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September 19, 2016
We purchased SLM Corporation (“SLM”) this summer because it was trading at 10x 2017 estimated EPS and is growing its loan portfolio more than 20% annually. SLM is the renamed student loan company formerly known as Sallie Mae. The student loan industry has gone through significant changes over the last 10 years. The industry used to originate a mix of government guaranteed loans and private loans. In 2010, the government ended the program of third-party lenders making government guaranteed loans. Now, the government makes direct student loans for up to $31,000 per student for the four years of college. Student lenders, like SLM, provide private student loans for costs above $31,000.
In 2014, SLM split into two companies: SLM and Navient. SLM retained the student loan origination platform and the newly created banking operation. Navient took most of the existing portfolio of student loans and the student loan servicing and debt collection platforms. At the time of the spin-off, we thought SLM was interesting because it would grow very quickly and we thought the student loan origination platform was a valuable asset, but we didn’t buy the stock because it traded at 25x earnings and a portion of the earnings were gains from selling new loan originations.
After the 2014 separation between SLM and Navient, SLM owned a new banking subsidiary and retained the large, dominant student loan origination franchise. SLM’s economic model was earning revenues from two sources: the net interest spread on loans it retained and gain on sale income on excess loan originations it sold. The reason SLM sold any loans was due to restrictions regulators placed on the growth of SLM’s banking subsidiary. Regulators typically place additional growth and capital limits on new banks because these growth restrictions reduce risk. This is a reasonable regulatory practice because history has shown that new banks are more likely to have problems and/or fail. SLM originates $5 billion of new student loans per year, but their banking subsidiary was not allowed to grow at a rate that would absorb all of these originations, so it sold the loan originations that it could not retain into the capital markets. SLM’s student loans are very attractive to buyers because they have high credit quality, they are variable rate, and they have spreads between 4% and 8% above Libor. In 2014 and early 2015, buyers paid a 10% premium for SLM’s excess loan originations.
In 2015 and early 2016, SLM’s stock price declined due to a decline in earnings from selling new student loan originations. This stock decline was interesting to us because we had placed a low value on the income from selling loans. Midway through 2015, the buyers stopped paying 10% premiums for SLM’s loans and only offered 6% premiums. This lower price led to lower revenue and earnings for SLM. SLM’s management team didn’t like selling the loans in the first place, but they had to because of the growth limits. When the market lowered the premium they were willing to pay SLM, SLM management went to their banking regulator to ask for a growth waiver, so they could retain the loans. SLM’s regulator granted the growth waiver, so SLM’s management could stop selling loans entirely and retain the loans on SLM’s balance sheet. We think it is better for SLM to retain the loans, have higher-quality recurring earnings and a faster growth rate. SLM’s stock declined during this time because near-term earnings estimates declined as gain on sale revenue and income went away completely.
The two main risks to the SLM investment thesis are a potential change to how student loans are handled in bankruptcy cases and some unforeseen problem with SLM’s credit underwriting. Borrowers still have to pay their student debt even if they declare bankruptcy. Congress would have to pass a law to give borrowers relief in bankruptcy. We don’t think a change will happen in the medium-term, but we constantly worry about a possible change. We believe SLM’s underwriting is strong and has improved by using higher credit scores, having more loan co-signers, and focusing on schools with higher graduation rates. But, we can always get a credit surprise, so we monitor SLM’s credit metrics to see if we can detect any bad trends.
At recent prices, SLM trades at 10.9x 2017 estimated EPS and is growing >20%. We think other investors will recognize this as the company reports earnings over the next year. In addition, we believe SLM’s dominant 50% market share of private student loan originations is attractive to a major bank looking to grow their balance sheet.
Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.