Navient Corporation (NAVI) Earnings Call Transcript & Summary

Good afternoon, and thank you for joining us. I'm Barclays Consumer Finance Analyst, Mark DeVries, and I'm pleased to be joined by Navient CEO, Jack Remondi. We'll be conducting a fireside chat, but we'll break it up with some polling of the audience. We'll also leave time for any questions that come up from the audience during this session. [Operator Instructions] Before my first question for Jack, I'd like to lead off with a question for the audience. [Operator Instructions]

So first question for the audience, what do you view as the biggest catalyst for NAVI over the next year? Gaining share in the new in-school origination market, continued growth of consolidation refi business, better-than-expected credit resolution around CFPB or capital returns? With that, first question out of the way, Jack, let's start with an update on the overall origination environment. What are you seeing in the market for refi loans currently? And what's competition like?

So I actually missed the first thing. Was that a -- did you have a question for the audience is what, I guess.

Yes.

Okay. So on the origination side of the equation, we're participating in both the refi marketplace and the in-school lending area. The refi marketplace is a much bigger opportunity for us right now. We -- the success we've had over the last year, particularly in 2019, heading into 2020 was very strong. With COVID hit, we took a pause here and really peeled back a significant part of our marketing effort to make sure that the credit profiles that we were seeing of our customers were going to actually play out as we expected in the current economic environment. As we began to gain some experience with that customer base, how they were exiting forbearance, what kind of payment rates we saw, we -- our confidence returned, and we started to market in that space today. And we expect to do about $2 billion of originations in the second half of the year as a result of that. But overall, demand is very strong in that side of the equation. And I would say we continue to be cautious in our credit underwriting criteria as well as in our pricing, so that we're underwriting to slightly higher standards and our pricing margins as a result are also wider today than they were, say, in 2019. In the in-school marketplace, there's been far more disruption in that side of the equation, certainly due to the ways different colleges and universities started classes this fall. It's a little bit of a hodgepodge of fully remote to hybrid to in-school. It definitely has reduced the overall demand in the marketplace. My expectation, it's still early to see what the numbers look like, but it looks like it's going to be at least a double-digit decline in origination volume this academic season. Our focus in that marketplace is a bit narrower. We are only targeting first-time borrowers at a segment of the schools, 4-year, not-for-profit educational institutions. And so here, like in the refi side of the equation, we've got, I think, conservative underwriting standards and practices, so that we can understand the credit profile of our customers. I expect our volume originations to be about what we had targeted. We had hoped to see a little bit more than that. But I think the cautious underwriting and the pullback in demand will keep us closer to the original target. I do think one of the things we do in both products is somewhat unique in the underwriting space and that we link -- the customer links their transaction account with us. So we're able to see transactional data in their checking accounts. And it gives us a better real time -- or closer to real-time picture of their financial inflows and outflows compared to just, say, FICO report or a pay stub from a month ago type of thing. And so we feel pretty confident with what we -- with our underwriting practices at this point.

Okay. Got it. Yes, as you alluded to earlier in the second quarter, you slowed refi originations significantly and then provided guidance in July that you'd expect $2 billion of originations for the second half of the year. What changed to allow you to provide that guidance? And what would the risk to that number be here?

What changed was really the performance, right? So when we paused, in March unemployment was spiking pretty dramatically. And as the concerns were how deep was this economic crisis going to be. It's obviously been very painful to a segment of the population. But in other parts of the population, it really hasn't impacted the much at all. And our customer base, particularly in the refi side of the equation, are more knowledge workers. And so they are able to either work remotely or their businesses, say if they were in the medical space, have reopened based on need. And they're back at work. We've seen over 90% of the customers in the refi space that requested a forbearance back in March and April, May time frame to return to repayment. And return to repayment successfully with -- in terms of making payments overall. So when you look at our overall forbearance rates across the portfolio, we peaked at $3.4 billion back in April. We're down to $1 billion of forbearances as of August 31. And if you look at our 30-day delinquencies, so any account, 30 or more days past due, that number is half the what the rate that it was in December -- on December 31, 2019. So no degradation in terms of performance overall and very consistent with what we would expect that population to be, but frankly, a little bit better than what the economic environment would have indicated.

