Description

Poor Sallie has been indelibly linked to good ole’ Fannie & Freddie since her formation; the second name Mae synonymous with GSE (“government sponsored entity”). However, the ties between Sallie and Fannie & Freddie end with the name Mae, for the Sallie Mae of 2019 is dramatically different from the Sallie Mae of 1973 to 2013.

Sallie began to distance herself from Fannie & Freddie in 2010 when the federal government started lending student loans directly, thereby allowing Sallie to generate private school loans while still servicing previously federally guaranteed loans. In 2014, the business split into Sallie Mae (SLM) and Navient (NAVI), with SLM acting as an originator of private school loans (i.e. not federally guaranteed) and NAVI servicing the federal loans portion of the business.

SLM provides student loans to pay for the costs not covered by federal loans, offering super prime loans (>740 FICO) with low delinquencies due to an 87% co-signer rate.

Of course we are all aware of various proposals from politicians from loan forgiveness to free community college, but most SLM loans are given to students at private schools, making demand for SLM’s products likely to continue. 

Perhaps the best statement on what SLM’s business is, and is not, came from the CEO at a conference in September:

“The funding for higher education in the United States is still done about half by the family and about half by some combination of the schools and federal lending. Private student lending is actually a very small part of that. So, when we look at what we are targeting for, it's a small group of middle-class families that want to send their children to college, that are taking advantage of whatever the college will give them in grants, stipends, et cetera, or work-study, who are taking advantage of their rights under the federal program and who still need gap financing, frequently for more than one student per household.

“So we hear a lot about free college.  And so, the thought is free college is going to disrupt the market, possibly.  Free college typically means what?  It typically turns out to be not free college in the sense of all the costs are covered.  It turns out to be free tuition.  Free tuition where?  Free tuition typically at state universities.  For everyone?  Typically not.  All the politicians who have articulated the program have a means test of some form, typically $100,000 or $110,000 or $125,000 cutoff for households. 

“How is that going to impact us?  We believe we have a good case study in the Excelsior Program that was started in New York a couple of years back.  So, free college in New York was the banner.  Was it free college?  No, it was free tuition.  Was it free tuition everywhere?  No, it was at state universities.  Was it for everybody?  No, there was a means test.  It was successful in its goal which was to help those households who have children who want to go to college, but are not able to finance them.  These people deserve to go to college.  They’re young, they’re ambitious, they come from economically challenged households.  They are not our customers.  Our customers come from stable, middle income households.  They are the people who qualify, who have on average 747 FICOs.  That is our target customer.  That is not the target for free college.”

Today, SLM controls 55% of the Private Education Loan (“PEL”) market. Their largest competitor is Discover, followed by Wells Fargo, and then Citizens.  When SLM and NAVI separated in 2014, a non-compete was signed whereby NAVI could neither originate PELs nor consolidate loans already in SLM’s portfolio. The non-compete expired at the beginning of 2019, adding another player to the mix. However, NAVI is offering similar rates and terms and have yet to be a disruptor. Other competition comes in the form of 3^rd party loan consolidators, such as SoFi and other non-bank lenders. SLM fully acknowledges college students do not want to speak with anyone and prefer to apply for a loan on their mobile devices or computers. SLM’s strength is being able to approve a loan in 6 seconds for a college financial aid worker who has a student starting classes in an hour. The threat of these 3^rd parties will be discussed in more detail below.

Overall, there has been and continues to be a strong secular drive for education. A combination of student loan demand and tuition increases gives SLM 5%+ annualized loan growth for the foreseeable future.

In the near-term, shares of SLM have fallen from a high of $13 in April 2017 to the $8.50 level today for four reasons: 1) A misinterpreted ‘free public college tuition for all’ into ‘free college tuition everywhere’ policy; 2) New business line uncertainty; 3) The threat of 3^rd party consolidators; 4) GAAP accounting change.

First, SLM often gets confused with being a GSE. As previously discussed, it is not.

Second, SLM is now looking to diversify into personal loans and credit cards. They want to use their existing customer base to cross-sell these new products. Unsecured personal loans run a slightly higher yield (about +100bps) than a private student loan, but the risk is much greater (no guarantee of co-signers, though SLM is encouraging co-signers). SLM began building its personal loan infrastructure about two years ago. In 2017, SLM had zero exposure and now the personal loan portfolio is over $1bn, comprising 4% of the total loan portfolio.

On the 4Q18 earnings call, management indicated a desire to grow the personal loan book to $2bn through the next few years. They disclose the quality of the personal loan borrower as being comparable to a FICO score of 715; the expected ROE of the loan book going forward is 15%. To be sure, management isn’t interested in growth for growth’s sake - this year they have paused private unsecured loan growth to evaluate how the current book is doing.

This new business will likely have a material impact on the intrinsic valuation of the business after it gets to be >10% of the portfolio, which is probably another two years out.

