After merging with and going public through a special purpose acquisition company (SPAC) in June, the artificial intelligence loan underwriting platform Pagaya Technologies (PGY 7.33%) is beating the market, with its stock up roughly 11.5% this year, while broader market indexes are all way down.
The company has created a two-sided network between bank and fintech partners and institutional investors. Pagaya serves as the middleman, assisting banks and fintechs with loan underwriting and then facilitating the sale of those loans to investors, enabling banks and fintechs to get those loans off their balance sheet and make more fee income.
Given the company's outperformance in these difficult market conditions, is the stock a buy?
An interesting quarter
A few weeks ago, Pagaya reported earnings results for the second quarter of the year, its first time reporting earnings as a public company. The company reported a net loss of more than $146 million on total revenue of roughly $181.5 million. However, almost the entire loss was driven by share-based compensation. Adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) came in at $4.9 million.
Data source: Pagaya.
Network volume came in at $1.9 billion for the quarter and is now at $3.6 billion for the first six months of the year. Management is guiding for network volume of between $7.2 billion and $7.8 billion, revenue of $700 million to $725 million, and adjusted EBITDA between -$20 million and $10 million.
Even though network volume growth seems to be slowing, I am actually surprised that the company expects it to hold steady and potentially grow a bit through the rest of the year. Most fintech companies facilitating or selling loans to institutional investors have struggled this year because rising interest rates have raised the cost of capital for a lot of these investors, which has in turn led to them demanding higher returns. Additionally, with the economy potentially headed into choppy waters, investors have been less willing to purchase certain loans on credit quality concerns.
But Pagaya partly solves this funding issue by raising capital in advance, and the company said it raised $1.8 billion of funding in the second quarter through the securitization market and privately managed funds. Management also said that its partner banks tend to find Pagaya more useful in times like this when they are tightening their credit boxes but still want to make loans to potential customers without taking the risk on their balance sheet, which I had not previously considered.
Still, I do wonder how long this funding resilience can last, given the Federal Reserve's 75-basis-point (0.75%) interest rate hike in July and the potential for another similar rate hike in September, although I imagine management has baked this into their full-year guidance. In the medium term, Pagaya hopes to grow network volume to more than $25 billion and achieve an adjusted EBITDA margin of 20% -- adjusted EBITDA margin in Q2 was 3%.
Manipulated trading
Despite reasonable, although mixed, results in the second quarter, the real reason Pagaya is trading up this year has nothing to do with its business performance but everything to do with it going public through a SPAC.
After a SPAC announces an acquisition candidate, shareholders can redeem their shares if they don't like the acquisition candidate or for any other reason. Many redemptions on Pagaya happened to leave an incredibly small public float of less than 1 million shares once the company began trading independently.
Seeing this, investors grabbed hold of all the outstanding public shares and drove the stock price higher. Pagaya's stock at one point soared to nearly $30 per share and nearly a $20 billion market cap. Shares have since come down, but the stock still trades above $11 per share and has more than an $7.5 billion market cap.
But even this price might be short lived because other shareholders, such as the founders, SPAC sponsors, and other stakeholders, still hold hundreds of millions of Pagaya shares that could flood the market once certain lock-up agreements end.
In a previous regulatory filing, Pagaya said that 90 days after the SPAC merger closes, if the share price surpasses $12.50 for any 20 trading days within a 30-day trading period, these other shareholders can sell their shares. This condition was met in August, and 90 days from the deal closing would be on Sept. 20, so more shares could start to flood the market sometime in the near future.
Is Pagaya a buy?
I didn't think Pagaya's second quarter was all that bad, considering it plans to hold its network volume steady, which many other consumer-lending fintech companies have not been able to do because of funding issues in the rapidly rising-rate environment.
But I'm curious to see how long of a runway Pagaya has before it starts to run into funding issues of its own. I will also be watching how credit quality holds up in a more difficult economy.
At a roughly $7.5 billion valuation, the business looks expensive, with the company basically breaking even right now. I think the stock price is only holding up because of the low float and could fall further once more shares flood the market, so I am staying on the sidelines right now.
