Pagaya Technologies Ltd. Q4 FY2022 Earnings Call

Good day, and welcome to the Pagaya Q4 and Full Year 2022 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. At this time, I'd like to turn the call over to Jency John, Head of Investor Relations. Thank you. You may begin.

Thank you, and welcome to Pagaya's fourth quarter and full year 2022 earnings conference call. Joining me today to talk about our business and results are Gal Krubiner, Chief Executive Officer of Pagaya; and Michael Kurlander, Chief Financial Officer. You can find the presentation that accompanies our prepared remarks, our earnings release, and a replay of today's webcast on the Investor Relations section of our website at investor.pagaya.com. Our remarks today will include forward-looking statements that are based on our current expectations and forecasts and involve risks and uncertainties. These statements include, but are not limited to, our competitive advantages and strategy, macroeconomic conditions and outlook, future products and services and future business and financial performance. Our actual results may differ from those contemplated by these forward-looking statements. Factors that could cause these results to differ materially are described in today's press release and in our most recent Form 6-K as furnished with the U.S. Securities and Exchange Commission, as well as our subsequent filings made with the SEC. Any forward-looking statements that we make on this call are based on assumptions as of today and we undertake no obligation to update these statements as a result of new information or future events. Additionally, non-GAAP financial measures will be discussed on the call. Reconciliations to the most directly comparable GAAP financial measures are available in the earnings release and in the appendix to the earnings presentation, which are posted on our Investor Relations website. With that, let me turn the call over to Gal.

