Navient Corporation (JSM) Earnings Call Transcript & Summary

Good morning, everyone, and welcome to Navient's Strategy Update Conference Call and Webcast. Please note that this call is being recorded. [Operator Instructions] I'll now turn the call over to Jen Earyes, Navient's Head of Investor Relations.

Good morning. Thank you for joining Navient's strategy update. With me today are Edward Bramson, Chair of the Navient Board of Directors; David Yowan, Navient's CEO; and Matt Palese, Earnest SVP. After the presentation, we will open up the call to take your questions. During today's call, we will refer to a strategy update presentation, which you can find on navient.com/investors. Before we begin, keep in mind our discussion will contain predictions, expectations, forward-looking statements and other information about our business that is based on management's current expectations as of the date of this presentation. We will discuss an illustrative financial model related to Earnest, a division of Navient. This model primarily makes adjustments for anticipated changes in operations as well as a more optimized funding structure, among other things. This discussion is meant for illustrative purposes only and is not intended to be a forecast of future results. 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-K and other filings with the SEC. During this conference call, we will refer to non-GAAP financial measures, including core earnings, and various other non-GAAP financial measures that are derived from core earnings. Thank you. And it is my pleasure to turn the call now to Edward Bramson.

Good morning, everybody. Thank you for joining us. I'm going to start on Page 3. And I'm Ed Bramson, the Chairman of Navient. With me today is David Yowan, who is the Chief Executive Officer; and Matt Palese, who runs Earnest, which is a lot of what we're going to talk about today, and we appreciate you joining us for the update on Phase 2 of our strategy. So if we go to Page 4, I'm not going to spend a lot of time on Phase 1 because it's now behind us. But just to remind you, the purpose of Phase 1 was to maximize the cash flows from our legacy portfolios into the future. And David and his team have done an excellent job on that. I have a fair amount of experience in turning around. We've done a dozen or more. And this one has been about as well executed as I would've assumed. And the upshot of that good work is that in addition to the cash flow coming in that we had before, we've added another $2 billion of discretionary cash that we can use for growth or for other effective distributions. Moving on to Phase 2. That starts on Page 5. And Phase 2 is about growing Earnest. Taking a step back, when we started this -- actually, Phase 1 and Phase 2 started at the same time. It's just that we didn't talk much about Phase 2. And what we concluded was that our stock has suffered from inertia for a long time now. And part of that inertia comes from the fact that people still think of Navient as a student lender, which it actually isn't anymore. We make some student loans, but they're relatively small. So in order to break away from that, we decided that we had to do some different things and explain them differently. So as we go through the presentation today, when we talk about Navient, what that's going to do is our legacy loans, FFELP, private, our in-school business, which currently is in Earnest, but we're moving to Navient, and that's what Navient will do as we go through the presentation. Earnest means our student loan refinancing business, personal loans which we're in the process of entering and some other products that we expect to add in the future. The purpose of doing this is twofold. Firstly, what Earnest does is more akin to what a fintech does. And what Navient does is more akin to a specialty finance company. So we're trying to help people see the differences. The other thing is that going back even a couple of years, it struck me that as I listen to our earnings calls, we spent a lot of time talking about things that we report that actually don't control, like floor income or net interest margin on legacy loans. We spent a lot of time controlling things at Earnest that weren't talking about them, and that's one of the things that we want to change going forward. So as we think about Earnest and recognizing it's in a different sector, we said, "Look, we need to start measuring the shareholder value metrics for Earnest differently." And so on the table here, the things that we look at principally at Earnest are its growth rate, our capital intensity, the proportion of fee income that it has. And the ultimate measurement is return on equity. So it's not interest margin or other things, it's return on equity. And as we go through the presentation, we'll tell you about how we've addressed these things. So the first 2 points on the slide are, let's say, [ reoriented ] in how we explain things. The third thing on the slide is a specific strategic objective that we started a couple of years ago. And we decided to grow Earnest because we thought it was such an interesting opportunity. And the easy thing to do is just go out and grow it. And what you can do when you do that is to say, "Look, we're not competitive today, but if we double or triple, it will take care of itself." The problem with that strategy is that the people you compete with are also doubling and tripling. So we run the risk of ending up in a place where you're still not competitive, [ you bigger ]. So the goal that we set was to say that at a relatively modest origination level, we'd be competitive. And then when we are, we grow from there. So should we go to Page 7. I think it might be helpful just to remind everybody of what Earnest actually is. We