SLM Corporation (SLM) Q2 2015 Earnings Report, Transcript and Summary

Good morning. My name is Chris and I will be your conference operator today. At this time, I would like to welcome everyone to the 2015 Q2 Sallie Mae Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-session. [Operator Instructions] Thank you. Brian Cronin, Senior Director of Investor Relations, you may begin your conference.

Thank you, Chris. Good morning and welcome to Sallie Mae's second quarter 2015 earnings call. With me today is Ray Quinlan, our CEO, and Steve McGarry, our CFO. After the prepared remarks, we will open up the call for questions. Before we begin, keep in mind our discussions 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-Q and other filings with the SEC. During this 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 Form 10-Q for the quarter ended June 30, 2015. This is posted along with the earnings press release on the Investors page at salliemae.com. Thank you and I'll now turn the call over to Ray.

Thank you Brian, thank you Chris and thank you all for your attention this morning, and in reporting on the second quarter and indeed on the year-to-date results for Sallie Mae, we are in the middle of a very good year for ourselves. I'd like to touch on several topics as we have done in prior calls. First of course is that this is the end of the second quarter of 2015. It is our first overlap quarter. So it's the first time we are having a second second-quarter, having been launched on May 1, 2014 and as you will all recall during the first 12 months one of the major tasks for the management was to separate ourselves and pre-existing company and we have kept you abreast of those steps in progress, and at this particular point we are virtually done. The last major system to be utilized by the Bank which will give us independence from [indiscernible] is the [Atlas Fulfilment] [ph] System and as we have just called the [Atlas Fulfilment] [ph] is handling over 90% of our volume and we expect full separation to continue as that moves to 100 over the next 40 days or so. Second point was putting our team in place. It was last year at this time that we completed the last major senior hire in Jeff Dale as Chief Risk Officer. We have all been together now for a year. There have been no changes in senior management and no changes in organization and you'll start to see some of these steps to efficiency in very small ways. So Jonathan Boyles and his team has once again filed the 10-Q and the earnings release simultaneously which will allow this call to be better informed. In regards to our customer, we have and continue to be grateful for a very strong franchise. Our year to date disbursements are over 8% higher than last year, the quality of through the door population is judged by our credit evaluation is very strong and continues to improve. Credit trends as a result are all favorable in the portfolio. In regards to servicing those customers, we've taken several steps to improve the quality of our delivery including onshoring of all previously offshore [indiscernible] that is standard student loan servicing, we've introduced Saturday service, we've introduced our metrics and as of June we now have online servicing in a mobile app. In addition to that and in keeping with our status within the industry as the industry leader, we have recently released the latest version of How America Pays for College 2015 and we see in that research document the continuing trend that Americans value, have a very high value on the value of college at 97% favorable that families continue to support students as they move along to improve themselves in college and the parent contribution has in fact increased while at the same time the price of the college education has also gone up. In regards to our financials, we've had a good quarter and our results are on our financial model. We are on track for our full year goals. As mentioned before, our credit is performing well, our charge-off rate at 0.8% is right where we want it to be at this particular point as vintages mature, we have ample funding and it is in place, our risk-based capital ratio overall at 16% is extremely healthy and we're able to maintain that ratio which of course is very important for ourselves and the regulators, while at the same time posting admirable results in regard to return on assets of 2.82% in the quarter and 2.13% year to date and returns on equity that are in excess of 25% in the quarter and 19% year to date. Our NIM at 5.49% continues to be in the top tier of the industry. As a backdrop, while we are selling some assets as you all know, it's important for us to keep track of the size of our servicing portfolio because it reflects our interaction with our customers. The servicing portfolio has doubled from May of 2013 till today. So in two years it's up from $5 billion to $10 billion. In regards to our operating expenses, our efficiency ratio as we calculated it in prior calls, from the fourth quarter of 2014 and that run rate because as you'll recall due to this trend conversion the quarters leading up to the fourth quarter of last year were somewhat highly variable, so we used the fourth quarter as jumping off our efficiency ratio in that quarter annualized as 48%, our efficiency ratio in 2015 is at 42%. The marginal efficiency ratio which we have discussed on previous calls stands at what I would say is an industry leading 21%. In regards to the regulators, the FDIC, the UDFI and the CFPB, we continue to experience very good relationships with all of them and we're grateful for that. As we trend to the future and as Steve will discuss in more detail, we are reinforcing our guidance in regard to originations, OpEx, loan-loss reserves and the EPS. As we look forward to continued enhancements in our service platform over the course of the fourth quarter, we will bring online applications to a mobile base which will bring us current so far as technology is concerned, we have to play and catch up for quite a while, we'll have a new desktop that will be utilized by our collectors and our customer service area both of which will experience quite an upgrade from current system, and over a period of time you'll see us continue on our financial model including diversification. And so with those remarks I'd like to turn the call over to Steve. Thank you.