Thanks, Jency. Thank you all for joining us today to discuss our fourth quarter and full year 2022 results. Today, I will discuss financial and operational highlights from the fourth quarter and full year 2022, review our business model and differentiated value proposition and provide an update on the expansion of our network infrastructure. I will then hand it over to our CFO, Mike Kurlander, to discuss our financials and 2023 outlook. We will then take your questions. This was an incredible year of growth for our company. We delivered $7.3 billion in network volume, which grew 49% year-over-year and was approximately 5 times higher than our volume in 2020. We achieved total revenue and other income of $749 million, which grew 58% and was above the high end of our 2022 guidance. Financial markets were highly volatile with higher costs of funding, driven by multiple interest rate hikes and widening spreads. Our AI network, powered by millions of data points on consumer behavior, enabled us to react quickly and adjust our model to drive better relative performance. Even with significantly higher costs of capital, we delivered near breakeven adjusted EBITDA of negative $4.8 million in full year 2022. Our results in the fourth quarter reflect the resiliency of our business. We delivered $1.8 billion in network volume, growing 10% year-over-year. Total revenue and other income grew 25% to $193 million. Adjusted EBITDA was negative $9 million. Mike will discuss our financials in more detail in a few minutes. This still exceeded my expectations. We achieved major milestones while learning how to be agile in rapidly shifting external conditions. We are a different company than we were a year ago. In 2022, we made significant progress on our key strategic objective, expanding and monetizing our network infrastructure. We successfully transitioned to a public company, giving us the fuel to drive future expansion. We delivered record top line results and added industry leaders to our management team, creating a bench with decades of expertise across both tech and financial services. We onboarded six new partners to our network in 2022, including Visa, Klarna, and a top three auto lender. We evaluated twice as many applications in 2022 compared to 2021 and raised more than $7 billion in funding. I’m proud to announce we also completed our first ever M&A transaction, taking advantage of the current market dislocation to position our business for the future. We acquired Darwin Homes, elevating our SFR offering into a premier end-to-end solution. We also received our first AAA rating from Moody's and DBRS on a single-family rental securitization. With these achievements, we are entering 2023 with strong momentum. The exceptional growth we have seen in the past few years is a testament to the strength of our network infrastructure. In just three years, we grew from $100 million in revenues to $750 million, helping our partners originate over $7 billion in assets annually and providing access to unique investment opportunities for our institutional investors. I want to take a few minutes to go over the basic fundamentals of our business model. Pagaya is a B2B2C platform, founded with a mission to make financial opportunities more accessible by innovating legacy underwriting systems with AI technology and data science. Pagaya is not a lender or a servicer. We partner with financial institutions who originate assets with the assistance of our technology. At the same time, we connect partners to institutional investors who want exposure to these assets, and now we promise to grow with limited incremental risk or capital. We employ a unique upfront funding model that enables better optimization of investor returns by locking in the cost of funding first before sourcing assets that meet the required return thresholds. Finally, our network is diverse across five products in consumer credit and real estate with an addressable market opportunity in the trillions. We believe these attributes make our business scalable, resilient, and positioned for long-term growth. The level of infrastructure we are building is getting stronger with time, as we onboard new partners, scale new products, and open new channels. We are collecting more than 25 financial institutions across five products with hundreds of investors across the country, powering the real economy by facilitating billions of dollars of asset creation annually. Since inception, approximately $1.1 trillion in application volume has come through our network, an incredible amount of data in consumer behavior insights that continuously make our model smarter as we grow. We have been able to deliver consistent value creation over time for our partners and investors. Network volume is driven by two factors; the application flow we see from our partners and the rate at which that application flow is converted to network assets. Application flow, as you can see on Slide 10, grows consistently over time. In 2022, we saw application flow grow nearly 100% versus the prior year, driven by growth from new partners and as we scale newer products such as auto. As macro conditions evolve, we can optimize for investor return through our conversion rate. When facing tighter market liquidity conditions or more challenging credit environments, we can reduce our conversion rate to improve asset returns. Our conversion rate declined by nearly 50% in Q4 2022 compared to the prior year as we shifted the portfolio to a more resilient borrower archetype. Partners are seeing immediate value creation when they join our network. On average, partners have seen 3 times growth in origination enabled by our network between the third and twelfth months of onboarding. In 2022, approximately $650 million of network volume was generated by new partners and channels on our platform. Institutional investors connected to our network get one-stop-shop access to low-duration high-yielding consumer credit and real estate assets. AI analytics and data-driven insights enabled relative outperformance of assets originated by our partners versus the broader market. On Slide 12, we show the great performance of our personal loan portfolio from Q1 2021 to Q3 2022 at three months on book. Our portfolio has consistently outperformed the comparable market benchmark. This is a result of our ability to dynamically adapt to optimize returns as market conditions evolve. We show an example of this on Slide 13 of our presentation. In the fourth quarter of 2021, we spotted credit deterioration in several cohorts in the personal loan borrower population market wide. We reacted quickly to adjust the widening of our portfolio across several attributes, including borrower annual income, longer term, and direct payment. As of December 2022, approximately 70% of our personal loan book was widened to borrowers with greater than $70,000 in annual income compared to only 55% in January 2022. We adjusted the duration of the portfolio to reflect a larger proportion of 60-month loans versus 36-months. We saw that a significant portion of borrowers seeking shorter-term loans were looking to refinance following the expiration of the government stimulus. Lastly, we reduced exposure to borrowers who do not opt into Autopay at origination, improving the consistency and stability of payments. Let me shift now to give an update on two of our newer products, auto and single-family rental. Auto is our second largest product after personal loans. We launched auto in 2019 and have seen the product grow to approximately $110 billion of application volume evaluated annually, 8 times the level we saw in 2020. We have over 10 auto partners, including a top three U.S. auto lender who we onboarded in the second quarter of 2022. We are now connected to approximately 20,000 franchised and independent dealerships through our partners, helping them serve consumers in all 50 states. The power of our network lies in many cross-application opportunities to apply AI-driven data science and technology. In 2020, we made a decision to apply AI to real estate, recognizing the significant potential for disruption in the SFR market. There are roughly 16 million single-family rental households in the United States, with an estimated value of approximately $4 trillion. We believe we can reshape the SFR investment landscape with a truly tech-first solution. Our AI engine, powered by nearly 300 million unique consumer data points, generates insights on evolving credit, demographic, and economic trends. We offer a unique value proposition to investors by leveraging these insights to select, acquire, and operate homes on their behalf. To take our SFR offering to the next level, we recently acquired Darwin Homes, an industry-leading property technology platform led by two founding members of DoorDash. The combination of Pagaya’s core AI technology and data network with Darwin’s proprietary software and operations accomplishes three main goals. The first creates a tech-first fully integrated solution for all participants, including residents, investors, and third-party service providers. Second, it elevates the living experience for residents with a mobile app that offers the full spectrum of services from the application process to payment processing to monthly bills. Third, it enables research and data-driven decision-making to optimize asset performance on behalf of our investors. I am excited about the path forward in SFR. It's another example of the cross-applicability of our AI network in new spaces to create incremental value. While our SFR product is still in a very early stage, the opportunity is significant and I'm confident in the combined capabilities of Pagaya powered by Darwin platform. To summarize, our achievements this year reflect the hard work and dedication of our team and the strength of our business model that can deliver through all environments. Now let me hand it over to Mike Kurlander, our CFO, to discuss our financials and 2023 outlook.

