After suffering a painful selloff in recent weeks, Pagaya Technologies Ltd. stock recorded a double-digit jump yesterday after reporting a solid set of numbers for Q3 2023 and raising guidance for FY 2023.
For Q3, Pagaya beat expectations across all key metrics and achieved a positive quarterly GAAP operating income for the first time in its history.
In this note, I provide an update on the growth of Pagaya's two-sided AI network and discuss the company's path to $25B in network volume.
Further, we reevaluate Pagaya's fair value and expected return using TQI's Valuation Model.
Pagaya Technologies is a two-sided, B2B network that helps loan originators (lenders) and loan buyers (institutional investors) unleash the power of AI-based lending through superior credit underwriting. Amid Fed's aggressive monetary tightening, Pagaya has showcased incredible business resiliency over the past year. And the company looks set for a re-acceleration in coming quarters. Given its relatively tiny scale (2023E network volume: ~$8B) compared to a humongous TAM (annual loan origination in the US: $4T+), Pagaya has a long, long runway for growth.
Pagaya's credit performance has remained healthy in recent quarters, and early delinquencies in recent vintages are back to 2021 levels. The business is well-capitalized and ready for hypergrowth in the AI era. With the ongoing rate hike cycle getting close to its conclusion, the macroeconomic headwinds for Pagaya are likely to subside in the upcoming quarters. While most near to medium-term oriented investors are worried about the economy going into a recession [and the end of this ongoing credit cycle], I believe that if we do end up in a recession on the back of FED's aggressive monetary policy tightening, rate cuts will follow at some point, and that would be an incredible tailwind for Pagaya. As I see it, Pagaya is a fantastic long-term [3-5+ years] investment for those willing to look beyond the current credit cycle and toward the next one.
Artificial intelligence will make fortunes, and Pagaya is one of my favorite stock ideas to play this secular megatrend in the 2020s. According to TQI's valuation model, Pagaya is deeply undervalued, and the long-term risk/reward for PGY is truly asymmetric. In a nutshell, Pagaya is a well-run, asset-light AI lending infrastructure platform business that's trading at a dirt-cheap level. Given its humongous opportunity set in AI-based lending, I think Pagaya's risk/reward for long-term investors buying PGY stock at $2.20 per share is truly asymmetric!
Since then, Pagaya's stock has declined by ~35-40%, and now sits smack in the middle of the second big support zone I shared in my previous note:
In light of its Q2 2023 earnings release, Pagaya stock briefly broke out above $3 in the after-hours session. However, we have seen a clear rejection from this gap resistance level. For now, PGY's daily chart seems to have formed a local double top at ~$2.83, and we are seeing a breakdown of the bullish megaphone pattern playing out right now.
Pagaya stock chart (8/17/2023) (Webull Desktop)
The ongoing pullback in broader equity indices seems ominous given elevated stock market valuations; however, in my view, Pagaya is an incredible buying opportunity at current levels, with the stock offering a 200%+ upside to fair value. For the near term, I see $1.80-2.04 and $1.28-1.56 as big support zones for PGY stock. At TQI, we have a 4.5% position in Pagaya within our GARP strategy, and we will be accumulating more shares slowly via DCA.
In today's note, I will provide a brief update on Pagaya in light of a solid Q3 report and a couple of key partnership announcements. Without any further ado, let's get started!
Brief Review Of Pagaya's Q3 2023 Report
For Q3 2023 , Pagaya delivered a solid beat across all KPI metrics, with network volume ($2.1B, up 10% y/y), revenues ($211.8M, up 4% y/y), and adj. EBITDA (+$28.3M) coming ahead of management guidance and street estimates. While Pagaya's take rate moderated slightly to 9.5%, "FRLPC margin" improved by 50 bps to 3.4% to enable stronger-than-expected bottom line performance.
Pagaya Investor Relations
In Q3 2023, Pagaya achieved positive quarterly GAAP operating income for the first time in its history. Furthermore, management raised revenue and adj. EBITDA guidance for FY-2023 to $800-825M and $65-75M, respectively.
