Sallie Mae is a business that is recovering from a painful regulatory earthquake.  As a result, they are undergoing a massive overhaul. Investors have been rightfully concerned and dismayed by the one-two punch of the severe credit crisis and the government's desire to fundamentally alter the federal student loan programs. Nonetheless, Sallie Mae is dealing with it as best they can. With its common stock in the $11.50 to $12 range, I feel it is significantly 30%-70% undervalued today.

Right up front, I do think the stock is selling at a discount due to a mix of the following reasons:  

(a) the newly implemented Higher Education Opportunity Act of 2008 which eliminated new federally-guaranteed loans from being originated by private lenders, (b) complex securitized trust accounting that forces Sallie Mae to account for their sold securitized trusts on-balance sheet (c) uncertainty regarding the economy and the follow-on credit quality concerns of their private student loans (d) a general hatred of consumer-lending stocks, (e) the slowdown of private student loan originations due to higher federally-guaranteed loan limits, (f) no near term catalyst in the form of a sale or even a partial sale, and (g) management just announced that investors should not expect a dividend until at least the end of 2011 as they consider the lengthening of their unsecured debt structure a higher priority.

There are likely other reasons, but this list is long enough!   However, I believe there is value in Sallie Mae's common stock that isn't currently being recognized by the market.

Business Background:

Before getting into the valuation work, here is a little background for those not too familiar with the business.

After the massive change in federally-guaranteed student lending regulations with the enactment of the Higher Education Opportunity Act of 2008 (just implemented on July 1, 2010), Sallie Mae should now be thought of as the largest pure-play private student loan lender in the US.  

Aside from private lending arm, Sallie Mae also runs a student loan collections business and a loan processing business for the various non-profit guaranty agencies related to the Education Department (ED) guaranty program as well as directly for the ED itself.  These can be considered their ongoing businesses.  Given the government's heavy involvement today, these are not high growth businesses at this point.

As mentioned, Sallie Mae's federally-guaranteed student loan origination business is finished as of July 1, 2010.  This was their bread-and-butter and without it, they are undergoing a big restructuring that involves significant head count and cost reductions over the next year.

In addition to their ongoing businesses, I contend they have real value that isn't apparent on their complex balance sheet in the form of Residual Interests, Floor Income and the Servicing Contracts related to their continued involvement with their big pile of federally-insured securitized student loan trusts.  This value is effectively hidden by the analytical challenges presented by the recent off-balance sheet vs. on-balance sheet accounting rule change implemented on January 1, 2010.

Student Loan Securitization Primer:

For those not entirely familiar with the student loan securitization process, here is quick primer.   For those that know the understand the securitization process, you can skip ahead.

Like all securities backed by receivables, typically there are multiple tranches created for each securitized trust.  Sallie Mae originates the loan, packages them up and sells them to a newly created trust.   The newly created trust pays for the loans with money raised by selling various debt securities that possess certain rights to the future principal and interest payment streams.

First, the Sallie Mae, the servicing agent, gets paid about 60 basis points annually (paid monthly) based on the outstanding principal of the loan pool, then the trust holds back some cash-flows that go into various typical reserve accounts, then the tranches get the payments in the order of preference.

The interest is paid at the agreed upon LIBOR-based rates to the various tranches.  Any excess interest, depending on the spread between commercial paper (more on this below) and LIBOR, will flow to the Residual Interest holder, Sallie Mae.   

When principal is paid back, the highest-rated tranches get paid off first until they are fully paid back, then the next tranche in line gets the subsequent principal payments, etc.  Remember, the Education Department (ED) guarantees that around 98% of the principal will be paid regardless of eventual default rates.  As a result, there is little-to-no credit risk in these pools.  And, again, at the end of this line of principal payments is the Residual Interest holder, Sallie Mae.

It is important to note that most, if not all, student loan securitized trust's debt securities pay a "LIBOR plus spread" to the security owners (that is, the owners of the tranches).  All of the payments into these federally-guaranteed student loan trusts come in as variable rate loans, usually based on spread above then-current commercial paper rates.  

Explanation of Floor Income:

There is something unique about securitized trusts backed by federally-guaranteed student loans and that is the Floor Income concept.