Thank you, Gal. Good morning, everyone. I'm going to spend the next few minutes discussing how our strategy translates into results with a focus on the key metrics that drive our performance. We had a strong year in 2022. Network volume grew by 49% to $7.3 billion. Total revenue and other income grew 58% to $749 million, exceeding the high end of our 2022 outlook. Revenue from fees, which make up more than 90% of total revenue, grew by 54% year-over-year. Fee revenue less production costs, a measure of gross profit for our business, grew 10% as the resiliency of our business model more than offset the impact of significant capital markets volatility. I'll discuss this in more depth in a few minutes. Adjusted EBITDA was near breakeven at negative $5 million, reflecting meaningful investments in our platform to support our future growth. We saw financial markets worsen in the second half of 2022. However, we remained focused on what we could control, and our fourth quarter results reflect this. Network volume was up 10% year-over-year, and total revenue and other income increased by 25%. Revenue from fees grew 24%, reaching a record take rate of 10% in the quarter. Production costs, which are expenses incurred from our partners related to the origination of network volume, grew by 60% as newer products and partners grew at a faster pace than our more mature products and partners. We exercise discipline on our fixed cost base with operating expenses, excluding stock-based compensation, roughly flat in the quarter compared to the prior year. I would also note that in the fourth quarter, we returned to a more normalized run rate of stock-based compensation expense of $19 million compared to our first two quarters of being a publicly traded company. Adjusted EBITDA was negative $9 million in the fourth quarter. As we enter 2023, we're focused on delivering sustainable profitability on an adjusted EBITDA basis. The fundamentals of our B2B2C business model set us up well to achieve this. Pagaya is a connector in the financial ecosystem. The ability to scale and monetize our network is meaningful. By not having to build a consumer-facing platform from the ground up but rather connect into partners that have existing application flow, we can grow rapidly, as we've clearly demonstrated over the past few years. And then by ultimately connecting those partners to investors, the monetization opportunity is significant. Combined with increasing scale and disciplined cost management, we have a clear path forward to profitability. Now diving deeper into the components of our revenue model, which you can find on Slide 21 of our earnings presentation. First, network volume is the critical driver of our fee revenue. We have three fee revenue streams, comprised of AI integration, capital markets execution, and contract fees, which combined make up our take rate. AI integration fees are earned from both sides of our network, partners and investors. Partners utilize Pagaya’s technology to expand their customer base. Investors obtain diversified exposure to unique assets. Pagaya sits in the middle earning fees for the creation, sourcing, and delivery of these assets. In 2022, AI integration fees grew from 48% to 65% of total revenue, as we began to earn incremental fees from certain partners related to the growing contribution of Pagaya’s network on their total volume. Moving on to capital markets execution and contract fees. We have multiple funding channels to enable the purchase of network assets from our partners such as asset-backed securitization. Capital markets execution fees are earned from market pricing of our ABS transactions, while contract fees are related to the management performance and other fees earned for administering these vehicles. In 2022, as a result of tighter market liquidity and a materially higher investor cost of capital, we saw capital markets execution fees decline from 32% to 15% of total revenues. Contract fees remained relatively stable at 12%. Finally, interest and investment income, which is not part of our take rate, is primarily earned from our risk retention assets and corporate cash balances. To summarize, revenue grew by 58% year-on-year driven by the 49% growth in network volume combined with a greater ability to monetize both sides of the network, taking our take rate to a record of 10%. Now let me discuss our unit economics and how they've evolved over time. Our take rate grew from 9% of network volume to 10% during the year. At the same time, we onboarded six new partners in 2022 and scaled into newer products such as auto, which led to production costs increasing to 7% of network volume in the fourth quarter of 2022. As a result, gross profit was 3% of network volume in the fourth quarter. When put into the context of high inflation and a rapid increase in the cost of capital driven by 400 basis points of interest rate hikes during the year, we are proud of our ability to deliver a relatively stable gross profit even in such a volatile macro backdrop. Now turning to operating costs. As our business grows, operating leverage is being created with scale, as you can see on the left side of Slide 23 of our earnings presentation. We are reaching a stabilizing operating expense level after significant investments over the past two years in public company and bank partnership readiness. Operating expenses, excluding stock-based compensation, as a percent of total revenue fell from 43% in the first half of 2022 to 39% in the second half of '22, while revenue grew 36% over that same time period. We're also taking proactive measures to reduce our fixed cost base as we enter 2023. I recently announced a headcount reduction, in conjunction with other new expense initiatives, to be implemented throughout the year, which are expected to result in approximately $50 million in annualized run rate savings. Now I'll spend a few minutes discussing our 2023 outlook. In the first quarter, we expect network volume to range between $1.7 billion and $1.8 billion, total revenue and other income to range between $175 million and $180 million, and adjusted EBITDA to range between negative $5 million and breakeven. In the full year 2023, we expect network volume to range between $7.5 billion and $8 billion, total revenue and other income to range between $775 million and $825 million, and adjusted EBITDA to range between $10 million and $25 million. The core assumptions underlying our 2023 outlook include; first, an expectation that the first half of the year will be more challenging than the second primarily due to the state of financial markets. Also, with rate uncertainty driving expected higher costs of funding in the first half, we're continuing to manage our conversion ratio, which we expect will lead to lower network volume in the first half of the year compared to the second. Finally, we expect volume from new partners to our network to ramp up in the second half of the year.