From a numbers perspective, Pagaya (as a business) is performing at an exceptionally high level and business momentum is expected to remain strong in Q4 2023 and FY-2024 despite ongoing disruption from the conflict in the Middle East given Pagaya's Israeli roots. In my view, Pagaya is once again showing tremendous resilience as a company, which we saw ample evidence of throughout the Fed's aggressive rate hiking campaign.
The Pagaya Network Is Getting Stronger
As we have discussed in the past, Pagaya Technologies is a two-sided, B2B network that helps loan originators (lenders) and loan buyers (institutional investors) unleash the power of AI-based lending through superior credit underwriting. And since my last update, both sides of the platform have gotten stronger, with Pagaya striking transformational partnerships in recent weeks. In October, Pagaya onboarded a top-5 US bank (by assets) for its Personal Loans product and a top-4 auto captive (financing arm of an OEM that did 1.5 million in annual vehicle sales in the U.S. in 2022, with more than 10% market share in new vehicle sales among large U.S. OEMs).
Pagaya Investor Relations
Pagaya Investor Relations
On the other side of its platform, Pagaya is seeing growing investor demand as a result of its growing scale, improving efficiency, and innovative structuring. Pagaya was once again the largest Personal Loans ABS issuer in the U.S. during Q3, and according to their report, the last four ABS deals have been oversubscribed by an average of 2x. Since August, Pagaya has added six new institutional investors to its network, including two top-tier firms from whole-life insurance and asset management industries, each with over $400 billion in total assets under management.
As of now, Pagaya is integrated with 28 lenders across 5 markets, with a funding network of 90+ unique institutional investors. On the earnings call, Pagaya's management shared that Personal Loans made up ~60-65% of its network volume in Q3, but that other loan segments were growing faster, i.e., Pagaya's lending products are becoming more diverse, which is an attraction for institutional investors. Further, the growth of Pagaya's institutional investor base is reducing concentration risk by alleviating reliance on top-5 investors on the platform.
The Path To $25B In Network Volume And $500M In Adj. EBITDA Gets Clearer, But Balance Sheet May Be A Limiting Factor
With its Q3 report , Pagaya provided a clear path and strategic initiatives to hit its medium-term network volume goal of $25B [FRLPC: $1B, adj. EBITDA: $500M]. The plan is simple -
Grow application volume via expansion of product integration across new and existing lending partners (large U.S. banks and auto captives)
Increase application conversion rate through AI model improvements
Keep building the funding (investor) side of the platform.
Pagaya Investor Relations
After loosely guiding towards that $25B network volume goal, Pagaya's management finally provided a breakdown of how the company scales up to this milestone:
Pagaya Investor Relations
Pagaya Investor Relations
Pagaya Investor Relations
Over recent quarters, Pagaya's management has delivered (and beaten expectations) on their partnership and financial targets. Bagging a top-5 U.S. bank and a top-4 auto captive validates the strength of Pagaya's value proposition, and I expect more and more large financial institutions to join hands with Pagaya to power their lending operations with AI.
Pagaya Investor Relations
In addition to adding more lending partners and investors to its platform, Pagaya is looking to grow volumes via improvement in application conversion rates, which stand at a measly ~1%. To improve loan conversion, Pagaya is continuously making enhancements to its data science and credit models.
In the current environment, considering lower risk tolerance by our lending partners, we developed newer models that improve pricing by focusing on reducing delinquency rates and optimizing between channels. This translates to higher returns for every incremental unit of underwritten risk. For example, in Q3, we introduced an updated credit model in our personal loan product. This version focuses on better utilizing our network proprietary data to predict activation sensitivity (the probability a consumer will accept a loan offer) and loan return. We expect that these enhancements can lead to up to a 50 basis points increase in annualized asset returns. We also made critical updates to our auto underwriting technology. These updates include enriching our existing methodology with additional vehicle valuation data points, improving the predictive accuracy of asset performance over time.
Now, I want to discuss a potential limiting factor for future growth - Pagaya's balance sheet. Having turned operationally profitable, Pagaya's ~$250M cash should be ample liquidity cushion for the near term. However, in order to scale up the business to $25B in annual network volume, Pagaya could need additional balance sheet firepower (capital raise) of $1-1.5B in my opinion.
