Turning to a more controversial financial industry bet, describe your interest in Sallie Mae [SLM].
BC: Everybody knows about the bad news for Sallie Mae, which is the dominant provider and servicer of student loans, both federally guaranteed and private. The government has changed reimbursement levels on the loans it guarantees, making that business far less profitable for Sallie. The private-equity deal to buy Sallie at $60 per share fell through. The returning CEO had a disastrous conference call with investors.
Credit quality and access to capital markets are big worries.
We’re not ignoring any of that, but our basic view is that the current stock price reflects all of these negatives, while not valuing the quantifiable competitive advantages the company has. Walk through those key advantages.
BC: While federally guaranteed loans will be less profitable going forward, we believe the company can earn its cost of capital on that business (while smaller competitors will likely lose money and withdraw), and its dominant presence there will give it a big advantage in private loans, which is where it’s going to make most of its money. Because Sallie Mae already has the relationships with borrowers through its federal loans, it can acquire private-loan customers at a much lower cost than others – roughly half the $600 per-loan acquisition cost of competitors.
Because of its scale and installed technology, Sallie can process and service a loan for $25 less per year than competitors. Its scale also gives it an underwriting edge: with a giant database of actual lending experience, it can better price loans and judge the credit quality of individual borrowers pursuing different degrees at different schools. That competitive underwriting advantage may be worth another $25 per year, from higher rates and lower losses per loan. Sallie’s tangible book value today is around $5 billion, which is what its ongoing business would be worth if competitors didn’t allow it to earn excess returns.
But it does earn excess returns, and we calculate the present value of its competitive advantages in private loans to be around $6 billion. That puts the value of the ongoing business at around $11 billion, a considerable premium to the current market value [at a recent share price of $15.16] of $7.1 billion.
Do you see additional free call options here as well?
BC: Yes, partly from strong growth in the private educational-loan market. The demand for higher education will remain strong as the return on it continues to increase. Tuition costs are rising more rapidly than inflation, requiring larger loan levels overall and more private lending on top of federally guaranteed loans. Sallie’s position as the low-cost provider may allow it to increase market share – in both public and private loans – at a greater rate than expected. We’re also modeling a 4% loan charge-off rate for private loans, which is essentially at a recession level forever. As the macro situation eventually improves, that would provide upside as the charge-off rate declines. Another related point: student loans can’t be discharged in personal bankruptcy, which drives better recovery in the long-run.
The seize-up of credit markets is obviously a problem for the company. How are you viewing that?
BC: They clearly need well-functioning credit markets to fund their business and will be crippled if credit spreads remain wide or if loan charge-offs go to Depression levels. Could that happen? Yes, but our view is that the situation will normalize before the company has to refinance next year. That said, this is a rare investment that could go to zero if we are wrong. As a result, the position size today is about half of our normal 5%.