Citigroup Should Have Split Off Student Loan Corp.

Includes: C, DFS, SLM, STU
by: Derek Pilecki, CFA

In early August, I posted an article arguing that Student Loan Corp. (STU) was undervalued. I did not have to wait long as seven weeks later the company was sold to Discover Financial (NYSE:DFS). The gain was 24%. I had purchased Student Loan because it appeared abnormally cheap for a profitable lending company. At the time of purchase, it was trading for 35% of tangible book value. Credit quality appeared manageable given that 75% of the loan portfolio was government guaranteed.

The question surrounding STU was: How desperate was its 80% owner, Citibank (NYSE:C)? Citi had stated that Student Loan was part of its CitiHoldings and therefore on the block to be sold. I thought the market was too pessimistic about how desperate Citi was to sell down its CitiHoldings assets. I thought Citi would not sell STU unless they received a price higher than the current stock price and potentially at least at book value. My thesis was that Citi could extract at least the current stock price from earnings and release of capital in as little as 10 quarters if they put STU into run-off. My model was the Primerica transaction earlier this year where Citi created a growth company from a slow growing life insurer by retaining most of the existing term life policies on its balance sheet and allowing the policies to run-off naturally. In the Primerica example, Citi showed that it was not desperate and structured a smart transaction that created value for its shareholders.

I was both right and wrong.

Citi did sell Student Loan for higher than the then current stock price, but Citi still sold it for only 45% of book value. The acquisition, which will close in Q4, is a complex four-party deal between Student Loan, Citi, Discover and Sallie Mae (NYSE:SLM). To make it simple, Citi essentially gave the government guaranteed student loan portfolio to Sallie Mae for little premium. Then, Citi gave Discover about $400 million, a perfectly good private student loan lending platform that had scarcity value and a portfolio of the recently originated, pristine-quality private student loans at par. Finally, Citi booked a $500 million loss and still kept all of the risk by retaining questionable quality 2006-07 vintage private student loans.

There was a better solution for Citi shareholders that could have still moved the assets off of Citi’s balance sheet without Citi retaining the same risk: Citi should have made STU an independent company. STU is too small relative to Citibank to spin-off the shares directly to Citi shareholders because a Citi shareholder would only receive 1 share for every 1,500 Citi shares held. Instead, Citi should have proposed an exchange offer where Citi shareholders could choose to swap 4.5 of their Citi shares for 1 share of STU owned by Citibank. This would have put STU into the hands of shareholders who made an active decision to own STU. This exchange transaction would have moved STU’s assets off of the CitiHoldings balance sheet and Citi shareholders would have benefitted from 72 million share reduction in Citi shares outstanding, but Citi would have still had a $6 billion loan outstanding to STU. After the exchange offer was completed and STU was independent, STU’s management and shareholders could have decided on the best way to pay off Citi’s loan to STU and create value for STU shareholders. Either they could have found another lender to take out Citi’s loans to the company and continued to originate new student loans, or they could have run-off STU’s loan portfolio and paid-off Citi from the natural pay-down of their loans. Either way, both STU’s and Citi’s shareholders would have been better off with an exchange transaction than they are with the deal to sell STU’s assets to Discover and Sallie Mae.

Citi did not help its own shareholders with this transaction. Citi had an undervalued asset and gave it away to competitors, but still kept all of the risk. It sold STU at such a cheap price in order to demonstrate that it is making progress in reducing the assets of CitiHoldings. However, this is a bill of goods because Citi kept all of the risky assets and gave away capital that could have covered the losses from those risky assets. I would argue that this transaction increased the risk at CitiHoldings. If regulators were awake and truly concerned about risk instead of asset size, they would stop Citi from consummating this transaction. Of course, it is deplorable that Citi’s management doesn’t recognize the poor economics of this transaction and stop the transaction themselves.

This article is an excerpt from my 2010 3rd Quarter investor letter. If you would like to see the entire letter, please send me an email

Disclosure: long DFS, long PRI