Great. Turning back to the audience response questions, it looks like on the first question, more people are [ looking ] for resolution around CFPB as being the biggest catalyst. Moving to the next question for the audience. What is the biggest risk to shares, political headline risk, worse than expected credit, lack of recovery for BPS segment, lower-than-anticipated in-school loan originations or other. So as you respond to that, move on to the next question for Jack. Jack, what are you seeing so far in in-school origination market? Can you talk about your approach this year and how it's differed from last year?

So the biggest change that was made was how the loan product was originated. In the last year, we were marketing the product primarily through state licenses. And in a number of states -- well, let's just say, those state licenses have different rules and regulations from state to state. And as a result of that, it meant that we couldn't offer a uniform set of products or terms to schools, student population across -- since they were dealing with customers from all 50 states typically. And so this year, we launched -- relaunched our product with a bank partner, which allows us to originate the loans under a single set of terms and conditions nationally. And we also made some significant changes to the operational flow of an application so that students and parents as they're completing their application instead of having separate and distinct flows, they can actually do it simultaneously and move back and forth in one setting, which is, I think, is going to be extremely helpful to the customer base. But our focus is narrower. We're only focused on first-time borrowers attending, as I said, 4-year not-for-profit institutions. And so we don't have any of the serialization benefits and upper classman-type borrowing components in our base overall.

Got it. Next question for you. What kind of challenges does COVID introduce for lenders in the in-school market? And how are you dealing with it?

Yes. I think the big question has really been about demand. And the changes in demand based on students enrolling and how they enroll in school, whether they're in-person or not. People have talked about whether or not this is going to change the overall environment for higher education. I think that may be an issue depending on the type of institution. But for those institutions, the highest quality institutions, the 4-year not for profits that are providing both an educational experience as well as a lifelong living experience, I think that value proposition is going to continue. Certainly, the economy is a big factor here. Where is it going? Will it stay open? Will there be another shutdown? Those are things you have to take a look at? A little bit less impactful on the current origination volume because you're focused. That's a bigger issue when the student graduates versus when you're making the loan. But those are certainly things that we would take -- that are challenges in this environment. The visibility is further today than it was back in April and May, but it's still not very far.

Right. Okay. Turning to another question for the audience, if you could weigh in here. Next question is, reserve levels are adequate, over reserved or under reserved? Moving back to Jack. A number of your competitors are either leaving the space or changing their approach to the market. Do you think the implementation of CECL will lead to further exits? And what is the opportunity for you to grow this business? Has the opportunity changed for Navient in recent quarters?

Yes that's a great question because I do think CECL is a very significant capital tax on consumer lenders. And in-school lending probably has amongst the highest impacts in that space. Even if you are expecting a relatively healthy portfolio with, say, a 6% life of loan loss rate, that's a pretty hefty charge to take day 1, right? In any lender's model, never mind a bank where you have strict regulatory capital requirements. So I think you are seeing some banks change the way they operate in this space, either by exiting or developing a make and sell or some hybrid kind of model in that space. And I do think you'll see more of that for sure. It's a big -- it's not an insignificant challenge. And just to compare it to refi, if we expect a life of loan loss rate of around 1% in our refi portfolio versus 6% in an in-school lending, that's a pretty significant difference in capital retention requirements to run a business and to earn an appropriate return on it. So it's definitely impacting who plays and how they play.

Okay. Does the fact that you're a nonbank, that will give you a little bit of an advantage in terms of your willingness to -- if you don't have the regulatory capital requirement, you may impact your economic capital in the same way, but does that create a bit of an arbitrage for you?

I think it does, for sure. I mean it certainly -- we can allocate -- we have different capital requirements on the front end side of the equation. And I think we have different alternatives that we can use as well through either securitization and risk retention or risk outplacement, if you will, that gives us some advantages through -- that you can more easily execute through the securitization market versus an on balance sheet lender has a more difficult time managing through that. And I do think an entity that's also specialized in the space, where the story can more easily be understood versus a component piece of a diverse book, it makes it a little bit harder to understand the capital implications of a small part of your overall business.