bought Earnest in 2017, 2018. At the time, we probably had a strategy that was run, those were SoFi was at that time. We changed that to focus more on education lending. In the last couple of years, we've been moving back in that earlier direction. So what Earnest is today, it's actually a brand name of Navient. We do track it. It has its own measurement, but it's actually a division of Earnest at the moment. What it's been doing is it's originated all new loans essentially that Navient has made over the last 7 years, and it's developed all of the new customer-facing software that Navient does. Earnest is fairly self-contained, but we're in the process of completing that movement to being able to stand alone. And the key thing we're doing at the moment is integrating our capital markets capability into Earnest from Navient, which we'll talk about. And Earnest's strategy to date has been to generate long-term relationships with high lifetime value customers, and we'll talk about that in a moment. We do plan to go beyond that, but I think it's useful to look at who our customers are. So if you go to Page 8, this is a snapshot of Earnest customers. We have about 375,000 unique customer relationships today. Going into next year, we expect to add maybe another 40,000 to that. At the time that we became customers of Earnest, they averaged 29 years of age. So that says that our average customer now is probably somewhere in the early to middle 30s. Their income is about $200,000 a year, and their FICO score is above 770. So if you think about it, that's a very high potential customer group to have. If you go to Page 9, this is our people. So Earnest today has about 330 employees, which actually is more employees than Navient has now. There are 3 hubs in Oakland, California; Austin, Texas and Salt Lake City, and Salt Lake is where we run our servicing -- customer satisfaction operation from. It's a pretty long group. Its average age is about 33. The executive team has an average age of 44, and that's right about where [indiscernible]. If you go to Page 10, one of the points I want to make here is that there are a lot of homegrown Earnest people in very responsible positions, including the person who runs lending, the person who runs servicing, the person who's handling, the person who runs the introduction, the person who runs compliance. They're all long-term Earnest team members. But what we've been doing recently is to expand the pool of people that we fish on to the industry as a whole. So in the last 2 years, we've started to add people from a broad industry background. There's a person on the chart here, Leanne, who I would like to call out specially. She's the Head of our People Operation. She's built an excellent recruiting team. What's helped in doing that is when people in the industry who do know who Earnest is, come in and talk to us, they're very excited about what we're doing. And so I think it's very encouraging that we're becoming a destination for superior talent. And if you look at the slide, you see such places they come from. So if you go to Page 12, this is just a snapshot of Earnest as we look at it. What this is, it's the expected income statement for Earnest for 2025 on the basis that we have already moved out the in-school and graduate lending that they actually do at the moment back [indiscernible]. So on that basis, you'll see that we have a couple of hundred million of revenue, roughly 25% of that is still income from servicing. And I think the other numbers speak for themselves. So for the year, we're expecting an operating profit of around $70 million. If you go to Page 13, what this says basically is that at the moment, Earnest has about $10 billion of outstanding loans. Most of them have already been securitized. The ones that are in warehouse will be securitized. I think the point to make here is that the securitized loans actually, although they're on our balance sheet, we don't own them. They've been sold to securitization trusts. So we account for them as if they were our assets. They're actually not. If you look at liabilities, the securitization trust borrowings are borrowings in those trusts. They're not ours. We just account for them that way. The warehouse borrowings are actually on our balance sheet, and they get paid off when we securitize, [ divest it]. Similarly, on our balance sheet of about $10 billion, we have about 7% of it in equity at the present time. If you go to 15, back at the beginning, we talked about how do you get ready to really compete. And that falls into 3 key areas. Another thing is that you need to be competitive at the scale you're actually at, which is lower than our competitors. So in marketing and product development, we made quite a few changes to significantly strengthened that team. And the mandate for that was increase the lead generation we're getting and get lower lead costs. And we'll talk about how that turned out. Another thing that we've been doing is that our marketing is quite effective, but it's reactive marketing. What it does is it says if you know that you want a loan, we will make sure you know that we're there. We're in the process of adding to that a more proactive marketing strategy, which says maybe you need a loan, you haven't thought about it. And also if you have thought about a loan before and didn't take it, maybe you should think about it. And as we start to cross-sell, that's going to be an increasingly important thing that we do. And then the final piece of expanding the team is as we move into personal loans, it's not that it's very different from what we do today, but there are some differences, and we wanted to enhance the expertise in the team in advance of that introduction. So moving to technology and operations, that's our