A Different Kind of AI Stock And Nearly a Double-Bagger YTD

When I wrote about Pagaya Technologies (PGY – NASDAQ $2.16; US$1.5 B market cap) in January the stock had fallen over 90%–to $1/sh–as interest rates started to rise in the spring of 2022. The Street considered it a sub-prime, fintech lender, and that whole sector was crushed. Remember these charts, as interest rates started their climb 18 months ago?

I said at the time that Pagaya made my “Spidey-sense tingle”. I wondered if it or another of the Fintech lenders could turn out to be a 10-bagger.

Today it trades for over $2. In this market, I’ll take that as a win.

I think a 10-bagger is still on the table, but it is no sure thing and, arguably, the “easy money” in the stock has already been made.

But if you think of PGY as NOT being a sub-prime lender, as it takes no balance sheet risk; instead it’s an AI match-maker for customers who didn’t quite qualify for Tier 1 credit. A group of them get matched to a pool of investors hungry for the slightly higher yield that a well-vetted “sub-prime” customer brings. Then this stock makes A LOT of sense.

I want you to think of Pagaya the Tinder of sub-prime lending, not the lender itself. Pagaya is just the marketplace.

Q2 numbers last week showed the business has some strong operating leverage. In fact, they produced as much EBITDA in Q2–$18 million–than what they originally guided to for the entire year! Guidance is now way up to $50 million EBITDA. From that, the Street has started to bump up EBITDA and price targets—even after this run from 80 cents in May to $2.40.

Could there be even more room for this stock to run? I think the answer is yes. What they are doing better than competitors is:

1) Using their AI to pick better clients to lend to

2) finding buyers to securitize their loan books to–they oversubscribe by 200% everytime lately–and have really good investors buying them. They are actually THE LARGEST asset-backed “securitizer” in the US right now. (I just made up that word but it fits)

There was a big macro tailwind as well in 2023—the impending recession never did arrive, and that environment has helped the stock for sure.

Source: Stockcharts.com

A RECAP OF WHAT THEY DO

This is a great business model. Partnered banks send them a huge number of clients they don’t want to lend to. Pagaya uses their fully automated, AI-driven credit decision platform to take on the next level of risk–the AI decides who should get credit. And the Q2 financials show that it’s clearly making good choices!

They have something special there. Here’s what they DON’T have:

1. High customer acquisition costs–the banks send them their clients for free!
2. loan service costs
3. loan risk
4. securitization distribution costs

They raise the money for the loans to their customers–all chosen by their AI program (it should have a name, like HAL from A Space Odyssey)–from their client financial partners.

Their partners (that are actually at the other side of the table) are fintech firms like SoFi Technologies (SOFI – NASDAQ), Ally Financial (ALLY – NASDAQ), banks like Lending Club (LC – NASDAQ), and financing companies like Stellantis Financial Services, (Private), Upgrade (Private) and Visa (VISA – NYSE).

Pagaya is not like a bank or sub-prime lender that sits at the opposite table to their customers. They never shake the hands of their borrowers. It’s all fully automated through their AI, and through their APIs to the financial partners.

That financial partner list expands every quarter. Pagaya said on the Q2 call that they are in discussions with “many of the top-25 banks”. Having any bulge-bracket bank come on as a partner has to be a big catalyst for this stock.

These partners use Pagaya’s AI platform to see if a loan can be made from their “reject” pile.

A SeekingAlpha article by Kevin Mak described where Pagaya operates as well as anywhere I have seen:

Source: SeekingAlpha

Pagaya is looking for gems in the rejection pile.  A thin slice of loans that aren’t being approved by lenders but should be.

It is a no-lose proposition for the lending partner. They have already rejected the loans using their own criteria. If they can make the loan via Pagaya, that is gravy (and more fees)–and all without credit risk to Pagaya, as the bank/lender/partner keeps the client–and all the loan servicing costs etc.

How does Pagaya do it? The entire business boils down to an AI-based decision-making tool that takes in all the info about the lender and comes out with a yes/no answer (along with a recommended rate) in a few seconds. Pagaya is a very legitimate AI stock.

They are training their lending platform on an ocean of data of loan approvals and continually updating it as more data comes in. (They employ over 200 data scientists!) That lending platform is constantly learning, which is leading to better decisions. And the decisions they are making seem to be doing well.

OUTWORKING UPSTART

Pagaya’s closest comp in the public markets is Upstart (UPST – NASDAQ). Through 2021 Upstart was one of the market darlings.  Pagaya was thought of as an Upstart-wannabe.

But as we move through this downturn that seems to be changing. Pagaya has been outperforming Upstart. This was even more apparent so far this year.

