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Earnings Transcript for PGY - Q1 Fiscal Year 2024

Operator: Good day, and welcome to the Pagaya 1Q 2024 Earnings Conference Call. [Operator Instructions] Please note that this event is being recorded. I would now like to turn the conference over to Jency John, Head of Investor Relations. Please go ahead.
Jency John: Thank you, and welcome to Pagaya's first quarter 2024 earnings conference call. Joining me today to talk about our business and results are Gal Krubiner, Chief Executive Officer of Pagaya; Sanjiv Das, President; and Evangelos Perros, 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 strategy, macroeconomic conditions and outlook, future products and services and future business and financial performance, including our financial outlook for the second quarter and full year of 2024. 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 filings and in our Form 10-K filed on April 25, 2024, 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, including adjusted EBITDA, adjusted EBITDA margin, adjusted net income, Fee Revenue Less Production Costs or FRLPC, FRLPC margin and core operating expenses will be discussed on the call. Reconciliations to the most directly comparable GAAP financial measures are available to the extent available without unreasonable efforts in our earnings release and other materials, which are posted on our Investor Relations website. We encourage you to review the shareholder letter, which was furnished with the SEC on Form 8-K today for detailed commentary on our business and performance in conjunction with [ accompanying ] earnings supplement and press release. With that, let me turn the call over to Gal.
Gal Krubiner: Thanks, Jency, and good morning, everyone. I'm actually very pleased with our first quarter results. At Pagaya, we are always striving to build the future where more Americans have access to the financial products they deserve through our technology. Our operating performance was strong. We grew fees with our lending partners and raised a record of $2 billion in funding. I'm very proud to announce that this month we added Elavon to our network, a top 5 global payment company and 18 new funding investors. Our network is now connected to 30 lenders and 116 funding partners. This accomplishment speaks to the power of our business, but I'm especially proud of the progress we are making on our bank enterprise sales strategy. Let's go back to 2022 for one second. When we reported earnings for the very first time as a public company, I spoke about one of the key reasons why we decided to go public, which was to execute our enterprise bank sales strategy, partnering with the largest banks in the country. Now fast forward two years, we now have three of the country's top banks using the Pagaya product and many more in the pipeline. And as I shared, we also added Elavon, U.S. Bank's Merchant Services and Payment Solutions to our POS vertical. Just one quarter after announcing the addition of U.S. Bank to our personal loan vertical. That speaks to the value of our products. On the financial side, we once again delivered record-breaking financial results, exceeding our outlook with network volume of $2.4 billion, total revenues of $245 million and adjusted EBITDA of $40 million. Fee Revenue Less Production Costs was up 84% year-over-year to $92 million, and our FRLPC margin extended 109 basis points year-over-year to 3.8%. That's the highest level we have seen since the beginning of the rate high cycle in early 2022. This is obviously a clear proof that our strategy is working and that there are more room to increase our unit economics going forward. We delivered a fifth back-to-back quarter of improvement in adjusted EBITDA and positive quarterly GAAP operating income for a third time of $8 million. We reported our third quarter of positive and growing operating cash flow in a row, delivering $20 million of operating cash flow [ base ] quarter. We continue to manage credit performance very closely to deliver strong and consistent asset return to our funding partners. We are seeing continued strong performance on our 2023 vintages with delinquencies trending at their lowest level since early 2021. Sanjiv will speak to this in more details in just a moment. As I look ahead, Pagaya is on a path to be connecting infrastructure between all major U.S. loan originating systems and public and private capital markets. Since we started back in 2016, our teams have been working day-in and day-out [indiscernible] the right infrastructure and capabilities to put us on this path. The connectivity we built thus far, 30 of the country's largest loan origination and over 100 of the country's largest funding providers is the foundation of the enterprise value of our business. We got here faster than I thought possible. Just three years ago, our business was connected to 10 lending partners and around 20 investors. As you can imagine, each new partner we onboard is adding to our institutional knowledge and capabilities to build better and smarter products for lenders across the country. As we build our product ecosystem, we're making our relationships with our lending partners stickier and increasing the overall pool of economics we can share in. And we are growing new enterprise-grade lenders to the network from top 5 consumer bank to the world's largest payment providers. Now let's talk strategy. From a strategy perspective, we're focused on two simple priorities