Sure, sure. Okay. Turning to earnings. You're one of the few companies to provide earnings guidance, and you expect $2.95 to $3 per share this year. Is that still the number we should expect? And can you talk about what gives you confidence to provide that number in such uncertain times?

Right. It was -- I think we -- I think that ability comes from the fact that we have such strong visibility in our earnings profile overall, both on the revenue side as well as just overall earnings. That has been a strong point for us. The low rate environment that has occurred this year has been a windfall for us or a tailwind, I should say, for us as well, not as strong in the second half of the year as the first, but still quite strong. Credit is really -- was the variable for us, all those other factors of top line revenue, operating expense were much more visible to us, but it was how much credit deterioration might the portfolio suffer in a dire situation. That has actually been the opposite of what we would have expected. It's been much better on that side of the equation. And then our focus on operating expenses continues to be a big part of this as well. And so when you look at those 4 components together, we saw the ability to have a tremendous amount of confidence in what we can generate in earnings this year. And frankly, even beyond 2020, that visibility continues to exist. And I think probably one of the more frustrating parts of where we sit today, trading in the $8 to $9 a share range is this is a company that can generate $3 of earnings pretty consistently here with a 7% plus, 7.5% plus dividend yield, and we're trading at less than 3x earnings. It's a bargain, as they say. So that's probably been the biggest frustration given the strength and the visibility of our earnings profile here.

Okay. Well, what are some of the drivers that could cause the biggest surprise around that guidance, whether it's to the upside or to the downside?

So I think on the portfolio side of the equation, the net interest margins are relatively stable and have been stable through this component with the variable being the benefit from floor-related income. That's pretty much either baked in or hedged at this stage in the game. So not a lot of variability or volatility expected there. On the other side of the revenue equation, the BPS revenue is certainly something that has more potential volatility to it. But frankly, it's been on the upside of that equation. We were able to demonstrate the nimbleness of our operating platforms to be able to pivot from doing work for state or federal agencies and hospitals to doing work for states on COVID-related projects, so processing, unemployment insurance claims or contact pricing. We have almost 2,000 people now working in those fields for states. And it's -- I think in the third quarter, you're going to see the full impact of that, whereas second quarter was still a partial benefit from it. On the other side of the BPS components, the businesses we do for states and federal governments and the health care side, hit their lows in the second quarter in terms of volume of activity relative to pre-COVID levels, and they are now all starting to return. So in health care, we're back up to the 85%, 90% of norm similar where 90% of norm in tolls, we're starting to work placements for some of our federal contractors again. The only space that really hasn't come back yet is parking. And that's a relatively small part of our overall book. So I'd look for a strong third quarter in BPS because of the factors that are combining here. The real variable is going to be credit, right? That's the one that can have the biggest impact. And because of CECL, it gets magnified because it's a life of loan impact, not just a one quarter level. But our reserves on our private book cover -- can absorb 12% credit losses, 18% default rates on our federal side of the equation. So we think we are more than amply well reserved at this stage in the game. It's premature to talk about releases at this point, but it is certainly, if the economy continues the way it is and the performance of our portfolio continues to be as strong as it is, that's certainly a potential down the road.

Okay. Well, you'll be related to hear that the investors listening and agree with you. In response to the last question, everyone indicated you're either adequately or over reserved with no one saying under reserved. So moving on to the next question for you. The low rate environment has been a benefit to you, obviously, as you alluded to from an earnings standpoint, but it's resulted in derivative marks that have lowered your capital ratios. Will this have any kind of impact on your buybacks for future years?

It should not. The rating agencies, I think, understand the one-sided nature of these marks. This is one of the benefits of not being regulated, having regulatory capital requirements. When we hedge floor-related optionality in our student loan portfolio, only one side of the transaction gets marked, the derivative, the asset value that produces the floor benefit does not get mark-to-market. And the hedges that we had in place prior to COVID, obviously, as rates fell, took a negative mark. But each year, each quarter, as time passes, that mark reduces in size. And so it will naturally resolve itself over a period of time. And this is something we spend a good amount of time discussing with the rating agencies, so they understand both why that mark happens and how it dissipates over time. So that effectively, we get that reversed out in our capital calculation. So that should not have an impact.