Thank you. We will now be conducting a question-and-answer session. We will take our first question from the line of Rayna Kumar from UBS. Please go ahead.

Good morning. Thanks for taking my question. You provided some really good data on your unsecured personal loan portfolio on the delinquency rates. Can you talk a little bit about how delinquency rates for your other asset classes are trending?

Definitely, and thank you so much for joining the call today. So first and foremost, I want to make the point that when we are looking at performance, we are looking only for relative performance. And within the last few years, we've been very consistent in outperforming the benchmark as we show in the slide. Our two main products are personal loans and auto loans. On the personal loan side, to put things in perspective, in October, our month on book three, days past due is coming at 1.25%, which was much lower than the average of 1.6% in Q3 2022. And to put that in context versus I would say higher than expected vintages of Q3 2021, which was lending at 2.34. So we are seeing very strong momentum in getting the delinquencies to be where they need to be. 2022 is expected to be much better than 2021. We are constantly working to improve this, reaching now 50% lower days past due than we used to be in the highs of 2021. On the other side, we didn't experience the same type of phenomena that we saw with personal loans. So 2021 vintages are actually performing as management expectations. From that perspective, in 2022, we saw a little bit of coming to normality, but delinquencies are not skyrocketing and they are actually stable. With that, we have increased our weighted average coupon by 200 to 300 basis points to align with investor return and the economy around us.

That's extremely helpful. Thank you. And then, as you mentioned earlier, you went through a 20% workforce reduction in January. How do you think your position now in terms of your cost structure and how are you thinking of balancing near-term expense management with longer-term investments in products, including expanding into new loan categories?

