Navient Corp Q2 FY2022 Earnings Call

Good morning, ladies and gentlemen. Thank you for standing by and welcome to Navient's Second Quarter 2022 Earnings Conference Call. Please be advised that today's conference may be recorded. I would now like to turn the conference over to speaker host, Jen Ines. Please go ahead.

Thank you, Olivia. Good morning and welcome to Navient's second quarter 2022 earnings call. With me today are Jack Remondi, our CEO; and Joe Fisher, our CFO. After their prepared remarks, we will open up the call for questions. Before we begin, keep in mind, our discussion will contain predictions, expectations, forward-looking statements and other information about our business that is based on management's current expectations as of the date of this presentation. 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, adjusted tangible equity ratio, and various other non-GAAP financial measures derived from core earnings. Our GAAP results and description of our non-GAAP financial measures and a full reconciliation to GAAP can be found in the second quarter 2022 supplemental earnings disclosure. This is posted on the Investors page at navient.com. Thank you. And now I'll turn the call over to Jack.

Thank you, Jen, and good morning, everyone, and thank you for joining us today and for your interest in Navient. I am pleased to report another quarter of strong financial results. We saw strength in net interest income, credit performance, fee revenue, and operating expenses even as loan demand declined and interest rates rose. Our financial performance is the result of our ongoing efforts to leverage our strengths and reduce our risk. This quarter's results also reflect our proactive planning to prepare for rising rates and higher inflation. The current economic and political environment have led to a significant reduction in the demand for refinance loans. Several factors are contributing to this. For example, the increase in interest rates has reduced the balance of loans that could benefit from refinancing by more than two-thirds. In addition, the multiple extensions of the interest waiver and payment pause on Federal direct loans and the potential for a broad-based loan forgiveness program have led borrowers to take a wait-and-see approach. As these conditions change, we expect to see renewed demand for refinance loans given the strong financial benefits it delivers. For the quarter, we earned $0.92 in adjusted core earnings per share and a return on equity of 20%. With year-to-date adjusted core earnings of $1.82, we are once again raising our earnings guidance. We now expect adjusted core earnings for the full year to be between $3.35 and $3.45 per share. In consumer lending, we originated $420 million in high-quality education loans during the quarter. We continue to project a strong year for in-school originations as we enter the peak season. Last year, we acquired Going Merry, which provides high school guidance counselors with digital tools that help juniors and seniors prepare for going to college. Through Going Merry, students and their families can more easily complete the FAFSA, apply for local and national scholarships, and compare financial aid offers from multiple schools. Going Merry's user base increased by over 500,000 during the 2021 and 2022 academic year. It now includes an estimated 15% of all high school seniors who are planning to go to college. These tools help students and their families explore ways to reduce the cost of earning their degree, make informed financial decisions, and capture the value of a college education. Through these services, we are developing engaged relationships with going-to-college students that help highlight and enhance the value of our consumer lending products. In Business Processing Solutions, we continue to leverage our core operational skills in workflow processing, customer contact, and revenue cycle enhancement for clients in government, healthcare, and commercial sectors. While year-over-year revenue decreased with the expected wind-down of our pandemic-related projects, we see meaningful growth potential given our strong value proposition. This includes leveraging our pandemic-related performance to win new business. Credit performance remains particularly strong. The expected and planned-for increase in delinquency and default rates as COVID payment pauses came to an end has not happened, as the return to repayment has been significantly stronger than expected. In fact, private loan delinquency and default rates are lower than pre-pandemic levels, and we expect these trends to continue. We've taken several steps beginning last year to plan for the changing economic environment. This included hedging for a rising rate market and pre-funding some of our liquidity needs in anticipation of higher rates and credit spreads. In addition, we are focused on managing our operating expenses to reflect the new levels of refinance loan demand and the reduction in pandemic-related BPS services. We are also focused on managing the impact of inflation and our ongoing efforts to consistently improve operating efficiency. Our capital levels remain robust and support both our existing assets and the growth we seek in our consumer lending and BPS segments. At June 30, our adjusted tangible equity ratio was a very healthy 7.5%. Our cash flows and capital ratios continue to support our dividend and share repurchase plans. We've delivered very strong results through the first six months of 2022, and I would like to thank my teammates for their efforts. I'm particularly pleased with our ongoing agility to manage volatile conditions and changing demand. Our focus on profitably building our growth businesses, successfully managing interest rate volatility, generating high-quality assets, improving operating efficiency, and our disciplined capital management is delivering value for our customers, clients, and investors. I'm pleased with our strong financial performance, and I'm excited and confident in our ongoing ability to continue to deliver strong results. I'll now turn the call over to Joe for more details on the quarter, and I look forward to your questions later in the call.

