Description

Despite having more than doubled since a writeup last year (we owned it then too), SLM remains an extremely compelling investment at current levels.  Sallie Mae is a $5.5bn market cap leading provider of private student loans (PSLs) in the US with $5.7bn of annual loan originations. The company carries a dominant >50% share in US PSLs, a market that grows mid- to high-single digits annually and is occupied by relatively few players. The company’s unparalleled brand recognition and attractive channel dynamics within the PSL market drive 20%+ ROEs and close to 5% NIMs. Sallie Mae is well-capitalized and has a defensive loan portfolio that is 86% cosigned by parents and carries an average FICO of 749 at approval.

Despite these attractive characteristics, Sallie Mae trades at less than 6x 2021 EPS guidance. Investors have largely stood on the sidelines due to perceived political risk, concerns about increasing indirect competition from student loan refi players and late cycle / COVID-induced credit risk. While these concerns have mostly subsided over the past year, shares remain depressed and are backstopped by the significant asset value of the private student loan portfolio.

Investors have downside protection compared to broad-based bank indices with much lower ROEs. The company’s <6x 2021 EPS multiple compares to ~12x for the S&P Banks Index. Downside protection is further enhanced by historical whole loan sale transaction precedents, with recent private loan sale prices implying the value of the company’s loan portfolio at $16 per share and meaning that investors get the originations engine for only $2 per share.

A company with >50% share in a market growing MSD to HSD and similar returns on equity would easily trade at 20x+ earnings in this market. To take advantage of the large share price discount, the company is aggressively repurchasing its shares in the market and will repurchase 30%+ of the company in just two years by the end of 2021.

Business Description

Sallie Mae, based in Newark, DE, was originally formed almost 50 years ago as a GSE. The company came into its current form after being privatized and later separating from Navient Corporation (NAVI) in 2014. Sallie Mae kept the bank and the private student loan origination engine (including the brand) as part of the separation while Navient kept the vast majority of the FFELP and existing private loan portfolio, the federal servicing business, the outstanding debt and the litigation liabilities associated with the pre-spin servicing practices.

Since the spin, Sallie Mae has been re-building its balance sheet and now has $29bn of assets, including $20bn of loans, funded by $21bn of deposits, $5bn of debt, $2.1bn of common equity and $0.25bn of preferred stock. $19bn of the net loans are PSLs, but the company also holds $0.7bn of legacy FFELP loans. Management is testing credit card products in addition to student loans, but credit cards should remain a very small portion of the overall loan mix (only $11mm outstanding today).

The PSL loan portfolio is quite defensive because of its high cosign rate, high FICO score at approval and college educated borrower base. Normal net charge-offs are in the ~1.2% range.

The company has strong capitalization ratios with a CET1 Ratio of 13.7% and a Total Capital Ratio of 14.0%, implying that the company carries more than $800mm of excess capital on balance sheet above the buffer to regulatory requirements.

Sallie Mae’s loan portfolio has also shown extreme resilience throughout the COVID-19 pandemic, with net charge-offs flat at 1.2% from 2019 to 2020 and management expecting NCOs to increase to only 1.5% in 2021. Many borrowers were granted periods of disaster forbearance during early 2020 to ease the repayment burden during the height of the COVID-19 crisis which caused forbearance to peak in the mid-teens as a percentage of loans in repayment and forbearance. The company stopped providing disaster forbearance in June 2021, and forbearance (as well as delinquencies) are now at multi-year lows. Management has been consistently conservative on charge-offs throughout the pandemic, with 2021 charge-off guidance now at 1.5% after previous guidance of 2.5% after 2Q20 earnings, 2.3% after 3Q20 and 1.8% after 4Q20 and 1Q21. Part of the reason for the conservatism was to account for the expiration of the federal student loan moratorium on 9/30/21, but that moratorium has since been extended through the end of January 2022.

Market Overview

The private student loan market grew at a ~7% origination CAGR over the 5 school years from ‘14-’15 to ’19-‘20, supported by consistent increases in tuition, fees, room and board (TFRB) costs and annual enrollment growth at 4-year schools. TFRB grew at a 3.3% and 3.0% CAGR over the same period for private schools and public schools, respectively. While overall college enrollment is declining due to the declines in for-profit and 2-year institutions, enrollment at 4-year institutions (Sallie Mae’s core market) grew at +1.6% CAGR from 2014 to 2019. Demand for private student loans also tends to be countercyclical, with enrollment accelerations seen in the previous two economic downturns and state subsidies and family contributions typically declining in times of economic weakness. The strong PSL market growth trends should continue post-pandemic, driven by annual increases in the cost of staff and continued expansions in services provided to students.

