NAVIENT CORP NAVI
September 26, 2014 - 3:44pm EST by
kaizen
2014 2015
Price: 17.30 EPS $0.00 $0.00
Shares Out. (in M): 419 P/E 0.0x 0.0x
Market Cap (in $M): 7,256 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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  • Student Loans
  • Discount to book
  • Financial services
  • Consumer Finance
  • High ROE
  • low-cost provider
  • Great management
  • Low CapEx
  • GARP

Description

Please see the following link for the original document, which contains a number of tables and charts (including valuation output in appendix): https://www.dropbox.com/s/sxjplck65eyqxkn/NAVI_VIC.pdf?dl=0

Thesis:

Navient Corp is a highly attractive investment opportunity, which is trading at a 50% - 70% discount to intrinsic value. With its recent spin-off from Sallie Mae on April 30, 2014, Navient has become the leading education loan management, servicing, and asset recovery company. We believe that Navient now will have the ability to position itself to originators as a partner rather than a competitor, and will therefore, as the lowest cost provider, be able to drive significant growth in its acquisition and servicing fee businesses. Our view is that Navient has a high quality asset base that provides significant downside protection in a runoff scenario, a number of meaningful growth opportunities, a low-cost, high-performance, scalable servicing platform, and a best-in-class management team that is not being appreciated by the market. The company is currently trading purely based on a runoff valuation. We believe that classic spin-off dynamics, complexity surrounding the situation, and the heavy stigma associated with the student loan market have created a highly attractive risk-adjusted opportunity.

 We see the thesis as follows:

1) High quality asset base that provides highly predictable cash flows in a runoff scenario

    • Largest holder of Federal Family Education Loan Program (FFELP) and Private Education student loans (PSLs) with $100bn and $32bn, respectively
    • FFELP portfolio is 97 - 98% government guaranteed, providing downside protection
    • PSL portfolio credit trends are improving, and PSLs are typically non-dischargeable in bankruptcy (64% of portfolio has a cosigner)
2) Scalable servicing and asset recovery platform that requires little capital and generates high ROEs
    • Lowest cost operator and best-in-class performance with ~30% lower defaults than competitors
    • In the event of a macroeconomic decline, an increase in third-party servicing revenues should offset declines in other parts of the business, providing a natural hedge in business model

3) Multiple channels available to drive profitable growth in portfolio acquisitions and fee based opportunities

    • Integrated servicing and asset recovery business give Navient a cost-advantage that it can leverage to acquire FFELP and PSL portfolios, driving significant incremental cash flow
    • $150bn of FFELP loans and $70bn of PSLs not owned or serviced by Navient
    • Numerous third-party servicing and asset recovery fee business opportunities

4) Best-in-class management team that is properly incentivized to create shareholder value

5) Valuation suggests robust margin of safety with an upside of 50% - 70%


Student Loan Industry Overview

The cost of university education in the U.S. has rapidly risen by more than 40% in the past decade and there is now over $1.2 trillion in outstanding student debt. In 2014-2015 alone, the total estimated cost of education is projected to amount to $405bn, which is expected to be filled by $107bn of federal loans, $119bn of grants, $8bn of private education loans, and $149bn from family contributions. A brief overview of the supply and demand dynamics will provide a backdrop for understanding longer-term trends in the industry.

Demand: Drivers for Student Aid

Demand for student aid will continue to rise steadily due to various secular trends:

1)  Continued College Enrollment: College enrollment has increased by 37% since 2000, and is projected to increase 10%+ over the next decade. We believe that the widening earnings gap of young adults by educational attainment will continue to drive college enrollment. In 2012, workers with bachelor’s degrees earned 163% of the average salary of workers with only a high-school education

2)  Rising Cost of Education: Due to significant public spending cuts for post-secondary education programs, tuition fees have greatly increased and are projected to continue to rise. Over the past decade, inflation-adjusted tuition fees have grown by 180% and 270% for private and public four-year colleges, respectively

3)  Low Savings Rates: U.S. savings rates have been consistently below world averages, resulting in higher demand for student aid in order to finance college fees. After the recession of 2008, many families have had to rely on external financial sources to fund post-secondary education

Supply: Sources of Financing

The primary sources of student aid can be bifurcated into federal and private student aid. Students and parents who wish to take advantage of any forms of federal student aid will first be assessed by the Department of Education (ED) which determines the applicant’s Expected Family Contribution (EFC). The school deducts the EFC from the Cost of Attendance – tuition, fees, books, etc. – and helps the student defray the difference by obtaining various forms of federal aid. Private education loans bridge the funding gap between the cost of a college education and funds available through ED programs, grants, and other sources.

Federal loans represent approximately 85% of total student debt outstanding (~$1 trillion), and private loans represent 15% (~$150bn). While federal student loan originations have continued to increase each year and are up ~50% since 2007, private loan originations peaked in 2008 at roughly $25bn and have since dropped sharply to just ~$7bn. The drop in PSL originations from their peak was largely due to an increase in federal student loan limits, an increase in federal grants, and tighter underwriting standards. We note that federal student loan originations were $103bn and PSL originations were $7bn in 2013, respectively.

 

Business Overview

The Student Loan Marketing Association (SLMA) was founded in 1972 as a government-sponsored enterprise, and was originally a secondary market that acquired student loans. In 2004, SLMA terminated its charter and completed its privatization as Sallie Mae. On April 30, 2014, Navient was spun out of Sallie Mae. Sallie Mae has retained the high-growth consumer banking business that is focused on originating private education loans, and Navient is now the leading education loan management, servicing, and asset recovery company.

Navient is comprised of three main business segments:

1)  FFELP Portfolio: Navient holds the largest portfolio of FFELP loans, largely through residual interests in securitizations (bankruptcy-remote trusts). FFELP Loans are insured by not-for-profit agencies and reinsured by the ED. Congress terminated the ability to make new FFELP loans in 2010, and therefore Navient’s FFELP portfolio is in runoff

2)  PSL Portfolio: Navient similarly holds the largest portfolio of PSLs. Private student loans are made to students to bridge the gap between the cost of higher education and the amount funded through financial aid, federal loans, or families’ resources. PSLs bear the full credit risk of the student and any cosigner. Although Navient does not originate PSLs, it will likely continue to acquire and service PSL portfolios

3)  Business Services: Navient provides servicing and asset recovery services for its own FFELP and PSL portfolio, as well as for those of banks, credit unions, guaranty agencies, ED, etc.

 

FFELP Industry Overview

The Federal Family Education Loan Program (FFELP) was enacted by the Higher Education Act of 1965, authorizing third-party originators to issue certain student loans that would be reinsured by the ED. In 1993, Congress created the Direct Student Loan Program (DSLP) which directly funded federal student loans by the U.S. Department of Treasury. This began a trend away from the FFELP to DSLP, which the government viewed as a more cost-effective means of providing federal student loans. In 2010, Congress terminated the authority to make new FFELP loans effective July 1, 2010. As a result, FFELP Loans are now in runoff.