Okay. And as you mentioned earlier, with the stock trading around 3x earnings, it's quite cheap. How do you think about capital returns for the remainder of the year? And can you remind investors of your philosophy around deploying capital generally?

So each year, we try to be very transparent in what our capital return policy is going to be. And so we started 2020 with an objective to return $400 million to share repurchases in addition to our dividend. As we said in the last earnings call, we expect we will complete the repurchases up to that size, that took into considerations the CECL. Impact to capital did not on the derivative side, but that, as I said, has not been a big issue. As we move in at the end -- towards the end of 2020, we'll take a look again as to what we expect the capital generation and release to be for 2021. We'll look at the overall demand for capital in terms of net balance sheet growth in the private side of the equation, obviously, no balance sheet growth on the federal side, and make a determination based on where the stock is trading, what levels of volume we expect to be able to originate and really how we can choose to fund that, do we fund that on balance sheet? Do we manage it through off-balance sheet transactions in order to get to the point where we can both create value by building an origination franchise, leveraging the skills and the technology that we have in place today, while at the same time, taking advantage of the low stock price.

Great. Onto credit. How is the impact of COVID-19 placing your portfolio from a credit perspective? Also talking about overall forbearance usage trends and what you're seeing with that segment of your borrowers.

Yes. So the portfolio has really outperformed, I think the -- what people would expect given the levels of unemployment in the economy today. And that really is, as I said, it's been almost like a barbell impact on the economy. There are people who have been severely impacted, who -- if they are our customer, we are helping with payment relief and programs, and on the flip side, it's been a nonissue for many, many people. And what we're seeing that in the portfolio performance. So we're seeing borrowers who initially thought it was prudent to take a forbearance, just to hold cash on hand for the unexpected. And as their jobs continue to exist and they continue to get paid, a lot of customers also have reduced expenses, as they're doing less travel, entertainment and spend. They've been able to better manage their student loan liabilities. Even in the federal program, the Department of Education Loan program where all borrowers were put into a forbearance and payments wave now that will continue all the way through the end of this year, we're seeing borrowers sign up to make payments on their loans so that they can take advantage of the current rate environment and amortize their loan balances. But as I said, one of the other statistic that we look at is delinquency rates in our private loan portfolio, and our delinquency rate -- our 30-day plus delinquency rate, as I said, is half the rate that it was in -- on December 31, 2019, and our 90-day rate is less -- is 70% less than what it was at the end of December as well. So very, very strong performance in this area. And it really is a reflection of this barbelling of the economy or the impacts of the virus on this economy.

Okay. Got it. Let's shift back to a question for the audience. Next question is peak charge-offs this cycle will be a 1.5% to 2.5%, 2.5% to 3.5%, 3.5% to 4.5% or 4.5% plus. Shifting back to you Jack, what credit trends are you seeing today? And do you think that continues? I guess how should investors think about credit for this year and next?

There's no question, it is outperforming. And it's hard to see what -- other than a new shutdown in the economy and perhaps a shutdown that has broader implications, it's pretty hard to see what would happen here. I think a lot of folks have looked at the stimulus packages that have been passed and wondering whether or not that stimulate -- those programs are creating benefit in the credit marketplace. And certainly, I think that's true for those that lost their jobs. There's a -- there's also a significant benefit in the Department of Ed Loan Program. That's probably providing somewhere around $4.5 billion to $5 billion of payment relief to borrowers each month. But there's not as much -- there's not a significant overlap between Department of Ed owned loans and our FFELP portfolio or Department of Ed owned loans and our legacy private loan portfolio. And so I think what's really happening is customers' financial cash flows have been relatively stable on the inside. And on the outflow, they've actually fallen a bit. And so I think in a crisis, people tend to take a look at their financial situation. They try to shore up their balance sheets. And I think we're seeing that. And as a result, people are paying down their debt and making payments on the loans at a better rate than they were pre-COVID.

Okay. You mentioned and the audience agree that you feel adequately reserved here. But what do you think about reserve levels if you see significant deterioration in the economy? Are you still kind of comfortable with that?

