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Is THERE A 10-BAGGER IN THE SUB-PRIME CARNAGE?
NASDAQ is down 33% from its peak in Q3 2021—but one of the worst sectors has been small-intermediate (SMID) FinTech—much of that sector is down 80% or more. Investors have been crushed. And then there’s the sub-prime lenders here, a sub-sector of Fintech/Nasdaq.
Look at these (ugly!) charts:
Source: Stockcharts.com
Almost all these companies went public in the last couple years via IPO or a SPAC—and either their businesses or their valuations were way off!
Look at Pagaya (PGY-NASD). I mean this was a $30 stock only 6 months ago—hitting a low of 54 cents. Someone thought their platform was worthwhile. A $20b company, now only $600 million!
But Upstart used to be a $150 stock (now $14). Affirm used to be a $180 stock (now $10). And so on…
Meanwhile the addressable market is huge – $4 trillion – yes trillion. Personal loans, auto loans, credit cards, and real estate. Lending to folks that couldn’t easily get a loan before is a massive business if you can make it work.
The problem that Pagaya and the rest of this group is running into right now is—we are likely headed into (at least a mild….) recession.
Recessions are the reality tests of the “this time it’s different” model.
We all remember 2008 – what happened there with subprime home buyers. The same happens every cycle, just with a different coat of paint.
The market is telling you what it thinks – it is skeptical. But that does not mean that none of these companies will be successful.
I’ve stayed away from the carnage – mainly because when I read about things like ABS backed financing or securitized personal loan portfolios my eyes start glazing over.
But with these companies all down so much, I have to wonder if there isn’t a diamond in the rough?
My big problem is just – how do you recognize the winner? Consider the following business descriptions from a few 10-Qs:
- Upstart (UPST – NASDAQ): applies modern data science and technology to the process of underwriting consumer credit
- Affirm (AFRM – NASDAQ): underwrites consumer loans with their proprietary risk model
- Katapult (KPLT – NASDAQ): Proprietary AI and machine learning risk model for e-commerce point-of-sale (“POS”) non-prime US consumers
At a very high level each does the same thing. Drill down and each has their own flavor and secret sauce. I have no idea which is the best.
A QUICK DIVE ON PAGAYA
Pagaya tries to find people worth lending to–among a huge pool of people that Tier 1 lenders deemed NOT worth lending to.
Investors are about to find out if AI–Artificial Intelligence–and machine learning can truly lead to better underwriting. Pagaya takes in large swaths of loan data, census data, demographic data and so on. They process it with correlations and algorithms.
In the end they think their AI comes up with a (better..??) assessment of whether a person is worthy of lending to, and what the risk of lending is.
Pagaya evaluates a lot of loans—77 million of them in the last 4 years. From those applications Pagaya funded a little less than $5 billion in loans in 2021. They are on track to exceed $7 billion in 2022.
Source: Pagaya 3Q 2022 Results Presentation
The cleverest part of Pagaya’s model is their “lead generation”.
Their partners, who are other fintech firms like SoFi Technologies (SOFI – NASDAQ), Ally Financial (ALLY – NASDAQ), Upgrade (Private), also Visa (VISA – NYSE), get a fee for passing on the name of a potential borrower to Pagaya.
What makes that clever is that these are borrowers that those referring lenders won’t lend to themselves.
It is a great trade for the partner, who are more than happy to funnel all their rejects to Pagaya for a fee. For Pagaya it means they have a steady stream of applications to evaluate.
A second positive is that Pagaya doesn’t keep the loan themselves. This limits default risk (but does not eliminate it entirely).
Instead Pagaya funds the loan volume through the asset backed security market (ABS) and from private lending funds. They get the funding first and then fund the loans to fill it.
The profit model is simple. Pagaya raises ABS or private market debt at 2-8%. The loans, being to borrowers of poor credit quality, are high-interest loans – around 20%. The spread, less defaults, is the profit. Pagaya also collects fees for originating and managing the loan portfolios.
When I compare Pagaya to its comps, the stock looks reasonable
Source: Company Documents, Analyst Consensus
The growth is weak for most of these names because of the incoming recession. In a robust economic environment, all these names can grow very fast.
But I just don’t know how these businesses look at the end of a recessionary cycle.
What gives me pause are charts like the one below. US brokerage firm Wedbush analyzed Pagaya’s loan issuances from 2019 to 2022. The two 2022 issues are too early to comment on, but the 2021 issues seem to be following a steeper default trend than earlier vintages:
Source: Wedbush Initiation Report
Second, the pressure on their funding cost is real. Consider this comment
Source: Bloomberg
Finally, there is the insider lockup. Half of insider-held stock became free trading September 20th and the other half December 19th.
That alone could pressure the stock – though I have to wonder how many insiders will be selling a stock already down from $10 to $1 in just 6 months.
And that really is the point here.
CONCLUSION–TIME IS THE ONLY CRYSTAL BALL
My Spidey-sense is tingling. This time, I can’t help but wonder if one of these beaten up stocks could turn out to be a ten-bagger from down here.
But which one?
Wouldn’t I love to know that! Unfortunately, unless I get a Nostradamus- like sign, I think that discretion will be the better part of valor with all these names. I’ll wait for the cycle to play out and see which one(s) are left standing.