Hi, Rayna. Thanks for joining. Let me take that in two parts. First, regarding your question about the reduction in workforce and how we're positioned. The most important thing to reiterate is that we're committed to EBITDA profitability on a sustained basis. The workforce reduction was a key step towards that. Also, as we mentioned during the call, we have a broader set of initiatives that we've identified, which is going to create $50 million in gross annualized run rate savings. Breaking that down further, that's comprised of $30 million in compensation-related savings from the reduction in force, and an additional $20 million from other expense initiatives we will bring in throughout the year. So we feel like that puts us in a really strong position and that allows us to guide towards a positive EBITDA in 2023. Regarding the second part of your question, how do we manage the balance of near-term management with longer-term investments? We are continuously focused on execution for the long haul. We have not changed at all our strategy or reduced investment in the strategy. We’re focused on big banks, the expansion of auto, growing our SFR business, and scaling of personal loans. So none of the actions we are taking this year are compromising those long-term objectives. To provide an example of how we're operating, we took advantage just in the last few weeks of the market dislocation to invest for the long term, which is part of our acquisition of Darwin. We feel like we've got significant runway in our existing products, and the expense reduction is allowing us to streamline our expense base alongside with revenue expansion. To summarize, we continue to invest in the long term, but we do see opportunities to save on expenses in the near term without compromising those goals.

Great, thank you.

Thank you. We will take the next question from the line of Eugene Simuni with MoffettNathanson. Please go ahead.

Hi. Good morning, guys. Thank you for taking my questions. So I wanted to ask about the trajectory of network volumes. It seems pretty clear that you guys are maintaining a conservative stance on your credit box from the data and approvals. As a result of that, network volume is staying stable, kind of flattish this quarter. That's what you're projecting for the first quarter of next year with a potential pick up after that. Help us understand a little bit of your philosophy and your considerations around this with a seemingly conservative credit stance. What I'm thinking about are signals of potential stabilization in the macro environment that I think are coming up right now and some lenders potentially maybe opening up their credit box a little bit. Can you compare and contrast a little bit how Pagaya thinks about it and when you might be comfortable relaxing this conservative credit stance?

Thanks, Eugene, and that's a really, really important question. Let me unpack that and talk about our business model. Think of us generating increased application flow through our partners, and that has continued to grow. You saw some of those metrics in the charts we showed in the presentation. As we continue to grow with new partners, we are scaling into five different products. That's generating a significant amount of application flow, to the point of over $1 trillion of applications that we've now seen. That application flow has grown over 100% year-over-year, and really that's the starting point for our network volume is the applications we see. We then manage the conversion ratio. As described, macro changes allow us to use that conversion ratio as a tool to optimize investor returns. As investor costs of capital increase, we've tightened the conversion ratio by around 50% compared to Q4 last year. We onboarded six new partners, including two large partners, and as we think about going forward, really, it's about seeing macro indicators that allow us to pivot that conversion ratio toward more volume. We start the year very conservatively, but if macro headwinds subside, it will allow us to improve that conversion ratio and generate more network volume while ensuring we generate investor returns that are expected.

Eugene, I think context here is helpful. Think of application flow as the driver for network volume. Everything we do is focused on connecting more partners, getting unique flows, and continuing to build that regardless of macro environment. You should expect this trend to continue in the coming quarters and years as we grow. On the other side, we're also managing short-term risks and opportunities, and that is primarily influenced by our conversion rate, which varies based on our management approach.

Yes, got it. That's very clear and very helpful frame. Thank you. I guess just a quick follow up on that. Are there any key macro factors that you are looking at to signal when the environment might be becoming more positive for you guys?

We approach this from two angles. We monitor relative to production and early indicators of production. The stage of the economy significantly drives our position. Consumer liquidity is a key driver. Additionally, the liquidity in the general market can be influenced by macroeconomic factors. Availability of credit is one part of it, but ultimately it is where the economy stands that determines our responsiveness. Many of our decisions stem from observations we made in 2021, leading us toward a more prudent approach.