biggest cost center. And within that, the biggest single piece by far is IT. And when we started out, we had a perfectly serviceable lending platform, but it really wasn't state-of-the-art and it caused a number of issues for us when we tried to change things. So the team actually developed, built and rolled out a completely new lending platform on a pretty tight schedule and it came online in February of this year, and it's a tremendous achievement that the team deserves a lot of congratulations for it. The difference with the old one is it's a modular architecture, which means that all the things that everybody needs are in a central core, the things that are specific to student loan, refinance or personal lending, and modules on top, which means that you can change things a lot quicker and you don't run the risk of corrupting the core. And we've got a lot of useful things out of that, including that we now have the basis growth for the loan sales platform, which you'll see is in our time line later in the presentation. Another thing that we got out of this was increased amount of automation. And that's two things. It obviously helps you with operating leverage as you grow the business, but it's also helped us to increase our conversion rate quite dramatically, which you'll also see as we move on. And then the final part is that Earnest for a long time, uses machine learning to do credit decisioning and pricing. And as we expand what we're doing, we want to have more data science that goes into that machine learning. This platform enables us to do that. And that brings us to the third thing on the page, which is financing. And I want to take a little bit of time on this because it's perhaps not intuitive. The first thing we did in the financing area is by anybody's estimation, Earnest is a very, very, very good digital marketer. It's also a very, very good software developer. Navient has an excellent capital markets group, particularly in securitizations. And Navient has secured over its history, hundreds of billions of issuer loans. And it's one of the most highly regarded, most experienced securitization teams in the industry. The only thing is they work in Navient. And what we did is bring those groups together, and we're starting to see some of the product of that so that we're optimizing our products now to fit better with the requirements of our investors and we're starting to see some results. The other important thing we do is actually to change how we securitize. And at the risk of repeating myself, securitization is easy to sell. The economics of the securitization are determined by the portfolio construction in the pool. How the economics get allocated is determined by the form of securitization that we do. So in the past, we've typically used a horizontal securitization structure. That's good if you want to maximize net interest income. It's not as good if you want to maximize return on equity. It's also saleable, but it's not easy to sell. So the structure that we use now, starting literally this year, is vertical securitization. That doesn't give you as good net interest income, but it gives you the best return on equity. And if you want to sell, it's the easiest one to sell. And there is a third thing, a hybrid, which if you plan to keep something, might be better than [indiscernible], but it's literally almost impossible to sell [indiscernible]. So what we see going forward, all the securitizations are vertical securitizations. And if you go to Page 16, one of the things we've had up to now, the things we've actually completed and it shows that on the slide if you notice. This next issue comes back against financing, it's something that's ongoing. We want to get the loans that we generate in the future off balance sheet as much as we can. The fashionable way of doing that at the moment is through loan sales. And loan sales have a particularly good attribute, which is that they get the loans off the balance sheet, they accelerate the income that you get and there's no continuing equity. So from an accounting standpoint, completely profitable. But everything has a cost. And so a lot of the economics that are involved in those loans can end up being transferred to the buyer from that. Securitization actually is a cheaper way of financing. And if you think about it, the securitization market is enormous. It's very deep. It's very liquid. All of the securitizations that we do are registered, they're tradeable and they have an agency rating. So the liquidity premium that goes with that actually accrues to us, which is why it's such an effective way of financing. It does require some continuing equity, and it does have to be on the balance sheet. So that's the downside of it. What we're looking at the moment is maybe innovating in some ways that will enable us to get the accounting benefits and the economic benefits. I can't promise you we'll be able to do that, but we'll come back to it in 2026. So if we go to Page 17. So we can do all the stuff, how do you turn to that? Back at the beginning, we talked about the way we want to measure Earnest from a shareholder value point of view. And first thing we talked about was getting the growth rate up. So the base year we're using here is 2023, and that's because it's before we started Phase 1 and 2. Since that time, you'll see that our originations are about 2.5x what they were. More importantly, in some ways, statistical quarterly rate check volume has quadrupled. What that is when somebody is interested in getting a loan from us and request a quote, that's a rate check. So when we talk about getting our lead generation up, that's really what that is. If you look at our sales and marketing expenses, even though those statistics have doubled and quadrupled, our