The primary FFELP participants are:

1)  Borrowers: Eligible students borrowed under Stafford, Consolidation, or PLUS loans

2)  FFELP Lender: Banks, savings & loan associations, etc. originated FFELP loans. As previously mentioned, the ability to make new FFELP loans was terminated in 2010

3)  Guarantors: Not-for-profit agencies and states guarantee ~97% of principal and accrued interest on FFELP loans. Guarantor assumes ownership of loan after paying claim and pursues recoveries, of which they retain a percentage and reimburse ED for the remainder

4)  Department of Education (ED): Provides Special Allowance and Interest Subsidy Payments (will be explained in detail later) to the FFELP loan holder and also provide reinsurance to Guarantors


FFELP Business Overview

Navient is the largest holder, servicer, and collector of FFELP loans with a portfolio of ~$100bn as of June 30, 2014. In 2010, Congress passed legislation, the Health Care and Education Reconciliation Act of 2010, which ended the origination of FFELP loans but left the rights of existing FFELP loans unaffected. As a result, Navient’s FFELP portfolio and servicing revenues are now in runoff. Its FFELP portfolio will amortize over 20 years and 85% of the portfolio is funded to term with securitizations. Navient earns net interest income on its FFELP loan portfolio as well as servicing fees (primarily late fees). Overall, the economics of this business are highly attractive due to the steady cash flow and significant downside protection provided by: 1) the government guarantee and 2) the interest rate subsidy known as the Special Allowance Payment.

The FFELP portfolio is 97-98% insured and reinsured by guaranty agencies and the government, and therefore has an extremely low expected loss. For the recently issued Navient Student Loan Trust 2014-1 with 100% FFELP collateral, Moody’s expected the cumulative net loss to be 0.54%.

Below is an example that illustrates how to estimate the expected loss for the FFELP portfolio:

 

Navient’s historical rejection rates have been closer to the 0.06% - 0.10% range, implying that Moody’s is assuming a gross default rate of ~17.5% for the FFELP loans. While we believe that this gross default rate is likely too high, to be conservative we assume that the cumulative loss rate for the FFELP portfolio will be 0.54% (discussed in valuation section).

The government also provides an interest rate subsidy known as the Special Allowance Payment (SAP). Navient earns interest at the greater of the student borrower’s fixed rate or a floating rate based on the SAP. As a result, the ED pays Navient in the event that the floating SAP rate is above the fixed rate paid by the borrower, effectively providing downside protection in the form of a fixed spread that the company may earn. For loans disbursed prior to April 2006 (~49% of portfolio), Navient is able to retain the excess interest earned when the borrower rate exceeds the SAP rate (Floor Income). For loans disbursed after April 2006, Navient must rebate the Floor Income to the ED. Navient benefits when interest rates are low, since a majority of their debt is variable and is matched to the SAP rate (this is accounted for in the valuation section). The company has hedged 63% of its portfolio that is eligible to earn Floor Income through 2016. Below is an example of Floor Income:

 


FFELP Market Opportunity

With the end of new originations under the FFELP, numerous players have been exiting the market. Due to the sheer volume of FFELP Loans that Navient services, the company is well-positioned to acquire portfolios from owners of FFELP loans and servicing business from guarantors who no longer find it economical to maintain the increasingly high levels of compliance, servicing, and collections standards. We believe that Navient is uniquely positioned, as the lowest cost operator, to roll-up this declining industry, which should provide meaningful incremental cash flow (see valuation section). Navient acquired $1.3bn of FFELP loans in the first half of 2014.

There are currently ~$150bn of FFELP loans that are currently not owned or serviced by Navient. Below are tables of the top ten non-profit and for-profit holders of FFELP loans as of September 30, 2013:

 

We note that several players have publically expressed interest in exiting the FFELP market. Wells Fargo in 2Q14 moved $9.7bn of FFELP loans to held for sale. “We transferred this portfolio to held-for-sale at the end of the second quarter, reflecting our intent to sell our entire government-guaranteed portfolio” – Wells Fargo, 2Q14 Earnings Call. In addition, Fitch has discussed the “growing interest from banks to sell non-core assets, specifically government-guaranteed student loans…” Similarly, Navient has stated that this growing interest “is driven by the fact that it's a legacy asset, no new loans are being originated, [there are] higher capital requirements for banks and increasing regulatory issues.”

However, we do concede that Navient will likely face competition from Nelnet for some of these FFELP loans (accounted for in valuation section). In April 2014, CIT Group (Student Loan Express) sold its $3.6bn FFELP portfolio to Nelnet. Navient has stated that they were interested in the CIT portfolio, but they thought that the “prices were higher than we thought appropriate.” Management discusses their view on acquiring these FFELP portfolios as follows: “I mean we're buying, in effect, finite income-generating portfolios… we have a very disciplined approach to the return levels that we would like to see on those portfolios and would hold fast to that. We certainly don't need to acquire loans or portfolios to maintain our economies of scale in our servicing operations…” We view this as a positive as Navient is clearly disciplined in their capital allocation (discussed in more detail in Management Section).

Overall, we believe that due to the operating leverage inherent in this business, Navient will be able to add significant incremental cash flow through FFELP acquisitions.

 

PSL Industry Overview

As previously discussed, PSLs currently represent approximately 15% (~$150bn) of total student debt outstanding. Private loan originations peaked in 2008 at roughly $25bn and have since dropped sharply to just ~$7bn in 2013. The drop in PSL originations from their peak was largely due to an increase in federal student loan limits, an increase in federal grants, and tighter underwriting standards.

Many players have exited the PSL market since the government became much more active in making federal students loans through the Direct Student Loan program. For example, Bank of America exited in 2009, Citigroup sold its 80% stake in Student Loan Corporation in 2010 to Sallie Mae ($28bn of FFELP loans) and to Discover (PSL business), U.S. Bancorp terminated its PSL business in 2012 after 15 years, and J.P. Morgan exited in 2013.

There are currently only three main players operating in the PSL market: Sallie Mae (52% market share), Wells Fargo, and Discover. The reduced competition in the PSL market has allowed the remaining lenders to tighten underwriting criteria and maintain attractive interest rates. We also note that PSL credit trends are showing positive performance. For example, based on MeasureOne data, private student loans with serious delinquencies (90+ days past due) peaked in 2008 - 2009 and have steadily declined by 49% even as the percentage of loans in repayment has almost doubled. Moreover, MeasureOne estimates that as of Q3 2013, only 3.9% of PSLs were seriously delinquent, which further declined to 3.0% in Q3 2013. In addition, PSL originations are projected to CAGR at 5% over the next several years.

 

PSL Business Overview

Navient is the largest holder, servicer, and collector of PSLs with a portfolio of ~$30bn as of June 30, 2014. Although PSLs bear the full credit risk of the customer and any cosigner, our view is that this is a high-quality portfolio with improving credit trends and limited exposure to high-risk borrowers. This risk is also mitigated by the fact that higher education loans are typically non-dischargeable in bankruptcy.

The PSL portfolio has the following characteristics: average loan size of $10k, avg. FICO score of 718, and 64% cosigned. The % mix of elevated risk borrowers has declined from 15% of the portfolio in 2007 to 9% in 2013. The company defines elevated risk borrowers as: loans to (i) customers attending for-profit schools with FICO score of >670 and (ii) customers attending not for-profit schools with FICO score of <640. In addition, charge-offs across the board have substantially declined since 2009. These improving credit trends are illustrated in the graphs below:

             

Furthermore, a majority of defaults on PSLs occur in the first 12 payments. Navient possesses a seasoned portfolio which is important, as the probability of default significantly declines as the number of payments increases.

 

For the recently issued Navient Student Loan Trust 2014-CT with 100% PSL collateral, Moody’s expected the cumulative net loss to be 8.5%. For the SLM Private Education Loan Trust 2014-A, Moody’s expected the cumulative net loss to be 12%. To be conservative, we assume that the cumulative loss rate for the PSL portfolio will be 12% (discussed in valuation section).

 

PSL Market Opportunity

We believe that there are two major sources of value in PSLs that Navient can capture: 1) Acquisitions of legacy PSL portfolios and 2) Acquisitions of new PSL originations (primarily from Sallie Mae).

There are currently $70bn of existing, legacy PSLs that are not owned or serviced by Navient. As previously discussed, many of these lenders are no longer originating and have legacy portfolios that they are not servicing. Similar to the FFELP industry, Navient should be able to leverage its low-cost position to roll these portfolios up, which would add substantial incremental cash flows.

