Business Context and Reporting Period
Nelnet, Inc. is an education services company providing student-loan financing and servicing, tuition payment processing, campus commerce, enrollment services, and related software. This unaudited Form 10-Q covers the three and six months ended June 30, 2011, with comparisons to the corresponding 2010 periods. Dollars are in thousands except per-share amounts.
Effective July 1, 2010, federal legislation ended new FFELP loan originations. Nelnet is therefore managing a declining legacy FFELP portfolio while expanding fee-based businesses and servicing federally owned Direct Loan portfolios.
Financial Performance and Position
| Metric | Three months ended June 30, 2011 | Three months ended June 30, 2010 | Six months ended June 30, 2011 | Six months ended June 30, 2010 |
|---|---|---|---|---|
| Total interest income | $139,790 | $156,657 | $277,874 | $292,625 |
| Net interest income | $88,736 | $97,414 | $174,513 | $182,523 |
| Net interest income after loan-loss provision | $83,486 | $91,214 | $165,513 | $171,323 |
| Total other income | $75,302 | $96,996 | $180,715 | $207,506 |
| Operating expenses | $100,557 | $108,221 | $200,189 | $211,925 |
| Income before taxes | $58,231 | $79,989 | $146,039 | $166,904 |
| Net income | $37,125 | $49,993 | $92,005 | $104,315 |
| Diluted EPS | $0.76 | $0.99 | $1.89 | $2.08 |
- Quarterly net income declined 25.7%; six-month net income declined 11.8%. Diluted EPS declined from $0.99 to $0.76 in the quarter and from $2.08 to $1.89 year to date.
- The effective tax rate was 36.3% for the quarter and 37.0% year to date, versus 37.5% in both 2010 periods.
- Net interest income after provision for loan losses and derivative settlements was $79,964 for the quarter and $157,839 year to date, down 9.0% and 4.6%, respectively.
- The variable student-loan spread declined to 0.94% in the quarter and 0.92% year to date, versus 1.06% and 0.96% in the comparable 2010 periods. Net fixed-rate floor income was $32,801 in the quarter and $64,483 year to date.
Balance Sheet, Cash Flow, Debt, and Liquidity
| Balance-sheet metric | June 30, 2011 | December 31, 2010 |
|---|---|---|
| Student loans receivable, net | $23,228,778 | $23,948,014 |
| Cash and cash equivalents | $116,341 | $283,801 |
| Restricted cash and investments | $610,730 | $668,757 |
| Total assets | $24,871,511 | $25,893,892 |
| Bonds and notes payable | $23,605,413 | $24,672,472 |
| Total liabilities | $23,882,727 | $24,987,259 |
| Shareholders' equity | $988,784 | $906,633 |
- Six-month operating cash flow was $168,216, compared with $61,411 in 2010; cash used in financing was $1,154,464, primarily reflecting debt repayments exceeding new borrowings.
- Cash and cash equivalents fell by $167,460 to $116,341, largely because the company repaid $1,782,953 of bonds and notes while issuing $745,554 of new debt.
- Total debt declined 4.3% from year-end. Debt consisted primarily of variable-rate obligations, including $20,346,991 of asset-backed securities, $2,497,198 under the Department of Education Conduit Program, and $469,578 under the FFELP warehouse facility.
- The $750,000 unsecured line of credit had $177,300 outstanding and expires in May 2012. Excluding the Lehman Brothers commitment, $532,600 was available. The company reported compliance with all applicable covenants.
- Primary liquidity sources totaled $371,078, including cash, trading securities, unencumbered student loans, and certain asset-backed security investments.
Material Changes Versus Prior Comparable Period
- Fee-based revenue was broadly stable year to date at $182,496 versus $182,555, but declined 2.0% in the second quarter to $88,825.
- Tuition payment processing and campus commerce revenue increased 15.4% in the quarter and 13.1% year to date, supported by more managed tuition plans and campus commerce customers.
- Enrollment services revenue declined 8.7% in the quarter and 3.6% year to date, primarily because for-profit schools reduced marketing spending amid regulatory uncertainty.
