Navient Corporation (NAVI) Q3 2014 Earnings Report, Transcript and Summary

Good morning. My name is Jake, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Navient third quarter earnings call. [Operator Instructions] Mr. Joe Fisher, Vice President of Investor Relations, you may begin your conference.

Thank you, Jake. Good morning, and welcome to Navient's 2014 Third Quarter Earnings Call. With me today are Jack Remondi, our CEO; and Somsak Chivavibul, our CFO. After their prepared remarks, we will open up the call for questions. Before we begin, keep in mind our discussion will contain predictions, expectations and forward-looking statements. Actual results in the future may be materially different from those discussed here. This could be due to a variety of factors. Listeners should refer to the discussion of those factors on the company's Form 10 and other filings with the SEC. During this conference call, we will refer to non-GAAP measures we call our core earnings. A description of core earnings, a full reconciliation to GAAP measures and our GAAP results can be found in the third quarter 2014 supplemental earnings disclosure. This is posted along with the earnings press release on the Investors page at navient.com. Thank you. And now I will turn the call over to Somsak.

Thanks, Joe. Good morning, everyone. During my prepared remarks, I'll be referencing the earnings call presentation, which is available on our website beginning with Slide 3. In the third quarter, we delivered solid earnings of $0.52 per share, acquired $1.4 billion of student loans, saw our annualized charge-off rates for Private Education Loans continue to improve to their lowest levels since 2008 and we returned $229 million to shareholders through both dividends and share repurchases. Slide 4 provides a summary of our core earnings. For the quarter, core earnings were $218 million or $0.52 per share. For the full year 2014, we expect core earnings to be $2.10 per share, excluding the compliance remediation expenses recorded in the first quarter. Our third quarter operating expenses totaled $195 million, which is flat compared to the second quarter. Now let's turn to Slide 5 to discuss our FFELP segment results. FFELP core earnings were $79 million for the third quarter compared with $91 million for the third quarter of 2013. The FFELP student loan spread was 102 basis points for the quarter. We expect the FFELP student loan spread to be at least 100 basis points in the fourth quarter of 2014. These assets continue to generate high-quality predictable returns and cash flows. During the quarter, we acquired $521 million of FFELP Loans, bringing our year-to-date FFELP Loan acquisition total to $1.8 billion. Let's now turn to Slide 6 in our Private Education Loans segment. Core earnings in this segment increased $23 million from the year-ago quarter to $98 million. Profitability continues to improve as spreads remain consistent and losses continue to decline. Our third quarter student loan spread came in at 4.06%. And for the remainder of 2014, we expect our private student loan spread to be between 4.0% and 4.1%. Our third quarter charge-offs were 2.3%, which is a reduction from the prior quarter and the year-ago quarter. We continue to see year-over-year improvement in both our total and 90-plus day delinquency rates. The improvement in our outlook for future charge-offs led to a decrease in our provision for loan losses, which came in at $130 million for the quarter. And that's a decrease of $46 million from the year-ago quarter. During the quarter, we acquired $848 million of private student loans, bringing our year-to-date loan acquisition to $1.6 billion. These acquisitions consisted of high-quality smart option loans originated by Sallie Mae Bank prior to the spin. Slide 7 shows our asset quality trends over time and how our portfolio is dominated by high-quality loans. The purple bars and lines at the bottom of both charts represent the highest-quality and lowest risk loans in our private portfolio. These assets now account for 68% of our portfolio. In contrast, the light blue bars and lines in both charts represent our highest risk segment, what we call nontraditional loans. These loans are now down to only 8% of our portfolio. And then, as you can see on the chart on the right, losses have steadily declined across all our loan segments in the past 4 years. This chart demonstrates that our portfolio is well seasoned, with 91% of our loans having made more than 12 payments. On Slide 8, we provide some additional detail on allowance for loan losses. Under our loan loss policy, we reserve for life of loan losses for certain loans where borrowers have received payment modifications. These loans are also known as troubled debt restructurings, or TDRs. The loans that are not in TDR status, we reserve for 2 years' worth of expected losses. Today, we hold $446 million of reserve for our non-TDR portfolio, which represents 2% of the $22 billion of loans outstanding. In contrast, we hold a $1.1 billion life of loan reserve for our TDR portfolio, and that represents 11.2% of the $10 billion of loans outstanding. Let's now turn to Slide 9 to review our business segment -- Business Services segment. In this segment, core earnings were $85 million for the quarter compared with $127 million in the third quarter of 2013. We saw a decrease in our asset recovery revenue of $39 million versus the year-ago quarter. This decline was driven by the bipartisan act of 2013, which reduced revenues earned from helping previously defaulted loan borrowers rehabilitate their loans. The new fee structure became effective on July 1. We do expect that our fourth quarter asset recovery revenue will be between $75 million and $80 million. The company now services loans for 12 million borrowers, including 6.1 million borrowers under the Department of Education servicing contract. Servicing revenue from this contract was $34 million in the quarter compared with $29 million in the prior year. Let's now turn to Slide 10 for highlights of our loan acquisition and financing activity for the quarter. The company acquired $1.4 billion of student loans in the third quarter. We continue to see increased activity in this space and believe student loan purchase opportunities will increase going forward. Our ABS transactions continue to attract strong investor demand. In the third quarter, we issued $1.3 billion of FFELP ABS, the AAA-rated notes in this transaction priced at LIBOR plus 62 basis points with a weighted average life of 8.4 years. We also issued a $463 million Private ABS during the quarter. The loans in these transactions are primarily from the 2009 CT trust that paid down earlier this year. This financing was done at AAA spreads that were 115 basis points tighter and an advanced rate that was 20% higher than the original 2009 trust. In the third quarter, we repurchased 9.5 million shares for $167 million. For the first 9 months, we repurchased 22 million shares for $432 million. We have $168 million remaining authority under our share repurchase program. And finally, turning to GAAP results on Slide 11. We record third quarter GAAP net income of $359 million or $0.85 per share, and that's compared to net income of $260 million or $0.57 per share in the third quarter of 2013. The primary differences between core earnings and GAAP results are the marks related to our derivative position, expenses related to the restructuring and reorganization and the income associated with SLM BankCo. With that, I will now turn the call over to Jack.