Sanjiv Das: Thanks, Gal. In Q1, we reorganized the operating business to increase capital efficiency and enhance our margin profile while still continuing to grow the business. We refocused the operations of Pagaya into two distinct areas
Evangelos Perros: Thank you, Sanjiv, and good morning, everyone. We delivered another record quarter across our key metrics. While we continue to operate in a higher for longer rate environment, we remain focused on profitability and capital efficiency. Network volumes reached a record $2.4 billion in the quarter, up 31% year-over-year and up for the fifth consecutive quarter. Application flow grew year-over-year. Our conversion rate remains low as we optimize for our most profitable lending channels and returns for our funding partners. As a result, personal loans are more scaled and highest margin product continued to be the largest driver of network volume at 55%. Total revenue and other income grew 31% to a record $245 million compared to the same quarter in 2023, driven by a 35% increase in fee revenue. We continue to improve our unit economics. Fee Revenue Less Production Costs once again outpaced network volume growth by a significant margin. FRLPC grew by 84% to a record $92 million compared to network volume growth of 31%. Sequentially, this equated to FRLPC growth of $16 million, the largest quarterly increase in our history. Fees from our lending partnerships amounted to 63% of total FRLPC in the quarter compared to 43% in the prior year. This is a testament to the growing fee generating power of our business, making us increasingly less reliant on network volume expansion to drive bottom line growth. FRLPC margin increased 109 basis points year-over-year to 3.8%, the highest level since early 2022. Our personal loan business generated an average FRLPC margin of 6%, over 200 basis points above the blended average and up 300 basis points compared to the same quarter last year. We grew fee rates across almost all of our personal loan lending partners in the quarter. Additionally, in the first few weeks of the second quarter, we further improved unit economics with some of our lending partners as we scale these channels. Higher FRLPC is translating directly to our bottom line. We delivered record adjusted EBITDA of $40 million with an adjusted EBITDA margin of 16.2%. We also delivered our third consecutive quarter of positive GAAP operating income, which was $8 million in the quarter. Core operating expenses, which excludes stock-based compensation, depreciation and onetime expenses increased $4 million year-over-year and $10 million sequentially. Record funding of $1.9 billion led to elevated ABS setup costs sequentially, which we expect to normalize in the second quarter given the excess dry powder we raised to fund network volume. Additionally, we are lapping a onetime compensation benefit from the fourth quarter. Net loss attributable to Pagaya $21 million, an improvement of $40 million from the prior year. Share-based compensation expense amounted to $15 million. Higher interest expense of $15 million reflects the addition of our new term loan facility in the first quarter. Credit impairments of $19 million after accounting for non-controlling interest on our investments in loan and securities represented less than 3% of our portfolio. We reported our fourth consecutive quarter of positive adjusted net income of $13 million, an improvement of $24 million compared to the prior year. Shifting now to discuss our approach to capital efficiency. First, let me discuss our funding in the quarter. Overall funding markets are on a stronger footing than in 2023. We are seeing spreads in our 2024 deals reduce by 150 basis points to 200 basis points compared to the peak in 2023. We took advantage of more favorable market conditions at the start of the year to raise $1.9 billion in funding, giving us excess dry powder of approximately $1 billion at the start of Q2. We added another 18 funding partners in the quarter. The tailwind of private credit deployment in consumer credit markets continues to work in our favor with alternative asset managers being the majority of new funding partners we added in the quarter. Capital efficiency is a key enabler as we march toward our next financial milestone of reaching cash flow positive. Our strategy is focused on minimizing the amount of upfront capital we utilize to fund new network volume. We plan to do this in two ways
Operator: [Operator Instructions] The first question comes from John Hecht with Jefferies.