In addition, there is a very sizable opportunity for Navient to acquire new PSL originations. Sallie Mae is currently targeting originations of $4bn+ a year. We believe that Navient will purchase a sizable portion of Sallie Mae’s annual originations. The company has stated that that they “hope to buy all of them…not just a good portion of them.” Similarly, Sallie Mae has said that they “expect Navient to be not only a significant buyer but a natural buyer because of a, their experience with the assets; b, their capital structure; and c, their servicing.” In fact, Sallie Mae entered into a definitive agreement on August 8, 2014 to sell $820mm of high-quality Smart Option Student Loans to Navient. We note that Sallie Mae provides life of loan unit economics based on their current business plan:

The projected unit economics for these loans seem markedly improved from the historical performance of Sallie Mae’s private education lending segment. While Sallie Mae very well may be able to execute on this business plan with a NIM of 6.3% and an annual loan loss rate of 1.0%, we assume much more conservative assumptions in the valuation section with a NIM of 5.0% and an annual loan loss rate of ~1.8% (12% cohort default rate).

Navient has stated that they have already acquired $1.6bn in PSLs so far in 2014. We believe that the company will continue to acquire PSL portfolios and newly originated PSLs, which should add significant incremental cash flow.

 

Business Services Overview

Navient is the largest education loan servicer, and currently services over 12mm customers and nearly $300bn of education loans. The company services its own portfolio of education loans, as well as those owned by banks, credit unions and non-profit education lenders. In addition, Navient provides servicing and asset recovery services to guaranty agencies and the ED. These services include account maintenance, default aversion, and asset recovery.  Navient is currently one of four large servicers to the ED under its Direct Student Loan Program and currently services ~5.8mm borrowers under this contract. The company also provides asset recovery services on a contingent basis to other asset classes (~20% of receivables), including government receivables, taxes, court/municipal, and school receivables.

Approximately 60% of the revenues generated by this segment are associated with FFELP loans (excluding intercompany servicing revenues), and will therefore also be in run-off. However, we believe that there is tremendous value in Navient’s scalable servicing and asset recovery platform, and that the company will be able to leverage this platform to drive profitable growth in portfolio acquisitions and fee based opportunities (see market opportunities sections). Not only is Navient the lowest cost operator, it also has best-in-class performance with ~30% lower defaults than competitors. In the most recent quarter, Navient’s ED serviced portfolio default rate continued to lead all 4 servicers, with the next-best default rate 50% higher. Although FFELP loans have been in run-off, the company has been able to service increasingly large volumes (see graph below).

 

Business Services Market Opportunity

Navient’s servicing and asset recovery platform gives the company the flexibility to acquire portfolios or service on a third-party basis. As discussed earlier, Navient’s integrated servicing and asset recovery business gives the company a cost-advantage that it can leverage to acquire FFELP and PSL portfolios, driving significant incremental cash flow. In addition, Navient has meaningful growth opportunities in its third-party servicing and asset recovery fee business. The company has discussed that there is a $200mm/year servicing opportunity with schools, a $308mm/year asset recovery business opportunity with states, courts and municipalities, as well as more than $500bn of outstanding non-ED government receivables that Navient could expand into. Finally, we note that Navient currently only has ~15% market share of the $1.5bn annual ED contracts for loan servicing, collecting, and originations. As the lowest-cost, best performing operator, we believe that Navient will be able to increase its share.  

 

Management

Our view is that management of Navient is fantastic. We note that it is interesting that the majority of Sallie Mae’s previous senior management team has moved on to the spin-off instead of remaining at the parent company (the high-growth consumer banking business). In addition, ~70% of senior management’s pay is variable and ~70% of their pay is stock-based. This gives us further conviction that Navient will not simply run-off, and that management has bigger plans for the company. It is evident that senior management is focused on returns on invested capital and that they are intelligent allocators of capital. Management discusses how Navient is “generating a substantial amount of capital through earnings each year... and how [they] deploy that is a function of opportunities in the space to acquire loan portfolios or build businesses. And if those opportunities are less attractive than returning it to shareholders, then the dollars go to shareholders.”

Also, because Navient is extremely levered, refinancings would create substantial equity value. Management clearly understands this and has been aggressively pursuing capital market transactions. In 2014 alone, management has:

1)  Issued $2.7bn of FFELP ABS and closed on an $8bn FFELP ABCP Facility

2)  Refinanced $1.1bn FFELP reset notes to term

3)  Issued $1.1bn of PSL ABS and closed on a $1bn PSL ABCEP Facility

4)  Issued 10-year 6.125% $850mm unsecured debt

5)  Returned $392mm to shareholders through share repurchases and dividends

Overall, we believe that this is a best-in-class management team that will create substantial shareholder value.

 

Valuation

Our overall methodology for valuing Navient involved projecting the business in runoff, and then layering on additional sources of value from profitable growth opportunities, resulting in a sum-of-the-parts buildup. We note that we used 430mm shares outstanding to be conservative, although the number of shares outstanding is currently at 419.4mm. We began with a very conservative bear case of $12.77, which assumes that the portfolio simply runs off and that management does not refinance any of the debt. Next, we layer on the value creation from refinancing the $17.5bn of unsecured debt, such that the maturities of the unsecured debt match those of the underlying FFELP and PSL portfolio in runoff. This gives us our base runoff case valuation of $16.23, which we view as the true downside case.

To arrive at our base case valuation of $27.80, we layer on the value creation from growth opportunities such as FFELP acquisitions, PSL portfolio acquisitions, and acquisitions of newly originated PSLs (at conservative economics). Finally, we incorporate the potential upside from acquisitions of newly originated PSLs at Sallie Mae’s projected unit economics, incremental earnings from fee-based opportunities in Business Services, and further value creation from refinancings. This gives us our bull case of $40.86.

The summary of our valuation is below (valuation output in appendix):

 

Bear Runoff Case

In our Bear Runoff Case, we projected the four business segments in runoff: FFELP Loans, PSLs, Business Services, and Other (e.g. corporate overhead). Management provides projected FFELP loan balances in a runoff scenario over 20 years, which we use as the foundation for how the entire business will run off. We attempted to model this in a manner that was as close as possible to economic reality, and we therefore focused on levered cash flows to equity.

For the FFELP loans segment, we projected Net Interest Margin for FFELP Interest-Earnings Assets (includes some restricted cash in trusts) to decline from 0.88% to 0.65%. We note that this is a very conservative assumption as historically NIMs have consistently been in the 0.80% to 1.0% range over the last few years. However, we made this assumption to account for the potential loss of Floor Income as Navient’s hedges roll-off and interest rates potentially increase. The second main source of revenue for the FFELP loans segment is service revenues (primarily late fees), which we estimated to be roughly 0.06% of the outstanding loan balance. In addition, in an attempt to match economic reality, we focused on future charge-offs instead of GAAP accounting-based allowances for loan losses. Therefore, we unwound any existing allowances and instead projected charge-offs based on a 0.54% life of loan loss rate as per Moody’s research. As discussed in the FFELP loan section, this is a conservative estimate and that the real life of loan loss rate is likely closer to 0.35%. Finally, we estimated a servicing cost of 0.12% of the average outstanding loan balance, which we boxed in using historical data from Sallie Mae and Nelnet. Overall, we arrived at an estimated per share value of $4.31 for the FFELP loans segment.