Great. Thanks, Sak, and good morning, everyone. Welcome to our first full quarter earnings call as Navient. Though we completed the legal separation last April, we've been hard at work preparing for the final steps of the separation, including the transfer of the loan servicing of the Sallie Mae bank-owned loans and the introduction of Navient as the new name in loan servicing to our 12 million customers. I'm really pleased to report that the conversion of the loan portfolio and the launch of Navient was successfully completed this past weekend. Many folks here worked very hard over the past year to ensure a smooth transition and launch. And I'm particularly proud of what our team has accomplished, completing this very large task on schedule and on budget. More importantly, for our customers, the process was smooth and uneventful. With the launch of the Navient brand, we introduced new repayment and financial literacy tools to help our customers successfully manage their student loans, expanding on our efforts and expertise, which already produced vastly superior results. For example, earlier this month, the Department of Education released the 3-year cohort default rate for borrowers who entered repayment in 2011. The good news is that the national rate fell for the first time in 7 years to 13.7% from 14.7% the year before. The great news is that Navient's performance was even better. Borrower service by Navient saw their 3-year cohort default rate fall to 8.3%, a 32% decline over the prior cohort year. And for the 28% of all borrowers who are serviced by Navient, they experienced a cohort default rate that is nearly 50% better than the rate of all other servicers. I'm extremely proud of this outstanding level of performance and the enormous benefit it produces for our customers. Delivering superior performance to our customers is a key ingredient of our value proposition. Over the long run, delivering superior results helps borrowers succeed, increases revenues for our clients and reduces expenses for taxpayers. It will also help generate growth in revenues and returns for our investors. Our results for the quarter was solid and consistent with our expectations. As Somsak noted, this quarter's results included core earnings of $218 million, a continued improvement in credit trends with private credit charge-offs declining 23% year-over-year to $158 million or 2.3% of loans in repayment. We're seeing activity in the student loan purchase market where we purchased $1.4 billion of student loans, and we returned $229 million to shareholders through dividends and share repurchases. From our FFELP and private loan portfolios, we continue to increase future cash flows through a combination of loan portfolio purchases, improving credit cost and better funding spreads. We purchased $1.4 billion in student loans during the quarter, including $848 million from Sallie Mae. And year-to-date, we've added $2.9 billion to our expected cash flows from our student loan assets. In addition, we're seeing increasing interest from potential sellers as we expected. Our scale, efficiency and superior performance are distinct advantages for us as we seek to acquire additional loans in this area. Credit performance also continues to improve. Our repayment programs, along with an improving economy and increased portfolio seasoning are all contributing to a strong and improving outlook. Our reserves for future credit losses remain strong. And as Somsak described, the total balance of our reserves is really coming from the sum of 3 components: Reserves for losses that we hold within the 2-year window for non-TDR loans, reserves for the estimated life of loan losses for the $10 billion in loans that are designated as TDR and an allowance for potential recovery shortfalls on previously defaulted loans. In aggregate, our reserves are substantial. The results in our Business Services segment felt the impact of the legislative reduction to the rehabilitation fee paid to guarantors. And while the results were also impacted by seasonal and timing issues, the fee reduction was the main driver. Last quarter, our contract to service direct federal loans was extended. This quarter, the department announced the new pricing terms and new performance metrics. Although there are major changes to pricing by loan status, the net impact is likely to be immaterial to our financial results. In addition, the performance metrics for servicer rankings were changed to focus on delinquencies versus defaults. The new metrics did not take into consideration the type of school attended. As a result, servicers with a higher percentage of 2-year and for-profit schools will see higher delinquency rates versus servicers with higher percentages of 4-year schools. And without insight into the school mix at each of the 4 [indiscernible], it's difficult to estimate the impact of this change and what it will have on our overall ranking and market share. Finally, the Department of Ed also announced its plan to allocate 25% of new loan volume to the not-for-profit servicers. With the separation of the servicing for bank-owned loans and the launch of Navient now complete, we're turning our focus to growth. We continue to see significant opportunities to acquire student loan portfolios, both federal and private; to grow our servicing business; and to increase our asset recovery business in both education and the governmental space. As we've consistently demonstrated, we'll continue to seek opportunities to create value and generate increasing returns for our shareholders. With that, let's open up the call for your questions.

