SLM Corporation (SLM) Q1 2016 Earnings Report, Transcript and Summary

Good morning. My name is Erica and I will be your conference operator today. At this time, I would like to welcome everyone to the Sallie Mae First Quarter 2016 Earnings Conference Call. [Operator Instructions] Thank you. At this time, I would like to turn the conference over to our host, Brian Cronin, Senior Director of Investor Relations. Mr. Cronin, you may begin your conference.

Thank you, Erica. Good morning and welcome to Sallie Mae’s first quarter 2016 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 discussion will contain predictions, expectations and forward-looking statements. Actual results in the future maybe materially different than those discussed here. This could be due to a variety of factors. Listeners should refer to the discussion of those factors in the company’s Form 10-Q 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 Form 10-Q for the quarter ended March 31, 2016. This is posted along with the earnings press release on the Investors page at salliemae.com. Thank you. I will now turn the call over to Ray.

Thank you, Brian and welcome to the call everyone else. I will cover certain highlights of our financial and other parameters and then turn the call over to Steve. And so in summary, the first quarter is a very good quarter. We are essentially on track to a little bit better. And as we go down the major parameters, I think that will be obvious. Starting with new loans, new loans are up 8% year-on-year as you know that’s a little bit faster than both our goal for the year as well as the market growth. So, we find that to be a good indicator early days in the year so far. This is reflected in our major earning asset on our balance sheet, which is the private student loan balances, which are up year-to-year from roughly $9.8 billion to $12.1 billion, a 24% increase. It’s also the case that between when the bank was originally launched at 12/31/13 right before the spin until the end of this year, 97% of the increase in our balance sheet will be directly attributable to the private student loan receivables. So, the balance sheet will become more productive as we move along. Through-the-door credit quality is gratifyingly consistent and high-quality. And so the average FICO for new loans granted in the quarter was 748, approximately equal to the 749 of the prior year. The co-signs rate is actually 100% flat at 90%. And so through-the-door credit quality is consistent with both our models as well as with our prior performance. NIM, a reflection of course of the pricing associated with that as well as our efficiency in cost of funds was 5.77 for the quarter, little bit over where we anticipated, but it is the nature of the business that the NIM tends to be a little bit elevated in the first half of the year until a little bit in the second half. Last year, however, with the same seasonality with 5.60, the NIM has gone up from 5.60 to 5.77 and we think that’s very good. As you know, in prior calls we have talked about you well with the NIM drop off significantly over time due to either competitive pressures or something else. And we had said there would be a number of at least 5.50 through the end of ‘16 obviously we are north of that. Our portfolio yield is flat, 8.07 last year, 8.03 this year through the door is very consistent with that. And so the NIM is the number on which we can rely. Our OpEx, which we have given guidance on and relationship to its relationship to revenue was – the efficiency ratio was 42.2% this quarter, down from 44.4% last year. As you know, our guidance is to improve from the 2015 number of 47%, down 8% to 10%. We are on track to go and do that. Credit performance is also very consistent. Our loan loss reserves, that’s been roughly flat from 1.03 at the end of the year ‘15 to 1.01 at the end of the first quarter. As a percent of loans in repayment, number is also flat moving from 1.57 to 1.56. Earnings per share in the quarter were affected by a one-time accounting estimate change associated with Upromise of $9.9 million. That is a revaluation of the liability. It is strictly a balance sheet. It’s a one-time deal. And so we are just putting it on the site here. If we were to take that out and look at the EPS for the quarter, it’s $0.13. Last year at this time, the EPS was $0.10. The increase in EPS year-on-year normalized is approximately 30%. As you know, on outlook numbers have not changed and we feel very confident in regard to them just with the 30% in the context of those, the $0.49 to $0.51 guidance on EPS, if we took the – the mean of that rather, that would be $0.50. And last year, if we remove the asset sales from the EPS actual, number was $0.39. And so the $0.50 is looked at that in relationship to the $0.39, the increase in EPS underlying organic growth in the franchise is 28.2%. So, 30% is quite consistent. ROEs remain gratifyingly high at an adequate level. After removing the Upromise estimate change, we are 14.3% in the quarter, up from 13.2% last year and our outlook on that remains consistent. And so in addition to all of these items, we also on Monday, the 18th, launched a new product, the parent loan, is in soft launch now. And we have so far seen that it is a successful soft launch, the software seems to be working. And we will be ready for the busy season with additional armament of the parent loan. Our funding remains robust in an industry where funding has been a challenge for the last 6 months or so. We remain consistent with the January call that we had our investors. We will be able to originate fund and hold all of our assets for the foreseeable future. And our funding is more than adequate to cover any growth we anticipate, which as you saw is significant. It’s also the case we will have our DFAST review with the FDIC for the first time with our filing to them due on 7/31 of this year. We are in very good shape in regard to that. And so that will be a major milestone for us as well. With that point, I am going to turn the floor over to Steve and look forward to your questions.

