Description
CAUTION
Before explaining this idea, it is worth noting that SLM must raise a significant amount of cash - perhaps more than $1 billion - in the very near future. This will be dilutive and may be impossible. As a distressed financial with an opaque balance sheet and high leverage - SLM has a meaningful possibility of being pushed into bankruptcy. While I believe the risk-reward more than justifies its purchase at this price, that possibility should guide your position size. Risk-reward is good, but margin for error is non-existent.
THESIS
Sallie Mae is by far the dominant provider and servicer of student loans, both Federal guaranteed (FFELP) and private. The government recently has changed reimbursement levels so that the business is far less profitable for SLM. The change has also made it a money-loser for other competitors. The current stock price reflects all of the short-term negatives without any of the long-term advantages.
The stock Price = $20
- embedded value (net of debt) = $7
- FFELP business = $5
- other businesses, incl JPM deal = $1-2
- markdown on share sale liability=45m shares x($43-$20)=$1bn = -$2
So the residual price of the private loan business = less than $10 (less than 6x normal earnings)
At that price, the private loan business is undervalued:
- High secular growth
- Student loans are not dischargeable in bankruptcy, so better recovery in the long run
- SLM has significant competitive advantages
- Market is too small for major institution to build up capability
SLM has three key competitive advantages in private loan business:
- Customer acquisition cost. SLM dominates FFELP, which provides them relationships with millions of potential private loan borrowers. Other firms have to pay around $600 to acquire a private loan customer.
- Processing & servicing cost. With huge scale technology and processing centers, SLM seems to spend around $25/ year to service a loan, compared to almost $50 for medium-sized competitors and the Federal government.
- Underwriting cost. With a huge database of actual lending experience, SLM can more skillfully price the different charge-off odds of, say, a medical student at Virginia vs. a lawyer at Chicago.
The value of these three advantages in the private loan space alone seems to be around $500m of incremental profitability = $6 billion+
- 1 million loans
- $350 = Customer Acquisition Cost savings
- $100-150 = PV servicing savings of $25/year for 8 years
- $100-150 = underwriting advantage of $25/year for 8 yrs
- Multiple on this sustainable and growing piece business = 12x pre-tax = $6bn+
Additional free call options – potential upside
- As competitors leave the FFELP business, and SLM abandons selected schools, Congress may be forced to withdraw some of the harshest cuts
- SLM competitors will have to exit, raising SLM market share
- Potential company sale at revised price
- Under new program, consolidation loans don’t make sense any more, which means FFELP loans last longer and are worth more to the originator (SLM)
- As competitors leave, costs of winning business will come down (client service, Florida trips, sales coverage, etc). Current models use old high cost with new lower revenue – not consistent.
- Our model for private loan chargeoffs assume 4% ongoing rate – this in effect assumes the US enters recession and never comes out again. If macro situation is better than this then private loan business could be more profitable than modeled.
Risks/Where we could be wrong
- liquidity problems caused by forward sale contracts and/or bad mark-to-market on private loan portfolio
- private loan defaults higher than planned (though latest numbers show improvement). If the new chargeoff rate is 7%, for instance, SLM is bankrupt. This seems unlikely but the consequences would be fatal.
- government ends non-discharging of private student loans
- govt rules favor non-profit providers, though this is small and their inefficiency seems to overwhelm the advantage
Why the market seems mistaken right now
- selling from unwind of risk arbs - not fundamental
- emotional selling post a disastrous CEO conference call - no fundamental information
- confusion with mortgage business, which has value problems, not liquidity problems – big difference
- not accounting for the fact that declining profitability in FFELP leads to less competition and better entre for private loans – people are using static analysis; not dynamic
- focused on short-term dislocation rather than long-term competitive advantage
Catalyst
If Sallie Mae is able to find an injection of capital in the coming days (or weeks), fear should abate and fair value should re-emerge. If it is unable to do so, there is still a catalyst, like a bullet is a catalyst.