[Operator Instructions] And your first question comes from Eric Beardsley from Goldman Sachs.

I think you talked about having 4Q, has to recover revenue somewhere between $75 million and $80 million. How should we think about the trajectory of that into next year?

Yes, as of right now, we're not providing any guidance into 2015, but one of the things you have to consider is that as part of that asset recovery revenue, there is an inventory of FFELP recoveries that we are working on.

Okay. In terms of growth opportunities there, are you seeing much?

Yes. So we see a number of opportunities in both expanding our presence within the education space. We're hopeful that under the new Department of Education contract we'll see our market share increase. Certainly, our performance in this area as the top performer would indicate that. And we've been looking and expanding in state and local government areas over the last couple of years and see significant opportunities for growth in that sector as well.

Okay. Then just lastly, do you have a sense of what was the margin was on the loans that you acquired in the quarter, and I guess if we'll have an upward bias on the private loan margin moving forward?

In terms of the margin, it's embedded in the guidance that we've provided to you at this point.

To be clear though, we know exactly what...

Yes, we do.

Well I guess the question is, are they higher margin than the loans you already have on the books? And as you acquire more loans from third parties, particularly newer loans, should we expect that margin to go up over time?

They are marginally higher but one of the things that you'll have to take into account is the -- obviously, the price that we -- the premium that we paid for those loans, and it has to be reflected in the margin through our premium amortization.

Okay. So net of premium amortization, it still comes in about where the existing book is?

Yes.