Thank you, Ray. Good morning, everybody. Ray has certainly covered the highlights of the quarter. I am going to drill down and just give you a little bit more detail on the couple of the numbers before we open the call up for Q&A. Turning to our cost of funds, Ray covered the return on asset and the NIM. Our cost of funds was 126 basis points, up 8 basis points from the prior year quarter and up 9 basis points from the year ago quarter. The increase was primarily due to the increase in LIBOR that happened back in December. $7.8 billion of our funds are directly indexed to LIBOR and another $2.5 billion are money market deposits that are correlated to LIBOR, but then re-priced with the December rate increase. Finally, $2.8 billion of our funding is fixed rate and this funding breakdown actually excludes our equity component. The fixed rate funding in our portfolio, along with lags and resets to the index, dampened the rate impact on our spread. Our funding strategy is to remain neutral to interest rate movements and maintain a steady manage with margin to the greatest extent possible. In fact, in our Q, we typically publish our earnings at risk and the economic value, equity table where we show the impact of 100 and 300 basis point interest rate shock. And as you can see from that, we are typically pretty neutral. One of the key assumptions in that model is that our money market deposits will re-price with increases in interest rates at sort of an 85% correlation. And of course this time around they did not so we benefited from that in this current quarter. Net interest income totaled $21 million in the quarter compared with $72 million in the prior quarter and $11 million in year ago quarter. The decrease was primarily driven by the $58 million of loan sales gains in the quarter. As a reminder, loan sales are no longer a component of our business plan. And also as Ray commented, in the quarter, there was a one-time $10 million gain resulting from change in the reserve estimate related to our Upromise business. Take a little bit of a closer look at OpEx. First quarter operating expenses were $93 million compared with $85 million in the prior quarter and $86 million including $5 million in restructuring in the year ago quarter. Expenses in the first quarter are typically higher than the fourth, due predominantly to staff-related expenses, associated with the beginning of the calendar year, such as the resumption of payroll taxes and various benefit accruals. And this accounts for most of the increases sequentially in expenses. The change from the prior year is driven by 31% increase in customer accounts and a 40% increase in total – in accounts and repayment as well as investments that we have made to improve the customer experience which we talked about in all of our recent quarterly results. And these are things, such as on-shoring our call center and investing in our mobile capabilities. Ray talked about our efficiency ratio and this I think just demonstrates the kind of operating leverage that we have in our model to handle those kinds of volume increases without any significant changes in OpEx. In the first quarter, the tax rate was 37% compared with 40% a year ago. We have received a couple of questions about this. Our expectation is that the tax rate will approach 39% over the remainder of the year. The bank remained very well capitalized with risk based capital ratio of – total risk based capital ratio of 14.4% at the end of the quarter, significantly exceeding the 10% obviously required to be considered well capitalized. As we have mentioned in the past, we expect our total risk based capital ratio, which is the main ratio that we focus on, to approach 13.5% as our portfolio grows over the course of the year. And this excludes a significant amount of excess capital available for the bank that we have at the holding company. Moving along to credit performance, loans delinquent 30-plus days were 2.1% compared to 2.2% in Q4 and 1.7% in the year ago quarter. We focus on the sequential quarter because the year ago portfolio was really just beginning to see season. Loans and forbearance were 3% compared with 3.4% in Q4 and 2.8% in the year ago quarter. We think that the sequential decline in delinquencies in Forbes is a positive for the portfolio, considering that we have $1.5 billion of loans that just ends with the repayment in November and December. And they are currently meandering their way through the various delinquency buckets. So we think our portfolio is performing very well here. And that is also displayed in our net charge-off rate, the net charge-offs for loans and repayment were 0.95% in Q1, down from 1.08% in quarter four. Gross charge-offs for loans and full P&I repayments came in at 2.1% in Q1. That’s also down from 2.4% in the fourth quarter. We now have $3.9 billion of loans in full P&I, that’s up from 50% a year ago. We ended the quarter with 32% of our loans in full principal and interest repayments. And we expect another $2.9 billion to enter full P&I over the course of 2016. Provision for private education loan losses was $34 million in the quarter compared with $16 million in the year ago quarter. And Ray mentioned earlier that we ended the quarter with an allowance for loan losses of 1.01% of total loans and 1.56% of loans in repayment. Our allowance coverage ratio is the solid 1.7%. Again, our portfolio is performing very well within our expectations. We would expect the allowance for loan losses to grow slightly over the course of the year as we cover expected losses on those new loans and enter full P&I in 2016. So that’s, I think, pretty much covers the quarter. So we would like now to open it up for questions.