As previously discussed, we projected the PSL portfolio to runoff in a similar manner to that of the FFELP portfolio. For the PSL segment, we projected NIMs of 4.0% which are in line with the historical range of 3.9% to 4.2%. We also projected a life of loan loss rate of 12.0% (annual charge-offs of ~1.8%). We estimated late fees at 0.08% of the outstanding balance and servicing expenses at 0.4% of the balance. All in all, we arrived at an estimated per share value of $3.60 for the PSL segment.

For the Business Services segment, we projected the FFELP-related revenues to decline in a manner similar to that of the FFELP loan portfolio. These FFELP-related revenues (excluding intercompany servicing revenues) comprised 58% of total Business Services revenues. We projected Other Servicing & Collections Revenues to grow at 2% or roughly in line with inflation. Based on these assumptions, we arrived at an estimated per share value of $4.45 for the Business Services segment.

The Other segment primarily consists of activities of the holding company, including corporate overhead. We again projected this segment to runoff in a manner similar to that of the FFELP loan portfolio. In addition, we modeled the runoff of the entire book of $6.0bn ($4.0bn including allowances for loan losses) under the Other segment. While Navient currently has $6.0bn in book value, we make the conservative assumption that most of this value needs to remain in place and that the book will amortize over time. This amortization consists of FFELP loans, PSLs, and excess other assets, which are cash inflows. Furthermore, the runoff includes the amortization of FFELP securitized debt, PSL securitized debt, unsecured debt, and excess other liabilities, which are cash outflows. Overall, we arrived at an estimated per share value of $0.42 for the Other segment.

Overall, our estimated per share valuation for the Bear Runoff Case was $12.77, or 26% downside to the current share price of $17.30.

 

Base Runoff Case

In our Base Runoff Case, we add in the incremental value from our Base Case Refinancing. We assume that management will be able to refinance the $17.5bn of unsecured debt, such that the maturities of the debt match those of the underlying FFELP and PSL portfolio in runoff. As previously mentioned, management has aggressively been pursuing capital markets transactions. For example, management recently issued $850mm of unsecured debt with a 2024 maturity and a 6.125% interest rate. As a result, we believe that this base runoff case is very reasonable. We estimated a per share valuation of $16.23 for the Base Runoff Case, which equates to 6% downside to the current share price of $17.30.

 

Base Case

To arrive at our base case valuation of $27.68, we layer on the value creation from growth opportunities such as FFELP acquisitions, PSL portfolio acquisitions, and acquisitions of newly originated PSLs (at conservative economics).

We estimated the incremental value from FFELP acquisitions based on a PV of the earnings stream, which we estimated to be worth ~$0.06 per share for $1bn of FFELP loans. However, we note that Navient would likely have to give up some of the economics when acquiring FFELP loan portfolios. To estimate the net value that Navient could receive from FFELP acquisitions, we analyzed how much Nelnet paid for CIT’s $3.6bn FFELP portfolio. Based on the Loan Sale Agreement, Nelnet paid ~$0.03 per share for every $1bn of FFELP loans. As a result, we believe that every $1bn of FFELP loans will be worth about $0.03 to Navient. There are currently $150bn of FFELP loans that Navient does not own or service, and we believe that Navient can acquire roughly $50bn of these loans. This gives us an estimated per share value of $1.50.

Similarly, we estimated the incremental value from PSL acquisitions based on a PV of the earnings stream, which we estimated to be worth ~$0.21 per share for $1bn of FFELP loans. We again assume that Navient will have to give up some of the economics, and arrive at a net value of $0.15 per share that Navient could receive from PSL acquisitions. There are currently $70bn of PSLs that Navient does not own or service, and we believe that Navient can acquire roughly $25bn of these loans. This gives us an estimated per share value of $3.75.

Finally, we incorporated the incremental value from acquisitions of newly originated PSLs. Sallie Mae is targeting $4bn+ originations per year and we believe that Navient will acquire a sizable portion of these loans ($3bn/year). As previously mentioned, Navient already entered into a definitive agreement on August 8, 2014 to sell $820mm of high-quality Smart Option Student Loans to Navient. While Sallie Mae projects NIMs of 6.3% and a life of loan loss rate of 7.0%, for our base case we assume much more conservative unit economics with NIMs of 5.0% and a life of loan loss rate of 12.0%. These loans will have a 7 year life and therefore we believe that this segment will reach steady-state by 2021. We estimate this segment to be worth $6.32 per share.

Our estimated per share valuation for the Base Case was $27.80, or 61% upside to a current share price of $17.30.

 

Bull Case  

In our Bull Case, we add in the incremental value from acquisitions of PSLs with Sallie Mae’s projected economics, increased earnings in the Business Services segment, and further refinancings. We estimated that Navient could capture an additional $4.73 per share of value, if the PSLs that Navient acquires from Sallie Mae are able to sustain Sallie Mae’s projected economics. Furthermore, we evaluated potential upside from increased Business Services earnings. As previously discussed, there are numerous channels for Navient to drive profitable growth in fee based opportunities. We estimate that Navient will be able to drive incremental normalized revenues of $500mm, which at a 60% margin and 38% tax rate would equate to $186mm of incremental earnings. At a conservative 10x multiple, this segment would add per share value of $4.33. Finally, we estimate that Navient could create $4.00 per share of value from further refinancings. Navient is extremely levered with substantial securitized and unsecured debt, and any refinancings that management pursues could create substantial equity value. Overall, we estimated a per share valuation of $40.86 for the Bull Case, which equates to 136% upside to the current share price of $17.30.

 

Management Case (Sanity Check)

Management provides guidance for estimated future cash flows before unsecured debt from their education loan portfolio. They believe that the portfolio will generate $36.5bn of highly predictable cash flows over 20 years, including ~$11bn of overcollateralization that will be released over time from residuals. There is currently $17.5bn of unsecured debt. As a sanity check, we can discount over 20 years the excess cash flow remaining after paying down unsecured debt ($36.5bn - $17.5bn = $19bn). If we discount $19bn over 20 years for annual cash flow of $950mm at a 12% discount rate, we arrive at a valuation per share of $16.50. At a 10% discount rate, we estimate a per share valuation of $18.81. Either way, this gives us further conviction that Navient is currently trading roughly in line with its runoff valuation.

 

Risks

The main risk to the thesis stems from regulatory risk.

1)  Consumer Financial Protection Bureau (CFPB): Navient is subject to CFPB enforcement and examination authority. The CFPB is currently evaluating changes to regulations that govern the private student loan market. Proposed measures in the Student Loan Forgiveness Act include capping interest rates and allowing for private student loans to be discharged in bankruptcy. In addition, the CFPB may directly or indirectly impose monetary penalties for violations of applicable federal consumer financial laws. For example, Navient was fined ~$100mm by the FDIC and DOJ earlier this year for failing to provide military personnel with required benefits pursuant to the Servicemembers Civil Relief Act

    • Mitigant: Though loudly publicized, we believe that the proposed legislation is largely infeasible and would likely result in the remaining private lenders to exit the market. This would lead to liquidity problems and a worsening of the current funding shortfall. We note that the PSL market is an important source of education financing. In addition, moving forward the FDIC will not regulate Navient (but will continue to regulate Sallie Mae). Most importantly, we believe that some of the regulatory risk is mitigated by the fact that Navient has very strong ties to Sallie Mae and the government. For example, following the $100mm fine, the ED still renewed its contract with Navient. The ED stated that there would be a large “potential ‘dislocation’ [that] borrowers would face if the department had to transfer loans from its servicers to a new batch of companies.” This seems to illustrate that Navient has captive customers    

2) Reduction in FFELP Portfolio Economics: Congress could potentially enact legislation that could reduce Navient’s CFs from servicing and/or interest income. For example, the Bipartisan Budget Act enacted on December 26, 2013 reduced the amount paid to guaranty agencies for defaulted FFELP Loans, which in turn is expected to reduce Navient’s FFELP guaranty fee income by $60mm in 2014