And your next question comes from David Hochstim from Buckingham Research.

I wonder if -- could you remind us about the seasonality in the asset recovery revenue and how to think about that even though you're not giving guidance for 2015? Which quarters besides the second are typically good quarters for that business?

Yes, hi, David. Really previous to the second quarter of '14, if you go back about 5 quarters prior to the second quarter, our asset recovery revenue has ranged between $99 million to $110 million. And if you were -- if you take that and take the $30 million a quarter impact of the rehab fee cut, you get back, I think, within the fourth quarter range that we had provided of $75 million to $80 million.

Okay. And then I think not too long ago, Jack said that you expected to see, I guess, larger volume of purchases in the second half of other student loans, and I wonder if that would be true without the Wells Fargo purchase or certainly with it, it would be but...

So we're just -- we are seeing increasing interest in activity from holders, particularly of FFELP loans but also private, in this sector. And it's something that we've been expecting to see. And the pace of activity and interest has been accelerating over the last several months here. It's not just one party.

Great. Okay. And then is there any update on the IRS collections contract? When that might be sorted out?

That is subject to legislative action. And as of right now, we wouldn't expect that to occur or any discussion on that to occur until later this year.

And your next question comes from Mark DeVries from Barclays.

Assuming that Sallie Mae completes the rollout of its servicing platform by year end, they have indicated they'll look to do future sales servicing retain. Could you just talk, Jack, about your interest about potentially acquiring those loans if Sallie is going to look to retain the servicing?

So the servicing conversion was completed this past weekend, and so they are -- they have assumed responsibility for that. Our interest in owning student loan assets is primarily with servicing performed by us. And the reasons for that are clearly based on our scale and efficiency, so it costs us less to manage that portfolio than we would have to pay a third party. But we also bring significantly higher performance to the portfolio. You saw it in the federal loan default statistics that I mentioned. We also think we bring the same level of performance to the private loan side of the sector. And we're -- we have more flexibility of working with borrowers in that space to help them -- struggling borrowers, in particular, to help them manage their loan payments. And that program, in addition to this, has been extremely successful for us at helping borrowers stay on track and more importantly, reduce their principal balance. So clearly, that would be our first interest. We do buy portfolios that are not serviced by us. But as I said, the economics are harder for us to work in those areas.

Okay. And just one clarifying question on the opportunity you're seeing from potential sellers. Are you seeing equal activity in both kind of the FFELP and private student loan?

Well it's not equal. I mean the share amount of federal loans outstanding is multiples of the private loan space so...

Yes, sure. I mean, in terms of number of potential sellers?

There are multiple parties in both segments that are -- that have been talking about selling their student loan portfolios.

And your next question comes from Brad Ball from Evercore.

On credit quality, I'm looking at the allowance, does anything in particular account for the uptick in the allowance for partially charge-offs loans?

Actually, the uptick -- are you comparing it, Brad, to the prior year level?

Yes.

Yes. I don't know if you recall, but in the second quarter, we had increased our reserve for recoveries. Previously, we had -- our growth book was based on the 27% recovery reserve and had reserved it to something like a 22% recovery rate and then in the second quarter, increased that reserve to approximately 20%.

Okay. I got it. And then on the broader credit trends that you're seeing, when would you expect the normalization in private credit losses? It seems that the nontraditional loans are a smaller and smaller portion of the overall pie, and I would imagine less and less are entering repayment. So do you expect private credit normalization to be very gradual or would that be something we could see in the next year or 2?

Well -- this is Jack, Brad, there are a combination of factors here. Certainly, the age of the loan, or where it is in its life cycle, the economic conditions and job placements for -- loans entering repayment. What you're seeing in our private loan portfolio is a more seasoned book. We provide statistics for you in the -- in this earnings release package that shows the incidence of delinquency and default as loans move through the number of months of repayment. And you can see the pretty dramatic drop-off that tends to take place as customers move from the first year of repayment to the second and third. We've talked in the past about how the improving economy has helped customers. So we've seen substantial declines in delinquency rates for our customers who are entering repayment for the first time. That's true in both the federal and the private loan book. And the trend lines here in terms of dollars should be a continuing decline as you take those kind of combination of factors into consideration going forward versus a flat dollar rate, yes.