Pagaya Investor Relations
While Pagaya's strategic partnerships and robust customer pipeline are great, Pagaya is required to carry at least 5% of the loans underwritten using its AI technology due to Dodd-Frank regulations. So, in order to originate $25B in loans, Pagaya would need to invest $1.25B in the loans, which will be held on its balance sheets. Even if we consider loan rollovers and cash generation of the business (FRLPC margin is only 3-4% of network volume), I believe Pagaya would need to find 2-3% of network volume in additional capital.
Given the current financial environment, raising money from the capital markets is going to be hard and expensive. The good thing is that Pagaya has turned operationally profitable, and it has deep relationships with lots of institutional investors (some of whom are strategic investors in Pagaya). Hence, while the balance sheet could prove to be a limiting factor on Pagaya's future growth, I think Pagaya's incredible leadership team will find the money (investment) from the capital markets. With the stock being so depressed, my guess is that any additional capital will be raised in the form of debt, but that's just my hunch, so take it with a grain of salt.
Pagaya Fair Value And Expected Return
Based on conservative assumptions (shared in the image below), Pagaya's intrinsic value is $7.87 per share or ~$6.3B in market capitalization, which is nearly ~5.5x of PGY's current stock price.
TQI Valuation Model (TQIG.org)
Note: I have reduced our Required IRR for Pagaya to 20% (from 25%) as the business has turned adj. EBITDA and operating income generative.
Assuming a base case exit multiple of ~15x P/FCF, Pagaya could be trading at $11.6 per share five years from now. At current levels, the projected 5-year CAGR return for Pagaya is ~52%.
TQI Valuation Model (TQIG.org)
Since Pagaya's projected CAGR return is much greater than our investment hurdle rate of 20%, Pagaya is a strong buy under TQI's valuation methodology.
Investment Risks
As with all investments, Pagaya carries some risks. Here are some of the major risks associated with Pagaya:
Pagaya's AI-based credit underwriting models haven't proven themselves through a full credit cycle. If Pagaya AI's credit performance ends up being at par or worse than its AI-lending peers and/or traditional FICO-based lenders, then Pagaya could fail as a business.
While I think Pagaya's ~$300M cash cushion is ample capital to get it through a recessionary period, the business is operating at breakeven income margins. The near-term macro outlook remains uncertain, and Pagaya's network volumes could come under immense pressure during a recession. In such a scenario, Pagaya may turn unprofitable again.
Concluding Thoughts
For investors willing to look forward to the next credit cycle, Pagaya offers an exceptional risk/reward, with PGY's 5-year expected CAGR standing at >50%. Given strong business momentum, I believe Pagaya's management will figure out the balance sheet problem sooner or later (most likely through a debt raise). As I see it, Pagaya is ready to scale up significantly over the next few years, with key partnerships already in place and a robust pipeline. With the reward far outweighing the risks, I am more bullish than ever on Pagaya and view the recent sell-off as an early Christmas gift from Mr. Market.
Key Takeaway: Pagaya Technologies Ltd. stock is a "Strong Buy" at $1.45 per share
Thanks for reading, and happy investing. Please share your thoughts, questions, or concerns in the comments section below.
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Pagaya Technologies (NASDAQ: PGY) intends to announce its second quarter 2024 earnings on August 9, 2024. A conference call to discuss those earnings will be held on the same day at 8:30 a.m. ET / 3:30 p.m. IDT. Details to register for the live webcast presentation will be available on Pagaya...
2024-07-06 19:10:00 ET Stock Traders Daily has produced this trading report using a proprietary method. This methodology seeks to optimize the entry and exit levels to maximize results and limit risk, and it is also applied to Index options, ETFs, and futures for our subscribers. This...
Prestigious awards program celebrates the bold leaders who disrupt markets, revolutionize industries and transform lives Krubiner honored for his creation of an industry-leading, AI-driven lending solution that delivers long-term value for American consumers, banks and investors ...
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