Got it. Okay. Thank you. And sorry if I can just throw one more in just a strategic question related to the Darwin acquisition that was very interesting. Can you provide a bit more detail on what you see as the synergies between that business and your kind of core lending enablement business?

Sure. To understand connectivity, let's take a step back. Pagaya interacts with consumers across various lending moments, whether it's through auto loans, credit card consolidation, or other initiatives. The SFR market presents another opportunity. Many renters face financial decisions regarding renting homes, and AI can assist in those choices. We initiated discussions over 18 months ago, aiming to model trends in demographics and housing needs across the U.S. SFR is a huge market underinvested by institutions. Darwin's successful property tech platform enhances our AI and data capabilities. This allows us to have a comprehensive solution for all players involved, enhancing the experience for residents and optimizing asset performance on behalf of our investors.

No, that was super helpful, Gal. Thank you very much, guys.

Thank you. We’ll take the next question from the line of Hal Goetsch with Loop Capital. Please go ahead.

Good morning. Thanks for taking my question. I wanted to ask about the auto business. You mentioned you're connected to 20,000 dealerships, both franchise and independent, and that's a staggering number because there are only about 18,000 franchise dealers in the country and many more independent dealers. Of the 20,000, how many of them are active or have done at least one loan? How have you penetrated your platform across these dealers?

To clarify, when we mention 20,000 dealerships, we refer to independent and franchise dealerships. We see applications from all of them, though we are not directly connected to them. We're connected through large lenders that effectively manage the relationships with many dealerships. We focus on partnering with lending institutions that have established pipelines to these dealerships, thus ensuring we can access the application flow from them. While I don't have a specific number on how many have completed loans, we are actively managing a significant portion of that network.

That's an even better setup. So is that the number three auto lender that you mentioned as your partner, or is it a dealer management system company helping you reach those 20,000?

We connect through over 10 partners, including one of the largest top three auto lenders, and they facilitate the connection with various dealerships. Flowing through that partnership, we see strong application activity coming in.

Thank you. We’ll take the next question from the line of Joseph Vafi with Canaccord Genuity. Please go ahead.

Hi, guys. Good morning. Nice results here in a tough environment. Maybe we start on the funding side a little bit; nice to see $7 billion in funding in 2022. Could you provide us an update from your perspective on continued investor appetite for these asset classes? Where are you right now, and how much runway do you see available into 2023 with existing funding vehicles? Any expectations on raising new ones this year?

From an appetite standpoint, Q4 was the toughest quarter with the least liquidity in the market, yet we closed $1.4 billion in ABS. The year has started much better, as we priced an $800 million ABS this week, which was significantly oversubscribed. We see a healthy rebound. As historical delinquencies decline, we anticipate increased funding opportunities. While these may not be the best days for discussions, we can see cost of funding show improvement from Q4 to Q1. We're well-established in the institutional investor market and are able to tap into it favorably as a leading player.

That's great. That's great color, Gal. And then I guess could you go into a little more detail? It sounds like the take rate is moving up some, but program fees are also moving up offsetting some of the take rate. How does that balance work?

Thanks for the question, Joe. I'll split this into two parts. On the take rate side, we've benefited from the two-sided network we've built, particularly our role in the ecosystem. AI integration fees grew in the fourth quarter. We've been able to demonstrate our value within partner networks, leading to higher economics. We've taken our take rate to a record 10% in the fourth quarter. Moving forward, I think we've communicated that 9% to 10% is a reasonable range for us for 2023, influenced by product and partner mix. On the production cost side, you are correct to point out costs are rising, driven by product and partner mix. Typically, in the early stages of partnerships, we see lower margins because we focus on proving the value proposition before optimizing economically. Consequently, production costs are higher, particularly in newer products like auto.

That was a good explanation. Thanks, Michael.

Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session. I’d like to turn the floor back over to Gal Krubiner, CEO, for closing comments. Over to you, sir.

In closing, I would like to reiterate how proud I am of our team and what we have accomplished in 2022. We have strong momentum entering 2023. I want to thank all of you for joining us today, and we look forward to continuing to partner with you in the future. Thanks a lot and have a great day.

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.