Earnings Call Transcript - PGY Q2 2023

Operator, Operator

Good day and welcome to Pagaya's Second Quarter 2023 Earnings Call. Today's call is being recorded. At this time, I would like to turn the call over to Jency John, Head of Investor Relations.

Jency John, Head of Investor Relations

Thank you and welcome to Pagaya's second quarter 2023 earnings conference call. Joining me today to talk about our business and results are Gal Krubiner, Chief Executive Officer of Pagaya; and Michael Kurlander, our Chief Financial Officer. You can find the materials that accompany our prepared remarks 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 certain risks and uncertainties. These statements include but are not limited to, our competitive advantages and strategies, 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 Form 20-F filed on April 20, 2023, with the US 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, including adjusted EBITDA, adjusted net income, and fee revenue less production costs will be discussed on the call. Reconciliations to the most directly comparable GAAP financial measures are available in our earnings release and other materials which are posted on our Investor Relations website. Before we begin our prepared remarks, we want to note that this quarter, we published our inaugural shareholder letter in lieu of our usual earnings presentation. We encourage you to review the shareholder letter, which was furnished with the SEC on Form 6-K today for detailed commentary on our business and performance in conjunction with the accompanying earnings supplement and press release. All documents are available on our Investor Relations website. With that, let me turn the call over to Gal.

Gal Krubiner, CEO

Thanks, Jency. At Pagaya, we strive for continuous improvement. As mentioned, we are committed to providing our existing and future shareholders communication that is transparent and comprehensive. Our shareholder letter is a reflection of these commitments and you can expect to see more of that in the future. We had a strong second quarter, exceeding the high end of our guidance across all our KPIs: Network volume, total revenue, and adjusted EBITDA. Our performance reflects our ability to consistently deliver for the lenders and investors on our network. We delivered record network volume in the second quarter of approximately $2 billion, despite a historically low conversion rate in light of the current macro environment. Our lending partners are sending more applications our way as they tighten their own credit boxes and investors continue to come to us to invest their capital. The demand is high for our products on both sides of the network. Total revenue grew by 8% year-over-year to $196 million. We are earning more fees on our lending platform product as demand grows, resulting in growth in our fee revenue less production costs, both year-over-year and compared to Q1 2023. Adjusted EBITDA grew to $17.5 million, more than triple the prior year period and our second highest EBITDA in our history. With the continued momentum in our business, we are raising our network volume and adjusted EBITDA outlooks for the full year, which Mike will speak to more in a minute. Now let me spend a few minutes discussing our business for those of you who are new to our story. I encourage all of you to read our shareholder letter index, which discusses our product offering and platform in more detail. Pagaya is designed to solve a critical problem in consumer credit. An estimated 42% of Americans are denied access to credit or don't get as much credit as they would like under traditional underwriting systems. Our mission is to unlock that opportunity with technology to help more people get access to more credit. To address this problem, we created a two-sided tech-enabled network that connects the lenders, who originate loans, to investors, who want to purchase those assets. Lenders who integrate with Pagaya's network originate more loans, gain new customers, and earn more revenues, all without taking any incremental risk. On the other side of our network, institutional investors get access to diversified and high-yielding asset pools at scale. We have pioneered the network comprised of two distinct products: a lending product and an investor product. We believe this model gives Pagaya an edge over other structures. We are proud of the organization we've built, housing best-in-class lending technology and asset distribution capabilities on one platform. We hired leading experts in their respective fields: lending and financial market industry veterans and world-class engineers. As a result, Pagaya offers a value proposition to lenders and investors that we don't believe is replicated anywhere else today and will be difficult to build organically at this scale. On the lender side of the network, our product suites provide access to fully automated credit decisioning technology, secured debt exchange, analytics, and real-time funding of any loan originated. The product is deeply embedded in each lender's loan origination system, utilizing customized seamless APIs. Once integrated, our product allows for smarter and faster credit evaluation with the ability to evaluate and price a loan in less than half a second. All of this results in a sticky product, evident by the fact that we have grown to over 25 lending partners, and since inception, no lender has left our network. Institutional investors on the other side of the network connect to a distribution platform that delivers a continuous flow of billions of dollars of assets across multiple markets, including personal loans, auto, and point of sale. In the first half of the year, we raised $3.1 billion across seven different ABS deals. We just closed on our most recent $800 million personal loan deal in July. We were once again the number one personal loan ABS issuer in the second quarter. Our reputation as a benchmark issuer and our performance track record continue to draw new investors to our network. We continue to see improving trends in asset performance. Early stage delinquencies for recent personal loan vintages, our two largest markets, continue to decline, while the weighted average coupon remained stable. This translates to improving returns for investors enabled by our continued low conversion rate. The flywheel effect is fueled by hundreds of millions of data points that flow through our network, which enables better outcomes for both existing and future network participants. The real impact is that over $7 billion of assets were created last year in the consumer finance ecosystem that would not have been created if it were not for Pagaya. The strength of our product offering reinforces my confidence in our ability to grow existing partners, add new ones, and attract new investors. With the pipeline we have today, we believe we can grow our network significantly over the next few years. And to my fellow Pagayans, I'm incredibly grateful for your hard work and commitment to achieving our mission of increasing access to credit for more consumers across the country. With that, let me pass it over to Mike to discuss our financial results in more detail.