    • Mitigant: Uncertainty is part of the reason why this opportunity exists, and we believe that Navient provides a robust margin of safety

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

 Navient successfully pursues any of the growth opportunities listed in the write-up which forces a re-rating of the stock.
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    Description

    Please see the following link for the original document, which contains a number of tables and charts (including valuation output in appendix): https://www.dropbox.com/s/sxjplck65eyqxkn/NAVI_VIC.pdf?dl=0

    Thesis:

    Navient Corp is a highly attractive investment opportunity, which is trading at a 50% - 70% discount to intrinsic value. With its recent spin-off from Sallie Mae on April 30, 2014, Navient has become the leading education loan management, servicing, and asset recovery company. We believe that Navient now will have the ability to position itself to originators as a partner rather than a competitor, and will therefore, as the lowest cost provider, be able to drive significant growth in its acquisition and servicing fee businesses. Our view is that Navient has a high quality asset base that provides significant downside protection in a runoff scenario, a number of meaningful growth opportunities, a low-cost, high-performance, scalable servicing platform, and a best-in-class management team that is not being appreciated by the market. The company is currently trading purely based on a runoff valuation. We believe that classic spin-off dynamics, complexity surrounding the situation, and the heavy stigma associated with the student loan market have created a highly attractive risk-adjusted opportunity.

     We see the thesis as follows:

    1) High quality asset base that provides highly predictable cash flows in a runoff scenario

      • Largest holder of Federal Family Education Loan Program (FFELP) and Private Education student loans (PSLs) with $100bn and $32bn, respectively
      • FFELP portfolio is 97 - 98% government guaranteed, providing downside protection
      • PSL portfolio credit trends are improving, and PSLs are typically non-dischargeable in bankruptcy (64% of portfolio has a cosigner)
    2) Scalable servicing and asset recovery platform that requires little capital and generates high ROEs
      • Lowest cost operator and best-in-class performance with ~30% lower defaults than competitors
      • In the event of a macroeconomic decline, an increase in third-party servicing revenues should offset declines in other parts of the business, providing a natural hedge in business model

    3) Multiple channels available to drive profitable growth in portfolio acquisitions and fee based opportunities

    4) Best-in-class management team that is properly incentivized to create shareholder value

    5) Valuation suggests robust margin of safety with an upside of 50% - 70%


    Student Loan Industry Overview

    The cost of university education in the U.S. has rapidly risen by more than 40% in the past decade and there is now over $1.2 trillion in outstanding student debt. In 2014-2015 alone, the total estimated cost of education is projected to amount to $405bn, which is expected to be filled by $107bn of federal loans, $119bn of grants, $8bn of private education loans, and $149bn from family contributions. A brief overview of the supply and demand dynamics will provide a backdrop for understanding longer-term trends in the industry.

    Demand: Drivers for Student Aid

    Demand for student aid will continue to rise steadily due to various secular trends:

    1)  Continued College Enrollment: College enrollment has increased by 37% since 2000, and is projected to increase 10%+ over the next decade. We believe that the widening earnings gap of young adults by educational attainment will continue to drive college enrollment. In 2012, workers with bachelor’s degrees earned 163% of the average salary of workers with only a high-school education

    2)  Rising Cost of Education: Due to significant public spending cuts for post-secondary education programs, tuition fees have greatly increased and are projected to continue to rise. Over the past decade, inflation-adjusted tuition fees have grown by 180% and 270% for private and public four-year colleges, respectively

    3)  Low Savings Rates: U.S. savings rates have been consistently below world averages, resulting in higher demand for student aid in order to finance college fees. After the recession of 2008, many families have had to rely on external financial sources to fund post-secondary education

    Supply: Sources of Financing

    The primary sources of student aid can be bifurcated into federal and private student aid. Students and parents who wish to take advantage of any forms of federal student aid will first be assessed by the Department of Education (ED) which determines the applicant’s Expected Family Contribution (EFC). The school deducts the EFC from the Cost of Attendance – tuition, fees, books, etc. – and helps the student defray the difference by obtaining various forms of federal aid. Private education loans bridge the funding gap between the cost of a college education and funds available through ED programs, grants, and other sources.

    Federal loans represent approximately 85% of total student debt outstanding (~$1 trillion), and private loans represent 15% (~$150bn). While federal student loan originations have continued to increase each year and are up ~50% since 2007, private loan originations peaked in 2008 at roughly $25bn and have since dropped sharply to just ~$7bn. The drop in PSL originations from their peak was largely due to an increase in federal student loan limits, an increase in federal grants, and tighter underwriting standards. We note that federal student loan originations were $103bn and PSL originations were $7bn in 2013, respectively.

     

    Business Overview

    The Student Loan Marketing Association (SLMA) was founded in 1972 as a government-sponsored enterprise, and was originally a secondary market that acquired student loans. In 2004, SLMA terminated its charter and completed its privatization as Sallie Mae. On April 30, 2014, Navient was spun out of Sallie Mae. Sallie Mae has retained the high-growth consumer banking business that is focused on originating private education loans, and Navient is now the leading education loan management, servicing, and asset recovery company.

    Navient is comprised of three main business segments:

    1)  FFELP Portfolio: Navient holds the largest portfolio of FFELP loans, largely through residual interests in securitizations (bankruptcy-remote trusts). FFELP Loans are insured by not-for-profit agencies and reinsured by the ED. Congress terminated the ability to make new FFELP loans in 2010, and therefore Navient’s FFELP portfolio is in runoff

    2)  PSL Portfolio: Navient similarly holds the largest portfolio of PSLs. Private student loans are made to students to bridge the gap between the cost of higher education and the amount funded through financial aid, federal loans, or families’ resources. PSLs bear the full credit risk of the student and any cosigner. Although Navient does not originate PSLs, it will likely continue to acquire and service PSL portfolios

    3)  Business Services: Navient provides servicing and asset recovery services for its own FFELP and PSL portfolio, as well as for those of banks, credit unions, guaranty agencies, ED, etc.

     

    FFELP Industry Overview

    The Federal Family Education Loan Program (FFELP) was enacted by the Higher Education Act of 1965, authorizing third-party originators to issue certain student loans that would be reinsured by the ED. In 1993, Congress created the Direct Student Loan Program (DSLP) which directly funded federal student loans by the U.S. Department of Treasury. This began a trend away from the FFELP to DSLP, which the government viewed as a more cost-effective means of providing federal student loans. In 2010, Congress terminated the authority to make new FFELP loans effective July 1, 2010. As a result, FFELP Loans are now in runoff.

    The primary FFELP participants are:

    1)  Borrowers: Eligible students borrowed under Stafford, Consolidation, or PLUS loans

    2)  FFELP Lender: Banks, savings & loan associations, etc. originated FFELP loans. As previously mentioned, the ability to make new FFELP loans was terminated in 2010

    3)  Guarantors: Not-for-profit agencies and states guarantee ~97% of principal and accrued interest on FFELP loans. Guarantor assumes ownership of loan after paying claim and pursues recoveries, of which they retain a percentage and reimburse ED for the remainder

    4)  Department of Education (ED): Provides Special Allowance and Interest Subsidy Payments (will be explained in detail later) to the FFELP loan holder and also provide reinsurance to Guarantors


    FFELP Business Overview

    Navient is the largest holder, servicer, and collector of FFELP loans with a portfolio of ~$100bn as of June 30, 2014. In 2010, Congress passed legislation, the Health Care and Education Reconciliation Act of 2010, which ended the origination of FFELP loans but left the rights of existing FFELP loans unaffected. As a result, Navient’s FFELP portfolio and servicing revenues are now in runoff. Its FFELP portfolio will amortize over 20 years and 85% of the portfolio is funded to term with securitizations. Navient earns net interest income on its FFELP loan portfolio as well as servicing fees (primarily late fees). Overall, the economics of this business are highly attractive due to the steady cash flow and significant downside protection provided by: 1) the government guarantee and 2) the interest rate subsidy known as the Special Allowance Payment.