Thank you, Jack, and thank you to everyone on today's call for your interest in Navient. During my prepared remarks, I will review the second quarter results for 2022. I'll be referencing the earnings call presentation which can be found on the company's website in the Investors section. Key highlights from the quarter, beginning on Slide 4, include second quarter GAAP EPS of $1.22, second quarter adjusted core EPS of $0.92, a private NIM of 111 basis points, the origination of $420 million of private education loans, reported BPS revenues of $87 million, and increased our adjusted tangible equity ratio to 7.5%, while returning $128 million to shareholders through dividends and repurchases. As a result of the strong earnings this quarter and our outlook for the remainder of the year, we are increasing our earnings per share guidance to a range of $3.35 to $3.45 for the full year. I'll provide additional detail on the quarter and our outlook by segment beginning with Federal Education Loans on Slide 5. Net interest margin increased 14 basis points from the year-ago quarter to 111 basis points, leading to an increase in interest income of $5 million compared to the prior year, even as the portfolio declined 11%. The benefit of the asset rate resets, along with the funding decisions we made in anticipation of a rising rate environment contributed to both the increase over the prior quarter and prior year and more than offset the reduction of unhedged floor income. As expected, felt delinquency rates increased to 15.9% and forbearance rates declined to 13.1% from the year-ago quarter with a charge-off rate at 9 basis points. The decline in fee revenue and operating expenses in this segment compared to the prior year are primarily attributable to the transfer of the Department of Education servicing contract that occurred in October of 2021. Let's turn to Slide 6 in our Consumer Lending segment. This quarter's net interest margin of 266 basis points was 14 basis points lower than the first quarter primarily as a result of the expected increase in the interest reserve as late-stage delinquency balances rose compared to the prior period. While credit trends continue to exceed our expectations with total delinquency rates below pre-pandemic levels, we expect charge-off rates to return to more normalized levels that are in line with our guidance of 1.5% to 2% for the full year. We feel confident that we are adequately reserved for the expected life of loan losses given the well-seasoned and high credit quality of our portfolio. In the quarter, we originated $374 million of private education refinance loans. This quarter saw an expected decline in demand for refinance loans due to the higher rate environment and the continuation of the CARES Act. Our forecast for originations this year assumes that the federal government will continue to provide a 0% interest rate to roughly 84% of the $1.7 trillion of outstanding education loans through an extension of the CARES Act for the remainder of 2022. While the reduced new loan volume results in lower than expected net interest income, this is being partially offset by a slowdown in prepayment speeds of the overall portfolio as higher interest rates provide less of an incentive for existing customers to prepay. Continuing to Slide 7 to review our Business Processing segment. Second quarter revenues totaled $87 million with increasing revenue from our traditional government and healthcare BPS services, partially offsetting the expected wind down of revenue from pandemic-related services in the quarter. The 16% EBITDA margin for the quarter is shy of our high-teen targets due to trailing costs for certain pandemic-related services. For the full year, we continue to target our high-teen EBITDA margins as we leverage our existing technology-enabled platform and infrastructure to provide dynamic solutions that meet emerging market demand. Turning to our financing and capital allocation activity that is highlighted on Slide 8. During the quarter, we reduced our share count by 5% through the repurchase of 7 million shares. In total, we returned $128 million to shareholders through share repurchases and dividends while increasing our adjusted tangible equity ratio to 7.5%. At today's price, our planned share repurchases for the remainder of 2022 amount to $180 million; we've reduced our outstanding share count by an additional 8%. During the second quarter, we issued $715 million of private education refinance loan ABS. We mitigate the risk of rising rates on our refinance and in-school portfolio by hedging our expected loan volume originations and issuing fixed-rate securitizations, locking in margins for the life of each loan. These actions have benefited us in recent quarters as rates continue to rise. Our unsecured issuance in the fourth quarter of 2021 and subsequent reduction of near-term maturities left us with no upcoming unsecured debt maturities until the first quarter of 2023. Turning to GAAP results on Slide 9. We recorded second quarter GAAP net income of $180 million or $1.22 per share compared with net income of $185 million or $1.05 per share in 2021. Finishing with our outlook for 2022 on Slide 10. Our efforts to simplify the business while improving efficiencies in the face of a challenging environment allowed us to achieve an overall efficiency ratio of 49% in the quarter and 50% year-to-date. The updated 2022 adjusted core earnings per share guidance of $3.35 to $3.45 reflects these efforts and is an increase of 11% compared to our original expectations. This updated outlook excludes regulatory and restructuring costs and assumes no gains from loan sales or debt repurchases while reflecting the continued rising interest rate environment and the extension of the CARES Act through December 31, 2022. Before I turn to questions, I would like to welcome Jen Ines as our new Head of Investor Relations and to recognize my teammates across all segments. These efforts led to continued success and positive results in the quarter while providing innovative products and solutions to our clients. Thank you for your time and I will now open the call for questions.