John Hecht: Thanks for all the great detail on the call. You spent a lot of time on the capital efficiency going forward, and you talked about forward flow agreements and whole loan sales. And Gal you even -- I think you cited maybe $1 billion in the pipeline and a 2% goal for the committed capital. I'm just wondering what -- are those $1 billion flow arrangements are they -- that are going to come into effect in this quarter or is this just developments over the course of the year? I'm just wondering about the cadence of how to think about this.
Gal Krubiner: Hi John, it's Gal here. Thank you very much for your question. I think the way to think about it is we are very focused on these points, as you mentioned, and we -- and I did mention that in my previous script. The main thing to consider is the following
John Hecht: Okay, great. And then you had a lot of very big adds of partners on the lending front in the latter part of last year. I know there's an onboarding process -- in a period of ramp that occurs. I'm wondering how those new partnerships are ramping relative to expectations.
Sanjiv Das: Hi John, I'll take this. This is Sanjiv. A couple of things. One is we talked about the new partners that we've onboarded last quarter, but we also talked about the disciplined approach with which we sort of monitor the volumes. There are a couple of things, John that I have looked at. One is I want to make sure that the quality of the flow is before we sort of turn on the taps completely to the quality of the flow is very carefully monitored. And that's what we are doing in the first quarter. We are watching for DTI, LTV, those kinds of things that we're taking on new partners and getting ready for the flow. What I'm seeing so far is that the quality is actually pretty good. And the other thing is with some of these auto partners, obviously, as you know, we go dealer by dealer by dealer, and so it takes a little bit of time to ramp it up. By the time we get the full potential, it's normally 6 to 9 months in terms of steady state, and we want to do this the right and disciplined way. Take the case of different sector, a U.S. Bank, for example, we are seeing enriched customer data coming in. So we started to look at that to see how we can continue to improve the quality of the flow. So pacing ourselves and before we ramp this up.
John Hecht: That's very helpful and appreciate the focus on the flow. Final question is the point-of-sale verticals -- it's becoming increasingly important and a good driver of growth. I'm wondering, can you maybe just give us the characteristics of the typical loan, the structure of the typical loan in that channel relative to, say, the installment loan business?
Gal Krubiner: Yeah, John. So let me start giving the high level of how we think about it, and then Sanjiv will get into specifics and details. So POS is definitely one of the frontier for growth for us, mainly because today, literally all of the banks are looking to have that as a product. And this is one of the areas where we have the strongest pipeline of partners and banks are calling us and asking the question of how can we help them accelerate their penetration into this market. So it's a market that the banks were a little bit left behind, and they are now looking to keep up with the FinTechs. And Pagaya, quite frankly, is maybe the only the best solution that allows them actually to keep the customers and not give it to anyone else, but in the same time, to offer that outcome. And for us and for the banks, it's very clear why to partner with someone that you need to give up on the customer when you can partner with Pagaya to be able to completely keep the customer. So that's the thesis that we have, and that's what the excitement that we see from the banks. The first piece that you can appreciate on the non-bank side is a typical [ pain for ] that exists out there and then there is some kind of a progression or mature into loans of like 6 to 12 months, again, a very interesting play for Pagaya because we have so much knowledge and capabilities on the full personal spectrum. So we are coming as a very natural add-on for this and helping the BNPL providers to have an enhancement in their ability to collect fees by extending loans to that. Sanjiv, do you want to add anything?
Sanjiv Das: Sure. I mean, look, as both of you said, the POS is, in fact, the fastest-growing sector in the consumer world. As a former banker, I know that when we were moving from personal installment loans to purpose-driven loans that the quality of the credit was substantially higher. There are three major categories, John that we are seeing this growth in within POS. One is in health, one is in education and then, of course, in medical -- I'm sorry, in home improvement. So those are the three major sectors where we are seeing growth. And the term structure is very similar to personal loans, which is why it fits Pagaya's model perfectly.
Operator: The next question comes from Joseph Vafi with Canaccord Genuity.