Student loan underwriting is unique relative to other types of loans because lenders are essentially underwriting the credit quality of 18-year-olds who don’t start repaying the loans until after graduation. As a result, private student lenders typically require parents to cosign the loan so that they are also on the hook for repayment. These loans are originated primarily to fund education at 4-year institutions, are split about 50:50 between students at public and private schools and are issued to households with an average of ~$100k of family income.

PSLs are often mistakenly viewed as similar to federal student loans, but their origination and use is quite different. PSLs represent only 2% of overall spend on higher education annually and are used as “gap financing,” meaning that they are taken out to fund the remaining portion of college costs after parent and student funding, grants, scholarships and federal student loans are applied. Stafford Loans, the most common federal student loans, have an annual maximum that limits typical borrowing to $27,000 cumulatively over four years. After students have exhausted federal loan borrowing, they turn to private student lenders to cover the remaining cost.

Competitive Landscape

Sallie Mae owes its dominant >50% share position largely to its unrivaled brand, which is synonymous with student loans, and the attractive channel dynamics in the private student loan market. The company’s significant brand value and channel positioning is best illustrated by originating almost 3x the student loan volume of Discover, the next largest competitor, despite Discover sending almost 5x number of mailings.

Students and parents tend to wait until the last minute to figure out school funding, and parents are the ones who usually make the decision on which provider to use. Most borrowers only submit one loan application before deciding on a provider, further entrenching players with the strongest brands like Sallie Mae. Rather than being a price competitive process as one might expect, student loan borrowing decisions are typically made without significant comparison. Sallie Mae’s name still carries the trust of a government entity for many borrowers which also helps support the company’s disproportionate share.

Financial aid recommendations are still often made by college financial aid departments, and US schools generally keep a preferred lender list (“PLL”) which parents and students access when deciding on a student loan. Schools with PLLs undergo an RFP process every 2-3 years and decide which lenders to include based on reputation, experience, customer service, interest rates, terms and approval rates among other criteria. Financial aid officers are fairly risk averse and tend to shy away from adding lenders with unproven (think SoFi) or negative (think Navient) reputations in order to protect student borrowers. Any potential new entrants will struggle to penetrate the channel of financial aid offices, but with the largest sales force in the industry and decades of experience, Sallie Mae appears on 98% of PLLs.

An indirect competitive pressure that investors often flag is the risk of increasing prepayment speeds because of student loan refi players, mainly SoFi and Earnest (owned by Navient), refinancing the higher credit student loans into lower rates. The ideal loans for these players are from borrowers that carry large debt balances but have very low risk profiles, like loans held by a doctor with $200k of medical school debt. Smaller check size and higher risk undergraduate PSLs don’t generate the same ROI for the refi players, but these loans are still subject to consolidation. The headwind from this competitive product is likely to abate over time as competitors face a shrinking TAM and potentially compressing spreads if interest rates rise. While student loan refis are likely to continue to grow, Sallie Mae’s financial profile is relatively insensitive to changes in refi growth.

Wells Fargo Market Exit

In the wake of the pandemic, Wells Fargo, an originator of ~$1bn of private student loans annually, announced a plan to leave the PSL market completely at the end of the 2020-2021 school year. They later announced plans to sell their existing loan portfolio to Apollo and Blackstone which closed in the first half of 2021. We expect Sallie Mae to capture at least half of the Wells Fargo volume over time which would increase Sallie Mae’s origination volumes by 9% from 2020 levels.

Valuation and Potential Returns

Sallie Mae trades at just <6x 2021 guided EPS of $3.20 and ~7x our estimates of a more normalized 2022 EPS, a discount to the broader S&P Banks index which trades at 12x 2021 EPS. Sallie Mae’s ROEs, share position and sustained market growth likely justify at least a mid-teens P/E multiple which would imply a doubling in the company’s share price.

Given the implementation of CECL distorted bank provisioning and increased the volatility of GAAP earnings, we prefer to look at EPS by adding back provision expense and then netting out after-tax charge-offs to get to a “cash” EPS on which we value the company. We also view Sallie Mae’s EPS as two separate income streams: one EPS stream from the existing business and one from the recurring gains on sale of loans. If you believe that the loan sales are truly recurring, then you might value the gains at a similar multiple to the rest of the business. We take a slightly more conservative approach, valuing the gain on sale EPS at only 5x and the rest of the business at 15x. Looking out to YE 2024, this approach implies a valuation of 12.5x on 2025 “cash” EPS and implies a potential IRR of 37%.

As explained in further detail below, recent private market loan sales also add downside protection, with the existing book almost worth the entire stock price at current private market valuations.

