Navient: Free Call On High Margin Growth Opportunities

May.13.14 | About: Navient Corp (NAVI)

Summary

3.9% dividend yield; 7.8x price-to-earnings ratio; 6% discount to lowest analyst target; 19% discount to average analyst target; 41% upside to high target.

Portfolio with low credit risk (77% effectively guaranteed by the Federal Government; balance is high quality) and low funding risk (80% of loan portfolio is funded to term).

High margin growth opportunities by levering its scale and expertise.

Experienced and shareholder friendly management; will distribute 30% of earnings as dividend and will use a bulk of the balance to repurchase shares.

About the company

Navient (NASDAQ:NAVI), spun out of Sallie Mae (NYSE:SLM) in May 2014, is a student loan management, servicing and asset recovery company. NAVI has four key businesses (see investor presentation and form-S1):

  1. Portfolio of student loans provided under the Federal Family Education Loan Program (FFELP Loans)
    With a $103 billion portfolio, NAVI is the largest holder of FFELP loans. 97-98% of this portfolio is effectively guaranteed by the Federal Government with NAVI at risk for a maximum 3% loss. 85% of NAVI's FFELP loans are funded to term with non-recourse, long-term securitization debt. Given the discontinuance of FFELP in 2010, this portfolio is in run-off (expected to amortize over 20 years with a weighted average life of 7.6 years). NAVI's goal is to maximize cash flow from its existing portfolio and to acquire additional FFELP loans from third parties who own loans generated prior to mid-2010.
  2. Portfolio of student loans provided by private lenders
    With a $31 billion portfolio, NAVI is the largest holder of student loans. These loans are not insured or guaranteed by the government and NAVI bears full credit risk. NAVI's private education loan portfolio is seasoned, with nearly 90% having made more than 12 payments and typically these are non-dischargeable in bankruptcy. 60% of NAVI's private student loans are funded to term with non-recourse, long-term securitization debt. NAVI's goal is to continue to grow this business by acquiring additional private student loans that are originated by third parties.
  3. Platform for servicing of student loans
    NAVI has an industry leading and large scale servicing platform and operations. In addition to servicing on its own portfolio of education loans, NAVI provides servicing of student loans owned by other financial institutions, including the Department of Education. NAVI has 11 servicing and asset recovery locations and services 12 million of the 45 million borrowers with a student loan. NAVI's goal is to expand its third party servicing relationships, which is a very high margin and capital light business, in which it has the advantage of scale and expertise.
  4. Business service
    This segment includes asset recovery services, guarantor services (account maintenance, default aversion) and student assistance and outreach solutions. The largest sub-segment is recovery services under which NAVI provides contingent collection services with a portfolio of $13.5 billion in student debt and $3 billion in other debt. NAVI's goal is to expand its third party recovery and other services relationships.

Shareholder friendly management

NAVI has committed to an approximately 30% dividend payout ratio and to returning excess capital and cash flow to shareholders after dividends are paid. It will also use cash generated to fund growth opportunities by acquiring portfolios.

High margin growth opportunities

The company will leverage its large scale servicing platform by acquiring loan portfolios and by entering into servicing and asset recovery agreements on a third-party basis. This was difficult to do for competitive reasons before it separated from its private loan originating business (new Sallie Mae).

Regulatory trends (capital constraints and compliance) will encourage banks to dispose their student loan portfolios to third party operators like NAVI. Private student loan originators will look to drive operating efficiencies by outsourcing servicing and asset recovery to NAVI.

NAVI has a demonstrated history of acquiring and converting loan portfolios originated by other financial institutions. Servicing business requires little capital and generates high return on equity.

New company to be led by an experienced management team

Jack Remondi, Chief Executive Officer (CEO) of NAVI's parent had decided to join NAVI as its CEO. Jack has 30 years of financial services experience and served as the CEO, COO and CFO of the parent at various times from 2008 to 2014. It is likely that Jack's decision to leave the parent and join NAVI is because he sees exciting growth prospects at NAVI.

The Chief Financial Officer (Somsak Chivavibul), Chief Operating Officer (John Kane) and Chief Risk Officer (Tim Hynes) have 25, 24 and 21 years of financial services experience respectively.

Valuation

The market is currently implying zero value to high margin growth opportunities. At the current price-to-earnings ratio, the assumption is that NAVI's will not be able to profitably acquire any FFELP or private loans and will not be able to enter into any new third-party servicing, recovery or other agreements. The company has guided to $2.05 of 2014 standalone core earnings per share. At the closing stock price on May 12, 2014 ($15.95), the stock is trading at a 7.8x price-to-earnings ratio.

Investors will earn a healthy and safe 3.9% dividend yield while waiting for NAVI's experienced management to exploit high margin growth opportunities. The company has guided to a 30% payout ratio.

Sell side analyst targets range from $17.00 to $22.50 (41% upside). The stock is currently trading at a 6% discount to the lowest analyst target and a 19% discount to the average analyst target ($19.56; 23% upside).

NAVI's $134 billion loan portfolio has an estimated $35 billion of highly predictable future cash flows that will be generated over the next 20 years. 77% of the portfolio is effectively guaranteed by the government, which bears losses in excess of 3%, which results in a predictable net cash flow through the life of the portfolio.

Student lending market

There have been two sources for government supported student loans: (1) capital provided directly by the federal government under the Federal Direct Student Loan Program (2) Capital provided by private lenders under FFELP. Private lenders under FFELP are insured against borrower default risk by Guaranty Agencies which are in turn re-insured and subsidized by the federal government.

As of mid-2010, the Health Care and Education Reconciliation Act of 2010 prohibited federal student loan originations under FFELP. Consequently, all student loans would be originated under the direct loan program. However, the existing portfolio of FFELP Loans will remain as is until completely repaid by borrowers.

Private student loans are primarily provided to bridge the gap between the cost of higher education and the amount funded through financial aid, federal loans or personal resources. Losses on these loans are entirely borne by the private company.

Risks

Interest rate risk. While 80% of the loan portfolio is funded to term, the company is exposed to interest rate risk on its existing portfolio. Further, acquisition of portfolios from other financial institutions is easier in a low interest rate environment.

Regulatory risk. The student loan market is highly regulated and changing. Intended and unintended consequences of reducing the debt burden of past, current and future students can have a material financial impact on NAVI. Proposed legislation (S 2292 Bank on Students Emergency Loan Refinancing Act), while unlikely to pass, is an example of regulation that can have a negative financial impact on companies in the student lending market, including NAVI.

Debt rated non-investment grade by the rating agencies. Company is rated BB. However, it has a healthy interest coverage ratio with approximately 1.9x unsecured debt coverage.

Disclosure: I am long NAVI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: KL Investment Partners may change or exit its position (buy or sell shares) without updating this article and without informing the Seeking Alpha community.