sales and marketing expense actually stayed about flat. So we've achieved the goal of getting the lead generation up and generating a lower cost. And what it means is our sales and marketing expense to originations is down to 2.3% this year. The next category was getting efficient from an operating standpoint. And if you look at loan origination, for example, the new platform has taken us from 57% up to almost 80% and we have room to grow there. The conversion rate, which is a critical economic factor, is up almost 50%. We're supporting 3 product lines instead of 2, and we're doing that with about 4% of originations, which is a bit better than the 6% we were at. Turning to the bottom of the slide. This compares a typical 2024 securitization with a typical 2025 securitization. And normally, you would expect that when our volume is going up as much as it is, the way you would do that is that your credit score would go further down so you can address a bigger part of the market. If you look at the chart, our FICO has actually went up, and that's actually deliberate. The reason for it is that with the higher end credit in the pool, we're able to increase the percentage of the pool that's rated AAA, which enables us to reduce the initial economic equity we have to put in. So when you're focused on return on equity and use vertical securitization, that's the impact to this. So that's also, I think, been quite successful as you'll see. If we go to Page 18, going back to what our original goal was, it actually wasn't to get better. It was to get to be competitive with other people, which is a completely different measure. And also to be competitive with them at the lower volumes that we currently operate in. So if you look at this chart, it has some efficiency measures on it, which I think you can read for yourself. It says that our originations at the moment, they're growing well, I say the 1/4 of upstarts and maybe 15th place on SoFi. So we have to address that. But even at that lower scale, our sales and marketing expense to originations and our operating expense to originations are well in competition with these people. Two years ago, you could not have said that. So this is exactly what we set out to do. It's exactly what this young and enthusiastic team of people has done. And I talked to one my colleagues about this and said if this were a good, I'd do a mic drop. It simply isn't like that which takes us to Page 19. What does this mean for shareholders? What we have on the chart here is Earnest, which actually doesn't have a listing, so it doesn't have its own valuation, but it's part of Navient and the peers that we've talked about. It's pretty good to hear a management team not finding about how the market doesn't understand how great they are. So I'm not going to bother doing that. But if you look at the price/earnings and market values from comps, they're obviously much better than Navient. Earnest is part of the Navient. In addition, it has, I believe, $700 million of cash at the end of last quarter. It's got significant discretionary cash flow coming from its existing investments. It's going to have an in-school origination business and beyond generally Earnest. So the only point I would make is that for those firms to do 0.6 of book compared to the others seems like it's an interesting opportunity. So how do you work on that gap? That comes back to the improved disclosures that we talked about, presenting the information in a different way. And if we think and hope that over time, the perception will become to a greater and greater extent that Earnest is Navient and we hope that, that will help to address this valuation of that. If we go to Page 20, in order to accomplish what we say we want to do, we've now become competitive at small scale, we have to get to be bigger scale, which means that we need to address markets that are bigger. And I'll talk about that in a moment. If you take the core business of Earnest, which is the high lifetime value customers, we spent about $250 million over the years to acquire our current customer base. The way to think about it is that a 30-year-old comes in by refinancing their student debt. Over their life, they're going to need other products in various stages that we may or may not want to provide to them. And probably by the time they retire, they want wealth management. The way we would monetize those things really depends on what they are. We could do new products like some people do. We could do partnerships with some of them. And the ones that are really interesting, big opportunities, you might even make an acquisition. The fact is, though, that because our customers are late 20s and early 30s, they actually don't need most of these things yet. But the next logical thing that they're going to be interested in is personal loans. The reason for that is they're moving into a stage of life where they have those needs, and they're also bringing down the student loan refinancing debt, which gives them more capacity. So we're going into that. One of the benefits of it is that, that $300 million that we spent, we can now maybe amortize over 2 or 3 products rather than just one. So that's the lifetime customer value statement. And having the infrastructure that it takes to do all those things in marketing, technology and so on, we do have an infrastructure that we can leverage over different markets. It's not a novel observation. Other people are doing it. But we do have it in our time line to add a loan sales platform within the [indiscernible]. Page 21, so if you need a growth opportunity, markets need to be bigger, what are you going to do it? So we've moved the education and graduate lending down into a bullet. That's about a $12 billion annual opportunity, which helps