Michael Kurlander, CFO

Thanks, Gal. We exceeded all of our performance targets this quarter, reflecting the momentum of the business and our focus on profitable growth. While macro headwinds continue, we remain focused on what we can control. Lenders are sending more applications our way as they tighten their own credit boxes, enabling us to deliver our highest ever network volume while managing to a historically low conversion rate. On the investor side of the network, we're starting to see some green shoots with market liquidity starting to recover from the significant volatility we saw last year. Investor sentiment appears to be improving with consumer unsecured ABS issuances higher this quarter than the prior two sequential quarters, which supports our ability to continue to raise capital to fund new loan origination. We continue to improve unit economics as we scale. Total revenue and other income grew 8% year-over-year to $196 million. Revenue from fees, which made up 95% of total revenue in the second quarter, grew by 14% year-over-year. Our take rate, defined as revenue from fees as a percentage of network volume, grew by 110 basis points year-over-year to 9.5% and remained stable sequentially. Production costs grew by 15% year-over-year and amounted to 6.2% of network volume in the second quarter, 80 basis points above the second quarter of 2022, and a decline of 60 basis points sequentially versus Q1 2023. The net result is that our FRLPC, a measure of gross profit, grew by 12% year-over-year and 30% sequentially, amounting to 3.3% of network volume, which is within our target range of 3% to 4%. As you can see in our shareholder letter on page seven of our earnings supplement, this growth is primarily a function of the evolving composition of our fees, as well as partner and product mix. As a reminder, we earn margin on both sides of our network, both our partner product and our investor product. In today's environment, we see increased reliance on our lending partner product as our lending partners tightened their own credit standards and face more challenging funding markets. As a result, we are earning a higher margin on the lending side of the network. This is helping to offset the lower fees we're currently earning on the investor product in today's higher cost of funding environment. The resulting growth in FRLPC was the key driver of our EBITDA delivery this quarter, demonstrating the ability of our two-sided network to deliver consistent results. Moving on to operating expenses. Our total research and development, sales and marketing, and general and administrative expenses were approximately $85 million in Q2, down significantly from the prior year quarter, which was impacted by one-time stock-based compensation expenses related to our transition to becoming a public company. As we said in Q1, our goal this year is to deliver $50 million in annualized cost savings, excluding the impact of our recent Darwin acquisition. We delivered on this target earlier than our original expectation by accelerating our cost-saving initiatives, which included actions to reduce both compensation and non-compensation expenses. Core operating expenses, excluding stock-based compensation, depreciation, and one-time expenses, declined by $12 million versus the fourth quarter of 2022 or roughly $50 million in run-rate savings. The resulting operating leverage enabled our FRLPC expansion to drop straight to the bottom line. We delivered adjusted EBITDA of $17.5 million, compared to $5 million in the second quarter of 2022. We believe we are on track to continue to deliver sustainable profitability over the long term, supported by the strengthening of our value add to our partners and investors and the operating leverage embedded in our business model. Given the strong momentum of our business in the first half of the year, we are raising our full-year outlook ranges for network volume and adjusted EBITDA. Our outlook for the third quarter and fiscal year 2023 reflects a few assumptions. First, we expect to remain prudent in our conversion rate of application volume in light of the ongoing macro uncertainties. Second, we continue to target FRLPC as a percentage of network volume of 3% to 4% as our network grows and we strengthen our value proposition to both our partners and investors. While economics on our partner product have been improving, we are not factoring in any material improvements in financial markets, which can impact the level of capital markets execution fees we earn. Finally, we will continue to focus on cost discipline and driving operating leverage. In the third quarter of 2023, we expect network volume to range between $1.9 billion and $2 billion, total revenue and other income to range between $190 million and $200 million, and adjusted EBITDA to range between $10 million and $20 million. For the full year 2023, we expect network volume to range between $7.6 billion and $8.1 billion, total revenue and other income to range between $775 million and $825 million, and adjusted EBITDA to range between $40 million and $50 million. With that, let me turn it back to the operator for Q&A.