Thank you, Ray. Good morning everyone. I'll be referencing the earnings call presentation available on our Web-site during my prepared remarks, getting with our key financial results on Slide 4. Outstanding private education loans at June 30, 2015 were $9.3 billion, up 24% from the prior year. Our owned and serviced portfolio which includes loans sold with servicing retained is $10 billion, up 34% from the year ago quarter. Net interest income for the quarter was $168 million which was $3 million or 2% lower than Q1 2015 and $24 million or 16% higher than the prior year quarter. The decline from Q1 is due to lower average assets as a result of the loan sale that we did. The increase from the prior year is the result of the 13% increase in average assets. The average yield on our private education loan portfolio in the second quarter was 7.96% compared to 8.07% in the prior quarter and 8.22% a year ago. We expect our private student loan yield to stabilize here in the 7.90%. Our cost of funds was 1.17%, unchanged from the prior quarter and up from 94 basis points in the year ago quarter. A higher cost of funds in Q2 compared to the year ago quarter is primarily the result of fixed pay interest rate swaps that we entered into to hedge our fixed rate loan portfolio that were not in the cost of funds calculation in the year ago quarter because they weren't effective hedges. The fixed rate swap costs were recorded in the other operating income until they received effective hedge accounting treatment in Q3. The Bank's net interest margin on interest-bearing assets was 5.49% in the second quarter compared to 5.6% in the prior quarter and 5.32% in the prior year quarter. The change from the prior quarter was driven primarily by the lower yield on our private student loan portfolio. The increase from the prior year is due to the increase in private student loans as a percent of the total portfolio. We expect that our net interest margin will remain above 5% as private student loans increases as a percent of total assets. Noninterest income in the quarter totaled $89 million compared to $11 million in the prior quarter and $8 million in the year ago quarter. The increase this quarter was principally due to the result of loan sale premium of $77 million that we earned. The $5 million decline in other income was a result of one-time gains of $6 million in Q2 2014 and this was offset in the current quarter by $1 million of servicing revenue that we earned. Second quarter operating expenses excluding restructuring costs were $90 million compared with $80 million in the prior quarter and $60 million in the year ago quarter. The main drivers of the increase from the prior quarter was the seasonal increase in our direct to consumer spend and the ramping up of our sales call center for the peak selling season. In regards to the year ago quarter, you may recall that it consisted of one month of pre-split carved out financials and two months of actual standalone operations. In addition, Q2 2014 expenses [indiscernible] are reversal of an $8 million litigation reserve. So the increase from the prior year is due to the buildout of our own servicing platform, our [indiscernible] infrastructure and a significant increase in loan volume. Restructuring costs in the quarter were $1 million compared to $5 million from the prior quarter and $14 million from the year ago quarter. We still do expect to spend $1 million in restructuring costs in the second half of the year. The origination platform as Ray mentioned was the last major system to be converted post-spin. We implemented the final stage of the new loan origination platform in June and are currently processing nearly all of our new loan originations through this platform. In the second quarter the tax rate was 40% compared to 42% a year ago. The tax rate from the year ago quarter was higher because we were establishing a reserve for uncertain tax positions. We expect the full year tax rate to remain around 40%. The Bank remains well-capitalized as Ray mentioned with a risk-based capital ratio of 16% at the end of the quarter, significantly exceeding the 10% risk-based capital ratio required to be considered well-capitalized. In addition to this, the patent company has excess capital available to the Bank with an additional sources stream. We will continue to maintain high levels of capital to support the projected growth [indiscernible] and we don't anticipate returning capital to shareholders as we reinvest in our high-growth [indiscernible]. Turning to Slide 5, you will see a summary of our origination volumes. We originated $384 million of loans in the quarter, up 2% from the prior year, and loan originations were up 8% year-to-date. The loans we originated in the quarter have average FICO score of 747 and 90% of loans had a cosigner, very consistent with our typical originations. Keep in mind that the second quarter was an off-peak period for originations. We are currently in our peak season for applications and disbursements as students prepare for the fall semester. However, it's too early to get a read on how we're doing in the peak season and we'll update you on that in our third quarter