A confusing element of Consolidation federal student loans is that the actual student borrower often pays a fixed rate for the life of their loan.  This is called the "borrower rate".  However, the Education Department guarantees to the lender a commercial paper + spread yield.  This guaranteed yield is called the "lender rate".  This helps explain why securitized trusts backed by federally-guaranteed student loans basically all pay a floating rate to the security owners..

For loans prior to October 2006, if commercial paper rates falls enough - like now - Sallie Mae not only receives the "commercial paper + spread" rate but Sallie Mae is also entitled to get a special Supplemental Allowance Payment (SAP) from the ED that basically sets a floor on the rate that Sallie Mae gets to keep.  For these loans, the ED is also guaranteeing a yield floor for the the lender (a.k.a. Floor Income).

For example, let's say the lender rate is commercial paper + 250 basis points (let's say it totals 4.5%) and the student-borrower is actually paying a fixed 7%, then Sallie Mae is entitled to keep the 2.5% in Floor Income.  If, on the other hand, CP + 250 basis points totaled 8%, then Sallie Mae gets a 1% "top-off" payment from the ED.  The ED would subsidize Sallie Mae 1% in this case.  It was a win-win for the lenders like Sallie Mae.  Remember, the securitized trust debt is paid on a purely floating rate formula based on LIBOR.  So, you can see all of this amounted to a big subsidy provided by the ED.   

Unfortunately, the above applies to loans made prior to October 2006.  Predictably, and probably rightly, this floor income subsidy was eliminated.  

For 2007 and up until the new legislation that took effect on July 1, 2010, the ED eliminated the floor income subsidy payments.  For these loans, if CP rates fell, Sallie Mae was forced to remit back to the ED the positive difference between the borrower's higher fixed rate and the lender's lower CP + spread rate.  Now, if CP rates rose, then the ED stills pay the SAP payment that allowed the lender to get its guaranteed CP + 250 basis point payment.  In other words, floor income was eliminated and that benefit is remitted back to the ED.

The discussion of Floor Income appears all over the place in Sallie Mae's financial filings.  As you can see, this floor income is a variable amount depending on the level of interest rates.  This variable amount of the ED's possible SAP payments flows right through the securitized trusts and, if all goes according to plan, it finally settles into the account of the Residual Interest holder - Sallie Mae.   

Hedging Activities related to the Floor Income:

To hedge and monetize this variable stream of floor income cash coming from the ED, Sallie Mae has often entered into multi-year interest rate swap contracts with various counter-parties in order to lock-in this floor income for some time period ahead.   Additionally, they have also subsequently sold the locked-in floor income streams to yet other third parties in order to enhance liquidity.  For anyone reading their financial statements, all of this hedging and monetizing activity adds complexities to their balance sheet and income statements.

For example, it appears that the lump sum sales of this floor income must be amortized into the income statement over the life of the sold swap contract's life.  In other instances, the retained interest rate swap contracts must be marked-to-market on the balance sheet and these changes in the marks flow right through the income statement as well.   

Accounting for this derivative activity creates some undesired matching issues.  Because of the lack of fully-hedged accounting treatment given to these activities, the income statement often feels the brunt or benefit of the volatile derivative values while the natural offsetting balance sheet adjustments don't occur.  

Often the balance sheet asset - that is, the projected floor income embedded in the asset values sitting on the balance sheet-  remains unchanged yet the value of the interest rate swap contracts fluctuates via the income statement.  With true hedge accounting treatment - and I am certainly not a hedge accounting expert - I believe  there would be no income statement affect and all mark-to-market variations would by-pass the income statement and instead flow through some "other comprehensive equity" line.  

I feel the basic reality of what's going on with this floor income stream is not that complicated to understand.  By their choice, Sallie Mae sometimes sell off the ED-subsidized floor income streams and they sometimes simply try to lock-in for some period ahead the retained floor income via interest rate swap contracts.  To do so, it all requires the use of derivatives and complex hedge accounting.

This discussion above is admittedly complicated stuff, but I felt it was important to explain some of the reasons behind the complicated hedging activities that you'll see if you review of their financials.  

As I'll add later in what I admit is my weakest component of the valuation section, management has indicated that there is currently about $2.5 billion of projected, un-discounted, Floor Income embedded in their securitized trusts.  This Floor Income eventually accrues to the Residual Interest holder at the end of the line in these trusts.  That holder is Sallie Mae and this Floor Income is a non-trivial component of their value.

