Navient: Potential Bubble Or Potential Profit?

by: Almeida Investment Management
Summary

Navient's value has reached levels worthy of consideration.

A robust loan portfolio and cash flow will continue to support the dividend.

Their stock repurchase plan will continue to support share prices.

Navient Corporation (NASDAQ:NAVI), widely known as a student loan servicer, carries a strong dividend and may be a solid equity play to boot. Navient's stock price has remained rather stagnant for the last few years, as its portfolio of student loans has been in run-off mode and earnings have declined, however planned portfolio and services expansions may be the catalyst to lift Navient's stock price.

Big Money Operation, Declining Portfolio

Navient, a 2014 spin-off of Sallie Mae, provides asset management and business processing services to education, health care, and government clients at the federal, state, and local levels in the United States. The company operates in three segments: Federal Family Education Loan Program (FFELP) Loans, Private Education Loans, and Business Services. It holds the largest private sector portfolio of education loans ($77 billion) insured or guaranteed under FFELP, as well as the largest portfolio of private education loans ($23 billion), and originates private education refinance loans. Further, the company provides portfolio servicing, asset recovery and other business processing services via its Business Services segment.

FFELP loans represent the bulk of Navient's portfolio and it services even more federal loans, thus its main competitors are federal student loan servicers. After Nelnet's recent acquisition of Great Lakes Educational Loan Services, the three largest federal loan services are Nelnet, AES/FedLoan Servicing and Navient. Nelnet is public, AES is not. As of Sept 30, 2017, Navient had a 21% market share (Figure 1).

Figure 1: Market share of federal student loan loans by servicer, based on dollars outstanding

Federal education loan portfolios held by the "big three" are in run-off mode (amortizing) given that FFELP was discontinued in 2010 and all new federal loans are held by the Department of Education (ED). However, the ED assigns servicing rights for new loans to third party servicers. Servicing contracts with the ED are in place until June, 2019, and the government is planning a new system with a single web portal for borrowers to manage their debts. It is not clear whether the new system will actually happen nor whether it will involve multiple servicers. Thus, creating more diversified operations may be the key to growth for the big three.

Nelnet's stock price has outperformed Navient's stock over the last couple of years (Figure 2). The out-performance may be attributable to its larger servicing portfolio and its diversification into tuition payment processing and telecommunications. Nelnet's tuition payment processing division had a record year in 2017 and the telecom division began generating revenue in 2016.

Figure 2: NAVI and NNI stock price, weekly

Source: Yahoo Finance

Navient makes its money mainly from the spread between interest received from its portfolio of student loans and interest paid on the debt used to fund the portfolio. The spread is quite predictable given Navient's large FFELP portfolio has been in run-off mode. The portfolio predictably amortizes based on aggregated loan terms, and generates a relatively known interest income stream. Figure 3 illustrates Navient's declining total FFELP and private loan balances, $100 billion as of Q2 2018, along with their respective net interest margin since 2012.

Figure 3: Navient FFELP and private loan portfolio balance, net interest margin; GAAP basis

Source: 2018 2nd Quarter Investor Deck, 2017 Annual 10-K, 2014 Annual 10-K

Note: Years 2012 and 2013 represent operations while organized as Sallie Mae

Net interest margin has declined due to a rising cost of debt funding (rising interest rates). Further, the amortization of the portfolio naturally causes net interest income to decline. Figure 4 shows net interest income declining to $986 million from $1.6 billion over the last three years. As a percentage of total income, interest income (net of provisions for losses), fell to 55% in 2017 from 65% in 2015. Income from asset recovery services has picked up, reaching 27% of total income in 2017.

Figure 4: Income by income source, dollars and percentage of total; GAAP basis

Source: 2017 Annual 10-K

At $1.8 billion in 2017, the absolute level of income is quite large. Even after deducting total expenses of approximately $1 billion, income was roughly $800 million in 2017; and $300 million after tax. However, expenses have been rising. Higher expenses combined with lower interest income have equated to lower earnings (Figure 5) and ultimately to a stagnant stock price.