for Navient going to be addressing itself. So that leaves Earnest with student loan refinancing and person lending. So in 2025, student loan refinancing, the total addressable market is somewhere around $8 billion. Because of the tailwinds from interest rates and other factors, we think in 2026, that's going to be $11 billion. But it's worth taking a second to talk about that. The actual TAM for student loan refinancing in '26 is going to be about $135 billion. The fact is that nobody has ever been able to get more than 8% of the people who would benefit from taking a loan to take one. So one of our marketing strategies is to start to move that percentage up. But that's not what has changed here. In personal lending, we don't do any this year. In 2026, we're not expecting to do very much. We're talking about just a proof-of-concept type lending. The $36 billion we've put on there, I think it's important to say what that is. Those people who -- it's about 4% of the personal loan market, by the way. Those people are those who have a 750-plus FICO and have a credit file that's aged from 5 to 15 years. If that sounds like an SLR customer, because that's who that is. In 2028, the customers are the same. It's just because they're aged, they're now moving into an age category where they have a higher propensity to do personal bond. So it's the same people that's getting a little bit older. On the $36 billion, I think an interesting point to make is if you look at all of the people in that category, there are 2.4 million of them. We have 400,000 customers who look like that who clearly have a relationship with us, and there are a lot more of them who know what we are. So in that group as it moves through its financial lifetime, we're very well positioned. If you look at the thing a bit more broadly, what we're saying is in 2025, our total addressable market is somewhere between $8 billion and $10 billion. In 2028, if we just do what we're doing today, the addressable market is maybe 10x as big. So I think we're not really troubled about the opportunity to find new assets when we need to prove out our strategy. If we go to Page 22, there's a lot of growth here, how are you going to finance it? So the way we think about it is this on our current balance sheet because of the way we've been financing our securitizations, we have about 7% equity to assets. In the future, as those loans come in, we're going to get 7% back and we're either going to put out something less than 3% or we're going to sell them and put out nothing. So our expectation is that as we currently look at things, all the equity that Earnest has today is all the equity it's going to need. But if we see additional opportunities by being part of Navient, which is very well financed and has a very large amount of discretionary cash flow, we have all the capital we might need to take advantage of those opportunities if they come up. And then the other thing I didn't want to forget is we said that one of our objectives is to increase the proportion of fee income in the mix. As that origination volume grows, the servicing comes with it. And as we go into personal lending, there's also an opportunity for origination fee income. So on 23, we talked about our time line. This is a very deviated version of it. As you can see, from now to '28, we're going to be putting a lot of effort into expanding that 8% of the addressable market that again is student loan refinance. In '26, we are making some personal loans. The reason we're doing it is to have a big enough sample to get the rating agency rating. And we're assuming it's going to take to the end of '26 to do that. This is why we're not assuming a great deal of binding. If it happened a bit sooner, we would accelerate because we'd then be in a position to securitize the loans that we generate. And if we want to sell them, we need the same data to sell them anyway. The full launch is therefore assumed to be in 2027 for those high-value customers, the 4% in the market. And then in '28, we would launch a sales platform. The reason we wouldn't do it soon is if you don't have the inventory, you don't need it yet. And then finally, ongoing is the transfer of the in-school and graduate loans to Navient. So to sum up on Page 24, we started Phase 2 and same time, we started Phase 1. It's just happening in the background. During those 2 years, we've completely transformed Earnest's ability to compete and to compete in expanded market. Because of what we're doing and making it clear that what we're doing and what our objectives are, we think we can increase the ability of the market to discern what is really going on and how to value that. And then the last point is momentum, and '26 is a transitional year. We have a little bit of personal lending, but it really doesn't kick in until 2027. On the other hand, the rate check volume in SLR sets us up for, I think, a pretty good year next year. There will be some personal lending, maybe more than we think. And there are some drivers in the graduate in-school business that could also include Earnest increase Navient's overall originations. So we are looking even in this transitional period to be able to get to maybe around $4 billion of originations this year. That's not a forecast. It's not guidance. We'll do that later in the year. And then hopefully grow from there. So that's it. I've been talking a lot. So we do have to take some questions. But it's middle of the day, the market is open. So we'd like to just take a few and I'd like to issue an open invitation to anybody who wants to discuss this further. If you contact Investor Relations, we'll be happy to set up a one-on-one call and answer any other questions that you might have. So with that, I'd like to open it up for questions.

