Pagaya's Race Against Time

Summary

• Pagaya's recent losses and volatility have raised questions about its viability.
• Yet the company has seen steady growth in network volume, customers, and securitizations, and expects to reach sustainable profitability in the near future.
• A current challenge for Pagaya may be its required risk-retention investments, created by the rapid growth in its ABS securitizations. Has this led to a capital constraint?
• The recent equity raise (March 13, 2024) and credit facility (February 7, 2024) should have relieved this constraint in the interim.

As I sit down to write this evening, investors may have burning questions concerning Pagaya Technologies Ltd.'s (NASDAQ:PGY) long-term path to profitability. Is the investment still viable?

There's much to consider amidst recent gargantuan losses and sky-high volatility. In the previous week (March 8-15, 2024), Pagaya's shares suffered a -40% loss in 5 days, precipitated by a reverse 12/1 split. Three days following the split, there was an unexpected secondary offering that went badly (and got worse) by the hour, bringing the shares down to $10.78.

This mini-crash has left the question of why such a debacle took place, and the reason for the surprise secondary offering in the first place.

This article is an attempt to answer these two questions.

First of all, 2023 featured a large volume of BUY and STRONG BUY articles touting the progress and success of Pagaya as an ABS (Asset-backed Security) securitizer. Today Pagaya is the number one issuer of personal loan ABS transactions in the U.S. The company has never lost a large client. Once onboarded, they have stayed.

As reported in the company's recent Fourth Quarter and Full Year 2023 Results, there have been steady increases in network volume, customers, securitizations "ABS" (15 in 2023), record revenue from fees less production costs ("FRLPC"), and quarterly-losses are diminishing.

In Pagaya's 4Q'23 Shareholder Letter (2/21/24), the company states,

We are reaching a point of sustainable profitability, setting us on a path to deliver expected adjusted EBITDA in the range of $150 million to $190 million in 2024, and positive net cash flow by early 2025." (Page 5)

Consensus from analysts is that "Pagaya Technologies is on the verge of breakeven. They expect the company to post a final loss in 2023, before turning a profit of US$28m in 2024. The company is therefore projected to breakeven around 12 months from now or less."

On March 12, 2024, Zach's upgraded Pagaya to Strong Buy, citing the recent earnings revisions "as a reflection of an upward trend in earnings estimates -- one of the most powerful forces impacting stock prices."

So there is A LOT to like.

But if Things Look So Good, How Did They Suddenly Get So Bad?

I think the crux of Pagaya's current problem is its rapid growth in ABS securitization, juxtaposed with its required compliance with the Dodd-Frank Risk Retention Rules for those Securitizations.

Section 15G of the Exchange Act imposes risk retention requirements on any "securitizer" of ABS, approximately 5% (some say it's actually closer to 2-3% in practice) of the ABS that is securitized.

In 2024, Pagaya estimates it will securitize $9 billion to $10 billion in ABS, which would require a risk-retention investment of $450 million to $500 million in those ABS.

The question on investors' minds is, "Do they have the money for this risk-retention investment?" Hence the likely reason for the recent $280 million credit facility, and the secondary offering and capital raise (Approximately $90 million).

Currently, the company has:

• $190 million cash.
• $90 million from the recent secondary offering.
• $280 million credit facility.
• Total of $560 million.

The sudden sell-off

Investors are uncertain. Is Pagaya Technologies Ltd. (PGY) experiencing a temporary ceiling of capital constraint, just before the company predicts it will turn fully profitable? In a sense, it's a race towards a moving target, with the goal of profitability in a year's time.

Here is how the company's business plan plays out:

• There is a 3-year ramp, beginning when a new client begins the ABS securitization process with Pagaya.
• The transactions only become profitable in the 2nd year, so there is approximately a 12-month delay.
• The risk retention is established when the new ABS is securitized.

Pagaya's detailed explanation of the process

When we onboard a new partner, the first year - the integration year - is focused on expanding across the lender's network of branches, dealers, or merchants, ensuring our product is live and operating successfully at each point of sale.

In year two - the ramp-up year - we are focused on growing volumes with the lender as our models learn from the new flow, enabling an increasing conversion rate, all else being equal.

By year 3 - the expansion year - most partnerships are fully ramped up and the focus turns to further expansion and product innovation to drive consistent growth in volumes.

To put it into context, the partners and channels we onboarded in 2022 delivered an additional $800 million to our network volume in the first 9 months of 2023, and we expect this figure to grow to approximately $1 billion in full-year 2023.

We expect that our recently announced cohort of 2023 integrations (Westlake Financial, top 5 bank (U.S. Bank), and top 4 auto (Exeter), which are much larger in total size and volume potential compared to our 2022 cohort, has the potential to generate significantly more incremental network volume over the next 12-18 months.

