The November election caught me be surprise. I find it hard to complain about the resulting appreciation in the S&P, but now that it has cooled, I, like other investors, just don't know enough about Trump's policies to make an educated investment decision. I was looking at banks, as the ever-present rate hike looms on the horizon into 2017, but I can't shake the feeling of a financials pullback. Industrials had a great run, but with a rate hike and dismal global outlook, I can't be sure about that, either. Oil and energy plays looked good as well, but with global demand and constant commodity volatility, that's a tough call, too.
To look for some direction, I went over Trump's Cabinet appointments, and the Education Secretary caught my eye. Betsy DeVos was appointed as Education Secretary, and I believe her staunchly conservative policy bodes well for a trade on government-funded student loans. These loans carry an average 11% default/delinquency rate, provide below average coupon payments, and carry a higher repayment risk than most debt securities. This is because students aren't able to make large payments, and have more forebadance/deferment options than regular debtors. For these reasons, I believe the timing is right to short Navient (NASDAQ:NAVI).
Education Secretary Appointment
Betsy DeVos has previously served as the Republican Party Chairman for Michigan, where she made a local name for herself advocating for vouchers and school choice programs. These two ideologies are meant to steer control over the public education system away from the government, to the families themselves and for-profit corporations. Policy aside, I believe this opens up a door for those with a fair amount of risk tolerance. DeVos has proved time and again that she will successfully decrease the size and scope of government. Trump and DeVos probably would not remove government insurance on the loans, but they could very well remove exposure to future lending. This is because as it currently stands, claims on defaulting loans are insured by federal assets. If I had to speculate, I would say that could be the first item on a conservative's chopping block, and if that provision were to be removed, then Navient would see a drop in future loans and net interest income.
What has Trump said?
Trump hasn't said much regarding government-funded student loans. He's made it clear that he wants to work with Congress, and make college more affordable using forgiveness programs, and income-adjusted payment caps.
The only information I found on his policy surrounding federally-funded student loans is from a site called studentdebtrelief.us. It claims that he doesn't want the government profiting off of indebted students, and would prefer private lenders take care of the funding.
Where does this leave federal policy?
I believe that Trump, having close to zero public service experience, and DeVos, a conservative activist, will tread close to the grain in the first year of public service. But after that grace period, they may start to move on federally subsidized student loans. This is because both Trump and DeVos have proved themselves 'small-government' Republicans. As of now, there are $1.2 Trillion in federally funded student loans to deal with. With newly unified Congress and Executive Branches, they have a few options:
- Refinance non-insured loans under private lenders
- Forgive some loans
- Implement government vouchers
Vouchers, the tool of choice for DeVos, are essentially state-funded scholarships to attend private colleges. The administration may go with this tactic, because it has worked for DeVos, and it would move student debt away from the government, while also accomplishing the goal of decreasing the cost of college. With regards to Navient's value, these factors all decrease their asset base, and claim on borrower's interest payments.
With all of this in mind, I'd consider shorting Navient Corp. They manage, service, and recover (if needed) student loans originated by the government and other private lenders. The good part is that a portion of these loans are guaranteed by the government, which ensures a limited loss on their loan portfolio (3% on 57% of the portfolio). Their main source of growth is the acquisition of federally originated student loans. In fiscal 2014, they acquired $3.7B of such loans.
Analysis (USD - 1000's)
See table below for a few line items important to deriving value from this company. You'll notice right off the bat that Revenue and Net Interest Income have been decreasing over three years, resulting in declining Net Income. This is attributable mostly to negative loan growth (close to -5% per year). Their Free Cash Flow has also decreased, but at a lower rate. This is due to regular repayment of debt, and changes in operating cash. One thing I want to make clear here is that even though their losses on payments are capped at 3% of half of their portfolio, the other half is comprised of more risky privatized loans, and the federal guarantee doesn't protect the company from early repayments. Early repayments to this company removes the possibility of amortizing loans over a longer period of time, which decreases loan value. The current macroeconomic environment supports the idea that this may happen in the future, as wages and growth keep improving.
|Net Interest Income||$3,167||$2,667||$2,221|
|Long Term Debt||$136,648||$136,866||$124,833|
|Free Cash Flow||$2,000||$1,664||$1,910|
Quick Note on Interest Rates
Like most financial institutions, Navient is expected to benefit from a rate hike. According to their most recent earnings call, a 25 bps increase in the US benchmark could trigger a 16-17 bps increase in NIM.
If you're thinking about initiating a short position, Navient's recent expansion into government servicing should be on your radar. According to their most recent earnings call, they were awarded a servicing contract for the IRS. They expect to see front-loaded operating expenses in 1Q2017. Additionally, they are currently in contention for a similar Department of Education servicing contract. Their stock could see some appreciation as a result. That being said, these sort of contracts don't pay off until a significant amount of time after they're awarded. The company needs to integrate their software, update books, and then start operations.
Navient management successfully foresaw a few problems: a decreasing government-originated student loan market, increasing charge offs, and higher inherent risk in student loans. As a result, the company successfully penetrated this new market. This development would be catastrophic for a short position in the long term, but increasing expenses in the short term could be lucrative for a short trade.
With $124.8B in debt outstanding, due mostly before 2024, this company carries a massive amount of leverage. Their bonds trade wider than comparables, their average coupon is 6.34% (compared to ~3% on their loan portfolio), and their liquidity and leverage measures aren't convincing. See table below for a comparison to industry averages.
Management has noted that they're in the middle of a turnaround, but given the expectation of short term volatility and decreasing earnings, there could be increased downward pressure as a result of their debt levels.
After looking through their loans, their asset quality is actually fairly healthy. From these measures, it looks like the company will just face a sizing problem rather than a quality problem. 92% of their loans have a FICO score above 670 for schools and 640 for borrowers. 64% of loans had a cosigner, and seasoning is 61% long term (more than 48 payments). These factors point to a mostly performing loan portfolio. However, their most recent quarterly report is cause for some lowered expectations. See table below for information on delinquencies and forebadances as a percent of their loan portfolio.
|31 Dec 2015||30 Sept 2016|
|FICO Above 670/640||10.8%||9.7%|
|FICO Below 670/640||13%||11.9%|
|Troubled Debt Restructurings||14.7%||13.2%|
While these numbers are decreasing over time, they remain above the Fed's average for commercial banks (2%). The only number that came close was Residential (4%). The takeaway here is that their loans are much more risky than the average commercial lender. Even though some Federal loans are insured by the government, a maximum 3% loss on more than half their portfolio amounts to $2.1B.
With regards to prepayment risk, management has noted the average life of government loans is less than 9 years, and amounts to a long term 3% constant loss. But as rates continue to rise, this number may increase in the short term.
Timing the market doesn't usually work out, but I believe this company has reacted to systematic indicators in a big way. The November election spurred a 6% run in the S&P, while Navient posted close to a 35% appreciation in the same amount of time. Over the last 3 months, that levels out to a 22% gain, while the S&P was up close to 2%. This performance has been met with steadily decreasing earnings, and a relatively low PE (9.5), which leads me to believe it is overvalued with low growth prospects.
Most of the long term appreciation was a result of their dealings with the Department of Education, and the short term run up across all equities. But the fact of the matter is that their loans, net interest income, and income is expected to keep decreasing into 2017. Management has even reported that income from the IRS contract isn't supposed to be realized until late 2017. On top of that, the new political landscape should further decrease their claim on interest-bearing assets. From a value perspective, these factors support a short sale on the company until they can reallocate the business into 2017, attract more public entity contracts, and move away from risky student loans.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.