Background: CFSI is a specialty public education lender for the Federal Education Loan Program (FELP), specializing solely in consolidation loans. Loans are originated primarily in the direct-to-consumer (DTC) market and the company maintains relationships with the largest originators in the market. CFSI operates with three business lines: 1) Direct origination of and forward sale of private and federal (FELP) loans for which they receive a gain on sale margin of approximately 4% - 5%, 2) Net Interest Margin (NIM) associated with the loans that CFSI does not sell and funds through securitizations to be held on its balance sheet and 3) Third party servicing fees for loans that it originates for itself and for other clients that purchase their loans, fee ranges approximately 20bps - 25bps a year.
Growth in the industry has been unprecedented in the consolidation market over the past 3 years due to historically low interest rates that have allowed people to refinance higher yielding loans. This industry grew out of nowhere at a 50% CAGR during this period. CFSI was able to leverage there market position as the only pure-play consolidator in the market and originates approximately $4.5bn loans a year. The IPO has given them the funding to change their business model from relying on Gain on Sale margins to building a high quality portfolio of Federal Loans.
The loans that CFSI hold on its balance sheet are 100% guaranteed by the Federal Government; like Nelnet(NNI) the company has received a special accreditation that is awarded yearly to exemplary servicers allowing them to be reimbursed at 100% for defaulted loans as opposed to other originators like SLM which are reimbursed with 2% risk sharing (98% guaranteed). CFSI does not hold any private loans on its balance sheet which carry much higher default rates and therefore does not maintain any credit risk whatsoever.
The issues that people have with the stock are the following:
1) Very low Liquidity – I expect this to change as people warm up to the sector post the election and as we get closer to the re-authorization of the Higher Education Act (HEA)
2) Higher interest rates – CFSI’s loans earn a spread margin (NIM) which can be exposed to spread compression in a higher interest rate environment if not mitigated by hedging techniques. CFSI hedges 80% - 90% of their portfolio with interest rate swaps and is viewed as being highly sophisticated at it (the company estimates that 100bps increase in the Federal Funds rate effects their net income buy $4mm or approximately $0.08 - $0.10.)
3) The company’s funding relies primarily on the securitization market – which is exposed to widening and narrowing depending on investor willingness to buy its loans – the most recent securitization transaction spreads for CFSI were even lower than SLM’s funding.
4) Slowdown in the consolidation market – the consensus view is that the growth in the school lending consolidation market has been predicated on significantly lower interest rates. While I believe that a large part of that is true I also believe that the lack of federal funding coupled with the rapid increase in the costs of college tuition has created unmanageable debt levels for students, which is only getting worse. Upon graduation, people will refinance feel the need to refinance their school loan regardless of interest rates whether that it is to lock in a rate for the entire term of the loan or to cut payments in half by extending the repayment terms of the loan from 10 years to 30 years (this generally cuts payments in half)
5) Political risks related to the re-authorization of the Higher Education Act (HEA) – the current HEA expired at the end of September, although the current iteration has been extended until September 2005 so that congress can debate the appropriate funding changes and terms necessary for the next 5 years of implementation. Substantial changes have been proposed by the Democrats that have jarred the market including:
a. A minimal increase to FELP program funding loan limits
b. Elimination of the single-holder rule (if your school loan is held by one party it cannot be consolidated)
c. Changing consolidation loans from fixed rate to floating rate and eliminating special allowance payments
d. Elimination of the 9.5% loans – CFSI does not do this at all
e. Allowing consolidation loans to be re-consolidated (you can only consolidate once right now)
Except for e., all the provisions under the current proposals are not issues with CFSI, however the uncertainty surrounding the outcome of the HEA and its terms has shied investors away from companies in the education lending business. A republican congress and Bush victory would be a great catalyst for NNI, CFSI and SLM since they are not really for any substantial changes to the HEA.
Conclusion: CFSI trades at a +60% discount to SLM on a P/E (approximately 11x 2005 EPS) with a long-term earnings growth rate that is 2x greater (25%- 30%); while I do not expect CFSI to ever trade in-line with the much bigger and more established SLM I do believe that the discount will narrow as time progresses as people 1) recognize that this business is in a secular growth period 2) interest rates and other risk factors can be managed effectively and 3) they become familiar with the CFSI’s story. Bottom line, I believe that it the stock can trade to 15x- 16x by the end of the year which would yield an $18 target for +40% return.
I believe that in the next 2 months there are significant catalysts that will offset the above-mentioned concerns. They include:
1) Election Day – if Bush wins re-election I expect education lending stocks to significantly outperform as a source of uncertainty is removed from the market with regards to the shape of HEA (the final regulations will most likely be completed by 1Q05). SLM has historically traded at a 18x – 20x p/e multiple but due to uncertainty in its underlying business regarding HEA the stock has been trading at 14x – 15x levels. Recently, as Bush has regained a lead in the polls the stock has started to outperform and gravitate towards its historical multiple as people try to get ahead of the election – I expect the multiple for the other two players to follow suit after the election – (CFSI is really too illiquid for big money managers to bet ahead of the election so they have not moved yet).
2) CFSI 3Q Earnings – 3rd and 4th quarter earnings are typically the seasonally best quarter for education lenders; specifically for consolidators since school loans begin repayment periods typically 6 months after May/June graduation rates (if you were to refinance you would think about it then when you actually have to start making payments). Additionally, because of this years lower rate reset (set once a year by the government and 25bps lower after July 1st) CFSI held off loan volumes from Q2 to Q3 so that its customers could benefit from the lower interest rate this will significantly benefit CFSI’s 3Q figures.
3) Management will be conducting a road show after the Q3 earnings are announced to generate investor interest and I expect that this coupled with the election results will move the stock higher.