UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ______.
COMMISSION FILE NUMBER 001-31924
-----------------------------------------------------------
NELNET, INC.
(Exact name of registrant as specified in its charter)
NEBRASKA 84-0748903
(State or other jurisdiction of incorporation (I.R.S. Employer
or organization) Identification No.)
121 SOUTH 13TH STREET, SUITE 201 68508
LINCOLN, NEBRASKA (Zip Code)
(Address of principal executive offices)
(402) 458-2370
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of October 31, 2004, there were 39,678,606 and 13,983,454 shares of Class A
Common Stock and Class B Common Stock, par value $0.01 per share, outstanding,
respectively.
NELNET, INC.
FORM 10-Q
INDEX
SEPTEMBER 30, 2004
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.........................................2
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations......................13
Item 3. Quantitative and Qualitative Disclosures about
Market Risk..............................................37
Item 4. Controls and Procedures.....................................37
PART II. OTHER INFORMATION
Item 1. Legal Proceedings...........................................37
Item 2. Changes in Securities and Use of Proceeds...................37
Item 3. Defaults Upon Senior Securities.............................37
Item 4. Submission of Matters to a Vote of Security Holders.........38
Item 5. Other Information...........................................38
Item 6. Exhibits....................................................38
SIGNATURES....................................................................39
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2004 DECEMBER 31, 2003
------------------ ------------------
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
ASSETS:
Student loans receivable (net of allowance for loan losses of
$8,446 and $16,026, respectively)......................................$ 12,793,704 10,455,442
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party................. 4,363 188,272
Cash and cash equivalents - held at a related party..................... 40,832 10,151
---------------- ---------------
Total cash and cash equivalents............................................... 45,195 198,423
Restricted cash............................................................... 585,243 634,263
Restricted investments........................................................ 271,714 180,688
Restricted cash - due to loan program customers............................... 31,119 141,841
Accrued interest receivable................................................... 250,367 196,633
Accounts receivable, net...................................................... 14,196 17,289
Goodwill...................................................................... 16,533 2,551
Intangible assets, net........................................................ 10,546 9,079
Furniture, equipment, and leasehold improvements, net......................... 25,321 19,138
Other assets.................................................................. 70,858 76,839
---------------- ---------------
Total assets............................................................$ 14,114,796 11,932,186
================ ===============
LIABILITIES:
Bonds and notes payable.......................................................$ 13,526,343 11,366,458
Accrued interest payable...................................................... 29,748 17,179
Fair value of derivative instruments, net..................................... 39,386 677
Other liabilities............................................................. 79,585 100,542
Due to loan program customers................................................. 31,119 141,841
---------------- ---------------
Total liabilities....................................................... 13,706,181 11,626,697
---------------- ---------------
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Preferred stock, $0.01 par value. Authorized 50,000,000 shares;
no shares issued or outstanding......................................... -- --
Common stock:
Class A, $0.01 par value. Authorized 600,000,000 shares;
issued and outstanding 39,678,606 shares as of
September 30, 2004 and 39,601,834 shares as of December 31, 2003.... 397 396
Class B, $0.01 par value. Authorized 15,000,000 shares;
issued and outstanding 13,983,454 shares as of September 30, 2004
and 14,023,454 shares as of December 31, 2003....................... 140 140
Additional paid-in capital.................................................... 207,685 206,831
Retained earnings............................................................. 199,896 97,885
Unearned compensation......................................................... (97) --
Accumulated other comprehensive income......................................... 594 237
---------------- ---------------
Total shareholders' equity.............................................. 408,615 305,489
---------------- ---------------
Total liabilities and shareholders' equity..............................$ 14,114,796 11,932,186
================ ===============
See accompanying notes to consolidated financial statements.
2
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- ----------------------------
2004 2003 2004 2003
-------------- ------------- ------------- -------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Interest income:
Loan interest..................................................$ 153,032 85,574 466,158 267,929
Investment interest............................................ 4,918 2,716 11,750 11,984
-------------- ------------- ------------- -------------
Total interest income..................................... 157,950 88,290 477,908 279,913
INTEREST EXPENSE:
Interest on bonds and notes payable............................ 68,545 47,309 169,940 151,484
-------------- ------------- ------------- -------------
Net interest income....................................... 89,405 40,981 307,968 128,429
Less provision (recovery) for loan losses.......................... 2,300 4,015 (1,006) 8,875
-------------- ------------- ------------- -------------
Net interest income after provision (recovery)
for loan losses......................................... 87,105 36,966 308,974 119,554
-------------- ------------- ------------- -------------
OTHER INCOME (EXPENSE):
Loan servicing and other fee income............................ 24,167 27,087 72,388 77,324
Software services and other income............................. 8,391 4,565 18,998 13,676
Derivative market value adjustment and net settlements......... (56,214) (5,655) (58,598) (5,655)
-------------- ------------- ------------- -------------
Total other income (expense).............................. (23,656) 25,997 32,788 85,345
-------------- ------------- ------------- -------------
OPERATING EXPENSES:
Salaries and benefits.......................................... 25,060 35,901 101,865 92,749
Other operating expenses:
Depreciation and amortization............................. 4,951 5,257 14,036 17,124
Trustee and other debt related fees....................... 2,752 3,339 8,217 10,798
Occupancy and communications.............................. 2,950 2,963 9,167 9,155
Advertising and marketing................................. 2,916 2,379 8,200 6,693
Professional services..................................... 2,672 2,198 10,026 6,825
Consulting fees and support services to related parties... -- 417 -- 3,102
Postage and distribution.................................. 3,059 3,440 10,127 10,228
Other..................................................... 7,142 6,375 19,272 18,274
-------------- ------------- ------------- -------------
Total other operating expenses.................... 26,442 26,368 79,045 82,199
-------------- ------------- ------------- -------------
Total operating expenses.......................... 51,502 62,269 180,910 174,948
-------------- ------------- ------------- -------------
Income before income taxes and minority interest.. 11,947 694 160,852 29,951
Income tax expense................................................. 4,310 1,827 58,841 13,289
-------------- ------------- ------------- -------------
Income (loss) before minority interest............ 7,637 (1,133) 102,011 16,662
Minority interest in subsidiary loss............................... -- -- -- 109
-------------- ------------- ------------- -------------
Net income (loss).................................$ 7,637 (1,133) 102,011 16,771
============== ============= ============= =============
Earnings (loss) per share, basic and diluted......$ 0.14 (0.03) 1.90 0.37
============== ============= ============= =============
Weighted average shares outstanding,
basic and diluted............................... 53,648,788 45,038,488 53,644,056 45,019,823
============== ============= ============= =============
See accompanying notes to consolidated financial statements.