earnings, but we remain [indiscernible] our guidance of $4.3 billion of originations for the full-year, which is a 5% growth [indiscernible]. Turning to Page 6, we reported on our loan statistics. We've been talking over the last few quarters about [cohorted] [ph] loans have entered full principal and interest repayment in the fourth quarter of 2014 just under $1 billion. As discussed, this has resulted in increased delinquencies in the first quarter followed by a fall in the second quarter. The seasonality is evidenced in graphs on Slide 7 as monthly delinquencies and charge-offs as a percentage of loans in principal and interest repayment. As you can see, delinquencies peaked in January from March in the various delinquencies paid buckets and the fall peaked in May. This repay cohort is performing well within our expectations. Turning to the full repayment portfolio, loans delinquent 30 plus days were 1.7%, unchanged from Q1 and up from 0.7% in the year ago quarter. Loan in forbearance has increased to 5.7% from 2.8% in Q1 and 0.9% in the year ago quarter. I had mentioned in the press release [indiscernible] this is the result of a letter published by the FDIC which encouraged lenders to work constructively with borrowers impacted by the floods in Texas this spring. Accordingly, we granted a two-month disaster forbearance to residents of the impacted area. This doubled our forbearance rate. But important to point out that substantially all of the borrowers were current when the forbearance was granted and half of the borrowers continued to make payments, overall none [indiscernible]. Without the disaster forbearance, the forbearance rate in the second quarter would have been unchanged at 2.8%, and looking at the performance through July we can report that forbearance has already declined to 3.6% with no impact on our delinquency rates as this two month disaster forbearance expires. Net charge-offs in the quarter were 0.8%. Charge-offs increased from Q1 to Q2 due to the seasonality of the repayment wave we just discussed. We are very pleased with the performance of our portfolio and the continued strong results of our defaulter aversion efforts under our 120 day collection policy. We ended the quarter with 30% of our total loans in full P&I up from I think 28% in the prior quarter. As a result of our strong credit performance, our provision for the private education loans is $15 million in the quarter. We ended the quarter with an allowance for loan losses of 94 basis points of total loans and 1.54% of loans in repayment. We're not changing our provision guidance as portfolio growth and aging as well as growth in our TDR portfolio warrants increased provisioning in the second half of the year. On Page 8, we report our earnings metrics. SLM [indiscernible] called core earnings. The only difference between core earnings and GAAP net income is that core earnings excludes the mark to market on unrealized gains and losses and in fact the derivatives from earnings. We use derivatives as you know predominantly interest rate swaps to manage interest rate [indiscernible] in our portfolio. We believe all these hedges are sound economic hedges whether they are effective or not from an accounting standpoint. Core earnings for the quarter were $91 million, $0.20 diluted earnings per share, compared with $48 million or $0.10 diluted earnings per share in the year ago quarter. Core ROA for the quarter was 2.8% compared to 1.5% in Q1 and 1.7% in the year ago quarter, and core return on common equity was 25.2% compared to 13.2% in Q1 and 15.5% in the year ago quarter. Much of this favorability in the quarter was due to the loan sale that we booked and as Ray mentioned year to date ROA and ROE was very strong at 2.13% and 19.4%. As many of you know, we were in the market this week to raise term funding in the ABS market. This wasn't a [indiscernible] time to enter the market as spreads in general and for student loans in particular have widened substantially. FFELP spreads have widened significantly due to an issue that many of you are aware of regarding legal final dates on FFELP trusts, and this had a spill-over impact on private credit spreads. But the fact that we are able to issue without significantly widening our spreads, we think demonstrates a high quality of our private credit collateral and we're very pleased with the results of the transaction which will be officially priced this morning after our call and we expect that those prices will be consistent with our long-term funding plan. I know many of you are interested in when we will do our next private credit loan sale. We have that on the calendar for September and we look forward to reporting the results of that transaction to you. As we've mentioned, our guidance for 2015 remains unchanged. We still expect to originate $4.3 billion of our high-quality Smart Option loans, we expect our provision to be $95 million and our gain on sale is expected to total approximately $155 million for the full year. Operating expenses should come in at $347 million. And finally, our EPS range remains $0.57 to $0.59 for the full year. Thank you very much. We will now open up the call for questions.

