No. of Recommendations: 8
Upstart's CEO made it clear in their latest earnings call that a return to profitability
is a priority for 2023. He said their focus in the coming year will be on generating
positive cash flow and positive GAAP net income. He emphasized that to accomplish this they
need to bring their fixed costs more in line with the current lending environment.
The current lending environment has certainly been brutal for Upstart. Their loan volume
plunged 62% in 2022. Fee revenue, which closely tracks loan volume, nosedived 45%. Their
contribution profit, which is the revenue they can use to cover fixed costs, also fell 45%.
Meanwhile, their costs only dropped 16% during the same period. That's because some of
their costs are independent of loan volume. They have to pay rent and the bookkeeper's
salary no matter how many loans they book. As a result, Upstart swung to a GAAP loss in
the latter half of 2022, and the losses are expected to widen in Q1.2023. Here's a chart
that shows loan volume, revenue, and costs for 2021-2022 and projections for Q1.2023:
https://public.flourish.studio/visualisation/13270...In late January, Upstart announced they were laying off 20% of their employees in Q1.2023.
This is one of the steps they're taking to bring fixed costs in line with the lending
climate. But will it be enough to get them to GAAP profitability in the remainder of 2023?
That's the question I'll explore here, although I'm going to look at what it will take for
them just to breakeven.
Upstart's fixed costs tripled in the last two years!Upstart has two flavors of cost -- direct and fixed. Direct costs arise from acquiring and
servicing borrowers. Direct costs climb and fall in synch with loan volume. Fixed costs are
the expenses Upstart has to pay regardless of loan volume. Examples of fixed costs are R&D
salaries, lease on office space, and insurance.
Upstart's fixed costs tripled in the last two years as Upstart geared up for what they
thought would be years rapid growth ahead. Throughout 2021 and early 2022 Upstart brought
in enough fee revenue to more than cover these costs. When lending volume crashed in the
2nd half of 2022, however, they were caught by surprise. They could no longer cover these
fixed costs. The result was a GAAP loss in the latter half of 2022 and widening losses
anticipated going forward. Here's a chart that shows how Upstart's fixed costs have climbed
over time:
https://public.flourish.studio/visualisation/13189...Contribution profit is key to covering fixed costsUpstart has a measure they call contribution profit which is the leftover revenue they
can use to cover fixed costs after deducting their direct costs. When contribution profit
exactly covers fixed costs, then Upstart breaks even.
Upstart's contribution profit more than covered its fixed costs in 2021 and early 2022.
They were profitable. Since then, however, contribution profit has fallen well short of
covering fixed costs. If revenue stays flat after Q1, they won't come close to covering
their fixed costs in 2023, even after the planned 20% reduction in headcount in Q1. This
chart illustrates the relationship between contribution profit and fixed costs:
https://public.flourish.studio/visualisation/13269...Getting to GAAP breakeven in 2023 is unlikely, even after the 20% layoffs in Q1To get to GAAP breakeven in Q2 after the 20% layoffs in Q1, Upstart would need to double
loan volume and fee revenue from Q1. That's because the Q1 layoffs will only reduce their
fixed costs by 13% to $116M. That means their contribution profit would have to be $116M
to cover those costs. Using Upstart's historic contribution margin of 50%, that calculates
to fee revenue of $116M/50% = $232M and an implied loan volume of $2.3 billion, a 110%
increase over Q1. Here are two charts showing the breakeven scenario where Upstart is able
to double loan volume and revenue in Q2.2023:
https://public.flourish.studio/visualisation/13269...https://public.flourish.studio/visualisation/13277...The pivotal question is do we think Upstart can achieve $2.3 billion in loan volume
sometime in 2023? That $2.3 billion is more than double the loan volume forecast for Q1
and considerably higher than Upstart's loan volume in the last two quarters of 2022. Given
the depressed lending environment, which shows little sign of improving, it seems highly
unlikely that Upstart will double their loan volume in 2023. In fact, it's more likely that
their revenue will continue to decline. Hence it's doubtful they'll get to GAAP breakeven
anytime this year, much less profitability.
Perhaps a more pertinent question is did Upstart cut its fixed expenses enough? If revenue
stays flat after Q1, they would need to cut $56M from fixed costs in Q2 just to breakeven.
That's an additional 50% cut over and above the 20% layoffs in Q1. That additional 50% cut
would get their fixed expenses back to where they were in the beginning of 2021. Back then
they had the same amount of revenue as today, but their fixed costs were three times lower.
Bottom Line # 1: They either have to double fee revenue or cut fixed costs by 50% to get to
GAAP breakeven in 2023.
Getting to cash breakeven seems more likely in 2023Getting to cash breakeven is a much lower hurdle than achieving GAAP breakeven. That's
because their cash fixed costs don't include non-cash expenses. If we exclude these
non-cash items -- $34M of stock-based compensation and $4m of depreciation -- and deduct
the $14M in cash savings they'll get from restructuring, we get estimated cash fixed
costs of $82M for Q2.2023. That's much lower than our GAAP fixed cost estimate of $116M
for Q2.2023.
Using the historical average for contribution margin of 50%, we get $82M/50% = $164M for
the fee revenue necessary to cover these cash fixed costs. That implies $164M/10% = $1.6
billion in loan volume necessary to generate that revenue. That's about the same loan
volume and revenue they did in Q4.2022 and a 49% increase from our Q1 estimated loan volume
and revenue.
On the other hand, if revenue stays flat after Q1, they would need to cut $22M from fixed
costs in Q2 to get to cash breakeven. That equates to an additional 27% cut over and above
the 20% layoffs in Q1. Again, that is much less than the 50% cut they'd have to make to get
to GAAP breakeven.
Bottom Line # 2: They either have to increase revenue by 49% or cut fixed costs by 27% to
get to cash breakeven in 2023.
Closing thoughtsUpstart is in trouble. They geared up fixed expenses over the last two years anticipating
growth and then got walloped by the collapsing lending market. They've responded by laying
off some staff but it won't be enough to get to breakeven. Cutting costs further is not
attractive, so their hopes rest on finding ways to bring in more revenue. The search for
more committed capital, the UMI program, and the auto loan initiatives are some of the ways
they're trying to do this.
The economics of Upstart's business are quite attractive once they get to breakeven. Their
operating model has a lot of leverage because their fixed costs are quite low in relation
to the revenue they can support. If they can find a way to raise loan volumes -- sustainable
loan volumes -- then their future would be quite bright.
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Note that this analysis only addressed the core business -- revenue and expenses from
acquiring and servicing borrowers. I excluded associated activities such as collecting
interest from loans on the balance sheet. Those are not part of Upstart's long-term
strategy. As a practical matter, the income from those loans is usually more than offset
by the change in value of the loans, so excluding them should have minimal impact on our
outcomes.
I'm an amateur analyst. I went through this exercise to learn more about Upstart's
business, not to forecast their performance. If you rely on any of these numbers or
conclusions, you do so at your own peril. Comments and questions are always welcome.
Ears <long Upstart>