Well, as I said, on the private side of the equation, which is really where the biggest exposure is, we have over -- almost $1.1 billion in reserves as of the end of June. And that equates to -- that basically gives us a loss-absorbing capability of about 12% on the portfolio. That would be a double rate of what you would expect over the life of the loan. So I think from where we sit today, we are in a very, very good position. I think it's prudent to be where we are. I think there's enough uncertainty in the marketplace, but it's hard to see a situation given what has happened to date that would cause that number the need to be meaningfully higher than it is today.

Yes. And I think you alluded to the potential for reserve releases. But what do you think you're going to need to see before that actually happens?

I think we're going to need to see some resolution or insight as to a diminishing -- more confidence of a diminishing impact of COVID, right? So more clarity as to what's going to happen next, and that probably means some form of vaccine or some form of treatment that is highly effective at disrupting the economy. The fear factor -- the fear issue that I think everyone looks at is, is there a potential another hard shut of the economy as we were experiencing back in April and May. Hopefully, that does not come to happen. But if it did, we are prepared for it.

Got it. Let's turn back to one last question of the audience. Over the next year, would you expect your position in Navient to increase, decrease or remain the same? So next question for you, Jack. Well, actually, before I turn it down, we actually have -- we do have a question from the audience. Investor wanted to know kind of about the potential impact of a U.S. political regime change to your business.

So I think student debt is a highly politicized topic, right? And -- but it gets treated as if it's a uniform issue for all borrowers. And when the reality is it's very far from that. Most people -- the stories that get told are about students graduating from colleges with large debt burdens, with an inability to pay. But the reality is in the one program where it has national statistics, the federal student loan program, where there is no credit underwriting, the defaults don't come from borrowers with large debt balances. Only 4% of defaults come from students who borrow more than $40,000. By contrast, 2/3 of all defaults come from students who borrow $10,000. So this topic about broad scale loan forgiveness actually is one that ironically has a bigger impact and benefit on wealthier borrowers than it does on poor or low-income borrowers. And I think people are starting to realize that. Not to mention that if they were some broad scale loan forgiveness, $1.5 billion is a -- $1.5 trillion is a pretty big number. I would argue that if you look at the program overall, there are a couple of things that could be done and probably should be done. We should do more about helping students as they are enrolling for college, understand what it's going to cost to earn that degree and make sure they have a financial plan to be able to get there. You have to give students and families a better sense of whether that degree is going to drive value for them, right? in terms of job prospects and earnings. And then lastly, for students if there is a need for our result at the end of the day, where that income doesn't match up to what was originally expected, we do need to have some of these loan forgiveness programs, but they should be programs that forgive balances as you go. Today's loan forgiveness programs accumulate all the interest that you are deferring, while you're making lower monthly payments. And if all of a sudden, your income rises to a point where you can afford the monthly payment balances, all that interest gets added to -- back to your loan and you have to repay it. And that's just not the way the program should work. The program should have loan forgiveness as you go and run these programs in just a more educated, knowledgeable way going forward. And I think there's some pretty broad support for some changes like that, that are affordable, make sense. And at the end of the day alone an education is an investment in your personal capital position, right, your working capital position. And ultimately, if you're benefiting from that, there's a strong argument that you are the one who should be paying for that. And I think there's some strong sentiment on those fronts.

Great. Can you talk about this just kind of the latest on the Department of Education Servicing contract? What's your thought process around the decision not to proceed with the new terms?

So we did bid and participated in the RFP for what's called the next-gen contract, and this was split between a platform, a technology platform and the service operations, the call center, back office processing side of the equation. We were offered an award on that -- on the back end side to provide customer service and back office work. Unfortunately, the way the contract terms were structured, both in terms of price and risk, we just felt that it was too difficult for us to find a way to make that work, make that work for the consumer, the borrower and make that work for us as well. And so we chose not to participate in that. Right now, the department has indicated that it's going to issue a new solicitation in the coming weeks or month here. And they're changing it back a little bit to having full-service requirements of the system and the operation areas will be combined under a single contract or multiple contracts. They're talking about having 2. And so we're evaluating -- we will evaluate that and take a look at it with our partner on the platform side of the equation and see what that looks like. But the RFP has not been issued yet.