    The FFELP portfolio is 97-98% insured and reinsured by guaranty agencies and the government, and therefore has an extremely low expected loss. For the recently issued Navient Student Loan Trust 2014-1 with 100% FFELP collateral, Moody’s expected the cumulative net loss to be 0.54%.

    Below is an example that illustrates how to estimate the expected loss for the FFELP portfolio:

     

    Navient’s historical rejection rates have been closer to the 0.06% - 0.10% range, implying that Moody’s is assuming a gross default rate of ~17.5% for the FFELP loans. While we believe that this gross default rate is likely too high, to be conservative we assume that the cumulative loss rate for the FFELP portfolio will be 0.54% (discussed in valuation section).

    The government also provides an interest rate subsidy known as the Special Allowance Payment (SAP). Navient earns interest at the greater of the student borrower’s fixed rate or a floating rate based on the SAP. As a result, the ED pays Navient in the event that the floating SAP rate is above the fixed rate paid by the borrower, effectively providing downside protection in the form of a fixed spread that the company may earn. For loans disbursed prior to April 2006 (~49% of portfolio), Navient is able to retain the excess interest earned when the borrower rate exceeds the SAP rate (Floor Income). For loans disbursed after April 2006, Navient must rebate the Floor Income to the ED. Navient benefits when interest rates are low, since a majority of their debt is variable and is matched to the SAP rate (this is accounted for in the valuation section). The company has hedged 63% of its portfolio that is eligible to earn Floor Income through 2016. Below is an example of Floor Income:

     


    FFELP Market Opportunity

    With the end of new originations under the FFELP, numerous players have been exiting the market. Due to the sheer volume of FFELP Loans that Navient services, the company is well-positioned to acquire portfolios from owners of FFELP loans and servicing business from guarantors who no longer find it economical to maintain the increasingly high levels of compliance, servicing, and collections standards. We believe that Navient is uniquely positioned, as the lowest cost operator, to roll-up this declining industry, which should provide meaningful incremental cash flow (see valuation section). Navient acquired $1.3bn of FFELP loans in the first half of 2014.

    There are currently ~$150bn of FFELP loans that are currently not owned or serviced by Navient. Below are tables of the top ten non-profit and for-profit holders of FFELP loans as of September 30, 2013:

     

    We note that several players have publically expressed interest in exiting the FFELP market. Wells Fargo in 2Q14 moved $9.7bn of FFELP loans to held for sale. “We transferred this portfolio to held-for-sale at the end of the second quarter, reflecting our intent to sell our entire government-guaranteed portfolio” – Wells Fargo, 2Q14 Earnings Call. In addition, Fitch has discussed the “growing interest from banks to sell non-core assets, specifically government-guaranteed student loans…” Similarly, Navient has stated that this growing interest “is driven by the fact that it's a legacy asset, no new loans are being originated, [there are] higher capital requirements for banks and increasing regulatory issues.”

    However, we do concede that Navient will likely face competition from Nelnet for some of these FFELP loans (accounted for in valuation section). In April 2014, CIT Group (Student Loan Express) sold its $3.6bn FFELP portfolio to Nelnet. Navient has stated that they were interested in the CIT portfolio, but they thought that the “prices were higher than we thought appropriate.” Management discusses their view on acquiring these FFELP portfolios as follows: “I mean we're buying, in effect, finite income-generating portfolios… we have a very disciplined approach to the return levels that we would like to see on those portfolios and would hold fast to that. We certainly don't need to acquire loans or portfolios to maintain our economies of scale in our servicing operations…” We view this as a positive as Navient is clearly disciplined in their capital allocation (discussed in more detail in Management Section).

    Overall, we believe that due to the operating leverage inherent in this business, Navient will be able to add significant incremental cash flow through FFELP acquisitions.

     

    PSL Industry Overview

    As previously discussed, PSLs currently represent approximately 15% (~$150bn) of total student debt outstanding. Private loan originations peaked in 2008 at roughly $25bn and have since dropped sharply to just ~$7bn in 2013. The drop in PSL originations from their peak was largely due to an increase in federal student loan limits, an increase in federal grants, and tighter underwriting standards.

    Many players have exited the PSL market since the government became much more active in making federal students loans through the Direct Student Loan program. For example, Bank of America exited in 2009, Citigroup sold its 80% stake in Student Loan Corporation in 2010 to Sallie Mae ($28bn of FFELP loans) and to Discover (PSL business), U.S. Bancorp terminated its PSL business in 2012 after 15 years, and J.P. Morgan exited in 2013.

    There are currently only three main players operating in the PSL market: Sallie Mae (52% market share), Wells Fargo, and Discover. The reduced competition in the PSL market has allowed the remaining lenders to tighten underwriting criteria and maintain attractive interest rates. We also note that PSL credit trends are showing positive performance. For example, based on MeasureOne data, private student loans with serious delinquencies (90+ days past due) peaked in 2008 - 2009 and have steadily declined by 49% even as the percentage of loans in repayment has almost doubled. Moreover, MeasureOne estimates that as of Q3 2013, only 3.9% of PSLs were seriously delinquent, which further declined to 3.0% in Q3 2013. In addition, PSL originations are projected to CAGR at 5% over the next several years.

     

    PSL Business Overview

    Navient is the largest holder, servicer, and collector of PSLs with a portfolio of ~$30bn as of June 30, 2014. Although PSLs bear the full credit risk of the customer and any cosigner, our view is that this is a high-quality portfolio with improving credit trends and limited exposure to high-risk borrowers. This risk is also mitigated by the fact that higher education loans are typically non-dischargeable in bankruptcy.

    The PSL portfolio has the following characteristics: average loan size of $10k, avg. FICO score of 718, and 64% cosigned. The % mix of elevated risk borrowers has declined from 15% of the portfolio in 2007 to 9% in 2013. The company defines elevated risk borrowers as: loans to (i) customers attending for-profit schools with FICO score of >670 and (ii) customers attending not for-profit schools with FICO score of <640. In addition, charge-offs across the board have substantially declined since 2009. These improving credit trends are illustrated in the graphs below:

                 

    Furthermore, a majority of defaults on PSLs occur in the first 12 payments. Navient possesses a seasoned portfolio which is important, as the probability of default significantly declines as the number of payments increases.

     

    For the recently issued Navient Student Loan Trust 2014-CT with 100% PSL collateral, Moody’s expected the cumulative net loss to be 8.5%. For the SLM Private Education Loan Trust 2014-A, Moody’s expected the cumulative net loss to be 12%. To be conservative, we assume that the cumulative loss rate for the PSL portfolio will be 12% (discussed in valuation section).

     

    PSL Market Opportunity

    We believe that there are two major sources of value in PSLs that Navient can capture: 1) Acquisitions of legacy PSL portfolios and 2) Acquisitions of new PSL originations (primarily from Sallie Mae).

    There are currently $70bn of existing, legacy PSLs that are not owned or serviced by Navient. As previously discussed, many of these lenders are no longer originating and have legacy portfolios that they are not servicing. Similar to the FFELP industry, Navient should be able to leverage its low-cost position to roll these portfolios up, which would add substantial incremental cash flows.