Upstart’s transaction volume has declined 78% YoY in Q1 and 64% YoY in Q2.

While Upstart barely met estimates on revenue and missed on earnings, Pagaya beat across the board. That’s because Upstart takes loans on their own balance sheet and Pagaya does not (except for 5% mandated by the regulators). Pagaya also raised their full-year guidance.

Source: Pagaya 3Q 2022 Results Presentation

Pagaya has increased the number of lenders on their platform even through this difficult period. They have never lost a lender from their network.

The argument against Pagaya is usually that Upstart has a better AI model. I have no idea if this is correct. In fact, I wonder if even the analysts know, or if this has more to do with Upstart being better marketers of their product.

What I do see is that Pagaya has one big advantage over Upstart that is allowing it to outperform.

That is their access to the capital markets.

THEIR ABS ADVANTAGE

There are two sides to the lending business. You have to make the loan and you have to sell the loan.

Pagaya’s product is all about making loans. But those loans still need to be sold. Apart from a 5% regulatory residual that Pagaya must keep on their balance sheet, the rest is packaged off and sold to investors.

That means a big part of increasing loan volume is finding investors that are willing to buy.

Pagaya sells their loans through the asset-backed-securities (ABS) market. They pool up loans and sell off securities backed by them in tranches.

I don’t have to tell you that this hasn’t been the easiest time to go to the capital markets.

Yet Pagaya has been able to get their loans sold. In fact, in Q1 Pagaya gave a slide showing that they were #1 issuer of personal loan ABS in the last 12 months.

Source: Q1 Investor Presentation

Their 12-month trailing ABS issuance was $6.3 billion in Q2.

Source: Q2 Supplemental Presentation

Pagaya now lists 86 investor partners for their ABS deals–they’ve announced 5 new ones since June alone.

LOAN VOLUME

Pagaya was a huge growth engine from 2019 until 2022. 77 million applications were evaluated during those 4 years.

Source: Pagaya Investor Relations

From those applications Pagaya funded a little less than $5 billion in loans in 2021 and $7.3 billion in 2022.

This year that growth has been more muted. Full year network volume is expected to be between $7.6 billion and $8.1 billion.

But focusing strictly on growth is missing the point. Pagaya is clearly growing share and credibility with their lenders as they see a platform that can fund loans through thick and thin.

By doing that Pagaya is consolidating their position as the premier AI lending platform for consumer loans, auto loans, and most recently residential loans.

It is perhaps the most impressive testament to their performance that Pagaya has managed to hold and even increase margins in such a weak environment. Their take rate, which they call “Fee Revenue Less Production Costs” or FRPLC, increased to 3.3% of loan $ value in Q2.

Source: Q2 Supplemental Materials

It’s interesting–to me anyway–that Pagaya has chosen to be more conservative approving loans as their network volume grows–to ensure sustainable, profitable market share gains.

There’s another interesting twist here that is like a turbo-charge for profitability. Higher volume thresholds trigger a higher revenue share for Pagaya. The more the banks show they need Pagaya by referring them more business, Pagaya has it written in to their contracts that they get a bigger cut.

WHAT’S THIS AI STOCK WORTH?????

Look, Pagaya isn’t the distressed, high-octane optionality bet that it was in January. In January it was cheap. The stock has moved up in-line with the improving fundamentals, so I would say the stock is somewhat fairly valued.

But now that they have proven their model. They’re showing they can execute better than traditional fintech sub prime lenders. Investors could not only see EBITDA growth, but some growth in the multiple that the stock trades at–especially as an AI stock that makes sense (and money!).

Pagaya has a US$1.5 billion market cap today. It’s the junior guy on the team, and has the lowest valuation at 1.6x 2024 consensus estimated revenue. The stock is probably priced fairly on revenue, EBITDA, and current estimates of next year’s growth–as a fintech sub prime lender.

Even in that space, Open Lending LPRO-NASD trades 5.6x (it’s profitable), and the rest of the Fintech sub prime lenders are 3.5x – 4.5x. Pagaya could double from here and still be the cheapest stock in the group–and it arguably has a MUCH better business model with no balance sheet risk.

Pagaya has $300 million of unrestricted cash–lots to grow an asset light, automated business model.

But Pagaya may be undervalued on the most important thing of all, at least in the long run – their AI moat.

There is risk here. A recession—if and when it comes—could hurt their clientele harder than most (PGY bulls would tell you that PGY clients are ALWAYS in a recession so that’s not relevant).

But if they continue to take market share, increase margins and show resiliency through the economic cycle, then that original spidey-sense of mine may turn out to be right!

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