Operator, Operator

Thank you. Our first question is from Eugene Simuni with MoffettNathanson. Please proceed.

Eugene Simuni, Analyst

Hi guys, congrats on a strong quarter. Wanted to start with network volume trends. So good to see it exceed expectations. Can you talk a little bit more detail about what allowed network volume to be as strong as it was? Maybe the attribution across better-than-expected macro environment, better-than-expected demand from your existing customers, or a higher level of success with onboarding new customers? That would be very helpful.

Michael Kurlander, CFO

Hey, Eugene. It's Mike. Thanks for the question. You're right, we did see network volume hit a record level this quarter, and really what that was driven by to start with was really strong demand from both sides of the network. On the partner side, we had a 20% increase in application flow, and that's really the core driver. We also saw increased demand on the investor side, and that led to the network volume. Now, within that, we actually see that the macro headwinds were still with us. One of the things that we control on our side is the conversion ratio of that increased application flow. We kept our conversion ratio very low this quarter, and that's really a function of us being very prudent in light of the existing macro. Our core responsibility, of course, is to create the right returns for our investors. Even though we had higher demand from our lending partners, we kept the conversion ratio really tight, and within that, we delivered record network volume. That gives us a lot of encouragement around where we think we can go in the future, given the embedded growth that's within the network when we can pull that conversion ratio a little bit higher.

Eugene Simuni, Analyst

Got it. That's very helpful. And then a follow-up on that, can you talk a bit about your success with capturing and onboarding new customers, especially larger US banks?

Gal Krubiner, CEO

So, Hi Eugene. This is Gal, and I'm going to take this one. When we are speaking about where we are spending in the pipeline, we feel very confident in our pipeline today. We think we can land another big bank partner over the next 12 months, and we are actually in conversations with many of the top 25 banks that are seeing the unique product that we are offering to the lenders. Part of the context for that is some headwinds in the banking industry, that liquidity might be more constrained, and therefore, the fact that we can allow for the ability to process more loans with consumers is something that they are very much interested in, and therefore is giving us a little bit of a tailwind for that ability. We worked in the last year, if you remember, a little bit about how we invested in moving our product to become more AAA rated for banks, and we're feeling very strongly that our offering right now is at the level that is relevant. Therefore, we expect to see more conversions coming through based on the alignment and success we've had in the past.

Eugene Simuni, Analyst

Got it. Okay, thank you.