Loan Sales and Capital Return

Although equity investors don’t seem to fully appreciate the value of Sallie Mae’s portfolio, private market credit investors have shown a willingness to pay significant premiums for a piece of the company’s loan book. After recognizing this disparity, management announced a substantial capital return program in 2020 in which they sold $3bn of loans to private market investors for an ~8% premium to face value. Sallie Mae used the capital generated from the gain on sale in combination with the release of the reserves held against the loan portfolio to fund a $525mm accelerated share repurchase, ultimately repurchasing 14% of shares outstanding in 2020 alone.

The recent loan sale activity, including the sale of Wells Fargo’s portfolio, brought a lot more buyers to the marketplace as private credit investors increasingly understood the product. The strong demand allowed management to continue to build on the loan sale and capital return strategy in 2021 by completing the sale of an additional $3.16bn of private student loans and recording a $399mm gain on sale at a 12.6% premium. That loan sale was 8x oversubscribed, and we expect the company to have no issues continuing the annual $3bn loan sale over the coming years to take advantage of the arbitrage opportunity.

The 2021 sale, in tandem with another $1bn coming in Q4, will fund a $1.25bn share repurchase in 2021. Close to $1bn of stock was repurchased in the first half of 2021 through the combination of a tender offer and a 10b5-1 program, and $295mm of capacity remains under the current authorization. If the remaining $295mm is repurchased at current prices, it would imply a share count reduction of 20% in 2021 (PF for the final 2020 ASR shares) on top of the 14% reduction in 2020.

Investors commonly ask why Sallie Mae doesn’t further accelerate the loan sale. Further demand exists in the credit markets, but the limiting factor is actually the time that it takes to return such significant amounts of capital to equity holders. Unused capital generated from loan sales that sits on the balance sheet creates a drag on both earnings and NIM, and the company is trying to balance timing of loan sales to avoid that issue.

The opportunity to own a company that will repurchase >30% of its common shares in two years is obviously quite rare, especially for a business that has >50%+ market share of a market growing MSD to HSD.

Further, the recent private market loan sales highlight the significant downside protection in the stock today. If the remaining loan portfolio were valued at a similar premium to the 2021 loan sale, the existing loan portfolio alone would be worth $16 per share, implying only $2 per share for Sallie Mae’s origination engine and preeminent brand.

Leadership

In early 2020, Sallie Mae announced that Ray Quinlan would step down and Jon Witter would take over as CEO. Jon most recently served as Chief Customer Officer of Hilton, but he has extensive experience in the banking industry having served as President of Retail and Direct Banking at Capital One, as COO of Morgan Stanley’s Retail Banking Group and as Head of General Bank Distribution at Wachovia. Jon has committed to focus on the core PSL business, manage expenses appropriately and maintain the loan sale and capital return strategy. Since joining, Jon divested the lower-quality personal loan portfolio in late 2020, reduced operating expenses by 8% when compared to 2019, accelerated the capital return program and led the company through the COVID-19 crisis with only a minimal increase in NCOs.

Risks

Key risks often highlighted by investors include potential regulatory changes to the US student loan market, competition from new entrants like SoFi and Navient and late cycle or COVID-induced credit risks.

The main potential political risk that investors focus on is the concept of “free college,” a misnomer that in practice would likely include means-tested free tuition at in-state public schools and would not include room and board which makes up ~50% of 4-year public school costs. The current administration seems to have no appetite for offering free four-year college, and the Build Back Better higher-ed reforms are currently focused on free community college, Pell Grant expansion and subsidized tuition for some students at HBCUs, none of which would materially impact Sallie Mae. Even if a free 4-year public college were to be implemented, the impact on Sallie Mae would be relatively minor. Half of Sallie Mae’s loan originations are to students at private schools who would not be eligible for the tuition-free benefit. Out of Sallie Mae’s student loans issued to students at public schools, more than half of the loan volumes are to students that are out-of-state and also likely would not be eligible. The remaining <25% of loan volumes would likely be subject to some sort of means test which would further

reduce the pool, and management has indicated that free tuition would only hurt originations by 10% after means testing. Since Sallie Mae earns revenues from the balance of its overall loan portfolio and not from originations, a reduction in originations does not necessarily even translate into a reduction in revenues for the company. Sallie Mae’s balance sheet is still small relative to the size of its origination pool, so the company would still have grown its private student loan balance by 10% in 2019 even if originations were 10% lower.

Investors were previously more focused on competition from SoFi and Navient, but neither company has made much progress in the in-school student loan market. Sallie Mae has actually gained market share since Navient’s non-compete expired at the end of 2018.

While credit risks are always a concern when investing in a bank late in an economic cycle, Sallie Mae’s strict underwriting standards and low NCOs provides credit downside protection as evidenced by performance through the COVID-19 crisis.

Catalyst

continued redeployment of excess capital