- Student loan and guaranty servicing revenue increased 2.0% in the quarter but declined 0.4% year to date. Government servicing revenue rose, while FFELP and guaranty servicing revenue declined.
- Operating expenses decreased 7.1% in the quarter and 5.5% year to date. Lower depreciation and amortization, enrollment-service costs, restructuring costs, and other expenses offset higher salaries and benefits.
- Second-quarter other income was reduced by a $20,335 million? No: the filing reports a $20,335 thousand net expense from derivative market-value, foreign-currency, and settlement adjustments. This compares with a $10,608 thousand expense in 2010.
- The company recorded no second-quarter gain on debt repurchases, compared with $8,759 in 2010. Year-to-date gains were $8,307 versus $18,936.
- Student loans held for investment declined 2.8% from December 31, 2010 to $23,113,812 before premiums, deferred origination costs, and allowances. The company acquired $683,087 of loans during the first six months.
Guidance, Outlook, Risks, and Unusual Items
- No formal full-year earnings guidance is provided. Management expects significant fixed-rate floor income to continue if short-term interest rates remain low.
- Management expects continued pressure on student-loan earnings as the legacy FFELP portfolio amortizes, new FFELP originations remain prohibited, and the commercial-paper/LIBOR spread affects the variable loan spread.
- Management expects operating-margin compression in student-loan servicing as lower-margin government servicing becomes a larger portion of the portfolio.
- Management intends to diversify through tuition payment processing, campus commerce, enrollment services, and Direct Loan servicing. The company had agreements expected to add more than 12 million borrowers to its hosted servicing platform, with revenue expected to begin in 2012.
- On July 8, 2011, the company purchased the residual interest in $1.9 billion of FFELP consolidation loans. Management estimated incremental future cash flow of approximately $90,000 to $120,000, but the acquisition was not included in June 30 balances or the existing $1.63 billion cash-flow forecast.
- The company forecasts approximately $1.63 billion of future undiscounted cash flows from securitized student loans. The forecast would decline by approximately $330,000 to $390,000 if prepayment assumptions doubled, and by approximately $80,000 to $120,000 if the assumed LIBOR-to-commercial-paper spread doubled to 24 basis points.
- All of the company’s auction-rate securities were in failed-auction status, potentially increasing funding costs. Warehouse facilities also depend on periodic renewal of liquidity provisions and compliance with financial covenants.
- The company retained credit risk on sold or participated non-federally insured loans and had accrued $20,689 for related repurchase obligations. A $2,500 expense was recorded in the second quarter for these obligations.
- The Bais Yaakov TCPA fax litigation could involve substantial statutory damages if a class is certified, but the company stated that a reasonably possible loss cannot currently be estimated. No class had been certified as of the filing date.
- Standard & Poor’s August 5, 2011 downgrade of the U.S. sovereign rating could increase borrowing costs, reduce capital-markets access, increase collateral or equity-support requirements, and complicate refinancing of the $2.5 billion Department of Education Conduit balance.
- The company’s derivatives do not qualify for hedge accounting. Changes in interest rates, yield curves, and foreign exchange rates can cause significant earnings volatility; derivative assets were $182,450 and derivative liabilities were $23,383 at June 30, 2011.
Important Facts for Investors to Verify
- Whether the legacy FFELP portfolio runoff and spread compression offset growth in Direct Loan servicing and other fee-based businesses.
- The renewal and refinancing status of warehouse facilities, the unsecured line of credit, and the Department of Education Conduit Program.
- The sensitivity of future cash flows and earnings to prepayment speeds, LIBOR-versus-commercial-paper spreads, and changes in interest rates.
- The adequacy of the $42,300 allowance for loan losses and the $20,689 repurchase-obligation accrual, particularly for non-federally insured loans.
- The effect of for-profit college regulations on enrollment-services demand and the company’s litigation exposure.
- The accounting and economic impact of the July 2011 $1.9 billion FFELP residual-interest acquisition and related $46,200 of fixed-rate notes.
- The distinction between GAAP net income and management’s non-GAAP “base net income,” which excludes certain derivative, foreign-currency, and acquired-intangible amortization effects.