3
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
ACCUMULATED
OTHER TOTAL
PREFERRED COMMON STOCK SHARES CLASS A CLASS B ADDITIONAL UNEARNED COMPRE- SHARE-
STOCK ----------------------- PREFERRED COMMON COMMON PAID-IN RETAINED COMPEN- HENSIVE HOLDERS'
SHARES CLASS A CLASS B STOCK STOCK STOCK CAPITAL EARNINGS SATION INCOME EQUITY
-------- ----------- ---------- --------- ------ -------- --------- -------- ------- --------- --------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
BALANCE AS OF
JUNE 30, 2003........ -- 31,015,034 14,023,454 $ -- 310 140 38,053 88,686 -- -- 127,189
Comprehensive income:
Net loss........... -- -- -- -- -- -- -- (1,133) -- -- (1,133)
--------
Total comprehensive
income (loss).. (1,133)
Non-cash compensation
expense.............. -- -- -- -- -- -- 5,166 -- -- -- 5,166
---------- ----------- ------------ -------- ------- -------- ---------- --------- ------ -------- --------
BALANCE AS OF
SEPTEMBER 30, 2003... -- 31,015,034 14,023,454 $ -- 310 140 43,219 87,553 -- -- 131,222
========== =========== ============ ======== ======= ======== ========== ========= ====== ======== ========
BALANCE AS OF
JUNE 30, 2004...... -- 39,624,243 14,023,454 $ -- 396 140 207,359 192,259 -- 828 400,982
Comprehensive income:
Net income....... -- -- -- -- -- -- -- 7,637 -- -- 7,637
Other comprehensive
income (expense),
net of tax,
related to cash
flow hedge..... -- -- -- -- -- -- -- -- -- (234) (234)
--------
Total comprehensive
income......... 7,403
Issuance of common
stock......... -- 14,363 -- -- 1 -- 326 -- (97) -- 230
Conversion of common
stock....... -- 40,000 (40,000) -- -- -- -- -- -- -- --
---------- ----------- ------------ -------- ------- -------- ---------- --------- ------ -------- --------
BALANCE AS OF
SEPTEMBER 30, 2004. -- 39,678,606 13,983,454 $ -- 397 140 207,685 199,896 (97) 594 408,615
========== =========== ============ ======== ======= ======== ========== ========= ====== ======== ========
BALANCE AS OF
DECEMBER 31, 2002.. -- 30,947,834 14,023,454 $ -- 309 140 37,891 70,782 -- -- 109,122
Comprehensive income:
Net income....... -- -- -- -- -- -- -- 16,771 -- -- 16,771
--------
Total comprehensive
income......... 16,771
Non-cash compensation
expense........... -- -- -- -- -- -- 5,166 -- -- -- 5,166
Issuance of common
stock............. -- 331,800 -- -- 3 -- 803 -- -- -- 806
Redemption of common
stock............. -- (264,600) -- -- (2) -- (641) -- -- -- (643)
---------- ----------- ------------ -------- ------- -------- ---------- --------- ------ -------- --------
BALANCE AS OF
SEPTEMBER 30, 2003. -- 31,015,034 14,023,454 $ -- 310 140 43,219 87,553 -- -- 131,222
========== =========== ============ ======== ======= ======== ========== ========= ====== ======== ========
BALANCE AS OF
DECEMBER 31, 2003.. -- 39,601,834 14,023,454 $ -- 396 140 206,831 97,885 -- 237 305,489
Comprehensive income:
Net income....... -- -- -- -- -- -- -- 102,011 -- -- 102,011
Other
comprehensive
income, net
of tax, related
to cash flow hedge. -- -- -- -- -- -- -- -- -- 357 357
--------
Total
comprehensive
income......... 102,368
Issuance of
common stock........ -- 36,772 -- -- 1 -- 854 -- (97) -- 758
Conversion of
common stock........ -- 40,000 (40,000) -- -- -- -- -- -- -- --
---------- ----------- ------------ -------- ------- -------- --------- ---------- ------ -------- --------
BALANCE AS OF
SEPTEMBER 30, 2004. -- 39,678,606 13,983,454 $ -- 397 140 207,685 199,896 (97) 594 408,615
========== =========== ============ ======== ======= ======== ========= ========== ====== ======== ========
See accompanying notes to consolidated financial statements.
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------------
2004 2003
------------- ------------
(DOLLARS IN THOUSANDS)
Net income......................................................................$ 102,011 16,771
Adjustments to reconcile net income to net cash provided by operating
activities, net of business acquisition:
Depreciation and amortization, including premiums and
deferred origination costs.............................................. 72,601 74,500
Derivative market value adjustment........................................ 39,209 5,131
Ineffectiveness of cash flow hedge........................................ 64 --
Non-cash compensation expense............................................. 610 5,166
Gain on sale of fixed asset............................................... (3,037) --
Deferred income tax benefit............................................... (2,740) (7,307)
Minority interest in subsidiary loss...................................... -- (109)
(Recovery) provision for loan losses...................................... (1,006) 8,875
Increase in accrued interest receivable................................... (49,655) (30,500)
Decrease (increase) in accounts receivable................................ 3,117 (3,353)
Decrease in other assets.................................................. 20,130 6,593
Increase (decrease) in accrued interest payable........................... 9,658 (1,366)
(Decrease) increase in other liabilities.................................. (21,624) 12,303
------------ ------------
Net cash provided by operating activities........................... 169,338 86,704
------------ ------------
Cash flows from investing activities, net of business acquisition:
Originations, purchases, and consolidations of student loans,
including premiums and deferred origination costs...................... (3,587,393) (2,784,968)
Purchases of student loans, including premiums, from a related party...... (496,450) (594,996)
Net proceeds from student loan principal payments and loan consolidations. 1,835,432 1,820,830
Proceeds from sale of furniture, equipment, and leasehold improvements.... 3,573 --
Net purchases of furniture, equipment, and leasehold improvements......... (14,292) (9,522)
Decrease in restricted cash............................................... 146,884 61,461
Purchases of restricted investments....................................... (735,335) (323,202)
Proceeds from maturities of restricted investments........................ 644,309 306,477
Purchase of origination rights............................................ (7,899) --
Business acquisition, net of cash acquired................................ (10,829) (1,760)
Purchase of equity method investments..................................... (10,110) --
------------ ------------
Net cash used in investing activities............................... (2,232,110) (1,525,680)
------------ ------------
Cash flows from financing activities:
Payments on bonds and notes payable....................................... (3,479,226) (2,242,545)
Proceeds from issuance of bonds and notes payable......................... 5,403,576 3,687,380
Payments for debt issuance costs.......................................... (14,954) (11,527)
Payments for redemption of common stock................................... -- (643)
Proceeds from issuance of common stock.................................... 148 806
------------ ------------
Net cash provided by financing activities........................... 1,909,544 1,433,471
------------ ------------
Net decrease in cash and cash equivalents........................... (153,228) (5,505)
Cash and cash equivalents, beginning of period.................................. 198,423 40,155
------------ ------------
Cash and cash equivalents, end of period........................................$ 45,195 34,650
============ ============
Supplemental disclosures of cash flow information:
Interest paid.............................................................$ 151,856 145,063
============ ============
Income taxes paid.........................................................$ 43,975 19,081
============ ============
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF SEPTEMBER 30, 2004 AND FOR THE THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 2004 AND 2003 IS UNAUDITED)
1. BASIS OF FINANCIAL REPORTING
The accompanying unaudited consolidated financial statements of Nelnet, Inc.
and subsidiaries (the "Company") as of September 30, 2004 and for the three and
nine months ended September 30, 2004 and 2003 have been prepared on the same
basis as the audited consolidated financial statements for the year ended
December 31, 2003 and, in the opinion of the Company's management, the unaudited
consolidated financial statements reflect all adjustments, consisting of normal
recurring adjustments, necessary for a fair presentation of results of
operations which might be expected for the entire year. The preparation of
financial statements in conformity with U.S. generally accepted accounting
principles requires management to make estimates and assumptions that affect the
amounts reported in the consolidated financial statements and accompanying
notes. Actual results could differ from those estimates. Operating results for
the three and nine months ended September 30, 2004 are not necessarily
indicative of the results for the year ending December 31, 2004. The unaudited
consolidated financial statements should be read in conjunction with the
Company's Annual Report on Form 10-K for the year ended December 31, 2003.
Certain amounts from 2003 have been reclassified to conform to the current
period presentation.
2. RECENT DEVELOPMENTS
A portion of the Company's Federal Family Education Loan Program ("FFELP" or
"FFEL Program") loan portfolio is comprised of loans that are currently or were
previously financed with tax-exempt obligations issued prior to October 1, 1993.