Which, finally, brings me to the valuation of SLM.

I like to think of Sallie Mae in multiple pieces.  

First, they have a servicing business.  Second, they provide some loan processing services as well as loan collections work for existing student loans.  Together, I refer to these two business lines as their "non-interest-spread" businesses.  Third, they act as a pure private student loan lender on about $11 billion in non-securitized or retained loans that they've funded with their own liabilities.  Fourth, they own Residual Interests on all of the securitized trusts that they've created over the years.   And, lastly, they are entitled to the embedded ED-paid Floor Income as described just above.  

Taken together, this is Sallie Mae.

Servicing Business:

Sallie Mae performs the loan servicing duties for their securitized trusts and for this they receive about $950 million annually to perform this function.  This works out to about 60 basis points annually on the outstanding balance of the securitized loan portfolios.  For those interested, they do receive different compensation for their different federally-guaranteed loan types that I described above.  They receive 90 basis points for the $46 billion in Stafford loans, 50 basis points for the $80 billion in Consolidation loans and they get about 60 basis points on the $24 billion of securitized Private Education loans.  

In addition to the servicing revenues on the securitized assets on their books, they also service another $11 billion in Private Education loans that have not been securitized.  They refer to these assets as "unemcumbered assets".  Based on the same math, a close approximation of their servicing revenue on these assets is about $65 million per year.  

To round out the servicing revenues that should be expected for 2011, I also want to add in the revenues that they will earn on the newly acquired $28 billion securitized loan portfolio from the Student Loan Corporation.  This deal is expected to close by year-end.  Again, based on similar metrics as above, this will add another $150 million annual to the loan servicing revenue.  

In total, we can expected that their loan servicing revenues will be about $1.15 billion per year.

Side note:  To make the accounting a bit of a pain to understand, this servicing income is not explicitly shown on their income statement.  It currently flows through the broad "net interest income" line.   I am told they are going to begin splitting it out explicitly in the Q4 reporting.  I think this will help transparency. .

Side Businesses:

Sallie may has a couple of side businesses.  

For the non-profit guaranty organizations contracted by the Education Department, Sallie Mae acts a collections agency that works on a contingency basis.  This line of revenue will be in decline given that newly originated federal student loans will be now be done directly with the ED.  Sallie Mae will also be doing future collections work for the ED on their newly originated direct loans.   

Therefore, while the guarantor-related collections business will be in decline as the previously underwritten student loans season or age, the collections business on the direct loans made by the ED will grow as ED makes more student loans.  The cross-over point of these two lines of business isn't something I've analyzed closely..

In addition to this loan collections function, they also provide back-office loan processing services for these guaranty agencies as well.  Confusingly, they call this line, "servicing revenue" instead of "loan processing revenue".   Nonetheless, this service includes origination paperwork and other loan processing done for the ED-appointed guarantors.  Now, with the ED making direct student loans, Sallie Mae will not be earning any more origination paperwork fees from the guaranty agencies, but they are now contracted to do other loan processing work directly for the ED.   Again, it seems the lines will cross eventually at some sustained revenue level..

In summary, while some segments of these side businesses are in decline due to the direct loan arrangement with the ED, other areas are going to grow over time.  In total, these side businesses currently bring in revenue of around $350 million per year.  

Adding this "side business" revenue stream to the "servicing business" revenues, starting in 2011 Sallie Mae will have about $1.5 billion in revenue with which to work.  As of the Q3 2010 report, Sallie Mae still had about $1.3 billion in run-rate operating expenses.  Management has been clear that they are targeting a run rate expense level of $1 billion by the end of Q4 2011.  It makes sense that there is still some significant cost cutting to come as the ED just took over the federal student loan business on July 1, 2010 date.  Obviously, investors are focused on seeing this operating expense base fall to $1 billion per year or lower.

Valuation of their "Non-Interest Spread" Businesses:

In an attempt to value just the combination of the "servicing" + "side" businesses - I'll refer to this collectively as their "non-interest spread" businesses - it makes sense to jump forward to 2012 and assume an operating income stream of $500 million per year.  That is $1.5 billion in recurring revenue minus $1 billion in operating expenses.  I would expect that their after-tax earnings on these "non-interest-spread" related business is around $325-$350 million per year or $0.60-$0.65 per share.  