[Operator Instructions] Your first question comes from the line of Sanjay Sakhrani of KBW. Your line is open. Sanjay Sakhrani, your line is open.

Operator, maybe we'll take the next call.

The next question comes from the line of Michael Tarkan of Compass Point. Your line is open.

Thank you. Just on the operating expenses, with that pickup ahead of peak lending season this quarter, should we expect that to trend down in the back half of the year and then is that second half run rate of around $85 million a quarter, is that a good way to think about a run rate to grow off of as we think about 2016?

Mike, I think what you probably see is a slight increase as we continue our peak season spend on additional marketing and servicing in Q3 and it will drop off substantially into Q4.

And then is that second half run rate, is that a fair sort of assumption to start thinking about 2016?

Yes, I think if you factor the seasonality into it that should definitely work for 2016 OpEx.

Okay. And then on the student loan yield this quarter, you mentioned we should sort of stabilize in the 7.90s. Can you just talk about what drove yields down this quarter, is that a mix issue or are you seeing pricing come down a little bit in the industry, just kind of any color there?

So we actually implemented – we tweaked our pricing over a year ago for the last peak season. We tweaked our pricing in the pricing bin and we also introduced a graduate pricing tier to compete more effectively with the Plus loan and this has slowly bled into the portfolio, but we fully expect it to stabilize as I mentioned in my prepared remarks in the 7.90s on a go forward basis. And that of course will depend upon the mix of fixed and variable. Our variable rate loans, we expect to come in rough numbers around minus or plus 7.50 and our fixed-rate portfolio typically yields in the 9, so low 9. So depending upon the mix, the mix of fixed-rate originations does seem to stabilize in the low 20s but we'll see what the peak season brings.

Thanks. And just a follow-up on that, just competitively are you seeing just a rational sort of environment at this point, have you seen any kind of changes from your two largest competitors?

No, we haven't seen any pricing changes, Michael. They continue to be fairly stable. And as you know from our market share gains our pricing strategy has continued to work.

Thank you very much.

Your next question comes from the line of Sameer Gokhale of Janney Montgomery Scott. Your line is open.

Thank you. Good morning. A big part of this story here for Sallie Mae, I mean there are several moving parts but the idea as you can scale the business up, you've taken origination in-house, servicing in-house and generating pretty healthy gains on sale, so you talked a little bit about operating expenses in the second half of this year and the trajectory, but this year included like separation cost I think from the legacy Sallie Mae bringing some of these functions in-house. So as you think out incrementally into 2016, are there any additional areas of investment where you think that you will need to allocate more resources there or should we think of it as now all the expenses are sort of in the numbers and everything else is only going to be very marginal as we look ahead into 2016?

So, Sameer, as you know as we've discussed we've made several investments to improve our customer service and build our franchise, we've invested in onshoring our sales call center, we've reinvested in mobile apps. I mentioned that we did some additional brand spend to support the brand now that we're a separate company and we have a lot less hits on our Web-site. So we have made some significant investments. As we look forward, I think that most of the investments in infrastructure and the servicing platform are for the most part done. So I think we can begin to realize the efficiencies as you would expect from a stabilized and established servicing platform on a go forward basis.

Okay. And then I know a call or two ago we had touched on this, but again I wanted to just get your perspective on forward flow of arrangements. You're generating pretty healthy gains on sales with your loan portfolios. It seems like in the current environment given that you have those gain on sale margins, have you had discussions with any of your buyers about maybe locking in certain pricing for next year's expected loan production and would you consider doing something like that?