Based upon provisions of the Higher Education Act of 1965, as amended, and
related interpretations by the U.S. Department of Education (the "Department"),
the Company is entitled to receive special allowance payments on these loans
providing the Company with a 9.5% minimum rate of return. In May 2003, the
Company sought confirmation from the Department regarding whether it was allowed
to recognize these special allowance payments as income based on the 9.5%
minimum rate of return. While pending satisfactory resolution of this issue with
the Department, the Company deferred recognition of the interest income that was
generated by these loans in excess of income based upon the standard special
allowance rate. In June 2004, after consideration of certain clarifying
information received in connection with the guidance it had sought, including
written and verbal communications with the Department, the Company concluded
that the earnings process had been completed related to the special allowance
payments on these loans and recognized $124.3 million of interest income. At
December 31, 2003, the amount of deferred excess interest income on these loans
was $42.9 million and was included in other liabilities on the Company's
consolidated balance sheet.
Following the Company's disclosures related to recognition of such income,
Senator Edward M. Kennedy, by letter to the Secretary of Education dated August
26, 2004, requested information as to whether the Department had approved of the
Company's receipt of this income and, if not, why the Department had not sought
to recover claimed subsidies under this provision. By letter dated September 30,
2004, the Company furnished to the Department certain background information
concerning the growth of the 9.5% Floor loans in its portfolio, which
information had been requested by the Department. Senator Kennedy, in a second
letter to the Securities and Exchange Commission ("SEC") dated September 21,
2004, requested that the SEC investigate the Company's activities related to the
income recognized on these loans. More specifically, Senator Kennedy raised
concerns about the Company's disclosures in connection with its decision to
recognize the previously deferred income, and trading of Company securities by
Company executives following such disclosures. On September 27, 2004, the
Company voluntarily contacted the SEC to request a meeting with the SEC Staff.
The Company's request was granted, and representatives of the Company met with
representatives of the SEC Staff on October 12, 2004. Company representatives
offered to provide to the SEC information that the SEC Staff wished to have
relating to the issues raised in Senator Kennedy's letter. By letter dated
October 14, 2004, the SEC Staff requested that, in connection with an informal
investigation, the Company provide certain identified information. The Company
is furnishing to the SEC Staff the information it has requested and is fully
cooperating with the SEC Staff in its informal investigation.
The Company continues to believe that the concerns expressed to the SEC by
Senator Kennedy are entirely unfounded, but it is not appropriate or feasible to
determine or predict the ultimate outcome of the SEC's informal investigation.
The Company's costs related to the SEC's informal investigation are being
expensed as incurred. Additional costs, if any, associated with an adverse
outcome or resolution of that matter, in a manner that is currently
indeterminate and inherently unpredictable, could adversely affect the Company's
financial condition and results of operations. Although it is possible that an
adverse outcome in certain circumstances could have a material adverse effect,
based on information currently known by the Company's management, in its
opinion, the outcome of such pending informal investigation is not likely to
have such an effect.
6
3. STUDENT LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
Student loans receivable as of September 30, 2004 and December 31, 2003
consisted of the following:
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- ------------
(DOLLARS IN THOUSANDS)
Federally insured loans...........................................$ 12,538,209 10,222,547
Non-federally insured loans....................................... 92,247 92,327
------------- ------------
12,630,456 10,314,874
Unamortized premiums and deferred origination costs............... 171,694 156,594
Less allowance for loan losses - federally insured loans.......... (706) (9,755)
Less allowance for loan losses - non-federally insured loans...... (7,740) (6,271)
------------- ------------
$ 12,793,704 10,455,442
============= ============
Federally insured allowance as a percentage of ending balance
of federally insured loans...................................... 0.01% 0.10%
Non-federally insured allowance as a percentage
of ending balance of non-federally insured loans................ 8.39% 6.79%
Total allowance as a percentage of ending balance of total loans.. 0.07% 0.16%
The allowance for loan losses is estimated and established through a
provision charged to expense. Losses are charged against the allowance when
management believes the collectibility of the loan principal is unlikely.
Recovery of amounts previously charged off is credited to the allowance for loan
losses.
The allowance for the federally insured loan portfolio is based on periodic
evaluations of the Company's loan portfolios considering past experience, trends
in student loan claims rejected for payment by guarantors, changes to federal
student loan programs, current economic conditions, and other relevant factors.
The federal government guarantees 98 percent of principal and interest of
federally insured student loans, which limits the Company's loss exposure to two
percent of the outstanding balance of the Company's federally insured portfolio.
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company receives 100 percent reimbursement on all eligible FFEL Program
default claims submitted for reimbursement during the 12-month period following
the effective date of its designation. The Company is not subject to the two
percent risk sharing loss for eligible claims submitted during this 12-month
period. Only FFEL Program loans that are serviced by the Company, as well as
loans owned by the Company and serviced by other service providers designated as
Exceptional Performers by the Department, are subject to the 100 percent
reimbursement. In June 2004, the Company's allowance for loan losses balance was
reduced by $9.0 million and the provision for loan losses was similarly reduced
to account for the estimated effects of the Exceptional Performance designation.
As of September 30, 2004, service providers designated as an Exceptional
Performer serviced approximately 91 percent of the Company's federally insured
loans. Of this 91 percent, third parties service approximately one percent. With
an additional third- party service provider receiving the Exceptional
Performance designation in October 2004, more than 98 percent of the Company's
federally insured loans will be serviced by providers who have received such
designation. The Company is entitled to receive this benefit as long as it
and/or its other service providers continue to meet the required servicing
standards published by the Department. Compliance with such standards is
assessed on a quarterly basis.
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company charges off the loan when the
collection of principal and interest is 120 days past due.
7
4. ACQUISITIONS
The Company has positioned itself for growth by building a strong foundation
through acquisitions. Although the Company's assets and loan portfolios increase
through such transactions, a key aspect of each transaction is its impact on the
Company's prospective organic growth and the development of its integrated
platform of services.
On January 28, 2004, the Company acquired 50 percent of the membership
interests in Premiere Credit of North America, LLC ("Premiere"). Premiere is a
collection services company that specializes in collection of educational debt.
Total consideration paid by the Company for Premiere was $5.3 million, $2.3
million of which represents excess purchase price, which will not be amortized.
Included in the Premiere purchase agreement is a "call" option, which expires
six years after the purchase date, that allows the Company to purchase 100
percent ownership of Premiere at a price as determined in the agreement. In
addition, Premiere has a "put" option, which expires five years after the
purchase date, to require the Company to purchase 100 percent ownership of
Premiere at a price as determined in the agreement. The Company is accounting
for Premiere using the equity method of accounting. As of September 30, 2004,
the investment in Premiere and excess purchase price are included in other
assets and goodwill, respectively, on the consolidated balance sheet.
Effective March 11, 2004, the Company acquired rights, title, and interest
in certain assets of the Rhode Island Student Loan Authority ("RISLA"),
including the right to originate student loans in RISLA's name without
competition from RISLA for a term of ten years. Total consideration paid by the
Company for the rights to originate student loans was $7.9 million, which will
be amortized over ten years. As of September 30, 2004, these origination rights
are included in intangible assets on the consolidated balance sheet. The Company
also purchased certain assets, consisting primarily of furniture and equipment
from RISLA for $0.3 million and a portfolio of FFELP loans with an aggregate
outstanding balance of approximately $175.0 million. The Company further agreed
to provide administrative services in connection with certain of the indentures
governing debt securities of RISLA for a 10-year period.
On April 19, 2004, the Company purchased 100 percent of the senior stock of
SLAAA Acquisition Corp. ("SLAAA") and its wholly owned subsidiaries, Student
Loan Acquisition Authority of Arizona LLC and SLAAA Management Company, for
$11.1 million, including approximately $106,000 of direct acquisition costs.
SLAAA is a student loan secondary market. The excess of the purchase price and
acquisition costs over the fair value of the net identifiable assets acquired
was $6.0 million and has been recognized as goodwill. This acquisition was
accounted for under purchase accounting and the results of operations have been
included in the consolidated financial statements from the date of acquisition.