Our first question comes from John Hecht at Jefferies.

The first one is more of an industry question. I just think that we've all been taking a lot of questions on it. One of your competitors instigated an internal review regarding policies tied to collections and dischargeability of bankrupt loans. And I'm wondering, do you guys think there's any kind of broader industry ramifications tied to that? Or do you think that, that is more of just a one-off for the industry?

You're referring to the situation we are not familiar with, regarding the specific exam or investigation. Considering the process we've undergone over the years, we've likely been reviewed and audited by more regulatory agencies than all of the student loan entities combined. Our practices are very robust in that regard, and we continue to collaborate with these agencies to enhance how the student loan program operates for borrowers. With our exit from the Department of Education loan servicing contract, we anticipate a reduction in such activities moving forward.

Okay. Looking at the net interest margin performance to date compared to our guidance, can you comment on the incremental trends we should anticipate in the second half of the year that would drive the net interest margin towards the annual guidance? Also, how does the hedging strategy play a role in that?

So given the interest rate environment that we're in, we are certainly expecting for the remainder of the year, I would assume that the FFELP net interest margin will remain elevated. So while our original guidance was in the mid-90s, you saw 111 basis points in this quarter, I would expect that will remain above 100 basis points for the remainder of the second half of the year. So we're certainly well on pace to exceed our original guidance. And in terms of the private education loan NIM from that perspective, the continued movement from loans to from early-stage to late-stage delinquency could cause some of the pressure that you saw in this quarter just as we increase our interest reserve, but we're also on pace to be either at the high end or exceed the $265 million guidance that we originally provided.

And our next question coming from the line of Mark DeVries with Barclays.

Can you talk about your funding costs for private refinance loans currently and pricing to the borrower? How much of a refinance incentive is still there? And what does your addressable market look like today in the face of higher rates?

So historically, our client base in the refinance arena came from students who had earned an advanced degree, a Master's degree or some form of Doctor or law degree. Most of what was being refinanced were Grad PLUS loans that they had taken out in pursuit of those degrees. As interest rates have risen, the vast majority of the Grad PLUS loans have lower interest rates than what we would offer customers today. Therefore, our refinance demand is primarily coming from borrowers with private student loans, and most of those are variable rate private student loans. We expect as this new crop of borrowers goes to school and borrows at Grad Plus programs at higher interest rates, that as interest rates stabilize and begin to come down, that demand will return. But right now, as I said in my comments, two-thirds of the eligible customer base that we see in the federal loan space have interest rates on their current loans that are lower than what we can offer. Our funding mix, our funding sources are primarily ABS funding sources in the marketplace. So we're offering coupons today that average in the mid-6s to low 7s.

Okay, great. And then just a follow-up question on the FFELP NIM. I know you're not providing 2023 guidance yet but Joe, I heard you comment that you expect it to remain kind of above 100 bps for the back half of the year. Is the kind of the guidance going into the year of the '90s the right way to think about where it eventually trends to?

Yes. I want to stay away from 2023 guidance, but I think as you model out in the future, I would expect it to return to more normalized levels as we do benefit from the rising rate environment on the asset rate.

Our next question coming from the line of Moshe Orenbuch with Credit Suisse.

Maybe to follow up on that question, Joe. Could you just talk a little bit about disaggregating the impact in the quarter from the impact of the funding mismatch that you benefit from versus the impact of floor income and how that kind of interplay and what you've got left in unhedged floor income? Can you talk about that, please?