Rayna Kumar, Analyst

Hi, good evening. Thanks for taking my question. Just wanted to start with your third quarter guidance. I noticed that the midpoint of your Q3 guide implies a 120 basis point quarter-over-quarter decline in adjusted EBITDA margin. Just curious if that's seasonality or if there's any other underlying drivers there?

Michael Kurlander, CFO

Hey, Rayna, it's Mike. I'll take that one. Thanks for the question. Let me take a moment to mention that we're pleased with the profitability gains we've achieved this year. Regarding your question about the third quarter, our full-year expectation is now between $40 million and $50 million, which is ten times what we achieved last year. We accomplished this by increasing our FRLPC margin, which has positively impacted our bottom line. As a reminder, we are still focused on growth. Moving forward, we anticipate opportunities to invest in our growth, driven by a long-term focus on expanding the company. As we grow our network, we will continue to invest in our product while maintaining the profitability trend you've observed this year.

Rayna Kumar, Analyst

Got it. That's very helpful. And then just another question on conversion rates. Of course, the macro environment remains very fluid. But with more talk of a soft landing here, if the Fed were to pivot, how would you manage conversion rates? Would this be a signal to begin lifting the conversion rate, and would it be an immediate transition or would there be a few quarters lag before you become more constructive on it?

Michael Kurlander, CFO

Here's the way we think about it, Rayna. Really, rates are a bit of an indirect impact to us because we're not a direct lender. Our job is really to manage the investor returns holistically in terms of whatever is driving their investor returns and their hurdles. The way we think about it is we will lift our conversion rates when we feel comfortable doing so to meet our investor return thresholds. Obviously, those hurdles will come down and should drop when the macro environment becomes more stable. From a response perspective, one of the things we're proud of around what we've built here is that our responses are in real-time. You can go back to late 2021 when we started to see trends of consumer behavior deteriorating, and we responded in real-time. On the other side, when we see the environment improving, we also expect to respond in real-time. Now, with all of that said, we are going to remain prudent with the conversion rate in light of the continued macro, and within that, we were able to produce record volume, and we will look forward to improving that conversion ratio as soon as we feel comfortable that the macro is stabilizing.

Joseph Vafi, Analyst

Good afternoon, nice to see good solid demand from both sides of the network. Maybe, we just start I know application flow was also growing, not just network volume. I know you didn't really disclose that. But I wanted to get a feel if there is a kind of a range or a band that you wanted to throw out on what application flow growth might have been. And then also, I know you said that conversion rate was also muted. I was wondering if you dialed that down at all in the quarter or was it kind of flat sequentially? Then I'll follow up.

Michael Kurlander, CFO

Hey, Joe, it's Mike. Yes, our application flow this quarter was up 20% sequentially over the prior quarter. So the top of the funnel for us is really healthy. We're excited to see that growth come through. Now, if you think about that, in the range of how that translates into network volume, the application flow and conversion rate are ultimately what drives our network volume. We saw roughly $200 billion in additional applications for this quarter. Think about that in terms of our conversion ratio; we can produce in the order of 20% higher network volume to the extent we can increase our conversion ratio. That's the way we think about it, managing to a pretty low conversion ratio right now, slightly below 2%, and there's a lot of embedded growth there as we can grow the conversion ratio from there. Does that answer your question?

Joseph Vafi, Analyst

Yes, that makes sense. Obviously, with that kind of sequential growth and clearly, you have to filter that down and be prudent. That makes total sense. Just wanted to dig down also into FRLPC margin as a percentage of network volume and connect that back to your commentary on the investor side of the network, with fees being a little muted. That margin was up, I guess, to 3.3% here in this quarter versus 3% a year ago? I know that the lender side is doing well. I'm just trying to get a feel for whether you would say that margin year-over-year and FRLPC as a percentage of network volume is down on the investor side or do you think it's flat year-over-year? And then the gain was coming from the lender side, if that question makes sense? Thanks.