The allocation of the purchase price for SLAAA is shown below (dollars in
thousands):
Cash and cash equivalents........................... $ 277
Restricted cash..................................... 97,864
Student loans and accrued interest.................. 146,173
Other assets........................................ 133
Excess cost over fair value of net assets acquired.. 5,971
Bonds and notes payable and accrued interest........ (238,645)
Other liabilities................................... (667)
-----------
Purchase price........................... $ 11,106
===========
The pro forma information presenting the combined operations of the Company
as though the SLAAA acquisition occurred on January 1, 2004 and January 1, 2003
is not significantly different than actual 2004 and 2003 results.
On April 20, 2004, the Company purchased 50 percent of the issued and
outstanding capital stock of infiNET Integrated Solutions, Inc. ("infiNET").
InfiNET provides customer-focused electronic transactions, information sharing,
and account and bill presentment for colleges, universities, and healthcare
organizations. Total consideration paid by the Company for infiNET was $4.9
million, which generated $5.7 million of excess purchase price that will not be
amortized. The Company is accounting for infiNET using the equity method of
accounting. As of September 30, 2004, the investment in infiNET and excess
purchase price is included in other assets and goodwill, respectively, on the
consolidated balance sheet.
In October 2004, the Company entered into an agreement to acquire all of the
outstanding stock of EDU-TRI Holdings Inc. and its wholly owned subsidiary,
EDULINX Canada Corporation. EDU-TRI Holdings Inc. is a Canadian corporation that
engages in full servicing of approximately $7 billion (U.S.) of Canadian student
loans. The transaction is expected to close prior to the end of the fourth
quarter 2004, subject to regulatory approval and satisfaction of closing
conditions.
8
5. INTANGIBLE ASSETS
Intangible assets as of September 30, 2004 and December 31, 2003 consist of
the following:
AS OF AS OF
USEFUL SEPTEMBER 30, DECEMBER 31,
LIFE 2004 2003
------------- ------------- ------------
(DOLLARS IN THOUSANDS)
Lender relationship and loan origination
rights (net of accumulated amortization
of $3,857 and $2,690, respectively)............ 36-120 months $ 8,024 1,292
Servicing system software and other intellectual
property (net of accumulated amortization of
$18,538 and $13,273, respectively)............. 36 months 2,522 7,787
------------ ----------
$ 10,546 9,079
============ ==========
The Company recorded amortization expense on its intangible assets of $2.3
million and $2.8 million for the three months ended September 30, 2004 and 2003,
respectively, and $6.4 million and $10.0 million for the nine months ended
September 30, 2004 and 2003, respectively. The Company will continue to amortize
intangible assets over their remaining useful lives and estimates it will record
amortization of $1.6 million during the year ending December 31, 2005 and $0.8
million for each of the years ending December 31, 2006, 2007, 2008, and 2009,
respectively.
The change in the carrying amount of goodwill for the nine months ended
September 30, 2004 was as follows (dollars in thousands):
Balance as of January 1, 2004........... $ 2,551
Goodwill acquired during the period.. 13,982
--------
Balance as of September 30, 2004....... $ 16,533
========
6. BONDS AND NOTES PAYABLE
On January 15, 2004, April 29, 2004, July 20, 2004, and September 29, 2004,
the Company consummated debt offerings of student loan asset-backed notes of
$1.0 billion, $1.0 billion, $1.4 billion, and $2.0 billion, respectively, with
final maturity dates ranging from 2009 through 2041. The majority of notes
issued in these transactions have variable interest rates based on a spread to
LIBOR or reset under auction procedures. Included in the January 2004 issuance
was $210.0 million of notes with a fixed interest rate that resets August 25,
2005. The Company entered into a derivative financial instrument to convert this
fixed interest rate to a variable rate until the August 2005 reset date (see
note 7). The proceeds from the September 2004 debt offering were used to redeem
$1.7 billion of the Company's student loan asset-backed auction rate notes.
In July 2004, the Company redeemed a portion of its student loan interest
margin notes for $47.4 million, which included a call-premium. The call-premium
of $1.9 million and write-off of the unamortized debt issuance costs of $0.7
million were expensed during the three months ended September 30, 2004 and are
included in other operating expenses and interest on bonds and notes payable,
respectively, in the consolidated statement of income.
7. DERIVATIVE FINANCIAL INSTRUMENTS
The Company maintains an overall interest rate risk management strategy that
incorporates the use of derivative instruments to minimize the economic effect
of interest rate volatility. The Company's goal is to manage interest rate
sensitivity by modifying the repricing or maturity characteristics of certain
balance sheet assets and liabilities so that the net interest margin is not, on
a material basis, adversely affected by movements in interest rates. The Company
views this strategy as a prudent management of interest rate sensitivity. The
Company accounts for derivative instruments under Statement of Financial
Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND
HEDGING ACTIVITIES ("SFAS No. 133"), which requires that every derivative
instrument be recorded on the balance sheet as either an asset or liability
measured at its fair value. Management has structured all of the Company's
derivative transactions with the intent that each is economically effective;
however, the majority do not qualify for hedge accounting under SFAS No. 133.
Effective January 14, 2004, the Company entered into interest rate swaps
with a combined notional amount of $6.0 billion. In addition, in connection with
the January 2004 debt offering, the Company entered into an interest rate swap
with a notional amount of $210.0 million that effectively converted debt with a
fixed rate to a variable rate (see note 6). In July 2004, the Company also
entered into interest rate swaps with a combined notional amount of $3.7 billion
that mature in 2005 through 2010. The fixed rate the Company pays on these
derivatives ranges from 2.18% to 4.25% and the weighted average is 3.51%. No
derivatives entered into by the Company in 2004 qualify for hedge accounting
under SFAS No. 133.
9
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of September 30, 2004:
NOTIONAL AMOUNTS BY PRODUCT TYPE
--------------------------------------------------------
FIXED/ FLOATING/
MATURITY FLOATING SWAPS BASIS SWAPS FIXED SWAPS TOTAL
- --------------------------------- --------------- ------------- ------------ ------------
(DOLLARS IN MILLIONS)
2004............................. $ 3,000 (a) -- -- 3,000
2005............................. 1,062 1,000 210 2,272
2006............................. 613 500 -- 1,113
2007............................. 512 -- -- 512
2008............................. 463 -- -- 463
2009 and thereafter.............. 1,450 -- -- 1,450
-------------- ------------ ------------ -----------
Total.......................... $ 7,100 1,500 210 8,810
============== ============ ============ ===========
Weighted average rate............ 2.43%
==============
Fair value (in thousands)........ $ (34,637) (3,743) (1,006) (39,386)
============== ============ ============ ===========
----------
(a) These interest rate swaps, carrying a 1.20% weighted average rate,
expired in October 2004.
The following is a summary of the amounts included in derivative market
value adjustment and net settlements on the consolidated income statements:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- --------------------
2004 2003 2004 2003
---------- ---------- --------- ---------
(DOLLARS IN THOUSANDS)
Change in fair value of derivative instruments.........$ 40,183) (5,131) (39,209) (5,131)
Settlements, net........................................ (16,031) (524) (19,389) (524)
---------- ---------- --------- ---------
Derivative market value adjustment and net settlements.$ (56,214) (5,655) (58,598) (5,655)
========== ========== ========= =========
The net settlements paid by the Company on the $3.7 billion notional amount
of interest rate swaps entered into by the Company in July 2004 was $17.2
million for the three and nine months ended September 30, 2004.