So, look, we have been approached by several of our residual buyers who would like to lock up [indiscernible] share of it or lockup [indiscernible] but you know how financial markets work, the very first thing that is mentioned to develop a full price is a discount from the spot price. So we could enter into arrangements of that nature, but look, we're very confident in the collateral, the private credit loans that we're selling here and this past couple of weeks has been a perfect example of the kind of volatilities that you can face in the marketplace. So there is a trade-off between price and certainty of sales but we think that the market will be stable enough and that this is an attractive enough asset that we would prefer not to enter into formal sale arrangements at this point in time.

Okay, thank you. And then just my last question was around or tied to the loss provisioning. Later this year I think we are expected to get new accounting rules which would require life of loan loss provisioning and maybe it's a little bit early because as I understand the rules won't become effective until 2019, so that's a ways out, but as you think about those rules and possible implementation and impact on capital ratios, have you at this point had a chance to contemplate that impact and love to get your perspective on that?

One is that we have reviewed that and we reviewed it both in-house as well as with the KPMG guys who are doing lots of [indiscernible] on it. Two is I agree with you that 2019 is just about [indiscernible], it's going to be under current planning horizon and so when it gets implemented we'll have a lot more information, many things are preliminary, we are as you know extremely well capitalized institution, certainly better than the industry, and since this will be an industry-wide directive when it occurs, we think that from a competitive position in regard to capital that we'll be well situated. Having said that, it's 2015, 2019 is a long way off and there's lots of uncertainty between now and the implementation on that particular point.

Alright, thank you.

Your next question comes from the line of Mark DeVries from Barclays. Your line is open.

Thank you. Steve, I believe you alluded to some widening that you've seen in private credit spreads in the last few weeks but you're still maintaining the 10.5% gain on sale margin guidance. Does that assume that margins are going to have to or spreads are going to have to tighten from here or are they still at levels that would support that level of gain on sale?

I think that they are at levels that would still support that type of a gain on sale. I mean it certainly would help if they tightened and we do think that they probably will tighten. The other thing that I would point out is that in this particular sale the bonds that were the most well bid were the higher yielding lower rated bonds. So in talking with some of the guys that invest in our paper and the residuals, it seems that the equity tranches remains particularly well bid, but we'll have to monitor the volatility in the marketplace as we move forward to the sale in September.

Got it, that's helpful. Next question, is it fair to assume that the NPV of selling at 10.5% gain on sale and then retaining servicing is actually higher for you right now than retaining loans, and if that's the case, are you thinking about maybe selling even more loans than you currently have been planning to?

There are several ways to look at it and we do several different types of analysis on this. 10.5% premium we basically essentially reaping upfront four years or five years of guaranteed ROA is very attractive. You can go at breakeven analysis in a number of different ways and come to different conclusions based on the assumptions you use on discount rates and capital and so on and so forth, but it's also true that if you hold the loans on a portfolio it doesn't take too long to double up significant additional earnings per share in future quarters and years. So we are still tending, we are still using the loan sales to manage our 20% growth rate cap and we are [indiscernible] to hold onto more loans than selling at this point in time.

Is there a level of gain on sale on which it just gets to the point where pricing is so stupid that you would sell more and retain less?

Yes, I mean we're pretty close to that percentage point or two would definitely compel us to sell additional assets into the marketplace.

Okay, fair enough. Thanks Steve.

Your next question comes from the line of Moshe Orenbuch of Credit Suisse. Your line is open.

Just following up on that question, is that 20% kind of calendar year-calendar year or can it be some sort of rolling 20%?

FDIC thinks that this is a fairly rigid way if it's calendar year.

Okay, got it. And when you think about, I mean you mentioned market share gains, maybe talk a little bit about what you're seeing if you're seeing anything different from your competitors or things that they are not doing that are kind of allowing you to continue those market share gains?

As said earlier, the competitive frame was Wells and Discover and ourselves being the dominant three players in the private student lending business has been fairly consistent. They are worthwhile competitors, they obviously changed their tactics over time, we monitor them very closely, and so we are in the midst of a season that has [indiscernible] advertising going on, direct response both in mail as well as on Internet, it's hard to know what the opposition is doing but I would have to say that we don't see anything that is categorically different. We see more of some items less of others but the basic competition is taking place on familiar battleground.