Joseph Vafi: And great to see all the progress both on partners, P&L, balance sheet, all facets of the business. That's great. Just I thought we'd start looking at the shareholder letter. It looked like total application flow was up about 5%. But obviously, network volume was up more than application flow. I was wondering if you could kind of drill down into underwriting in the quarter a little bit and what might have been driving the higher network volume versus application flow? And then I have a follow-up.
Gal Krubiner: Yeah. Thanks for the question. I'll take that. So look, application flow continues to grow. And as [indiscernible] since you mentioned, the value proposition of our product is quite unique. So as we add more partners, application flow will continue to grow and has been doing that for the last few quarters. What we are doing, we're very disciplined in our approach and focusing significantly more on the channels that will drive -- that have higher unit economics and drive higher FRLPC. And as a result, those are the channels where we will have more mature relationships. So that's why you would see effectively network volume growing by a faster rate than the application flow that we're seeing. So think about it as a higher conversion ratio for those types of channels that we get higher economics.
Evangelos Perros: And Joe, maybe one add-on on this. If you think about it that as we move into stronger institutionals that have higher quality of flow, you will expect to see lower growth on the application, but every application means much more because it's much more, call it, likely borrower that we would like to lend to -- so there is an inverse of like, as the company gets bigger and therefore, we are lending more unique marquee partners, the ratio between the two is rather different.
Joseph Vafi: Sure. That's great. That makes a lot of sense. And then secondly, I appreciate the movement to new funding sources to reduce net retention. I think that's a big positive here. Just wondering if you move to forward flows or other vehicles, is there a potential impact on the line in FRLPC upside from the investment side of the business? Great results.
Gal Krubiner: No. Thank you for the question. No, I think we'll continue to -- as you have seen, right, we're accelerating the fee generation power of the business and improving the unit economics. Obviously, the diversification of the funding sources will allow us to lower the net retention of what we're keeping from the deals. But I think over time, we will continue to see that growth in FRLPC while we continue to diversify this type of diversify the funding sources. So overall, as we look forward, we do expect the FRLPC to range between the 3% to 4% in line with what we have provided in terms of guidance before.
Operator: The next question comes from Michael Legg with Benchmark.
Michael Legg: And great results, guys. Question on the $1.9 billion raised. What was the cost of capital [ after ] fees and expenses for that?
Gal Krubiner: Mike, it's Gal. So cost of capital for this transaction, think about it from an IG perspective, it's trending below the 7%. So really robust and much stronger, like lower cost of capital as what we had in the past and even a little bit the IG something around the 8%.
Michael Legg: Okay, great. And then on the investment in loans and securities of the $800 million, do you have the tranches on that, like how many are from '23 issuances versus '21, '22? Do we have a breakout on that?
Gal Krubiner: Yeah, I'll take that. So majority of what we currently have in the portfolio is driven by the 2023 and then 2024 vintages as the previous vintages has mostly paid down or amortized. As we look forward, one thing I want to highlight is that in the recent transactions that we did, what's important to remember is that the mix of the portfolio is shifting. And the last deal that we did, we did get much more of the debt versus the equity securities. So the quality of the portfolio is improving. And actually, that has two very positive implications. First, we are able to secure better financing because the debt can now support the paydown of the secured borrowings. And more importantly, given the mix and the quality of what we're retaining, it is actually accretive to both the -- expected to be accretive both to the P&L and the balance sheet overall.
Michael Legg: Great. And then just last question. Just on the consumer. Are you seeing anything regionally or anything that gives any indication of what you're seeing with the consumer?
Gal Krubiner: Yes. So I just want to set the stage, as you know, but just repeating for all the folks on the call, Pagaya is in a unique place that can see, quite frankly, most of the consumer credit trends, the fact that we are connecting to 30-plus originators give us a very wide understanding of how these trends are actually happening. So we have a very unique vantage point on that. What we are seeing, and I think you heard us talking on the 2023 vintages, is especially on the personal loan, but generally in consumer credit, that there is a very steady environment already since the start of 2023. You did hear some different narratives, I would say, with different earning calls of different companies. So we heard and saw a little bit of softening on the higher FICO type of thing. But from our perspective, it's really driven because of higher demand for these segments. So as think about it as people migrated from the more average FICO to the higher FICO, they created a little bit over-competition, and therefore, losses are a little bit higher there. We are not playing in that segment because we don't see the value there per se right now, and we are sticking to the [ 670, 680 ], that's the areas where we are operating there. And over there, the performance, as I've mentioned, is very stable since 2023. And we are hopeful and looking forward to continue to watch it as a hawk as we go into 2024.