[Operator Instructions] Your first question comes from the line of Moshe Orenbuch of Credit Suisse.

Great. Thanks. I would like the fact that you kind of compared the earnings pulling out the gains on sale, but interestingly enough I guess since you actually don’t have the loans that were sold in the last nine months of 2015 in your numbers, it actually subtracts from your growth, right. So I guess I am trying to think about how we should think about the development over the next 1 year or 2 years in the various metrics. And maybe you could talk a little bit about in terms of loan growth and efficiency, because all of the costs of originating those loans and servicing them have been in your numbers and should be in the base and in the expectations, but you are layering on the revenue, so if you could kind of talk about that, I would like to discuss that?

Sure. Thanks for the question. And in this case, of course that when you sell the loans, they don’t appear on the balance sheet and so the basis that we would be comparing to in 2014 and 2015 have to be adjusted for that if we are looking at loan service, let’s say as opposed to loans owned. And so in this case though that we are where we are in relationship to the balance sheet. And as we have talked about on the prior calls, the loans that we are putting on have an actuarial life of about 7 years. And knowing the base we are starting from, which is in this quarter is ending balance sheet and knowing that our acquisitions of new loans are targeted to be $4.6 billion, I think that the numbers associated with the PSL receivable are pretty straightforward. In addition to that, as you know we do have both fixed and variable costs. And so while the acquisition cost is a sum cost, it is the case for that the operating costs associated with the loans are relatively low early days because they are not in repayment while the student is in college. And then the after graduation, in a six month grace period, then traditional servicing, especially associated with the collections and payment management, come to pass. And so it will not be the case that all the costs respond. But I think if we will use the current balance sheet as a basis for growth, we will use the guidelines for new volumes or we will take the actuarial fees into account. Looking at that yields of the receivable and looking at our efficiency ratio which we have already targeted, I think we pretty much have that P&L box.

Okay. And just the comments that you made about successful soft launch of the parent loan, any thoughts – is it still on track for $100 million in originations for this year that you had said before and any thoughts about what that could contribute over time?

Well, one is we did launch on-time, which is gratifying and that was last Monday. We are in soft launch and trying to ensure that all of our thoughts and preparations were going on to a larger audience already. And so that’s coming along as expected. It’s a product that has been received warmly by our professionals in the financial aid offices at schools. We think that our estimate is a fair one. We of course would like to exceed it. The quality of these credits will be almost identical to the credits in the base product. And so we are optimistic, but we think that the estimate that we have is a prudent one for the first time launch and obviously we have no history with this.

Right, great. And there were some comments in the Q about sales force expansion and kind of you are kind of targeting more schools, can you just discuss that? Thanks.