[Operator Instructions] Our first question will come from Bill Ryan with Seaport Research Partners.

First question relates to Page 12, the Earnest financial snapshot. It shows $75 million of operating profit. And then on the other slide, there's $644 million of tangible equity. So it looks like a pretax ROE of about 12%. And since it's 2025 snapshot, I assume there's no loan sales in there. There's obviously a CECL charge. But during the presentation, you talked about pursuing capital-light structures for funding. And so is it fair to assume that kind of like the 12% is the baseline that we're starting off at that if you pursue the capital-light structures that it would give a quite a bit of boost from that level? And also following up on that question, what is the pickup in the ROE as you change your securitization structures towards vertical?

This is Ed. I'll take those questions. But before I do, I don't think I quite understood the last question that you raised about ROE. Could you say that again, please?

Yes. I was just wondering what the pickup in ROE is between your 2 securitization structures as you move to vertical.

Fair enough. So on the 12% ROE, I'm not sure if -- I didn't actually run the calculation. I'll take your word for it. That would be pretax, of course. I mean there are a lot of things that we talked about doing to actually move all of the loans off balance sheet. There are other reasons to get them off, including volatility that's not helpful. I think the way to think about it is that if you look at the existing balance sheet, you could do everything on there that's currently got $700 million of equity in that if you turn it all over for about $200 million. So whatever the return on equity is now everything else equal, you're looking at maybe 2 or 3x that by going to a different securitization strategy. It's not quite linear, but it's sort of linear.

Okay. And then as a follow-up, just kind of a question about the TAM that you highlight for lending in the in-school channel. It's $12 billion; $9 billion of undergraduate, $3 billion of graduate. And I'm thinking about it that way, it's like if you take the $9 billion, it's a little bit less than what the private student loan origination market is today. So it looks like you may have excluded possibly some pockets of lending in private school lending. And secondly, as it relates to the graduate side, the $3 billion, I think the number you used historically is about $1.5 billion of that is currently private. And so is it the number to assume that you're assuming about $1.5 billion comes in from Grad PLUS in the second half of next year?

I'm not the best person to answer that because I've been talking about Earnest and we're moving that over to Navient. But maybe David would like to take that or...

Yes. Bill, this is Dave Yowan. Thanks for the question. Yes, I think the -- yes, I think you've got it about right in terms of how we get to the $12 billion. As you know, there's a variety of different estimates of size of market depending on what your underwriting standards are, et cetera. Certainly, that's true with Grad PLUS as well. There's a lot of uncertainty. The ecosystem has been -- will be disturbed beginning next year. I think what we're trying to communicate is that for us, the in-school product sits well with specialty finance from a financial profile, from a competitive set perspective. We just completed in the third quarter, our highest quarterly volume of in-school product. And so we're confident in our capabilities to find the customer segment that we've been targeting. It's predominantly the graduate student. Those capabilities that we've been developing, we're going to continue to rely on. They're not leaving the company. But since they have that different financial profile and different competitive set, we're going to have those outside of Earnest, and we've got a very experienced team that's still going to manage that product. We've got executives at Earnest -- or at Navient, excuse me, that have decades of experience in student loan originations. So we're confident in our ability to take advantage of those opportunities as they present themselves.

Our next question will come from Jeff Adelson with Morgan Stanley.

I guess maybe just wanted to dig in a little bit more into what gave you the confidence to decide this pivot into a newer product in personal loans. It's a pretty competitive space. You mentioned this is a natural extension of customer need where I think you're largely refinancing that customer student loans today. But is your research indicating that a high percentage of those customers are looking for personal loans, like they're leaving your ecosystem to get a personal loan? I guess maybe how do you think about your go-to-market strategy here in a way that would let you get that share, allow -- drive consumers to you over the competition? Like what do you think your advantage is here at this point? And maybe also just touch on like it sounds like you're targeting existing customers, but like maybe what's the mix of existing versus new that you're thinking about as you kind of roll this business out?