Okay. Helpful. And then just -- so separately following up on your comments about conversations with both FFELP and PEL sellers, would you expect that the recent rate environment, the rally in the long bond declining yields to impact willingness to sell here? Or are folks looking to jettison noncore business and expect that to follow through?

I think on the -- on both sides, if lenders are not active participants in the business, the driver here is the noncore activity for them. And one of the problems we've had in the past is that the sellers haven't -- or the potential sellers, haven't had a whole lot else to reinvest proceeds in. And as the economy has been improving and loan demand in particular has been growing, I think that's -- or those are the drivers that are creating some interest here.

Okay, fair enough. And then, finally, any update on the Department of Ed origination contract bidding? Any new news on that front?

Well we announced a month, 2 months or probably 4 to 6 weeks ago, that we had withdrawn from the bidding on that contract. It had morphed -- the RFP or the requirements had morphed from a processing-related business into something that was more of a major systems development initiative. And it was difficult for us to see how that could work from an economic perspective over a 5-year contract term.

[Operator Instructions] And your next question comes from Michael Tarkan from Compass Point.

In terms of the M&A environment, I saw that KeyCorp. sold the residuals of their student loan trust. It doesn't appear as though you guys were involved there. Can you just give us a little bit of color there, was it pricing related or maybe the lack of servicing attached? Any kind of thoughts there?

Yes. So these were residuals only. No servicing. The servicing component of the trusts were not sold and obviously, servicing was elsewhere. It was pure yield issues for us. We did take a look at it and someone else was willing to accept substantially lower returns.

Okay. And then I guess for the other large banks that are out there, are most of those loans whole loans or have they been securitized? Is the dynamic relatively similar or is it different?

Most of the -- most of the banks that own large portfolios of FFELP Loans are -- they're held as whole loans. And so the opportunity is for us -- and most of them are not life-of-loan servicing contracts. So our opportunity is -- where we can add value is to buy those portfolios, move them onto our servicing platform where we have better cost, better loan performance and can bring our financing capabilities to the table as well.

Okay. And then on the collection side, I know there's been some delays in terms of when Department of Education is going to announce the new direct loan collection contract award. Any update as to when that timing is going to play out? And then as a follow-up, I know there's -- sorry, 11 small business collectors this time around versus the 5 in the last contract. So any sense as to how many collectors -- how many unrestricted collectors they're planning on including under the new contract?

They have not provided any guidance on that, but we are expecting an announcement soon. It should be almost like any day, but it's been that way for a couple of weeks now.

Okay. And that relates to both when the award comes in how many collectors will be included?

Correct.

Okay. And then lastly, the updated guidance, does that reflect any additional share buybacks or debt repurchase gains in the fourth quarter?

It does, yes.

It does, yes.

It takes into consideration our plans.

And your next question comes from Sanjay Sakhrani from KBW.

I guess most of my questions have been answered, but I just had a couple of clarifying ones. The first one, just on the asset recovery change, I guess, variance between what was recorded this quarter and what you intend in the future. I mean, is the difference just you're expecting to take over more share? Or what's driving the increase in the run rate?

So there are -- so in the rehabilitation fee structure, the numbers can move around a bit from quarter-to-quarter based on how many weeks there are or weeks the guarantors can complete their sales based on a schedule. And so there were slightly more sales in the second quarter than there were in the third, and we expect that to be a more normal rate in the fourth quarter. That's the primary issue we were addressing by seasonal or timing differences.

Okay. And then when we think about the possible buyers of the portfolios out there that the banks might want to sell, I mean, how competitive is that market? You mentioned that other player kind of being -- willing to take much lower economics. But in the field of larger portfolios, how competitive is that market in terms of other competitions?