The following table shows the components of the change in accumulated other
comprehensive income, net of tax, related to one interest rate swap with a
notional amount of $150.0 million accounted for as a cash flow hedge:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- -------------------
2004 2003 2004 2003
---------- --------- -------- --------
(DOLLARS IN THOUSANDS)
Balance at beginning of period................................... $ 828 -- 237 --
Change in fair value of cash flow hedge....................... (255) -- 317 --
Hedge ineffectiveness reclassified to earnings................ 21 -- 40 --
---------- -------- --------- --------
Total change in unrealized (loss) gain on derivative. (234) -- 357 --
---------- -------- --------- --------
Balance at end of period......................................... $ 594 -- 594 --
========== ======== ========= ========
10
8. STOCK PLANS AND RELATED ACTIVITY
On February 19, 2004, the Company issued 22,409 shares of its Class A common
stock under its directors stock compensation plan to non-employee members of the
Board. These shares were issued in consideration for the Board members' 2004
annual retainer fees. The number of shares issued to the Board members was
determined by dividing the amount of the annual retainer fee by 85 percent of
the price paid per share by the underwriters in the Company's initial public
offering of its Class A common stock. The Company recognized a $0.5 million
expense in February 2004 as a result of issuing these shares.
On July 1, 2004, the Company implemented its employee share purchase plan
pursuant to which employees are entitled to purchase Class A common stock from
payroll deductions at a 15 percent discount from fair market value. For the
three months ended September 30, 2004, the Company recognized compensation
expense of approximately $78,000 in connection with issuing 10,063 shares under
this plan.
In August 2004, a principal shareholder gifted 40,000 Class B shares of
common stock to certain charitable organizations. Per the Company's articles of
incorporation, these shares automatically converted to Class A shares upon
transfer.
On September 10, 2004, the Company issued 4,300 shares of its Class A common
stock under its restricted stock plan. These shares vest at the end of two
years. The unearned compensation of approximately $97,000 recorded in
shareholders' equity on the consolidated balance sheet as of September 30, 2004
will be recognized as expense over the vesting period. For the three months
ended September 30, 2004, the Company recognized compensation expense of
approximately $4,000 related to these shares.
9. SEGMENT REPORTING
The Company is a vertically integrated education finance organization which
has four operating segments as defined in SFAS No. 131, DISCLOSURES ABOUT
SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION ("SFAS No. 131"), as follows:
Asset Management, Student Loan Servicing, Guarantee Servicing, and Servicing
Software. The Asset Management and Student Loan Servicing operating segments
meet the quantitative thresholds identified in SFAS No. 131 as reportable
segments and therefore the related financial data is presented below. The
Guarantee Servicing and Servicing Software operating segments do not meet the
quantitative thresholds and therefore their financial data is combined and shown
as "other" in the presentation below. The accounting policies of the reportable
segments are the same as those described in the summary of significant
accounting policies in the consolidated financial statements included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2003. Costs
excluded from segment net income primarily consist of unallocated corporate
expenses, net of miscellaneous revenues. Thus, net income of the segments
includes only the costs that are directly attributable to the operations of the
individual segment.
The Asset Management segment includes the acquisition, management, and
ownership of the student loan assets. Revenues are primarily generated from net
interest income on the student loan assets. The Company generates student loan
assets through direct origination or through acquisitions. The student loan
assets are held in a series of student lending subsidiaries designed
specifically for this purpose.
The Student Loan Servicing segment provides for the servicing of the
Company's student loan portfolios and the portfolios of third parties. The
servicing activities include application processing, borrower updates, payment
processing, due diligence procedures, and claim processing. These activities are
performed internally for the Company's portfolio in addition to generating fee
revenue when performed for third-party clients.
Substantially all of the Company's revenues are earned from customers in the
United States and no single customer accounts for a significant amount of any
reportable segment's revenues. Intersegment revenues are charged by a segment to
another segment that provides the product or service. The amount of
inter-segment revenue is based on comparable fees charged in the market.
11
Segment data is as follows:
THREE MONTHS ENDED SEPTEMBER 30,
---------------------------------------------------------------------------------------
2004 2003
------------------------------------------- ------------------------------------------
STUDENT STUDENT
ASSET LOAN TOTAL ASSET LOAN TOTAL
MANAGEMENT SERVICING OTHER SEGMENTS MANAGEMENT SERVICING OTHER SEGMENTS
----------- --------- --------- ---------- ---------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
Net interest income...........$ 90,759 271 3 91,033 43,000 151 2 43,153
Other income (expense)........ (55,176) 19,294 6,723 (29,159) (4,771) 20,945 7,609 23,783
Intersegment revenues......... -- 23,876 925 24,801 -- 17,149 699 17,848
---------- --------- --------- ---------- ---------- --------- --------- ---------
Total revenue............. 35,583 43,441 7,651 86,675 38,229 38,245 8,310 84,784
Provision for loan losses..... 2,300 -- -- 2,300 4,015 -- -- 4,015
Depreciation and amortization. -- -- 1,769 1,769 537 -- 1,782 2,319
Income tax expense (benefit).. (4,629) 7,585 (61) 2,895 (813) 4,418 232 3,837
Net income....................$ 4,039 8,867 749 13,655 6,812 1,486 1,578 9,876
========== ========= ========= ========== ========== ========= ========= =========
NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------------------------------------------------------------
2004 2003
------------------------------------------- ------------------------------------------
STUDENT STUDENT
ASSET LOAN TOTAL ASSET LOAN TOTAL
MANAGEMENT SERVICING OTHER SEGMENTS MANAGEMENT SERVICING OTHER SEGMENTS
----------- --------- --------- ---------- ---------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
Net interest income...........$312,107 617 6 312,730 132,020 652 7 132,679
Other income (expense)........ (55,570) 56,855 21,937 23,222 (3,184) 61,562 23,320 81,698
Intersegment revenues......... -- 62,498 2,728 65,226 -- 47,104 1,538 48,642
---------- --------- --------- ---------- ---------- --------- --------- ---------
Total revenue............. 256,537 119,970 24,671 401,178 128,836 109,318 24,865 263,019
Provision (recovery) for
loan losses................. (1,006) -- -- (1,006) 8,875 -- -- 8,875
Depreciation and amortization. -- -- 5,301 5,301 1,610 1,169 5,349 8,128
Income tax expense (benefit).. 50,839 16,494 (628) 66,705 4,279 9,892 1,554 15,725
Net income....................$112,876 21,686 3,411 137,973 30,669 10,875 1,008 42,552
========== ========= ========= ========== ========== ========= ========= =========
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
2004 2003
------------- ---------------
SEGMENT TOTAL ASSETS: (DOLLARS IN THOUSANDS)
Asset management..............$ 13,939,186 11,497,693
Student loan servicing........ 255,686 339,286
Other......................... 29,808 23,918
-------------- --------------
Total segments...........$ 14,224,680 11,860,897
============== ==============
Reconciliation of segment data to the consolidated financial statements is
as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- ------------------------
2004 2003 2004 2003
------------ ----------- ----------- ------------
(DOLLARS IN THOUSANDS)
Total segment revenues.....................$ 86,675 84,784 401,178 263,019
Elimination of intersegment revenues....... (24,801) (17,848) (65,226) (48,642)
Corporate revenues (expenses), net......... 3,875 42 4,804 (603)
------------ ----------- ----------- -----------
Total consolidated revenues...........$ 65,749 66,978 340,756 213,774
============ =========== =========== ===========
Total net income of segments...............$ 13,655 9,876 137,973 42,552
Corporate expenses, net.................... (6,018) (11,009) (35,962) (25,781)
------------ ----------- ----------- -----------
Total consolidated net income (loss)..$ 7,637 (1,133) 102,011 16,771
============ =========== =========== ===========
12
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
2004 2003
-------------- --------------
(DOLLARS IN THOUSANDS)
Total segment assets...................$ 14,224,680 11,860,897
Elimination of intercompany assets..... (213,680) (30,140)
Assets of other operating activities... 103,796 101,429
------------- -------------
Total consolidated assets..........$ 14,114,796 11,932,186
============== ==============
Net corporate revenues included in the previous tables are from activities
that are not related to the four identified operating segments, such as
investment earnings and revenue for marketing services. The net corporate
expenses include expenses for marketing, capital markets, and other unallocated
support services. The net corporate revenues and expenses are not associated
with an ongoing business activity as defined by SFAS No. 131 and, therefore,
have not been included within the operating segments.