Okay. Last question for me is on credit quality, I mean you've shown some slides in your regular handout that look at the vintage performance of the loans that have entered repayment 2011, 2012 and '13 and they seem to be seasoning kind of well below your target ranges and getting better. If you could just kind of talk through that and how you think about that relative to the high 7% cumu loss that you've got in there?

So there's a couple of things to point out about those charts. So as you noticed with each cohort the starting point of the charge-offs is lower and that's because in the older charge-offs – I'm sorry, the older cohorts the loan mix is slightly different. So for example in the 2011 loan cohort, that was when we first started originating Smart Option loans. So there was a higher percentage in those cohorts of dropouts which are of course [indiscernible] performing type of borrower and as you noticed the starting point lowers with each successive year. That being said, I think it is reasonable to say that the cohorts are running somewhat under our 7 point expected cumulative life of loan charge-offs, and if you look at the current cohort in Q2, the annualized charge-off rate for loans in principal and interest repayment was 1.99% and that compares to 2 plus percent in the vintage charge – I'm sorry, the life of loans charge that we put out several quarters ago. So while it is fair to say that the portfolio does appear to be performing better than our expectations, we are certainly not going to get complacent and we're going to continue to maintain a pretty conservative approach to reserving for and managing this portfolio.

Got it, thanks Steve.

[Operator Instructions] Your next question comes from Eric Beardsley of Goldman Sachs. Your line is open.

I was wondering if you could give us a projection of the dollar amounts of loans entering full P&I repayment over the next couple of years.

I can tell you that the next big repay wave which was the November to December repay wave is $1.55 billion. I don't have the next cohort handy but I can tell you that the percentage of loans in P&I of our total portfolio pan out sort of like this, Q3 '15, 31%; Q4 '15, 33%; Q1 '16, 33%; and then it jumps to like 39% in the second quarter of '16. Is that enough info?

Yes, that's helpful. Thanks Steve. And then just secondly on the FDIC cap on growth, I know it's early since you're only a year post-spinoff now but are you having any discussions with them of lifting that cap?

So look as you point out we're one year into it, that's early days. We do have our DFAST stress test coming up in – we have the post results in July of 2016, and I would suggest that any conversations that we have with our regulators related to growth or capital levels would certainly take place subsequent to filing those results and passing them with flying colors.

Great, thanks, that's all for me.

Your next question comes from the line of David Hochstim of Buckingham Research. Your line is open.

Steve, can you just talk about the cadence of provisioning in the second half and should we think about the second half as a good starting point for 2016 or something going on?

The cadence, our expectation of what's going to happen in Q3 and Q4 in terms of size and seasonality would not be much different to what happened in 2014 but I think it's a little early to start talking about 2016 loan-loss provision. It's obviously going to grow as the portfolio grows and it ages. I'm sorry I can't give you any more detail on that really at this point in time.

Okay, but Q3 and Q4 should be similar in size then?

The size of the provision but grossing up for the full 95.

Right, okay. And then could you just clarify what you said about servicing income, did you say $1 million?

Yes, we had $1 million of servicing income in the quarter. So I think that [truck] [ph] settled on April 30 of this year. So it was just [indiscernible] two months of servicing revenues.

So it will just be a part of the quarter, okay. And then is there any update on the effectiveness of those new sales people that you hired, is it too early or are they producing for the peak season now, are they?

So they are certainly out there in the field working with their school clients but that is a strategy that we would think would take a little bit more than one season to pan out. They've got to develop their relationships with the schools and prove their value before they start to generate any outsized gains in loan originations.

That said, we are happy with the additions so far.

Okay. And then just turning back to the theoretical discussion about holding loans versus selling them, if you had some kind of absurd premium available, is there a limit to how much you'd be willing to sell or would you…?

That is clearly a theoretical conversation. I mean you also have to remember that you need the demand for loans also. Every $750 million of loan sales becomes a little bit difficult because the investor appetite is not infinite. So that's a tough question to answer really.

Okay, all right, thanks a lot.

There are no further questions at this time. I return the call to Brian Cronin for final comments.

Thank you for your time and your questions today. A replay of this call and the presentation will be available through August 6 on our Investor Relations Web-site at salliemae.com/investors. If you have any further questions, feel free to contact me directly. This concludes today's call.

This concludes today's conference call and you may now disconnect.