Yes. As mentioned we did expand our sales force last year. And this is a relationship business and as part of the strength of our franchise is that we have relationships with the schools with particular individuals in our company that sometimes go as longer than a decade. And so it’s not a rapidly moving business from that standpoint, which if you are the market leader, is a position that is fortunate. The sales force expansion has been successful from our lives. One indicator we look at it, the number of – if you were to look at all the schools in the country and then say if you have many of those have a preferred lender list and what percent of those preferred lender list have us on it, the answer is over 97% and we have been able to increase our presence in regard to that preferred lender list directly attributable to the expansion of our sales force.

Thanks very much.

Your next question comes from the line of Sanjay Sakhrani of KBW.

Thank you. Good morning. First question was just secondary market conditions, I was just wondering if anything has changed kind of quarter-over-quarter and whether or not you would consider selling loans in the future given you have the ability to keep them on balance sheet now? Thanks.

Sure, Sanjay. So conditions in the secondary market are in the regular asset-backed market so for the senior bonds, it seems to be recovering pretty nicely in the last couple of weeks. There have been transactions getting done across the quarter, but spreads now do seem to be tightening. The residual end of that market, so it’s a more esoteric component of that security is I think recovering at a much lower pace. If we wanted to sell loans today which we certainly do not, I think the model is to originate some in hold. Our best guesstimate is we could probably garner our premium somewhere in the vicinity of 5%, but our interest is to hold these assets for the long haul. We think shareholders are better served as we grow our asset base. We have talked in the past about our breakeven point being in the vicinity of 8%. I think it would take a substantial increase above that level to compel us to want to shed some of our assets.

Okay. And then when we think about like regulatory capital, you guys feel pretty comfortable where you are operating with that growth going forward. I mean, what should we think as kind of a baseline for capital assuming the growth you guys are anticipating?

Well, so couple of things. So, when we look at our portfolio under extreme stress conditions, so that’s like a 99.9% confidence level and then loading up capital to cover potential operating issues. We think the smart option student loan should require maximum of 10% in a severely stressed environment. As Ray mentioned at the top of the call, we have just internally completed our DFAST exercise and I will have to walk the board through it. And then we will ultimately submit it in July of this year. I think that will give us an opportunity to have further dialogue with our regulators about the appropriate level of capital to the smart option student loan. With that being said, we are currently at a level of 13%. I honestly don’t suspect that we are going to be moving from that level in the near-term. I think that everybody is going to want to see a little bit more experience with how the credit actually performs before we take the next step in the downward direction.

Okay. Final question just on competition, obviously, we have heard a lot about these peer-to-peer guys, but even the government program, are you seeing anything noticeable in terms of the change in the competitive environment or is it pretty steady?

Fortunately, the competitive environment in the traditional full year not-for-profit originations is very consistent. It is the case that we still have major competitors that are daunting, Wells Fargo and Discover. It is the case that we track them school by school very carefully and of course I am sure they do us. It is the case also that we hear quite a bit about the peer-to-peers or FinTechs. We look for them constantly. We don’t see them in the origination of new loans. They have primarily been in the personal loan space and in the consolidation loan space. As we looked at that versus our liquidations and receivable, we don’t see any changes there at all. And I am sure you read the same stories I have that many of them have scaled back actually on their originations given the credit market conditions that Steve alluded to. So, the frame for a competitive environment is consistent.

Okay, thank you.

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

Thanks for taking my questions. Just on the guidance real quick, I guess I was a little surprised you didn’t increase it after the quarter given the beep, any specific reason for the conservatism?

So, Mike, we have not completed the first 3 months of a 12-month year. The quarter was very, very strong, but we do have a 3 point range in our EPS guidance, $0.49 to $0.51. I can be constructive and say that the beep certainly moves us toward the higher end of that range. But I think it’s a little premature to go through our guidance. So, we are very positive on our outlook for the year and we don’t see any hidden trap doors or pitfalls. So, we think the prudent thing to do is to remain our guidance – maintain our guidance for at least another quarter as we launch our performance here.

That makes sense. In terms of the NIM, I know it bounces around, but you had talked about 5.50 obviously we are higher than that this quarter. Are you still thinking about that 5.50 level? And then how sticky do you view your cost of funds at this point?