Michael Kurlander, CFO

Sure. Really the gains that we've seen are on the partner product. Demand on the partner product side has been very strong as our partners are relying on us more for growing their business and converting more of their application flow. When you think about that overall, we're really pleased about the evolution of our FRLPC by product. We talked last quarter about some of the new initiatives we had for unit economics, growing our unit economics on the partner products side. This quarter, going to 3.3%, shows you the full quarter impact of those taking hold. Now, as you said, we're actually seeing lower contributions from FRLPC on the investor side. We expect that will come back with market liquidity, but right now, compared to where we were a year ago versus today, we're excited about having a much more balanced approach and balanced mix of our FRLPC between the partner side and the investor side.

Michael Legg, Analyst

Thanks. Great quarter, guys. Can you talk a little bit about the ABS funds raised, how those funds have performed, and how it impacts current raises? And then can you relate that a little bit to your exposure to your investments in that? Further, how does that limit your capacity and the ability to raise those funds or can you raise as much as you want? Also, how does that affect your decisions on the conversion rate? Thanks.

Gal Krubiner, CEO

Hi, Mike. It's Gal here. From a funding perspective, we definitely see an improvement in market conditions. In terms of liquidity in the market, Q4 was the bottom, and hence then we see that reflected in productivity. What we are seeing is repeatable strength, like ourselves getting traction, while smaller institutions are not really managing to close deals. That speaks to the scale and importance of what we believe we can deliver. Just to give you one example, in July, we upsized the ABS deal from $600 million to $800 million at the peak, we had $2 billion of orders. This speaks to the strength and the ability of the team to deliver those capabilities into diverse funding strategies that are becoming material for our ability to perform in different market conditions. Regarding the investment side, Mike do you want to take it?

Michael Kurlander, CFO

Yes. From a balance sheet perspective, it's actually quite manageable, and I'll explain why. As you know, we don't actually put loans on our balance sheet. Our only asset on the balance sheet is the risk retention, which comes from issuing ABS and the 5% mandatory holdings we have to put on the balance sheet. If you think about that 5% and the fact that every quarter, we're receiving cash flows from our prior investments, we had material cash flows this quarter from previous investments around $65 million. The fact that we've been able to grow and diversify our funding facilities for investments in loans and securities means that the actual net outflow from a cash flow perspective is in the 2% to 3% range. So that gives us a long runway to be able to continue to grow the business. Long-term we're diversifying and supplementing the ABS distribution mechanism with other funding products that don't have the same balance sheet requirements. But in the near term, we feel good about our current position.

Hal Goetsch, Analyst

Could you give us a perspective on this application flow? $200 billion in the quarter is a staggering sum of money. Only about $2 billion of it is actually closed on 1%, which is a huge number, and a very selective process. Could you tell us more about that? And also maybe the mix of this application for how much of it is coming from auto loans and different private loans and how it compares to the previous year on application flow? Thank you.

Michael Kurlander, CFO

Sure. It's Gal here. On the application flow level, I think the important piece to share is the importance of seeing this flow, even if conversion is not happening because part of that is the data we're collecting and our ability to reach better parts of the American consumer base. We are choosing actively both because of the business and advanced modeling we need to do. But think about the network itself as a product or as connectivity; we are now seeing almost a trillion-dollar level of application yield. You can imagine the ability to create a lot of value and monetize that over time. We find more and better ways to do that. From a growth perspective on the network side, I would say the majority of applications are coming from home loans and personal loans, with personal loans being more flow from partners and also new partners that we have committed to bringing up. An example is the application in the point-of-sale sector; a year ago, we didn't have our partner Klarna, and this time around, we are seeing a lot of complications through that. This is a new space that our network was exposed to, and now we're starting to ramp up that connected data, taking a better model. Lastly, we believe our AI capabilities could improve the ability to convert by 20% to 30% year-over-year. Depending on the macro situation, this can change over a short-term period, but our focus has been on how we monetize that piece out of the network connectivity, and that's the secret sauce.

