Description

Intro:

Sallie Mae has been the subject of two high-quality writeups in the past. I recommend you read Supernova’s report from 2020 and manatee’s report from 2021 for a fulsome discussion of the drivers of the business, including history, strategy, and management. 

Despite continued excellent execution and capital allocation, the stock price is 15% lower today than it was at its last posting (about 19 months ago.) This is due partly to some hiccups in credit performance which seem to be in the rearview, partly to conservative 2023 guidance, and partly to the “baby with the bathwater” effect that has impacted nearly every non-SIFI financial institution thus far in 2023.

Credit Performance:

SLM has a $21.9B portfolio of student loans. Approximately 42% of this portfolio is variable rate (SOFR + 1.25% to 12.375%) and 58% is fixed rate (4.75% to 15.875%.) Given the rapid rise in interest rates over the last year, investors are understandably focused on credit quality. Higher rates mean higher payments for those on variable rates and potentially thinner budgets for those who may have a fixed rate with SLM but variable rates on other types of debt.

Charge-offs hovered in the low 1% range for much of 2017-21 but began to tick up H2 2021. While rates may have played a part in this phenomenon, management has detailed other factors. Specifically, there is always noise in credit metrics from students who leave college (for a gap year or to terminate the experience altogether). Because they granted borrowers forbearance during COVID-19, the 2021 and 2022 cohorts of dropouts/gap years got condensed into a shorter than usual timeframe. 

Management has also been candid that there was room for improvement in the people and processes around loan monitoring and collection. CEO Jon Witter, a former McKinsey consultant, has devoted significant time and resources to improving these functions. 

One quarter does not make a trend, but Q1 2023 results showed a sharp improvement in credit metrics from H2 2022. One can see why the market was increasingly concerned about charge-offs thru Q4 2022. If the improvement in Q1 2023 can be held stable, confidence should grow thru the remainder of the year that management has a handle on the issue.

Guidance:

In light of the unsteady back half of 2022, in early February 2023, management issued what we view as conservative guidance for 2023. 

This is compared to low double-digit origination growth in calendar 2022. It also didn’t help that they kept revising their net charge-off range higher throughout 2022 and then missed the guide (the final came in at $386MM vs. a $325MM to $345MM range.) 

In the first quarter of 2023, originations grew 12% and marked the highest level of originations in the history of the company. As you can see in the graphic below, FICO and cosign metrics were in-line with historical levels.

Charge-offs, as discussed above, came in at $83MM, slightly better than plan and significantly better than the previous three quarters. Another quarter in line with last and a guidance raise would seem in order.

Bathwater:

SLM is well-capitalized, with total liquidity of 19.7% of assets, a 13.3% total risk-based capital ratio, and only $471MM of deposits (~2%) uninsured. They experienced no deposit flight during the recent “crisis” and ending deposits in Q1 2023 were actually slightly higher than at the end of 2022. The company does hold marketable securities as a portion of its liquidity sources and has unrealized losses on that portfolio of $155MM. Realizing those losses would result in a capital charge of approximately 50bps, an outcome management does not anticipate. 

While it has recovered quite a bit of ground since, in March SLM stock declined 30%+ in a 2-week period surrounding the Silvergate, First Republic, Signature, etc. disasters. Should we get another such scare, SLM seems like a good candidate to buy in a dislocation. This is not a financial institution with an upside-down balance sheet. We know the company will be a buyer, which brings us to…

Capital Allocation:

Management has been very consistent in executing their plan (well covered in previous writeups) to sell loan portfolios at a premium and use those funds to buy back stock at a discount. Since Witter became CEO in 2019 and implemented this strategy, they have repurchased 44% of the stock outstanding.

The company very recently completed the sale of a $2B loan portfolio. While details are not available, the general tone from management indicates they received a premium in line with historical transactions. They plan to sell another $1B in loans in the third quarter of this year. 

One thing we find curious - their current buyback has just under $600MM remaining and on the last earnings calls they said they did not anticipate needing to re-up this in calendar 2022. While we recognize there are liquidity restraints on putting capital to work in buying back a company with sub $4B in market cap, we would love to see them be more aggressive, including entertaining options such as an ASP.

Conclusion:

SLM offers an opportunity to buy a great franchise with an “outsider” CEO committed to thoughtful capital allocation and sound strategy for 6x the low end of 2023 earnings guidance. While we recognize that a mono-line credit provider will never garner an enormous multiple, we believe the stock currently offerers very nice value as the company appears to be back on track after a few idiosyncratic issues and is very sound in a world where many financials are not.

Catalyst

- Buybacks

- Stablized credit metrics

- Guidance raise