Figure 5: Total income and expenses, Diluted EPS, quarterly and annual; GAAP basis

Source: 2017 Annual 10-K, 2Q 2018 10-Q

But, The Dividend…

With a steadily amortizing portfolio causing interest income to steadily decline, why does any investor own the stock? The answer rests largely on the consistent dividends that their large, predictably cash generating portfolio is able to support. Navient has paid a quarterly dividend each quarter since being spun-off from Sallie Mae. The quarterly dividend was increased to $0.16 per share in 2015 from $0.15 per share in 2014. The payout equates to an annual dividend of $0.64 per share and a yield of approximately 5% (Figure 6), quite healthy compared to the 1.8%average dividend of the S&P 500. The payout ratio (dividend per share divided by earnings per share) was 62% for 2017. That's big and typically reflects a well-established company that is a leader in its industry. However, the payout ratio was 30% and 25% in 2016 and 2015, respectively. The payout ratio spike in 2017 was due to the drop in earnings, which may not last based on Navient's plans (see next section). On a quarterly basis, the payout ratio is now closer to a solid 35%. Regardless, Navient's large, though declining, portfolio will continue to support a consistent dividend with an outperforming yield. By comparison, Nelnet (NYSE:NNI) has a similar quarterly dividend of $0.16 per share.

Figure 6: Dividend per share, yield, and payout ratio

Source: 2017 Annual 10-K, 2014 Annual 10-K, yield and payout ratio calculated

Potential Bubble or Potential Profit?

Though Navient has a predictable cash generating portfolio that provides a solid dividend to investors, the portfolio is declining and Navient must ultimately find a way to grow the business. They have begun to do so amidst the backdrop of a ballooning level of student loans in the United States - a level that raises predictions that it's the next bubble to burst. But while many foresee danger, Navient sees opportunity.

At $1.5 trillion as of Q3 2018, the education loan market is astronomically big. Navient appears poised to increase its slice of the market by providing loan refinancing and more loan servicing. The federal government owns or guarantees approximately 90% of the education loan market, and Navient plans to increase its loan servicing services to the department of education - a potential boost to servicing income. Additionally, Navient has started providing private loan refinancing. Navient offers private education refinance loans to financially responsible professionals as a meaningful growth opportunity. In November 2017, Navient acquired Earnest to accelerate its refinance efforts. Earnest originated $900 million in private education refinance loans in 2017 and $1.1 billion in the six months ended June 30, 2018. Navient acquired $771 million of private education refinance loans in 2017 and $1.2 billion for the six months ended June 30, 2018. Thus, while the refinance market may be a small percentage of the total, the total is huge and refinancing even a small amount adds billions to Navient's portfolio (Figure 7).

Figure 7: Navient refinance expectations; estimated education loan market

Source: 2018 2nd Quarter Investor Deck

The default rate on the ED's portfolio has been rising (see additional supplement, "Federal Education Loan Performance"), however Navient's FFELP portfolio is limited to 3% credit losses based on federal guarantees. This leaves their private portfolio. The annualized charge-off and 90+ delinquency rates of the private loan portfolio both decreased in 2017, to 2.0% and 2.6%, respectively, from 2.6% and 3.4% in 2015. The deferment rate has remained at approximately 3.8% since 2015. With charge-offs and delinquencies trending lower, the credit risk to Navient's private loan portfolio appears well controlled. Risk control is largely mandated by underwriting and servicing practices. Additionally, Navient uses the securitization market to fund a portion of its portfolio, effectively off-loading credit risk by selling loans to investors while maintaining servicing of those loans.

Conclusion

Navient provides investors with a steady dividend provided by a large cash generating portfolio of student loans. Their portfolio is amortizing and interest income is declining, however plans to increase their portfolio and expand their asset recovery/business services segment are expected to provide a boost to future income and earnings (Figure 8). Higher earnings should continue to stabilize or lift Navient's stock price, as will recently announced plans to restart their stock repurchase plans. The default rate for the nation's education loan portfolio is increasing, however Navient's portfolio performance remains strong and credit risk to the FFELP portfolio is limited.

Figure 8: Past and future earnings per share

Source: Simple Wall St

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.