The assets held at the corporate level are not identified with any of the
operating segments. Accordingly, these assets are included in the reconciliation
of segment assets to total assets. These assets consist primarily of cash,
investments, furniture, equipment, leasehold improvements, and other assets.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion and analysis provide information that the Company's
management believes is relevant to an assessment and understanding of the
consolidated results of operations and financial condition of the Company. The
discussion should be read in conjunction with the Company's consolidated
financial statements included in the Company's Annual Report on Form 10-K for
the year ended December 31, 2003.
This report contains forward-looking statements and information that are
based on management's current expectations as of the date of this document. When
used in this report, the words "anticipate," "believe," "estimate," "intend,"
"expect," and similar expressions are intended to identify forward-looking
statements. These forward-looking statements are subject to risks,
uncertainties, assumptions, and other factors that may cause the actual results
to be materially different from those reflected in such forward-looking
statements. These factors include, among others, changes in the terms of student
loans and the educational credit marketplace arising from the implementation of
applicable laws and regulations and from changes in these laws and regulations,
which may reduce the volume, average term, and costs of yields on student loans
under the Federal Family Education Loan Program ("FFEL Program" or "FFELP") or
result in loans being originated or refinanced under non-FFELP programs or may
affect the terms upon which banks and others agree to sell FFELP loans to the
Company. The Company could also be affected by changes in the demand for
educational financing or in financing preferences of lenders, educational
institutions, students, and their families; changes in the general interest rate
environment and in the securitization markets for education loans, which may
increase the costs or limit the availability of financings necessary to
initiate, purchase, or carry education loans; losses from loan defaults; and
changes in prepayment rates and credit spreads. The reader should not place
undue reliance on forward-looking statements, which speak only as of the date of
this Quarterly Report on Form 10-Q. The Company is not obligated to publicly
release any revisions to forward-looking statements to reflect events after the
date of this Quarterly Report on Form 10-Q or unforeseen events.
The Company is subject to certain risks related to its business and industry.
See "-- Risks."
OVERVIEW
The Company is a vertically integrated education finance company with $14.1
billion in total assets as of September 30, 2004. The Company is focused on
providing quality products and services to participants in the education finance
process. Headquartered in Lincoln, Nebraska, the Company originates, holds, and
services student loans, principally loans originated under the FFEL Program.
13
The Company's business is comprised of four primary product and service
offerings:
o ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS.
The Company provides marketing, originations, acquisition, and portfolio
management. The Company owns a large portfolio of student loan assets
through a series of education lending subsidiaries. The Company generates
loans owned in special purpose lending facilities through direct
origination or through acquisition of loans. The Company also provides
marketing and sales support and managerial and administrative support
related to its asset generation activities.
o STUDENT LOAN SERVICING. The Company services its student loan portfolio
and the portfolios of third parties. Servicing activities include loan
origination activities, application processing, borrower updates, payment
processing, due diligence procedures, and claim processing.
o GUARANTEE SERVICING. The Company provides servicing support to guaranty
agencies, which includes system software, hardware, and telecommunication
support, borrower and loan updates, default aversion tracking services,
claim processing services, and post-default collection services.
o SERVICING SOFTWARE. The Company provides student loan servicing software
internally and to third-party student loan holders and servicers.
The Company's Asset Management and Student Loan Servicing offerings
constitute reportable operating segments. The Guarantee Servicing and Servicing
Software offerings are operating segments that do not meet the quantitative
thresholds, and, therefore, are combined and included as other segments. The
following tables show the percent of total segment revenue (excluding
inter-segment revenue) and net income of each of the Company's reportable
segments:
THREE MONTHS ENDED SEPTEMBER 30,
----------------------------------------------------------------
2004 2003
------------------------------- -------------------------------
STUDENT STUDENT
ASSET LOAN OTHER ASSET LOAN OTHER
MANAGEMENT SERVICING SEGMENTS MANAGEMENT SERVICING SEGMENTS
---------- --------- -------- ---------- --------- --------
Segment Revenue........ 57.5% 31.6% 10.9% 57.1% 31.5% 11.4%
Segment Net Income..... 29.6% 64.9% 5.5% 69.0% 15.0% 16.0%
NINE MONTHS ENDED SEPTEMBER 30,
----------------------------------------------------------------
2004 2003
------------------------------- -------------------------------
STUDENT STUDENT
ASSET LOAN OTHER ASSET LOAN OTHER
MANAGEMENT SERVICING SEGMENTS MANAGEMENT SERVICING SEGMENTS
---------- --------- -------- ---------- --------- --------
Segment revenue....... 76.4% 17.1% 6.5% 60.1% 29.0% 10.9%
Segment net income.... 81.8% 15.7% 2.5% 72.1% 25.6% 2.3%
The Company's derivative market value adjustment and net settlements are
included in the Asset Management segment. Because the majority of the Company's
derivatives do not qualify for hedge accounting under Statement of Financial
Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND
HEDGING ACTIVITIES ("SFAS No. 133"), the derivative market value adjustment can
cause the percent of net income to fluctuate from period to period between
segments.
The Company's student loan portfolio has grown significantly through
originations and acquisitions. The Company originated or acquired $0.9 billion
and $3.1 billion of student loans during the three and nine months ended
September 30, 2004, respectively, through various channels, including:
o the direct channel, in which the Company originates student loans in one
of its brand names directly to student and parent borrowers, which
accounted for 63.5% and 47.8% of the student loans originated or acquired
during the three and nine months ended September 30, 2004, respectively;
o the branding partner channel, in which the Company acquires student loans
from lenders to whom it provides marketing and origination services, which
accounted for 9.8% and 25.8% of the student loans originated or acquired
during the three and nine months ended September 30, 2004, respectively;
and
o the forward flow channel, in which the Company acquires student loans from
lenders to whom it provides origination services, but provides no
marketing services, or who have agreed to sell loans to the Company under
forward sale commitments, which accounted for 18.8% and 19.9% of the
student loans originated or acquired during the three and nine months
ended September 30, 2004, respectively.
14
In addition, the Company also acquires student loans through spot purchases,
which accounted for 7.9% and 6.5% of student loans originated or acquired during
the three and nine months ended September 30, 2004, respectively.
Not included in the student loan origination and acquisition data above is
the addition of $136.1 million of student loans acquired through a business
combination in April 2004.
SIGNIFICANT DRIVERS AND TRENDS
The Company's earnings and earnings growth are directly affected by the size
of its portfolio of student loans, the interest rate characteristics of its
portfolio, the costs associated with financing and managing its portfolio, and
the costs associated with the origination and acquisition of the student loans
in the portfolio. See "-- Student Loan Portfolio." In addition to the impact of
growth of the Company's student loan portfolio, the Company's results of
operations and financial condition may be materially affected by, among other
things, changes in:
o applicable laws and regulations that may affect the volume, terms,
effective yields, or refinancing options of education loans;
o demand for education financing and competition within the student loan
industry;
o the interest rate environment, funding spreads on the Company's
financing programs, and access to capital markets; and
o prepayment rates on student loans, including prepayments relating to loan
consolidations.