Yes. So, actually what we anticipate happening is for the NIM to remain pretty steady through the second quarter and then in the third quarter as we start to build cash to position for our peak season from Jan ‘17 disbursements we would expect a little bit of a drag on the NIM as we hold higher cash balances earning a negative carry, but to answer your question, for the average for the year, we expect to certainly be 5.60 or slightly above that.

And to the point that Steve is making, if you look at our cash balances from the fourth quarter to the first quarter, they dropped off over $1 billion.

Yes, that makes sense. And then I got one more random one. And on the servicing side, I know you have the non-compete with NAVI regarding direct loan servicing and collections until 2019. Are you technically able to bid on this new single service or RFP that went out a couple of weeks ago given that it’s kind of a new contract?

Mike, to be totally honest with you, we don’t really focus on the loan servicing opportunity that exist out there. It’s not really the business that we are in. It’s not something we have looked at. It’s not something that we have considered. My guess is that under the non-compete at this point in time, we would not be able to participate in that if we wanted to.

But to Steve’s point, it is our concentration to originate and service in good form our customers. And we are in a consumer franchise business. And as you know, with the receivables growing 24%, maintaining quality there is in any sort of growth scenario is always a challenge and that will be our focus.

Okay, thank you.

[Operator Instructions] Your next question comes from the line of Arren Cyganovich with D.A. Davidson.

Thanks. The origination growth is a little bit higher than your full year estimate and a little bit higher than we are expecting. Is that – do you feel that, that’s more of a market share gain or is it actually an expanding marketplace of originations that you are seeing for the year?

There is at least three parts that we can talk about in regard to that. But the main piece that we should have in our thinking here is that a large part of the first quarter disbursements are actually related to the prior year’s contract and sign-ups. And so typical scenario would be student that gets accepted by school, they go to freshman year in September and they have a second disbursement in the spring. And so as we look at the first quarter, during the first 4 months of disbursements, a significant portion of that is related to what we referred to in the industry as serialization of the preexisting customer and the preexisting contract. And so that makes it a little bit cloudy not knowing other’s dynamics in regard to that to estimate the size of the market period, but also any changes in the market. It is the case of course that we are up 8% and prior models would indicate that for the full year, the market will be up some number of 5% or so. So we think we are in a good range. But in the first quarter that this mix of prior year, current year and then sort of like changes as things move along and so I think it’s a little bit hard to estimate the share growth, but I would rather be at 8% than 4%.

That’s helpful. Thanks. And then in terms of the loans that are going to be entering full P&I, can you help me understand the timing of that throughout the year and how that affects your provisioning and your credit metrics on kind of a seasonality basis?

Sure. So the $2.9 billion goes into repayment in two separate chunks. There is a May-June repay wave of roughly $700 million. And then in November-December, there is $1.5 billion repay wave. And then the cats and dogs come into repayment across that period. So we are always provisioning for losses for the next year and of course the life of loan allowance for our TDR portfolio. So the timing will give you an idea as to when to expect the provision to cover those loans entering repayments. Over the course of 2016, we expect our provisions to remain pretty stable throughout the course of the year, with the peak being in the third quarter of 2016.

Thanks. And then lastly on the new parent loan product, I believe that the federal loan plus product is slightly lower yield than your existing book, adding that to the mix, do you expect that there should be some sort of a drag on your yield as you rollout that product later this year?

No. As we are looking into the product and we have previewed it with many of our partners at the schools. We think that the pricing is extremely competitive. And we think that servicing associated with it is both better and simpler. And so in regard to the design of the product, we have taken the relative competition into account. And we think we are in a good position. That is the yields we think we are projecting we think are very competitive as well as very good for our shareholders.

Thank you.

Your next question comes from the line of Eric Beardsley with Goldman Sachs.

Hi. Thank you. Just wanted to go back to the margin, so the I guess the thought that it could be north of 5.6% for the year, does that contemplate another rate hike and I guess what would you expect to happen with the next Fed funds increase, would we see similar asset sensitivity to what we saw this quarter in terms of loan yield and the funding cost?