The first component you have to look at is whether the loans are securitized or not. A securitized portfolio in the sale of, in effect, the residuals, opens the universe to a wider range of buyers because they don't have to manage the loan portfolio, they don't have to arrange for the financing, the servicing contracts are already in place. And so you do see a different type of -- it's also the purchase price, the financial commitment is much, much smaller in the transaction, despite the par balance of the loan. In a whole loan transaction, particularly a large whole loan transaction, someone has to arrange financing, servicing. They have to manage the portfolio, and so the limited -- it does create more barriers to the process. So scale, efficiency, capacity are far more important there, all of which we bring to the table.

Okay. I guess, finally, just I saw CFPB put out something on private student loans today. And I was wondering what your observations were on that and if you had any comments on kind of the regulatory environment?

Yes. So we -- I think one of the things we've been doing in our private student loan business, is first of all we always take and seek impact -- input from our customers. So whether the complaint comes in from the CFPB or we're talking with customers on -- through our call centers and through our customer advocacy centers to try and make changes and improvements to the process to make it easier for customers. We are the only national player in this space that work with customers to -- who are having difficulty paying their loans, to get them into a repayment solution that works for them financially. And I think the thing that really separates us from other loan programs, including the federal loan programs, is that our repayment solutions are designed to help the customer actually reduce the amount of debt outstanding. So for example, we've got over -- about $2 billion worth of loans today in repayment solutions. These are struggling borrowers. And the typical customer in that program reduces their principal balance over the 12 months by about 3%. And so those are the types of things that I think the CFPB is looking for others to provide. We've been doing this for several years now and have a very successful track record in helping customers on that front.

And your next question comes from Alan Straus from Schroder.

Just 2 quick questions. How can we look at interest rates and your results? Because my assumption is that it moves kind of the 10-year or movement for rates really don't matter because it's pre-hedged. Is that the right assumption?

Well, certainly, impacts -- if you look at our cash flow forecast, we have estimated that we had about $1.9 billion of cash flow that will come from the floors embedded in some of our student loans. These would be older student loan portfolios. And certainly as the yield curve gets down or out, that value will fluctuate. About $400 million of that $1.9 billion is hedged today. And so it's about $1.5 billion that is subject to variability. The rest of the portfolio is, for the most part, variable rate in nature and so movements in the interest rates are -- don't have a whole lot of impact on the value of the variable-rate assets.

Are you thinking about hedging the rest of those residuals, the floors, I mean?

We're looking into that.

Okay. And second question. One, FFELP portfolios are transferred with servicing. Does the Department of Ed have any say on who services these portfolios?

Not on FFELP loans, no.

And your last question comes from Moshe Orenbuch.

This is a James Ulan on for Moshe. So I see that the cash balance is increasing, and I know that's FFELP cash flows in 2015 and 2016 are supposed to be pretty good relative to the 20-year period. And I'm kind of wondering how you guys decide how much cash to allocate to buybacks, dividends and then paying down debt, as well as maintaining cash for operating purposes.

Well, James, what we do is really consider all of those factors when we take a look at our liquidity position. One of the things that we're keeping an eye on is the fact that we've got, over the next 12 months, $1.9 billion of unsecured debt outstanding. So yes, obviously, that's an important consideration for us in terms of looking at our liquidity position.

Do you guys have a preference for refi versus paying down?

Yes, our preference is just to try to manage our debt balance to making sure it's at the lowest cost possible.

Okay. And then second question on self-guarantors, there's been changes in compensation. Do you guys think that you can win new business from FFELP guarantors you don't work with now?

Certainly when you look at our performance on the default prevention and collection side of the equation, we do help guarantors also deliver superior results. We work with 7 guarantors across the country on default recoveries, for example, and our 7 guarantors are all in the top 10 in terms of performance, including I think the top 5 slots overall. So certainly, as guarantors are -- and this is one of their big revenue streams, is recoveries. By working with Navient, they could improve their overall performance and help offset some of the reductions that are taking place on the fee side. We certainly look for opportunities there.

Okay. Thank you for joining our conference call today. That concludes our call.

This concludes today's conference call. You may now disconnect.