The Company's net interest income, or net interest earned on its student loan
portfolio, is the primary source of income and is primarily impacted by the size
of the portfolio and the net yield of the assets in the portfolio. If the
Company's student loan portfolio continues to grow and its net interest margin
remains relatively stable, the Company expects its net interest income to
increase. The Company's portfolio of FFELP loans generally earns interest at the
higher of a variable rate based on the special allowance payment, or SAP,
formula set by the U.S. Department of Education (the "Department") and the
borrower rate, which is fixed over a period of time. The SAP formula is based on
an applicable index plus a fixed spread that is dependent upon when the loan was
originated, the loan's repayment status, and funding sources for the loan. Based
upon provisions of the Higher Education Act of 1965, as amended, and related
interpretations by the Department, loans previously financed with tax-exempt
obligations issued prior to October 1, 1993 are entitled to receive special
allowance payments equal to a 9.5% minimum rate of return. In May 2003, the
Company sought confirmation from the Department regarding the treatment and
recognition of special allowance payments on a portion of its portfolio that had
been previously financed with tax-exempt obligations. While pending satisfactory
resolution of this issue with the Department, the Company deferred recognition
of the interest income that was generated by these loans in excess of income
based upon the standard special allowance rate. In June 2004, after
consideration of certain clarifying information received in connection with the
guidance it had sought, including written and verbal communications with the
Department, the Company concluded that the earnings process had been completed
related to the special allowance payments on these loans and recognized $124.3
million of interest income. At December 31, 2003, the amount of deferred excess
interest income on these loans was $42.9 million. The Company currently
recognizes the income from the special allowance payments on these loans as it
is earned and would expect its net interest income to increase over historical
periods accordingly; however, since the portfolio subject to the 9.5% floor is
not expected to increase, amounts recognized will decrease as compared to the
current period.
Net interest income increased by $48.4 million and $179.5 million, or 118.2%
and 139.8%, respectively, during the three and nine months ended September 30,
2004 as compared to the comparable periods in 2003. Net interest income,
excluding the effects of variable-rate floor income and the special allowance
yield adjustment, increased approximately $4.8 million and $24.0 million, or
11.8% and 20.8%, respectively, during the three and nine months ended September
30, 2004 as compared to the comparable periods in 2003, due to portfolio growth.
Net student loans receivable increased by $2.7 billion, or 27.2%, to $12.8
billion as of September 30, 2004 as compared to $10.1 billion as of September
30, 2003.
Interest income is also dependent upon the relative level of interest rates.
The Company maintains an overall interest rate risk management strategy that
incorporates the use of interest rate derivative instruments to reduce the
economic effect of interest rate volatility. The Company's management has
structured all of its derivative instruments with the intent that each is
economically effective. However, most of the Company's derivative instruments do
not qualify for hedge accounting under SFAS No. 133 and thus may adversely
impact earnings. In addition, the mark-to-market adjustment recorded through
earnings in the Company's consolidated statements of income may fluctuate from
15
period to period. In July 2004, to hedge substantially all of the loans that are
currently or were previously financed with tax-exempt obligations that earn a
9.5% minimum rate of return, the Company entered into interest rate swaps with a
notional amount of $3.7 billion that mature in 2005 through 2010 that do not
qualify for hedge accounting. The fixed rate the Company pays on these
derivatives ranges from 2.18% to 4.25% and the weighted average is 3.51%. Since
these swaps were not in place until the third quarter of 2004, the market
adjustment and net settlements will impact future periods accordingly and could
have a negative impact if rates were to remain at the current low levels.
Competition for the supply channel of education financing in the student loan
industry has caused the cost of acquisition (or premiums) related to the
Company's student loan assets to increase. In addition, the Company has seen
significant increases in consolidation loan activity and consolidation loan
volume within the industry. The increase in competition for consolidation loans
has caused the Company to be aggressive in its measures to protect and secure
the Company's existing portfolio through consolidation efforts. The Company will
amortize its premiums over the average useful life of the assets; however, the
Company will generally accelerate recognition of unamortized premiums when loans
are consolidated. The increase in premiums paid on student loans due to the
increase in entrants and competition within the industry, coupled with the
Company's asset retention practices through consolidation efforts, have caused
the Company's yields to be reduced in recent periods due to the amortization of
premiums, consolidation rebate fees, and the lower yields on consolidation
loans. If these trends continue, the Company could continue to see an increase
in consolidation rebate fees and amortization costs and a reduction in yield.
See "-- Student Loan Portfolio--Student Loan Spread Analysis." If the percent of
consolidation loans continues to increase as a percent of the Company's overall
loan portfolio, the Company will continue to see reduced yields. Although the
Company's short-term yields may be reduced if this trend continues, the Company
will have been successful in protecting its assets and stabilizing its balance
sheet for long-term growth. Conversely, a reduction in consolidation of the
Company's own loans or the loans of third parties could positively impact the
effect of amortization on the Company's student loan yield from period to
period. Also, as the Company's portfolio of consolidation loans grows both in
nominal dollars and as a percent of the total portfolio, the impact of
amortization as a percent of yield should decrease, as was the case in the third
quarter 2004, and ultimately stabilize unless the cost of acquisition of
consolidation loans or underlying loans increases substantially in the future.
Net interest income includes $18.4 million and $53.2 million, or 61 basis
points and 63 basis points, respectively, in yield reduction due to the
amortization of premiums and deferred origination costs during the three and
nine months ended September 30, 2004, as compared to $19.4 million and $49.8
million, or 83 basis points and 75 basis points, respectively, during the
comparable periods in 2003. The Company's unamortized premiums and deferred
origination costs, as a percent of student loans, decreased from 1.6% at
September 30, 2003 to 1.3% at September 30, 2004. Net interest income also
includes $17.8 million and $48.4 million, or 59 basis points and 57 basis
points, respectively, in yield reduction due to consolidation rebate fees during
the three and nine months ended September 30, 2004, as compared to $10.7 million
and $28.6 million, or 46 basis points and 43 basis points, respectively, during
the comparable periods in 2003. Consolidation activity increased in the third
quarter of 2004 as the Company and other industry participants held applications
for funding until after July 1 to coincide with the interest rate reset on the
underlying loans. The increase in the consolidation loan rebate fee, combined
with the lower lender yield of the consolidation loans the Company is
originating, has resulted in student loan interest spread compression, excluding
the effects of the special allowance yield adjustment and variable-rate floor
income, from 1.87% and 1.83% during the three and nine months ended September
30, 2003, respectively, to 1.56% and 1.71% during the three and nine months
ended September 30, 2004, respectively.
RECENT DEVELOPMENTS
As previously discussed, based on provisions of the Higher Education Act of
1965, as amended, and related interpretations, education lenders may receive
special allowance payments providing a minimum 9.5% rate (the "9.5% Floor") on
loans currently or previously financed with proceeds of tax-exempt obligations
issued prior to October 1, 1993. The Company holds FFELP loans, which are
receiving special allowance payments based upon the 9.5% Floor with an aggregate
outstanding balance of approximately $3.1 billion as of September 30, 2004. The
Company had previously sought confirmation regarding whether it was allowed to
receive the special allowance income based on the 9.5% Floor on such loans
following refinancing with proceeds of taxable obligations. For periods through
March 31, 2004, the Company had deferred recognition of a portion of the income
from the 9.5% Floor which exceeded ordinary special allowance payment rates
generated by these loans, pending satisfactory resolution of this issue. As
previously disclosed, after consideration of certain clarifying information
received in connection with the guidance it had sought and based on written and
verbal communications with the Department, the Company concluded that the
earnings process had been completed and determined to recognize the related
income.