    In addition, there is a very sizable opportunity for Navient to acquire new PSL originations. Sallie Mae is currently targeting originations of $4bn+ a year. We believe that Navient will purchase a sizable portion of Sallie Mae’s annual originations. The company has stated that that they “hope to buy all of them…not just a good portion of them.” Similarly, Sallie Mae has said that they “expect Navient to be not only a significant buyer but a natural buyer because of a, their experience with the assets; b, their capital structure; and c, their servicing.” In fact, Sallie Mae entered into a definitive agreement on August 8, 2014 to sell $820mm of high-quality Smart Option Student Loans to Navient. We note that Sallie Mae provides life of loan unit economics based on their current business plan:

    The projected unit economics for these loans seem markedly improved from the historical performance of Sallie Mae’s private education lending segment. While Sallie Mae very well may be able to execute on this business plan with a NIM of 6.3% and an annual loan loss rate of 1.0%, we assume much more conservative assumptions in the valuation section with a NIM of 5.0% and an annual loan loss rate of ~1.8% (12% cohort default rate).

    Navient has stated that they have already acquired $1.6bn in PSLs so far in 2014. We believe that the company will continue to acquire PSL portfolios and newly originated PSLs, which should add significant incremental cash flow.

     

    Business Services Overview

    Navient is the largest education loan servicer, and currently services over 12mm customers and nearly $300bn of education loans. The company services its own portfolio of education loans, as well as those owned by banks, credit unions and non-profit education lenders. In addition, Navient provides servicing and asset recovery services to guaranty agencies and the ED. These services include account maintenance, default aversion, and asset recovery.  Navient is currently one of four large servicers to the ED under its Direct Student Loan Program and currently services ~5.8mm borrowers under this contract. The company also provides asset recovery services on a contingent basis to other asset classes (~20% of receivables), including government receivables, taxes, court/municipal, and school receivables.

    Approximately 60% of the revenues generated by this segment are associated with FFELP loans (excluding intercompany servicing revenues), and will therefore also be in run-off. However, we believe that there is tremendous value in Navient’s scalable servicing and asset recovery platform, and that the company will be able to leverage this platform to drive profitable growth in portfolio acquisitions and fee based opportunities (see market opportunities sections). Not only is Navient the lowest cost operator, it also has best-in-class performance with ~30% lower defaults than competitors. In the most recent quarter, Navient’s ED serviced portfolio default rate continued to lead all 4 servicers, with the next-best default rate 50% higher. Although FFELP loans have been in run-off, the company has been able to service increasingly large volumes (see graph below).

     

    Business Services Market Opportunity

    Navient’s servicing and asset recovery platform gives the company the flexibility to acquire portfolios or service on a third-party basis. As discussed earlier, Navient’s integrated servicing and asset recovery business gives the company a cost-advantage that it can leverage to acquire FFELP and PSL portfolios, driving significant incremental cash flow. In addition, Navient has meaningful growth opportunities in its third-party servicing and asset recovery fee business. The company has discussed that there is a $200mm/year servicing opportunity with schools, a $308mm/year asset recovery business opportunity with states, courts and municipalities, as well as more than $500bn of outstanding non-ED government receivables that Navient could expand into. Finally, we note that Navient currently only has ~15% market share of the $1.5bn annual ED contracts for loan servicing, collecting, and originations. As the lowest-cost, best performing operator, we believe that Navient will be able to increase its share.  

     

    Management

    Our view is that management of Navient is fantastic. We note that it is interesting that the majority of Sallie Mae’s previous senior management team has moved on to the spin-off instead of remaining at the parent company (the high-growth consumer banking business). In addition, ~70% of senior management’s pay is variable and ~70% of their pay is stock-based. This gives us further conviction that Navient will not simply run-off, and that management has bigger plans for the company. It is evident that senior management is focused on returns on invested capital and that they are intelligent allocators of capital. Management discusses how Navient is “generating a substantial amount of capital through earnings each year... and how [they] deploy that is a function of opportunities in the space to acquire loan portfolios or build businesses. And if those opportunities are less attractive than returning it to shareholders, then the dollars go to shareholders.”

    Also, because Navient is extremely levered, refinancings would create substantial equity value. Management clearly understands this and has been aggressively pursuing capital market transactions. In 2014 alone, management has:

    1)  Issued $2.7bn of FFELP ABS and closed on an $8bn FFELP ABCP Facility

    2)  Refinanced $1.1bn FFELP reset notes to term

    3)  Issued $1.1bn of PSL ABS and closed on a $1bn PSL ABCEP Facility

    4)  Issued 10-year 6.125% $850mm unsecured debt

    5)  Returned $392mm to shareholders through share repurchases and dividends

    Overall, we believe that this is a best-in-class management team that will create substantial shareholder value.

     

    Valuation

    Our overall methodology for valuing Navient involved projecting the business in runoff, and then layering on additional sources of value from profitable growth opportunities, resulting in a sum-of-the-parts buildup. We note that we used 430mm shares outstanding to be conservative, although the number of shares outstanding is currently at 419.4mm. We began with a very conservative bear case of $12.77, which assumes that the portfolio simply runs off and that management does not refinance any of the debt. Next, we layer on the value creation from refinancing the $17.5bn of unsecured debt, such that the maturities of the unsecured debt match those of the underlying FFELP and PSL portfolio in runoff. This gives us our base runoff case valuation of $16.23, which we view as the true downside case.

    To arrive at our base case valuation of $27.80, we layer on the value creation from growth opportunities such as FFELP acquisitions, PSL portfolio acquisitions, and acquisitions of newly originated PSLs (at conservative economics). Finally, we incorporate the potential upside from acquisitions of newly originated PSLs at Sallie Mae’s projected unit economics, incremental earnings from fee-based opportunities in Business Services, and further value creation from refinancings. This gives us our bull case of $40.86.

    The summary of our valuation is below (valuation output in appendix):

     

    Bear Runoff Case

    In our Bear Runoff Case, we projected the four business segments in runoff: FFELP Loans, PSLs, Business Services, and Other (e.g. corporate overhead). Management provides projected FFELP loan balances in a runoff scenario over 20 years, which we use as the foundation for how the entire business will run off. We attempted to model this in a manner that was as close as possible to economic reality, and we therefore focused on levered cash flows to equity.

    For the FFELP loans segment, we projected Net Interest Margin for FFELP Interest-Earnings Assets (includes some restricted cash in trusts) to decline from 0.88% to 0.65%. We note that this is a very conservative assumption as historically NIMs have consistently been in the 0.80% to 1.0% range over the last few years. However, we made this assumption to account for the potential loss of Floor Income as Navient’s hedges roll-off and interest rates potentially increase. The second main source of revenue for the FFELP loans segment is service revenues (primarily late fees), which we estimated to be roughly 0.06% of the outstanding loan balance. In addition, in an attempt to match economic reality, we focused on future charge-offs instead of GAAP accounting-based allowances for loan losses. Therefore, we unwound any existing allowances and instead projected charge-offs based on a 0.54% life of loan loss rate as per Moody’s research. As discussed in the FFELP loan section, this is a conservative estimate and that the real life of loan loss rate is likely closer to 0.35%. Finally, we estimated a servicing cost of 0.12% of the average outstanding loan balance, which we boxed in using historical data from Sallie Mae and Nelnet. Overall, we arrived at an estimated per share value of $4.31 for the FFELP loans segment.

    As previously discussed, we projected the PSL portfolio to runoff in a similar manner to that of the FFELP portfolio. For the PSL segment, we projected NIMs of 4.0% which are in line with the historical range of 3.9% to 4.2%. We also projected a life of loan loss rate of 12.0% (annual charge-offs of ~1.8%). We estimated late fees at 0.08% of the outstanding balance and servicing expenses at 0.4% of the balance. All in all, we arrived at an estimated per share value of $3.60 for the PSL segment.