For our 2024 plan, we expect that all of our network volumes will be sourced from partners that are already part of our network as of today.

As each new customer is onboarded, a virtuous circle is created in their data, increasing conversions.

...As we receive higher application flow, we can enhance our credit decisioning capabilities through increased proprietary data, which can lead to both an improved conversion rate of applications and better returns for investors.

Our models get smarter over time as we see more data - we can detect behavioral patterns, better predict the impact of macro trends on the ability of consumers to repay or detect instances of fraud. With time, as the predictive power of our AI models improves, we can increase our conversion rate by approving more loans at similar or higher expected returns. Higher conversion rates also lead to a strengthened competitive moat with our lenders.

When we first plug into a new lender, our conversion rate tends to be lower than average as our models start to train on a new dataset. Over time, as shown in the illustration below, we expect the conversion rate for each lending partner, all else being equal, to steadily improve over time as our models learn about the incoming data flow.

If Pagaya is pushing up against a ceiling of available resources needed for their 5% investment in new securitizations (2024), they must resolve this quandary, and with some urgency.

The only way to do this is:

1. Raise cash through secondary offerings.
2. Take on increased debt, or a credit line.
3. Slow down growth (number of new ABS created) until the profitability of the ABS onboarded in 2023 ramps up later in 2024.
4. Arrange a forward-funding agreement in which some of the eventual profit from the new ABS is shared with a guarantor in exchange for a portion of Pagaya's 5% responsibility in each new securitization. The rules allow some degree of horizontal co-sharing. In this instance, Pagaya loses some profitability in the near term, but is able to grow their book of business with certainty throughout 2024.

When the company reaches core profitability by early 2025 (a very likely outcome), the forward-funding agreement (or portions thereof) would no longer be necessary, and future ABS could likely be self-funded.

In a sense, it is a race both against time and with time, because the company needs to get through 2024's onboarding of new clients - and the fuller integration of 2023's clients ($) on Pagaya's platform - before achieving profitability.

Takeaway

• There have been voluminous research, articles, and conference calls regarding Pagaya's prospects.
• There is no information (thus far) to support a collapse in the company or its prospects.
• The worst that the current state of affairs could be is a temporary ceiling of capital constraint that has now been resolved.
• The company has averred that it came to the US to create closer institutional partnerships with American financial companies, most of whom are headquartered in NYC.
• If Pagaya was on the verge of imploding, it would not move its headquarters to New York to pursue greater transparency in its accounting and to play by more stringent rules.

The company remains a Buy, with a one-year road to profitability, as previously stated by the company and the analysts which cover the company.

What Could Go Right With This Investment?

• Pagaya estimates it will achieve profitability within a year.
• We are currently in the most restrictive credit environment in 17 years, and yet Pagaya is thriving with only a 0.8% conversion rate.

• In a Fed-Easing cycle, that conversion rate could increase by 50% to 1.2%.
• When credit conditions ease, Pagaya's fees and profits could increase exponentially, because of 1) the conversion rate of new loans approved, and (2) the vastly-increased size of its future network.

Downside Risks

There are several downside risks:

• Pagaya restates its earnings. Four weeks ago, on February 21, 2024, the company upwardly revised its earnings estimates for Q1'2024 and for the year, estimating it would be fully profitable by 2025. However, if the company revised them downward in a surprise announcement going forward, it would have a material effect on the share price. After the recent sell-off on high volume, Pagaya should be considered a high-risk investment.
• Additional analyst downgrades. On March 15, 2024, Wedbush Morgan analyst Dan Chiaverini lowered his price target from $18 ($1.50/share pre-split) to $11.50 ($0.96 pre-split), while maintaining his neutral rating. He cited losses in the risk-retention assets mentioned in this article. On February 21, 2024, he had raised his estimates from $12 ($1.00/share pre-split) to $18 ($1.50/pre-split). Further downgrades by additional analysts could have a material effect on the share price.
• Additional equity raises or secondary offerings, diluting shareholders. Pagaya has a history of violent moves on the news. The latest short-interest on the company now lists it at 9% (TD Ameritrade). Because of the small size of the float (31.67 million shares), any news can create big moves in price. Another secondary offering later in the year could drop the price of the stock significantly. In the same manner, an announcement of a new large client, or major bank onboarding to Pagaya's platform, could have a very positive effect.
• Uncertainty. Amidst the panic-selling of the last 2 days - and the news vacuum that has occurred in the midst of it - there has been little to change evaluations of the company going forward, besides what was stated by the company just four weeks ago. An absence of a response by the company's Investor Relations to violent moves in the share price can quickly change investors' confidence to doubt.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.