Sure. So we earned about roughly 10 basis points of unhedged floors in terms of the component of that private NIM. So that's down roughly 7 basis points or so from the prior quarter in terms of where we were. As I think about going forward, the increase in the rates benefited that more than offset, as well as the fact that we have been proactive in terms of our fixed-rate funding mix. If you look at our fixed-rate funding compared to prior year, we're roughly about 30% fixed-rate funded in terms of our liabilities, and our assets make up about 18% fixed rate. So that delta is contributing on both the private and on the belt, and that will continue to contribute a stable benefit as we enter into next year.

Got it. Did you mention that self-prepay speeds are expected to decrease? I thought they had been increasing.

Yes. So there are two contributing factors here that somewhat offset. If you think about public service loan forgiveness, you are seeing borrowers that are consolidating a way to the direct loan program. So that does put pressure in terms of prepayment speeds. But you are seeing borrowers just with a rising rate environment naturally being less inclined to make a prepayment just given the benefit of the lower rate of the FFELP portfolio. So you are seeing those borrowers that are not following away make less prepayments, and we started to see that in more recent months. I certainly don't want to bring this up proactively, but I think in terms of the loan forgiveness discussion, a number of borrowers are also just waiting to see what happens there and certainly less inclined to prepay as a result.

I guess just a follow-up on that, Joe. One of your competitors had noted last quarter that they expected prepays to potentially rise rapidly because their loans, in other words, in order to be eligible for forgiveness, they'd have to consolidate, like you were talking about with the public sector, the corporate sector loan forgiveness. So I guess do you have a perspective on that?

Well, I think at this stage in the game, there are with the lack of any details of what loan forgiveness programs might look like, it's not clear how a program would be implemented and who would be eligible. The only thing that the President has indicated is that $10,000 would be the amount and there might be some income caps on the program. Our customer base is primarily borrowers with consolidation loans, which given their balances imply advanced degrees. So we would expect that a meaningful percentage of that borrower base would be ineligible based on income caps. But then you also have the possibility that any forgiveness program would take place where the borrower was versus forcing everyone into one program or another. But these are all to be determined. As I said, there is literally zero commentary on this. Even if you look at some of the programs that they've announced, there are still details on how those programs will be implemented, even though they've been publicly announced.

Next question coming from the line of Sanjay Sakhrani with KBW.

I'm wondering if you guys have heard anything on the student loan moratorium and whether or not it's going to be extended. And maybe sort of how you think it impacts the scenarios that you've considered?

We are no longer a service on the Department of Ed contracts. I guess our sources are the same as what we read in the press and what some of our former colleagues in the direct loan servicing business talk to us about. And that has just been that the department has had don't communicate with customers yet. I think it's given where we are in the calendar and the end date of August 31, it's hard for us to believe that it does not get extended. As Joe said, our working assumptions are that the 0% interest and the payment waiver will extend through all of 2022.

And you've contemplated that in your guidance?

Yes.

Okay. One sort of more high-level follow-up on the BPS segment. That continues to do quite well. I'm just curious how we should think about how you're thinking about that business long-term? Obviously, it made a whole lot of sense when you have that large servicing portfolio for the DOE but maybe just talk about strategically how you're thinking about that business.

Well, when we launched our activities in the BPS segment, it was leveraging the skills that we had developed and owned in the scale that we were delivering in loan servicing, for sure. Those skills are our ability to manage high levels of volume and workflow processing, really creative and comprehensive omnichannel types of communication strategies for customer contact and outreach, and then payment flows and revenue cycle enhancement activities. During the pandemic, the demand for some of these services spiked, unfortunately. We were able to respond quickly to necessary outreach to customers, helping them understand different programs, processing forms, and components for them. This included unemployment insurance and COVID vaccination outreach to hard-to-reach segments of the population to help them get appointments scheduled and increase the state's overall vaccination levels. For us, we were leveraging the skill sets that we had. Those skill sets remain even though we're no longer a Department of Education loan service. We are still servicing our own FFELP loans, we're still servicing our private loans, and the telephony, the systems, the workflow expertise remain. The data analytics that we've learned through the years on that side of the equation to help us be more effective are still front and center. The big difference in BPS in the last two years going forward is that during the pandemic, contracts in demand for services rose almost from zero to very high levels and needed to be responded to very rapidly. In some cases, we offered services, were awarded contracts, and started operations in a matter of days. In a more normalized business processing solutions contract award basis, we'll go through RFPs, bid letters. The time frame to replace pandemic work with longer-term arrangements has a longer cycle. But we're seeing from clients both existing that we had during the pandemic as well as new clients that our performance and capabilities in that space were well regarded, and we expect to be able to leverage that to new and longer-term contracts going forward.

