Sallie Mae Down to Neutral

We are downgrading our recommendation on SLM Corp. (SLM - Analyst Report), better known as Sallie Mae, to Neutral from Outperform based on a tepid economic recovery and the impact of the legislative changes on its business.

First Quarter Results

Aided by a fall in loan loss provisions and decrease in expenses, Sallie Mae’s first-quarter 2012 core earnings came in at $284 million or 55 cents per share, beating the Zacks Consensus Estimate of 52 cents. Results also compared favorably with the prior-year quarter’s core earnings of $260 million or 48 cents per share. However, the company experienced a decline in net interest income and reductions in debt repurchase gains.

On a GAAP basis, Sallie Mae’s first-quarter 2012 net income came in at $112 million or 21 cents per share, down from $175 million or 32 cents reported in the comparable quarter last year. Notably, in the reported quarter, Sallie Mae experienced a $131 million increase in unrealized “mark-to-market” losses on derivative contracts compared with the year-ago period.

Sallie Mae’s Consumer Lending segment’s core earnings were $81 million in the reported quarter, substantially up from $44 million in the year-ago quarter. Reduced loan loss provision aided the upswing. Moreover, its Business Services segment reported core earnings of $139 million, up 5% from the year-ago quarter. The company experienced a growth in servicing revenue in the reported quarter from the Department of Education loan servicing contract.

However, the Federally Guaranteed Student Loans (FFELP) business segment generated core earnings of $82 million in the reported quarter, down 25% from $109 million in the year-ago quarter. The reduction stemmed from lower net interest income that resulted from the fall in balances of the FFELP loan portfolio as well as higher funding costs.

Sallie Mae has reiterated its guidance for 2012. For the full year, management expects to generate core earnings of $2.00 per share and anticipates private education loan originations of $3.2 billion.

Our Take

Sallie Mae has a leading position in the student lending market. However, in order to comply with the legislation, the company along with other student lenders such as Nelnet Inc. (NNI) has stopped originating new federal student loans. To respond to such changes, the company is making efforts to diversify its business.

Though such efforts are encouraging, we believe it would take some more time for the company to reap the benefits of a transition to its business model. Moreover, going forward, we believe that with the run-off of its FFELP loan portfolio, its interest income would be under pressure.

However, dividend hikes and increases in share buyback authorization give a boost to investors’ confidence. And despite challenges, we anticipate that the company’s cost containment efforts would help it navigate through the current cycle.

Though the legislative actions challenged the company’s business model, we expect Sallie Mae to benefit from the Department of Education’s servicing contract, under which it would service and collect government guaranteed loans. Given its low-cost business structure, we believe this new role will support Sallie Mae’s profitability and help produce an acceptable risk-adjusted return.

As such, the risk reward profile of Sallie Mae seems balanced and hence, we have a Neutral recommendation on the stock.

Additionally, Sallie Mae retains a Zacks #3 Rank, which translates into a short-term Hold recommendation.