Okay. And can you -- you remind us what the timing is of those accounts moving off your platform? And how should investors think about the P&L impact?

So under the existing contract, we are servicing these loans through December of 2021. It's not -- we don't believe there's any ability under the existing contract rules to extend that contract further. But as to timing and de conversion, I don't have any clarity or insight onto that.

Okay. I think you talked about this some at the beginning, but can you just talked about what you're seeing for as recovery in the BPS space, in your government services and health care businesses?

So we're seeing -- so we look at the kinds of volume or transactional volume or placement activity that we're seeing relative to levels we saw pre-COVID and most of those are returning to similar types of levels. So as I said, like toll traffic is basically back to where it was pre-COVID. Placement activity on the court municipal, some of the federal government contracts is just starting to ramp up again. And so that's a positive sign. Health care is moving back as well. It is in the almost 90% of pre-COVID level. So all of those are positives for us. I do think on the hospital side of the equation, we continue to see this as a very interesting market and one that has a lot of opportunity for us. I think COVID has impacted the hospitals and health care providers fairly significantly. And one of the things we bring to the table is a lower cost and a more cash flow positive process for managing their accounts receivables. And this is not collections work. This is just managing insurance claim payments, the patient pay portions, helping people understand what they're obligated to pay, what their insurance company is going to pay and get that cash flow moving a little bit more quickly. And we can do it at a lower cost for hospitals. And I think that businesses has a significant opportunity to grow over the next couple of years here for us.

Okay, great. And then just one last question from me. Can you provide an update on the CFPB state AGs issues?

Yes. So this is probably the most frustrating aspect of my job, right? Because it is -- the logic and even rules don't seem to apply in some of these areas. The CFPB launched a lawsuit over 4 years ago, and their claim was that we were -- they found that we were steering hundreds of thousands of borrowers inappropriately into forbearance instead of income-driven repayment plans. And they made that statement before they had listened to a single phone call of any of our customer service representatives. Four years later, after extensive discovery, access to tens of thousands of phone calls, millions of pages of documents, terabytes of data, they come up with a list of 15 witnesses, who they say were harmed as a result of this. All 15 witnesses and depositions, and this has been filed in the court and is public, you can actually read their summary depositions. All 15 of them acknowledged that Navient did in fact inform them of income-driven repayment options available to them. 1/3 of them were actually in income-driven repayment plans. So I'm not quite sure how they were a witness on that side. This process, however, takes forever, right? I mean, 4 years in, we're not even -- we don't even have a court scheduled trial date yet. What we do have is that we have filed our motions. All of our briefings are in and the motions to dismiss the case for lack of evidence. The judge that's been with the judge now for a couple of months. When new rules will be based on his calendar and schedule, but we feel very confident about where we are. At the end of the day, I think the CFPB was looking to change the way student loans were serviced and decided that they wanted to do it through an enforcement action rather than a rule-making process. We would be all willing to participate in trying to find the best way to service a student loan or improvements to that. We try it every day ourselves. So one of the things we've done just in the last 2 years is change the way we help our customers apply for income-driven repayment plans. It is an incredibly complex process under the federal program. It's a 10-page application filled with jargon. And one of the things we've done is we have -- we take that information from customers over the phone, something we're not necessarily permitted to do, but we pre-fill the application and send it back to the customer for e-signature. And that took -- when we did this in response to looking at our data, we found that only about 27% of customers were successfully completing the form within a 60-day window. And what we were able to do is take that 27% completion rate up to over 70% completion rate in 10 days. And that's the kind of innovation and development that really helps the borrower, much more than saying, here we are creating a laundry list of things that you must have on every single phone call. So we think we're doing a great job in this space. I think the data supports us. If you look at delinquency and default rates on the Navient service loan portfolios, we consistently outperformed the industry. Our federal student loan cohort default rate on loans we service is 35% lower than everybody else's. And I think those are the facts that really matter in cases like this, and we're eager for a full resolution here.

Great. Great. Well, I think we're going to need to end on that note. But let me thank you, Jack, for all your time and insights today. We really appreciate it.

Great. Thanks for having us, Mark, and thanks for having this conference.

Thank you.