David Scharf, Analyst

Hi, good afternoon, and thanks for taking my questions. I appreciate all the color on the current cyclical backdrop. Maybe I can focus a couple of questions on future new business in secular growth. First, I'm curious about the personal loan side. The bulk of the volume is still originated by legacy branch-based companies like OneMain, Mariner Finance, World Acceptance, Landmark, and so forth. Obviously, your partners are digital lenders. Are any of these legacy non-prime or near-prime personal lenders exploring using third-party services like yours for handling turn-downs?

Gal Krubiner, CEO

Yes, definitely. To my comments earlier in the Q&A, we are speaking with top 25 banks, and part of the conversations involve personal loans. We have two very promising prospects that we are discussing on this basis, and there are others as well. I would say that the banking industry is interested in three main products: personal loans, auto, and point of sale. Point of sale is obviously a bit newer, with people trying to get their hands around it, and gaining market share. From the auto perspective, there is maturity in that space, and we are relevant particularly to the subprime side rather than super-prime banks.

David Scharf, Analyst

Okay, maybe a good segue to my next question, which was to get a little better understanding of what products you'd be involved in with the large banks. The companies I just mentioned were non-bank financials. Historically, large banks haven't cared much about personal loans. It's been an afterthought asset class they dabble in here or there. Given this context, are you exploring card or revolving credit with them?

Gal Krubiner, CEO

I'm not sure who that question was directed at, but to your points: our growth strategy is really diverse. The capabilities Pagaya has is divided into two. In connectivity to banks, becoming embedded in loan origination systems, we enable seamless integration. The second piece is utilizing all data we have to improve approval volumes. Thirdly, we distribute those assets into the investor community. Across personal loans, auto loans, point of sale, and credit cards, we are exploring all avenues. Personal loans are smaller compared to credit cards, but we have significant knowledge and capabilities in this area, so it's natural for us to continue exploring this with banks. When addressing credit cards, which represent the biggest opportunities for banks, we have a partnership with Visa to support our capabilities and offerings to banks, which is in motion.

Vincent Caintic, Analyst

Hi, good afternoon, and thanks for taking my questions. It's nice to see both good volume growth and solid EBITDA growth as well. I wanted to compare your business versus the rest of the fintechs, particularly lending fintechs in the industry. It's interesting to see your strong growth, ability to launch several ABS this year, and sign on new bank partners, while others in the industry appear to be struggling. Can you describe how you have maintained the success of these partnerships?

Michael Kurlander, CFO

Hey, Vincent. It's Mike. Thanks for the question. I really think it comes back to a little bit of the business model, and we are in a unique position in the ecosystem. A number of players that you just spoke about are actually partners of ours. Our business model, when we were formed, was to solve the problem of consumers not getting access to credit. We solve that through technology and data while partnering with lending institutions. As they look to grow their businesses, whether it's fintech or large banks, we are partnering with them to help grow their underwriting and lending volumes, subsequently connecting those assets on the investor side. This is very different from how most other participants play in the market. Most are either on one side or the other side of that equation. What we have tried to do over our history is really combine both. That's led to a lot of the growth you have seen because we have a unique vantage point. We are seeing not only all the data science that comes with all available data, but we are also seeing the application flow from 25 different lending partners. We believe that gives us a bit of an edge in applying the data science to that amount of information that we see coming through every day. The core focus on the actual capability itself rather than the other aspects of running a consumer-facing business puts us in a good position for our lending partners to deliver and grow their network volumes while providing investors access to these sorts of assets.

Operator, Operator

We have reached the end of our question-and-answer session. I would like to turn the conference back over to Gal for closing remarks.

Gal Krubiner, CEO

Thanks, operator. I'm proud of our accomplishments this quarter, which I believe reflect the strength of our organization. We continue to exceed our short-term goals while advancing our long-term growth strategy to expand our network. Above all, we are driven by our mission of delivering more financial opportunities to more people. Thank you all for joining today and we look forward to building our partnership with you. Thank you.

Operator, Operator

Thank you. This concludes today's conference. You may disconnect your lines at this time and thank you for your participation.