And the next question is from Bill Ryan.

I have a couple of questions. First, regarding your in-school loan demand. Looking back at last year, you had approximately $153 million in volume. How is that progressing? I understand it may be early, but what trends are you seeing in loan demand? I also recognize there has been some additional competition in the market due to a decrease in refinance volume. Secondly, about the provision for loan losses, it appears you had around $7 million on new originations, roughly 1.7% of the volume. Additionally, there seems to be about an $11 million adjustment related to the existing loan portfolio, mainly due to an extension of its duration as you previously mentioned. Have there been any changes to the CECL reserves related to the in-school and refinance volumes?

So thanks for the questions. Our outlook for in-school origination product is one of optimism regarding the demand that we will see this year and the volume that we'll originate. As you point out, it is early in the peak season, so we're just starting to see application flows. Every year is a little bit different in terms of when demand peaks in cycles, but we believe our product design, the application flow enhancements that we've made, and the outreach we are making is positive. The comments I made about Going Merry are also significant value enhancers for us. These are products that help students and families better plan for how to pay for college and hopefully by taking advantage of things like completing the FAFSA, using the scholarship search engine, which is the only scholarship search engine in the country that has both local and national scholarships. This is really an opportunity to help students and families find ways to reduce the amount they need to borrow, and as I said, it enhances the value proposition of what we're bringing to the table. On the provision side of the equation, our outlook is that our credit performance has been particularly strong. It has been better than what we expected. Our reserve levels, however, have not changed up or down in terms of our life of loan loss estimates for in-school or refinance or the legacy portfolio. We remain conservatively positioned in terms of credit outlook, just given the uncertainty in the economy. But as we said, credit performance to date has been significantly better than expected.

Our next question is coming from Courtney Bahlman with Barclays.

Jack, Joe, congrats on the results, and Jen, congrats on your new role. So just a quick one for you guys. I know that you mentioned in the release that you'd be handling your near-term maturities with liquidity, those aside, given current valuations of the bonds, how are you guys thinking about opportunistic repurchases for the remainder of 2022? And any color on how that might fit into your capital allocation priorities?

Yes. So as we've done in the past, I think opportunistic is a good word. To the extent that there is availability, when you look at our maturities over the next 12 and 24 months of where there are opportunities. Even in the past, we've gone out well beyond 10 years if it's attractive enough to us. We feel very comfortable from a liquidity perspective and availability of us to raise cash quickly should there be an opportunity to pay down unsecured debt. Unfortunately, there haven't been those opportunities in the near term to take some of that down in the last two quarters, but we continue to look for that. If that comes about, we will certainly take advantage of it.

Your line is open.

I know you're probably load the comment on a specific court case. But there was a ruling in early July in the case on the dischargeability of private student loans and bankruptcy. Instead of the specifics on the case, just wondering if you can comment on just changes on view on dischargeability and is this kind of any material change or I'm guessing it's possible that it's just a small and material change but would love your view.

We have long been advocates for reform and bankruptcy dischargeability. Our proposals have generally focused on borrowers who have been in repayment for some brief period of time after school and then incur some financial hardship that they should be eligible for discharge similar to other forms of credit products. I think the rulings that are coming out here have to do with whether a loan is an eligible loan under the definition and some of our loan products like a bar study or residency programs or even some of the direct-to-consumer component products that we offer that Sallie Mae offered over ten years ago, but we own some of those loans today, get caught up in that. But it's a relatively small component piece for us. As I said, we've been advocates for reform. I think one point I would just make, remind folks that in a bankruptcy situation, the borrowers are already in default typically at that stage in the game, and so it's really more about recovering the defaulted loan balance that gets impacted here.

I'm not showing any further questions at this time. I would now like to turn the call back over to Jen Ines for any closing remarks.

Thanks, Olivia. We'd like to thank everyone for joining us on today's call. Please contact me if you have any other follow-up questions. This concludes today's call.

Ladies and gentlemen, that does conclude the conference for today. Thank you for your participation. You may now disconnect.