Frankly, the "non-interest spread" businesses are not going to get a big multiple as they are inherently slow growth / stagnant / or possibly shrinking businesses as the existing loans pay down over time.  For this "non interest spread" business, as a rough estimate, I would only assign a multiple of 6-8 times earnings to it.   This works out to be about $3.50 to $5.00 per share.  

Value of $11 Billion in Non-Securitized or Unencumberered Loans:

To isolate the value of the Residual Interests that Sallie Mae has embedded in their securitized loan pools, it helps to first isolate out the $11 billion in non-securitized Private Education Loans loans (referred internally as "unencumbered assets") on their balance sheet.  

As originally underwritten, these private loans were meant to make a pre-provision spread of 3.5% over their funding costs.  At a 3.5% spread, I estimate there is about $400 million of pre-tax, pre-provision net interest income.  

From this, they have stated that they expect to experience 6% in credit losses over a six year time-frame or about 1% per year.  It only averages out to 1% per year as they expect to experience heavier losses in early years and fewer losses in the later years on a particular loan pool.   

Based on these figures, they target earning 2.5% pre-tax on this $11 billion or about $275 million.  After tax, this could be estimated to be around $175 million per year.  I am not hitting this revenue with any overhead or administrative costs as these operating expenses have been fully incorporated in the "non-interest-spread" businesses in the section above.   

As a rough way of estimating the value of this income stream, it makes sense to use some embedded ROE target.  Using a 20% ROE target, as provided to me by Sallie Mae, implies that there is about $1 billion in shareholder equity backing this net income stream.  This ties reasonably with idea that this lending business uses about 10x leverage.  Another rough estimate is to give it apply a multiple of 8-10x earnings.  The combination of the two methods values it at $1 billion to $1.75 billion - a wide range.

However, we all know that this $11 billion of unencumbered asset pool was underwritten quite poorly during the heydays.  This means there are some losses to fund via existing loss reserves.  

Today, taking a pro-rata 30% of their $2 billion in reserves that Sallie Mae currently has backing their entire $35 billion private student loan pool (including the securitized private student loan trusts), I figure that there is about $600 million in loss reserve backing this $11 billion unencumbered loan pool to cover projected credit costs over time.  Assuming this is sufficient and released over the life of this loan pool, I then subtract this $600 million from the $1 billion to $1.75 billion value placed on this block of loans and estimate that Sallie Mae's $11 billion Non-Securitized Loan pool is probably worth $400 million to $1.1 billion or about $1.00 to 2.00 per share.

It might be important to note that things are improving with regard to default, delinquency and forebearance rates on this block of loans.  Nonetheless, to be reasonable and conservative in my assumptions, subtracting $600 million in loss reserves makes sense for the purpose of value estimation.  

Given these assumptions, the total value attributable to the "non-interest spread" businesses + the "unencumbered assets" pool results in an admittedly wide range of $4.50 to $7.00 per share.  

Residual Interest:

Which brings me to the next - and largest - value component of Sallie Mae; the Residual Interest holdings in all of their related securitized trusts.  And, believe me, this isn't an easy thing to pinpoint as these Residual Interests are inherently long-tailed and very assumption dependent.  Additionally, the on balance sheet accounting treatment required for securitized trusts makes it doubly hard to isolate this value..

From my estimation, there are a few ways to reasonably estimate their value to Sallie Mae.

First, Sallie Mae gave a reasonable hint of a rule-of-thumb valuation tool for their Residual Interests.  On January 1, 2010, new accounting rules dictated that Sallie Mae bring $35 billion of securitized trusts back onto their balance sheet.  In doing so, they erased an estimated $1.8 billion of Residual Interest value sitting on the asset side of their books.  This showed that, based on Sallie Mae assumptions on prepayment speeds, discount rates, etc., that they internally valued their Residual Interest at about 5% of the securitized trust assets.  This $35 billion was made up of a particular mix of Stafford, Consolidation as well as private student loans.  So, like most things involving these Residual Interests, it is a rough rule-of-thumb, in my opinion.