Operator: The next question comes from the line of David Scharf with Citizens JMP.
David Scharf: I had a general question about unit economics and how we ought to think about them evolving. There are obviously a lot of moving pieces associated with how rapidly you're growing both asset classes beyond personal loans as well as exploring new funding structures. Maybe a question for you, Evangelos. Personal loans is the most profitable product. Does the FRLPC margin -- does it change over time as you do more auto and more point-of-sale lending versus personal loans? And then on the funding side, do the fees from your capital markets partners, do the economics of that change as you engage in more whole loan sales and forward flows. Just trying to understand as the business evolves, it sounds like it may be considerably different mix, even just 12 months from now, whether that impacts the consolidated unit economics.
Evangelos Perros: Great. Thanks for the question. Look, we see very positive momentum on our FRLPC growth, right? I think it's actually faster than we expected, partly obviously because the value proposition that we're offering to our lending partners and also because of our disciplined approach this year to focus on the higher sort of fee paying partnerships. And as you pointed out, PL is now at 6% this quarter, which has -- it's the highest it has been in our history, up 300 basis points year-over-year. And we believe we can achieve the same things for auto and even POS over time. Obviously, those continue to be investment areas for us. So there are a few years behind, let's say, than the personal loan. But the playbook is the same, and we know we can achieve that in those verticals as well. Now to your question, generally as we look ahead, we have given you guidance historically of FRLPC being between 3% and 4%. And even now this quarter, again, it's 3.8%, one of -- on the higher end of the range. It's always going to be a mix of partners between new partners coming in that are coming in at lower economics and that being offset by the higher fee paying channels. So we feel very comfortable about continuing that 3% to 4%. When it comes to funding, the capital markets fees are pretty much the same. They don't really change between the different products across ABS and some of the other funding sources that we're using. And over time, given the [indiscernible] access to capital that we have to the network of over 115 partners, we can achieve this new diversified sources of funding with a goal of getting to an average 2% to 3% net retention over time across all verticals.
David Scharf: Got it. No, that's very helpful. And on the risk retention front, it sounds like you're in a lot of advanced discussions and making terrific progress there. As we think about modeling the balance sheet exposure, with that 2% to 3% of network volume target, did you have a timeframe in mind when you hope to be able to achieve that? I mean is that as early as the end of the current year or is that a kind of longer-term goal?
Evangelos Perros: Yeah. So obviously, the 2% to 3% is an average that we expect to achieve over time. And we have actually demonstrated that in our [indiscernible] if you go back. What I would say is we're progressing in a very fast way in diversifying our funding sources. We're already in discussions with multiple parties to execute on forward flow agreements or whole loan sales that could lead up to $1 billion each. I can't speak specifically on the timing, but overall, we're progressing over the year, and we do expect to see some of those rare benefits for the remainder of the year.
David Scharf: Great. And if I can just add one quick maybe product question. Specifically for Elavon, I know it's the old NOVA Merchant Solutions. It's one of the world's largest merchant processors. Are they actually providing point-of-sale loans currently? I wasn't exactly sure maybe what the product set is at Elavon?
Sanjiv Das: Hi David, I'll take this. This is Sanjiv. The short answer is they are about to with the Pagaya solution. And so for example, we met with the BNPL POS lending head. And we know that, that's the direction they want to go in. And as you rightly pointed out, they are a top 5 payment process, and listen, my background itself from [indiscernible] demonstrates that the ability to -- for a payment processor to add more value to the merchant at the point-of-sale is really what is critical to them, and we've been talking about very, very late stage, I mean obviously onboarding right now on -- in terms of making sure that we fulfill their [ second look ] value proposition.
