Potential Split Could Create New Opportunities and Increase Shareholder Value
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Through its board of directors, once-mighty student lender SLM Corporation (NASDAQ: SLM) has received official permission to execute a long-anticipated spin-off. The split would separate SLM's education loan management division from its student loan origination business and create two smaller companies that would operate in tighter, better-defined niches. It may be the surest sign yet that the American higher education sector will face tremendous challenges in the years ahead.
On its surface, this deal looks to present solid opportunities for current and future SLM investors. Since the company never fully recovered from the financial crisis of the late 2000s, it might have a better chance of survival as two smaller, more nimble entities. However, there are plenty of pitfalls associated with splits like these. Before rushing in headlong, investors should take a moment to evaluate SLM's relative strength as well as its position in the broader banking ecosystem.
SLM is still occasionally known by the more familiar Sallie Mae moniker, but a concerted re-branding effort has minimized this more fraught name in favor of the more generic current title. In any event, SLM competes directly with a number of other financial companies that originate and service student loans. Although they are not pure-play student lenders like SLM, Bank of America (NYSE: BAC) and KeyCorp (NYSE: KEY) both have significant student loan portfolios.
It should not be surprising that Bank of America is the largest of these three firms. Its market capitalization of $146 billion exceeds that of SLM by a factor of 14 and that of KeyCorp by a factor of 15. In 2012, SLM earned about $1.2 billion on revenues of just under $3 billion. This compares to earnings of $3.5 billion on revenues of $78 billion for Bank of America and a profit of $828 million on revenues of $4 billion for KeyCorp. In addition to being more profitable than its peers, SLM is also more expensive: Its price-to-book ratio of 2.3 is considerably higher than KeyCorp's even ratio and far more impressive than Bank of America's depressed .67 ratio.
Unfortunately, long-term debt obligations are SLM's Achilles heel. The company's obligations add up to about $160 billion and dwarf its cash reserve of about $5.5 billion. By comparison, Bank of America has about $618 billion in debt and over $500 billion in the bank. KeyCorp has debts of about $10.6 billion and cash reserves of just over $2.2 billion.
How and When the Split Might Occur
According to the tentative terms of the deal, the pending spin-off will occur at some point before the end of the second quarter of 2014. Given the complexity of the deal, it is possible that this timetable could change in the coming months.
Regardless, the split will produce several important changes. The company's current CEO will leave and be replaced by two underlings. The "legacy" loan servicing business that has driven SLM's revenues will end up owning about 95 percent of the company's current portfolio, including its substantial basket of publicly backed student loans. However, the loan origination firm will grow over time with the initiation of new credit vehicles. The loans that this new firm originates are unlikely to enjoy public backing.
This deal is not without its risks. Most importantly, the student loan industry is changing rapidly. Although SLM remains a quasi-public agency that enjoys significant backing from the U.S. Government, it seems unlikely that the newly created loan origination division will have such support. This will expose aptly named Sallie Mae Bank to the vagaries of the private financial markets and increase the potential for losses related to student loan defaults. With the rate of such defaults surpassing 13 percent last year, this presents a very real, very tricky problem.
Could it Create New Value?
Then again, Congress appears to recognize the problem and has taken steps to produce a solution. Since pending legislation that ties student loan rates to Treasury bond rates over a 10-year period is likely to pass in some form, investors in the newly formed companies may not have to wait long for clarity on the issue. This clarity would provide shareholders with a clear choice between a stodgier company that services a predictable portfolio of existing loans at fixed rates and a more dynamic firm that could profit from steady, predictable rises in student loan interest rates over time.
Long-Term Outlook and Possible Plays
More broadly, the higher education industry faces structural and secular challenges that will not be easy to overcome. Although American students continue to finance their educational endeavors with ever-increasing amounts of debt, it is unclear whether this is sustainable over the long haul. Since this is a sensitive political issue with far-reaching ramifications, it is difficult to predict its eventual outcome. However, it is safe to say that SLM's future depends on a successful resolution that permits interest rate increases without creating a large-scale default crisis.
In sum, investors who believe in the fundamental health of the student loan industry would do well to look at this potential split. It seems obvious that this split will create two focused, nimble firms that will compete well in a dynamic financial sector. Nevertheless, investors who believe that the student loan industry's challenges are insurmountable would do well to look elsewhere for value. As usual, this situation's benefits are in the eye of the beholder.
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Mike Thiessen has no position in any stocks mentioned. The Motley Fool owns shares of Bank of America and KeyCorp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!