NRUC

Business Context and Reporting Period

Company: National Rural Utilities Cooperative Finance Corporation (CFC), including consolidated subsidiaries Rural Telephone Finance Cooperative (RTFC) and National Cooperative Services Corporation (NCSC).

Reporting Period: Quarterly period ended November 30, 2004 (Six months ended November 30, 2004).

Business Overview: A not-for-profit cooperative providing financing and credit enhancements to rural electric and telecommunications utility systems. The company does not have stock; it is member-owned.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Turnaround: The company reported a net margin of $136.9 million for the six months ended November 30, 2004, a significant improvement from a net loss of $137.3 million in the prior year period. This swing was primarily driven by a $333 million increase in the estimated fair value of derivatives and a $21 million increase in gross margin.
• Loan Portfolio Contraction: Net loans to members decreased by $967 million (5%) to $18.9 billion. This decline was largely due to prepayments of RTFC loans, specifically a $900 million prepayment by a major borrower which generated $30 million in fees.
• Liquidity Improvement: Cash and cash equivalents increased significantly from $140.3 million to $587.1 million, driven by net cash provided by investing activities ($1.04 billion) and operating activities ($133.4 million).
• Derivative Volatility: While derivative forward value contributed a $146.6 million gain in the current period, it had resulted in a $185.6 million loss in the prior year. Foreign currency adjustments resulted in a $79.1 million loss, compared to a $48.6 million loss in the prior year.

Guidance, Outlook, and Risks

• Outlook: Management expects the loan portfolio balance to remain relatively stable or decline slightly through May 31, 2005. The adjusted gross margin is expected to remain stable or decline slightly. Adjusted leverage and debt-to-equity ratios are expected to be slightly lower by year-end due to equity retention.
• Key Risks:
  • Derivative Accounting: GAAP reporting of derivatives (SFAS 133) and foreign currency debt (SFAS 52) causes significant volatility in reported earnings and equity, which management excludes in its internal "adjusted" analysis.
  • Liquidity: The company relies on access to capital markets to refinance debt. $1.36 billion of debt matures within the next twelve months.
  • Credit Concentration: The ten largest borrowers represent 19% of total loans and guarantees. The company monitors this closely.
  • Problem Loans: Significant exposure exists to CoServ ($606 million, non-accrual) and VarTec ($184 million, non-accrual, in Chapter 11 bankruptcy). Litigation is ongoing with ICC ($484 million, currently accruing).

Investor Verification Checklist

• Derivative Valuation: Verify the sensitivity of the $146.6 million derivative forward value gain to changes in interest rate projections, as this is a non-cash item driving current profitability.
• Non-Performing Loans: Review the status of the $187 million in non-performing loans, specifically the $184 million exposure to VarTec (in bankruptcy) and the $606 million restructured loan to CoServ.
• Adjusted vs. GAAP Metrics: Confirm the company's "Adjusted TIER" (1.16) and "Adjusted Net Margin" ($71.2 million) to understand core operating performance excluding derivative volatility.
• Debt Maturity Wall: Assess the refinancing plan for the $1.36 billion of debt maturing within 12 months and the reliance on $4.65 billion in revolving credit facilities.
• Loan Loss Allowance: Evaluate the adequacy of the $573.7 million allowance given the concentration of impaired loans ($791 million) and potential increases in calculated impairment if variable rates rise.