Evangelos Perros: And David, as you can think about that, it's exactly what I was mentioning when I spoke about POS. This is a great use case -- of someone who is looking to a bank that is looking to enhance their capabilities. And obviously, we love them, and they're a very good partner and has a lot of capabilities. And together with Pagaya, the ability to open that and become a major business for them, obviously, not just on us. We are a complementary piece. It's a very appealing value proposition for them and quite frankly, for us, too.
David Scharf: Great. Great. No, that's an exciting development. I mean it kind of potentially opens up the broader merchant processing vertical to the extent they want to get into point-of-sale lending.
Operator: The next question comes from Harold Goetsch with B. Riley.
Harold Goetsch: My question is on the automotive channel. Could you just give us an update on the automotive partners like Ally and others and where they're at in their rollout by state or by a number of dealerships? And how the overall auto business is going for you?
Gal Krubiner: Hi Har, it's Gal, I will take a question here. So yeah, definitely, as we said, auto loan, the auto space is something that we had been working a lot less deal. And we are definitely focusing on completing the rollout on Ally, there are a few states left. And on Westlake and other, we are continuously improving the product and finding the right place where we can add the most amount of value. Auto loan in general, I would say, was a little bit softer throughout the year from a world of funding, etcetera, and what has been through in this type of environment for that specifically versus auto loan. And therefore, when we are disciplined focused on higher unit economics and on higher return, etcetera, we might shift more towards the PL or the other things or de-prioritize. And as we see things are becoming stronger in different places, we are over-allocating there. I think it's a very good use case to how Pagaya is having solved both the long-term growth and the ability to lend more partners and to increase the network capabilities. But in the same time, managing the short-term goals of shifting capital in between different parts to make sure we are lending on the right financial side.
Operator: Does that answer your question [ Mr. Ward ]? We move to the next question. The next question comes from Sanjay Sakhrani with KBW.
Steven Kwok: Hi. This is actually Steven Kwok filling in for Sanjay. Within the prepared remarks, you talked about further improving the unit economics and that you made some additional changes in the first two weeks of the second quarter. Could you just provide an update around where we are within the process? And then how does the benefit like flow through? Do we see it on the take rate side or is it on the production cost side or is it both?
Evangelos Perros: Thanks for the question and looking forward to working together. So to your point, what we are doing, as we said, right, our strategy is now to continue to be very disciplined and improving unit economics across the portfolio. And what I wanted to highlight there in the prepared remarks is that we actually continue to take more action as we did in the early part of Q2 to continue to improve the fees as our value proposition to our lenders continue to resonate. So obviously, that will take over time, and we expect that to basically translate to higher -- on an apples-to-apples basis, higher FRLPC and get the full benefit of that into sort of second half Q2, most importantly, into a full quarter impact in Q3. And that will come both to your point, reflected both on the take rate as well as obviously the FRLPC rate.
Sanjiv Das: And if I may, I just wanted to add to what EP just said which is again part of our remarks, and Sanjay, good to talk to you again. I will say that in terms of our pricing power today in the market, I feel very, very confident to be able to deliver FRLPC -- the FRLPC numbers that we are projecting to sort of talking about in Q3. I will say to you, just cut to the chase here, in our -- many of our top five accounts, we have a dominant share of their business, and we are realizing that our ability to work closely with them to increase our pricing [indiscernible] is actually very, very high.
Operator: This concludes our question-and-answer session. I would now like to turn the conference back over to Gal Krubiner for closing remarks.
Gal Krubiner: Thank you. So to close, I want to speak for a minute on our growing value proposition in the U.S. lending ecosystem. We have truly a unique solution for lenders in the U.S. that can add real value immediately. You're seeing this reflected in the additions of top banks and lenders to our network. The increasing fees we're earning and the rapid pace of funding that we are bringing to our network. Thank you all for joining today, and I look forward to our continued partnership in the future.
Operator: Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.