Second, back in early July and now posted on their website, Sallie Mae further provided an estimation of the "excess spread income" they expect to receive the principal amount of $121 billion of securitized federal student loan trusts (referred to as FFELP loans) that had on their books as of June 30, 2010.  This "excess spread income" is what is due to the Residual Interest holders.  

Based on this projected cash flow stream and using a rough 10% discount rate, the described $9 billion of non-discounted excess interest spread over the next 23 years is likely worth $5 billion.  This estimation values the Sallie Mae's Residual Interests at about 4.15% of the loans.   

By the way, about 50% of this "excess spread income" comes in the next 6 years.  It is a front-loaded stream of cash flow and makes the discount rate a bit less important in the analysis.

Before using these two indications of value, as of the start of 2011 Sallie Mae will have a Residual Interest position on a block of approximately $180 billion of securitized trusts on their balance sheet.  This $180 billion includes the $28 billion from the Student Loan Corp. acquisition as well as the $24 billion in securitized private student loans on the books.  These two items help explain the difference from the $121 billion that Sallie Mae used in early July.

Using these two valuation yardsticks, I'd estimate that their Residual Interests are worth, before taxes, $7.5 billion to $9.5 billion.  After tax, assuming corporate tax rates, this equates to about $5 billion to $6 billion or $9.50 to $11.50 per share.

I must say that also tried to use a third valuation marker laid down by their recent portfolio purchase of Citi's Student Loan Corporation.  They paid $1.2 billion for both the servicing rights as well as the Residual Interest positions on the $28 billion securitized loan pool.  Obviously, they did purchase this at a discount but given that this acquisition included both the servicing rights as well as the Residual Interests, the price paid does not fully jive with our above 4-5% rule-of-thumb.   

Looking at this marker more closely, given that they will get about $125 million per year in servicing revenue to start, I estimate that the servicing contract value of this $28 billion acquisition is likely worth around $400-$500 million.  By default, this leaves about $700-$800 million attributable to the Residual Interest holdings.   I would expect that the Student Loan Corp. did sell at a discount of 10%-20%.  Excluding this this discount equates to a 3%-3.5% rather than 4%-5% metric.  

I fully admit that this is a worthy counter-point to my above valuation of the Residual Interest, but for whatever reasons (including possibly self-serving ones) Sallie Mae has expressly cautioned against using the Student Loan Corp. portfolio acquisition as a metric for valuing their own Residual Interest value.

Value of Floor Income:

Finally, at the Barclay's conference in September, CEO Albert Lord estimated that $2.5 billion of embedded Floor Income was expected to come in over the next 23 years.  This cash flow was in addition to the expected servicing and excess spread income depicted in their July disclosure posted on their website.  

Some of this Floor Income has already been economically hedged (and some of the hedged cash flows have been sold) while the remaining cash flow is still set to fluctuate as interest rates change in the future.  This is an inherently volatile set of cash flows.  As a rough estimate, this $2.5 billion in gross cash flow on a discounted basis is likely worth somewhere in the range of $2-$3 per share.  This is admittedly a guess and admittedly the weakest component of my valuation work..

Preferred Stock Outstanding:

Following the conversion of the still outstanding $810 million SLM Preferred C shares into 33 million more shares, Sallie Mae will still have about $565 million in outstanding preferred stock outstanding.  This is approximately $1.00 per share of equity that is owed to other than common stock holders and must be subtracted.

Total Estimated Value.

All told, Sallie Mae's five components of value; their "non-interest spread" businesses (servicing business + side businesses), their $11 billion unencumbered private student loan assets, their Residual Interests in their securitized trusts and the value of their expected ED-paid Floor Income totals approximately ($3.50-$5.00) + ($1.00-$2.00) + ($9.50-$11.50) + ($2-$3) per share - ($1.00)= $15-$20 per share.  

Sallie Mae certainly has enough negatives to go around as laid out at the beginning.  However, I would say the biggest negative at this point lies in the fact that there is no near-term catalyst to point to that would shock the market into recognizing the value in one fell swoop.  Nonetheless, with Sallie Mae's earnings guidance of $1.50 per share for 2011 and with the cost cutting underway in earnest, I believe that there is inherent value in Sallie Mae's common stock at $11.90 today.

None in the short-term.  Intermediate or longer-term, I feel a sizable dividend will be initiated or the outright sale of the company.