. And then as the amount of money that we bring to the table grows, we can keep increasing amount of it. So that's something that I think will play out more slowly over the years.

Got it. We're about halfway through. So I just wanted to flag for any of the listeners. If you have any questions, you can raise your hand or shoot me a Bloomberg or e-mail and I'm happy to ask it on your behalf or if you want to just raise your hand, we can call on you. But one question that I know we'll get just because I've gotten a ton is around UMI, the increase in UMI to the top end of your -- I think for this year, the guidance is 1.4 -- you had assumed 1.4 to 1.5. UMI is probably close to the top end of that range, but you've held your guidance. I guess what's the offset? Like what's helping you keep -- come in within your full year guidance despite UMI being higher? And at what level of UMI does the math stop working and force to revisit either the medium-term or short-term guide?

Yes. So we've shared that every 5 points of change in UMI is worth 5% to 10% in relative size of originations, which tends to be pretty proportional to everything else kind of revenue and contribution profits. And so if you do the math on that, I mean, it's a pretty sizable effect. I think if we were in the low or mid part of the UMI range for the year that we thought we might be in, probably we would have been raising guidance. And I think that's because we had a pretty extraordinary Q2 in terms of execution on what's in our control. We control our ability to build better models. We control our ability to build better user experiences, more automation, reach more customers. And all of those things, I think we have done exactly the right things and prioritized exactly the right areas of businesses, and I think the results show that. So I think if not for the rise in UMI, I think we probably would have landed in a pretty different spot on guidance. And as it is, I think we look at those two things and say, well, there's kind of a great execution on the one hand and sailing against a bit of a macro headwind on the other and those kind of net out. So that's how we landed where we did on guidance. Of course, we also want to make sure that the bar for making any changes to guidance is just high. And we always want to make sure that people understand that if we're going to affirmatively come out and say something, we really mean it, and we have a lot of confidence behind that statement.

Got it. I actually see a couple of hands up already. So Luke, why don't we go to you first and then Jeremy, we will come to you next. Luke, if you want to go ahead?

Yes. Great. Can you hear me okay?

Yes.

Okay. Great. I have a couple of quick questions. The first is just on kind of the commentary on the focus on the core in 2Q. Obviously, you put a lot of emphasis on it, and it was really strong growth year-over-year. It sounds like that was a big push for you guys through the first half and then the second half is kind of getting the contribution profit neutral. I think it was breakeven by 4Q in the secured products. Should we basically like say that the growth rate that we saw in the core Personal should flatten out into the back half of the year? Or like as we look into next year and obviously beyond, like how should we think about the sustainability of the growth rate on the unsecured versus secured? Because obviously, getting to contribution profit margin breakeven on the secured side will right in tide lift all boats on the overall contribution profit dollars.

Yes. So our kind of strategic focuses and priorities aren't really changing. So growing in core Personal Loans is still very, very high priority for us. We've also shared that getting our secured products contribution profitable is a top priority for us. And so there, you're certainly right. Those are some of our top priorities. I would not say that we are significantly deemphasizing core Personal Loans compared to before, anything like that, still right up there at the top. Now having said that, our guidance is our guidance. We have two pieces of guidance out there. One is around this year and one is around our growth rate that you can expect over the next few years. And we've been guiding to a 35% compounded growth rate. And of course, because the core business is such an important part of that, those are going to be somewhat tightly related to each other. And so I would just point you back to that, if you're looking to model something in terms of what kind of growth rate we think is sustainable for this business. And then, of course, our job is to execute as best we can and do the very best possible job against that guidance we possibly can. And it is, of course, in context of what's going on in the macro because our very first -- maybe the meta priority of the business is always to do credit right. And so if you get a bit of credit tailwind, that's going to probably push you a fair bit ahead. And if you get some of the credit headwind, then maybe the opposite direction. So [ TLDR ] is sort of like look at our kind of long-term guidance, and I think that probably is going to be closely related to what's going on in the core business. And from an execution perspective on things that are within our control, a.k.a things that are not macro, the core continues to be very important to us, and we're going to do everything in our power to grow that business.