Third, loan consolidation. This is a trickier issue. SoFi and other non-bank lenders offer fixed rate, student consolidation loans and there is concern these players continue to take profitable loans away from SLM before SLM gets a full five years of interest. In FY’18, loan consolidations were around $330m each quarter and over the last few years, loan consolidations have steadily increased as a result of the aforementioned competition. Through FY’19, loan consolidations have been more volatile, jumping to $394m in 1Q19, falling to $313m in 2Q19, and coming to $346m in 3Q19. Management remarked on the 3Q19 call that they believe the cost of funds has gone as low as it can for the consolidators and a continued decline in rates shouldn’t increase volume. SLM could enter the refi business, but the ROE is lower, and they mentioned on the 3Q19 earnings call they are having a difficult time developing a refi model that doesn’t cannibalize their own portfolio. It also appears as though loan consolidations have already begun to plateau and aren’t even a sizable portion of the market yet.

Four, the GAAP accounting change, otherwise known as CECL. Beginning January 2020, CECL adoption will commence and take place over a 3-year period. The new regulation requires regulated financial institutions to estimate the future deterioration of the credit book and place reserves against this approximation at loan origination. There will be an initial build of the loan loss allowance that will be booked through retained earnings on a tax-adjusted basis. Management estimates that had CECL been adopted as of September 30, 2019, the additional PEL allowance would have been $1.05bn to $1.2bn, bringing the total reserve to $1.4bn or 6% of ending total PEL balances and the estimated additional personal loan allowance would have been $0.07bn to $0.08bn, bringing the total reserve to $150m or 14% of ending total personal loan balances. As a result, the estimated reduction to total equity would have been $0.84bn to $1.03bn and the deferred tax asset impact would have been $0.25bn to $0.35bn. In other words, if CECL implementation resulted in the max equity reduction, BVPS would have gone to $5.08 from $7.50. After the initial build, additional reserves will be recorded as loans are originated and the reserve build will vary by quarter do the seasonality of the PEL business. Of note, CECL will replace the current TDR accounting and SLM will not need additional capital to adhere to the new regulation. Moreover, SLM has always used lifetime loss in their underwriting model; CECL just makes them put these estimates on their balance sheet. The implementation of CECL does not change the underlying cash flow economics.

To be prudent, management has suspended share repurchases until CECL is adopted to ensure regulators concur with their capital levels. As a result, the Net Interest Margin has been declining this year as cash becomes a higher percentage of interest-earning assets despite PELs growth and an improvement in PEL rates. While suspending repurchases is indeed prudent, the decision has had made some investors skeptical as to what CECL could really mean for the Company and created confusion around Net Interest Margin. However, management has tried to explain multiple times that this excess cash is real and will be used in the future.

Valuation

If we were told a business exists with +20% earnings growth, +20% ROE and 60% market share, our expectations for valuation would not be a single digit P/E multiple. FY’19 EPS is estimated to be $1.24, implying the stock is trading at 6.9x earnings. FY’20 EPS is expected to be even higher at $1.40. Using an intrinsic multiple of 15x given the ROE and asset growth potential, the fair value comes to $21. This is a high return on capital business where 3-5% topline growth is probably in line with its market, leaving excess capital for share repurchase or dividends.  Shares are trading below 7x due to lack of visibility in a few areas and investor misunderstanding of headline political risks.

Political noise may cap potential upside, particularly through the 2020 presidential election, but this risk seems unlikely over the long-term. State regulation tested in New York had minimal impact to the business. Once CECL is implemented, more facts will help clear up the uncertainty pressuring the valuation.

This feels ripe for a takeout. SLM has a loan book of +$20bn, generating a NIM of 5.8% and ROE of +20%. They have excess capital to grow but have funding costs about 1% above other banks. A large bank with cheap deposits seeking a quick, accretive path to grow should be looking here.

Associating Sallie with Fannie & Freddie and layering the headline of “free education for all” may lead one to believe SLM’s downside risk is zero. That would be a very extreme view.  Ultimately, even if the most extreme plan were to be enacted, private student loans would still have to be repaid to SLM, whether it be by the government or the actual borrowers. In this instance, SLM would be a run-off, meaning the downside isn’t $0, but closer to book value. Obviously if Republicans hold the Senate and/or the Presidency in 2020 these risks are off the table. 

We can think about valuation probabilistically.  Our base case would be a slower growth business, say 3-5% top-line, maintaining its market share.  Given the high return on equity, there would be excess capital to buy back stock and pay dividends.  Perhaps that gets a 12-13x valuation, which puts us in the mid teens.  There would be a higher case where reinvestment growth is higher and compounding higher.  And we could assign some probability to a draconian case where the business goes into runoff and is worth a discount to book value a couple years from now, say $5-6.  For us that probability would be small (10% range if that) as many things all would have to happen politically to get from here to there.  That leaves us with a valuation in the low-mid teens. 

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing. The author will not undertake to supplement, update or revise such information at a later date. The author may hold a position in the securities discussed.

Catalyst

Political risks diminish, perception changes

Takeover