    For the Business Services segment, we projected the FFELP-related revenues to decline in a manner similar to that of the FFELP loan portfolio. These FFELP-related revenues (excluding intercompany servicing revenues) comprised 58% of total Business Services revenues. We projected Other Servicing & Collections Revenues to grow at 2% or roughly in line with inflation. Based on these assumptions, we arrived at an estimated per share value of $4.45 for the Business Services segment.

    The Other segment primarily consists of activities of the holding company, including corporate overhead. We again projected this segment to runoff in a manner similar to that of the FFELP loan portfolio. In addition, we modeled the runoff of the entire book of $6.0bn ($4.0bn including allowances for loan losses) under the Other segment. While Navient currently has $6.0bn in book value, we make the conservative assumption that most of this value needs to remain in place and that the book will amortize over time. This amortization consists of FFELP loans, PSLs, and excess other assets, which are cash inflows. Furthermore, the runoff includes the amortization of FFELP securitized debt, PSL securitized debt, unsecured debt, and excess other liabilities, which are cash outflows. Overall, we arrived at an estimated per share value of $0.42 for the Other segment.

    Overall, our estimated per share valuation for the Bear Runoff Case was $12.77, or 26% downside to the current share price of $17.30.

     

    Base Runoff Case

    In our Base Runoff Case, we add in the incremental value from our Base Case Refinancing. We assume that management will be able to refinance the $17.5bn of unsecured debt, such that the maturities of the debt match those of the underlying FFELP and PSL portfolio in runoff. As previously mentioned, management has aggressively been pursuing capital markets transactions. For example, management recently issued $850mm of unsecured debt with a 2024 maturity and a 6.125% interest rate. As a result, we believe that this base runoff case is very reasonable. We estimated a per share valuation of $16.23 for the Base Runoff Case, which equates to 6% downside to the current share price of $17.30.

     

    Base Case

    To arrive at our base case valuation of $27.68, we layer on the value creation from growth opportunities such as FFELP acquisitions, PSL portfolio acquisitions, and acquisitions of newly originated PSLs (at conservative economics).

    We estimated the incremental value from FFELP acquisitions based on a PV of the earnings stream, which we estimated to be worth ~$0.06 per share for $1bn of FFELP loans. However, we note that Navient would likely have to give up some of the economics when acquiring FFELP loan portfolios. To estimate the net value that Navient could receive from FFELP acquisitions, we analyzed how much Nelnet paid for CIT’s $3.6bn FFELP portfolio. Based on the Loan Sale Agreement, Nelnet paid ~$0.03 per share for every $1bn of FFELP loans. As a result, we believe that every $1bn of FFELP loans will be worth about $0.03 to Navient. There are currently $150bn of FFELP loans that Navient does not own or service, and we believe that Navient can acquire roughly $50bn of these loans. This gives us an estimated per share value of $1.50.

    Similarly, we estimated the incremental value from PSL acquisitions based on a PV of the earnings stream, which we estimated to be worth ~$0.21 per share for $1bn of FFELP loans. We again assume that Navient will have to give up some of the economics, and arrive at a net value of $0.15 per share that Navient could receive from PSL acquisitions. There are currently $70bn of PSLs that Navient does not own or service, and we believe that Navient can acquire roughly $25bn of these loans. This gives us an estimated per share value of $3.75.

    Finally, we incorporated the incremental value from acquisitions of newly originated PSLs. Sallie Mae is targeting $4bn+ originations per year and we believe that Navient will acquire a sizable portion of these loans ($3bn/year). As previously mentioned, Navient already entered into a definitive agreement on August 8, 2014 to sell $820mm of high-quality Smart Option Student Loans to Navient. While Sallie Mae projects NIMs of 6.3% and a life of loan loss rate of 7.0%, for our base case we assume much more conservative unit economics with NIMs of 5.0% and a life of loan loss rate of 12.0%. These loans will have a 7 year life and therefore we believe that this segment will reach steady-state by 2021. We estimate this segment to be worth $6.32 per share.

    Our estimated per share valuation for the Base Case was $27.80, or 61% upside to a current share price of $17.30.

     

    Bull Case  

    In our Bull Case, we add in the incremental value from acquisitions of PSLs with Sallie Mae’s projected economics, increased earnings in the Business Services segment, and further refinancings. We estimated that Navient could capture an additional $4.73 per share of value, if the PSLs that Navient acquires from Sallie Mae are able to sustain Sallie Mae’s projected economics. Furthermore, we evaluated potential upside from increased Business Services earnings. As previously discussed, there are numerous channels for Navient to drive profitable growth in fee based opportunities. We estimate that Navient will be able to drive incremental normalized revenues of $500mm, which at a 60% margin and 38% tax rate would equate to $186mm of incremental earnings. At a conservative 10x multiple, this segment would add per share value of $4.33. Finally, we estimate that Navient could create $4.00 per share of value from further refinancings. Navient is extremely levered with substantial securitized and unsecured debt, and any refinancings that management pursues could create substantial equity value. Overall, we estimated a per share valuation of $40.86 for the Bull Case, which equates to 136% upside to the current share price of $17.30.

     

    Management Case (Sanity Check)

    Management provides guidance for estimated future cash flows before unsecured debt from their education loan portfolio. They believe that the portfolio will generate $36.5bn of highly predictable cash flows over 20 years, including ~$11bn of overcollateralization that will be released over time from residuals. There is currently $17.5bn of unsecured debt. As a sanity check, we can discount over 20 years the excess cash flow remaining after paying down unsecured debt ($36.5bn - $17.5bn = $19bn). If we discount $19bn over 20 years for annual cash flow of $950mm at a 12% discount rate, we arrive at a valuation per share of $16.50. At a 10% discount rate, we estimate a per share valuation of $18.81. Either way, this gives us further conviction that Navient is currently trading roughly in line with its runoff valuation.

     

    Risks

    The main risk to the thesis stems from regulatory risk.

    1)  Consumer Financial Protection Bureau (CFPB): Navient is subject to CFPB enforcement and examination authority. The CFPB is currently evaluating changes to regulations that govern the private student loan market. Proposed measures in the Student Loan Forgiveness Act include capping interest rates and allowing for private student loans to be discharged in bankruptcy. In addition, the CFPB may directly or indirectly impose monetary penalties for violations of applicable federal consumer financial laws. For example, Navient was fined ~$100mm by the FDIC and DOJ earlier this year for failing to provide military personnel with required benefits pursuant to the Servicemembers Civil Relief Act

      • Mitigant: Though loudly publicized, we believe that the proposed legislation is largely infeasible and would likely result in the remaining private lenders to exit the market. This would lead to liquidity problems and a worsening of the current funding shortfall. We note that the PSL market is an important source of education financing. In addition, moving forward the FDIC will not regulate Navient (but will continue to regulate Sallie Mae). Most importantly, we believe that some of the regulatory risk is mitigated by the fact that Navient has very strong ties to Sallie Mae and the government. For example, following the $100mm fine, the ED still renewed its contract with Navient. The ED stated that there would be a large “potential ‘dislocation’ [that] borrowers would face if the department had to transfer loans from its servicers to a new batch of companies.” This seems to illustrate that Navient has captive customers    

    2) Reduction in FFELP Portfolio Economics: Congress could potentially enact legislation that could reduce Navient’s CFs from servicing and/or interest income. For example, the Bipartisan Budget Act enacted on December 26, 2013 reduced the amount paid to guaranty agencies for defaulted FFELP Loans, which in turn is expected to reduce Navient’s FFELP guaranty fee income by $60mm in 2014

     

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

     Navient successfully pursues any of the growth opportunities listed in the write-up which forces a re-rating of the stock.
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