So Eric, the 5.60 number that I threw out there, upside from that is basis points, in the single basis points. When we do model, we do model with the yield curve factored in there. And we would expect that if the Fed does raise rates again and my personal view is that they probably won’t, but we would model in that the cost of our money market deposits would increase by 85% of what will be the increased in Fed funds was. And I think it’s reasonable, nobody was really surprised that, that sector of the bank deposit market do not react to the first Fed fund rates hike and whatever it was 10 years. But I would suspect that if there is another, there probably would be some pressure on that component of the bank deposit market.

Got it. And just on the funding mix over the course of the year, how should we think of that evolving between the broker, retail and then any wholesale borrowings you do?

Sure. So we will hold steady to a 60% broker, 40% retail ratio. We and our regulators are already comfortable with that approach. We do have in our 2016 plan that we will tap the ABS market. The ABS market does, as I mentioned earlier, look like it is tightening in. However, if it doesn’t get inside the hurdle rate, we will forgo the ABS market and grow our retail and broker deposit mix, which we are very confident we would be able to do in the absence of wholesale funding availability.

Got it. And what’s that hurdle rate in terms of your all-in costs on ABS?

I don’t want to dip my hands on the ABS, it’s we will not.

I guess, is it significantly south of 3% or…?

I am sorry?

Is it somewhere more significantly south of 3%?

Well, we are talking about the spreads to LIBOR, so it would be way south of 3%.

Okay, got it. Thank you.

Your next question comes from the line of Rick Shane with JPMorgan.

Guys thanks for taking my questions. Steve, you have really touched on this a little bit. But is we are still learning the company, I would like to think about the timing of things in terms of both the left side of the balance sheet and the right side. You have the strange characteristic, obviously the business is very seasonal, but Q1 I assume the disbursements are very early in the quarter and that’s why you build the deposits in the fourth quarter. And in Q3, the disbursements are leaner in the quarter, so I am assuming we won’t see a big surge in deposits in the second quarter in the way that we did in December?

That’s right. We will start growing our deposit balance in the third quarter and the cash balances will remain fairly lumpy through the January disbursements….

Go ahead, sorry, I didn’t mean to interrupt.

I was going to ask you, were you curious about the rest characteristics of the assets and liabilities on the balance sheet?

No. What I was really curious about is how – what is the timeframe to build the deposit base, I mean again, given your unique demand for capital in very compressed windows, how do you manage that and again is it a one month ramp to build those deposits or does it take a couple of months, how should we be thinking about that?

So the third quarter disbursements happened for the most part in August and September. So we will be starting to tap the various deposit markets in late June, July, August, September, October and so on and so forth. So there is not that lengthy of a ramp.

Got it. And is it a matter of negotiating with the markets basically saying, we need X billion dollars of incremental deposits, where is the mark to get that?

No, not really. I mean, the broker deposit market is pretty price sensitive. So we know where the market is and we place orders and basically they get filled depending upon the name and the timing and the term. We have some leeway in terms of being 5 basis points to 10 basis points under or over the market. But we typically target longer term funding of 1 year, 2 years, 3 years, 5 years to do and not a lot of guys are out there in those sectors. But we will also fill in the holes around the three months and the six months deposit market as well. There is a little bit more of a ramp time in the retail deposit market because we will have do start posting our rates in there. We typically raise money in the MMDA arena in 1-year and 3-year CDs.

But the dynamic is pricing and demand elasticity, it’s not quantity purchased.

Okay, great. That’s helpful. Again just as we are thinking about things and new ways – it’s very helpful. Thank you.

At this time, there are no further questions. And I will turn the call over to Ray Quinlan for final remarks.

Thank you, all for your attention. It’s been a pleasure to report on what we believe is a very strong quarter. We are off to a good start on all major parameters for 2016. We believe that the numbers are starting to illustrate more the strength of our franchise. Our spreads are good. We have a steady income. Our credit is where we want it to be. We think it’s very viable base on which to grow the franchise. As you saw, our major revenue generating asset is growing at 24% versus last year. We expect that rate to continue. And so it’s a real pleasure to be able to report back on these results, which, of course are the reflection of all the efforts of our entire team. So thank you for your attention.

Great. Thanks Ray. Thank you for your time and your questions today. A replay of this call and the presentation will be available on the Investor page at salliemae.com. If you have further questions, please contact me directly. This concludes today’s call.

Thank you for participating. You may disconnect at this time.