Following the Company's disclosures related to recognition of such income,
Senator Edward M. Kennedy, by letter to the Secretary of Education dated August
26, 2004, requested information as to whether the Department had approved of the
Company's receipt of the 9.5% Floor income and, if not, why the Department had
not sought to recover claimed subsidies under the 9.5% Floor. By letter dated
September 10, 2004, the Company furnished to the Department certain background
information concerning the growth of the 9.5% Floor loans in its portfolio,
which information had been requested by the Department. Senator Kennedy, in a
second letter to the Securities and Exchange Commission ("SEC") dated September
21, 2004, requested that the SEC investigate the Company's activities related to
the 9.5% Floor. More specifically, Senator Kennedy raised concerns about the
16
Company's disclosures in connection with its decision to recognize the
previously deferred income, and trading of Company securities by Company
executives following such disclosures. On September 27, 2004, the Company
voluntarily contacted the SEC to request a meeting with the SEC Staff. The
Company's request was granted, and representatives of the Company met with
representatives of the SEC Staff on October 12, 2004. Company representatives
offered to provide to the SEC information that the SEC Staff wished to have
relating to the issues raised in Senator Kennedy's letter. By letter dated
October 14, 2004, the SEC Staff requested that, in connection with an informal
investigation, the Company provide certain identified information. The Company
is furnishing to the SEC Staff the information it has requested and is fully
cooperating with the SEC Staff in its informal investigation.
The Company continues to believe that the concerns expressed to the SEC by
Senator Kennedy are entirely unfounded, but it is not appropriate or feasible to
determine or predict the ultimate outcome of the SEC's informal investigation.
The Company's costs related to the SEC's informal investigation are being
expensed as incurred. Additional costs, if any, associated with an adverse
outcome or resolution of that matter, in a manner that is currently
indeterminate and inherently unpredictable, could adversely affect the Company's
financial condition and results of operations. Although it is possible that an
adverse outcome in certain circumstances could have a material adverse effect,
based on information currently known by the Company's management, in its
opinion, the outcome of such pending informal investigation is not likely to
have such an effect.
Certain recent legislative developments have occurred in connection with the
Higher Education Act, as amended. As the Higher Education Act was set to expire
on September 30, 2004, Congress passed a one-year extension of the Higher
Education Act. Reauthorization of the Higher Education Act for a period of five
years is now anticipated to be addressed prior to the lapse of the one-year
extension on September 30, 2005. As previously disclosed, the Company cannot
guarantee that reauthorization will occur or what form reauthorization will
take. See "-- Risks."
In October 2004, Congress passed and President Bush signed into law the
Taxpayer-Teacher Protection Act of 2004 (the "October Act"), which prospectively
suspended eligibility for the 9.5% Floor on any loans refinanced with proceeds
of taxable obligations between September 30, 2004 and January 1, 2006. The
Company's FFELP loans, which have been refinanced with proceeds of taxable
obligations and are receiving special allowance payments under the 9.5% Floor,
were all refinanced with proceeds of taxable obligations well prior to
September 30, 2004. The Company had ceased adding to its portfolio of loans
receiving special allowance payments subject to the 9.5% Floor in May 2004, and
thus the language in the October Act should not have an effect upon the
eligibility of such loans for the 9.5% Floor, nor should it have a material
effect upon the Company's financial condition or results of operation.
Senator Kennedy and others have been proponents of legislation which could
act to retroactively remove eligibility for the 9.5% Floor from FFELP loans that
have, prior to September 30, 2004, been refinanced with proceeds of taxable
obligations. The Company cannot predict whether such legislation seeking to
retroactively eliminate the 9.5% Floor will be advanced in the future. If such
retroactive legislation were to be enacted and withstand legal challenge, it
would have a material adverse effect upon the Company's financial condition and
results of operations. Senator Kennedy and others in congressional debate in
October 2004 called for such retroactive legislation. However, the Department
has indicated that receipt of the 9.5% Floor income is permissible under current
law and previous interpretations thereof. The Company cannot predict whether the
Department will maintain its position in the future on the permissibility of the
9.5% Floor. The Company has previously disclosed the risk of legislative or
regulatory changes to permissibility of the 9.5% Floor in its Form S-1, its Form
10-K, and its Form 10-Qs, and such risk is still present.
ACQUISITIONS
The Company has positioned itself for growth by building a strong foundation
through acquisitions. Although the Company's assets and loan portfolios increase
through such transactions, a key aspect of each transaction is its impact on the
Company's prospective organic growth and the development of its integrated
platform of services. As a result of these acquisitions and the Company's rapid
organic growth, the period-to-period comparability of the Company's results of
operations may be difficult. A summary of 2004 closed and pending acquisitions
follows:
In January 2004, the Company acquired 50 percent of the membership interests
in Premiere Credit of North America, LLC ("Premiere"), a collection services
company that specializes in collection of educational debt. This investment is
being accounted for under the equity method of accounting.
In March 2004, the Company acquired rights, title, and interest in certain
assets of the Rhode Island Student Loan Authority ("RISLA"), including the right
to originate student loans in RISLA's name without competition from RISLA for a
period of ten years. The Company further agreed to provide administrative
services in connection with certain of the indentures governing debt securities
of RISLA for a 10-year period.
17
In April 2004, the Company purchased SLAAA Acquisition Corp. ("SLAAA"), a
student loan secondary market.
Also in April 2004, the Company purchased 50 percent of the issued and
outstanding stock of infiNET Integrated Solutions, Inc. ("infiNET"), an
ecommerce services provider for colleges, universities, and healthcare
organizations. InfiNET provides customer-focused electronic transactions,
information sharing, and account and bill presentment. This investment is being
accounted for under the equity method of accounting.
In October 2004, the Company entered into an agreement to acquire all of the
outstanding stock of EDU-TRI Holdings Inc. and its wholly owned subsidiary,
EDULINX Canada Corporation. EDU-TRI Holdings Inc. is a Canadian corporation that
engages in full servicing of approximately $7 billion (U.S.) of Canadian student
loans. The transaction is expected to close prior to the end of the fourth
quarter 2004, subject to regulatory approval and satisfaction of closing
conditions.
NET INTEREST INCOME
The Company generates the majority of its earnings from the spread between
the yield the Company receives on its portfolio of student loans and the cost of
funding these loans. This spread income is reported on the Company's income
statement as net interest income. The amortization and write-offs of premiums or
discounts, including capitalized costs of origination, the consolidation loan
rebate fee, and yield adjustments from borrower benefit programs, are netted
against loan interest income on the Company's income statement. The amortization
and write-offs of debt issuance costs are included in interest expense on the
Company's income statement.
The Company's portfolio of FFELP loans generally earns interest at the higher
of a variable rate based on the special allowance payment, or SAP, formula set
by the Department and the borrower rate, which is fixed over a period of time.
The SAP formula is based on an applicable index plus a fixed spread that is
dependent upon when the loan was originated, the loan's repayment status, and
funding sources for the loan. Depending on the type of student loan and when the
loan was originated, the borrower rate is either fixed to term or is reset to a
market rate each July 1. The larger the reduction in rates subsequent to the
July 1 annual borrower interest rate reset date, the greater the Company's
opportunity to earn variable-rate floor income. In declining interest rate
environments, the Company can earn significant amounts of such income.
Conversely, as the decline in rates abates, or in environments where interest
rates are rising, the Company's opportunity to earn variable-rate floor income
can be reduced, in some cases substantially. Since the borrower rates are reset
annually, the Company views earnings on variable-rate floor income as temporary
and not necessarily sustainable. The Company's ability to earn variable-rate
floor income in future periods is dependent upon the interest rate environment
following the annual reset of borrower rates, and the Company cannot assure the
nature of such environment in the future. The Company recorded no variable-rate
floor income during each of the three months ended September 30, 2004 and 2003,
and recorded approximately $348,000 and $12.7 million of variable-rate floor
income during the nine months ended September 30, 2004 and 2003, respectively.
On those FFELP loans with fixed-term borrower rates, primarily consolidation
loans, the Company earns interest at the greater of the borrower rate or a
variable rate based on the SAP formula. Since the Company finances the majority
of its student loan portfolio with variable-rate debt, the Company may earn
excess spread on these loans for an extended period of time.
On most consolidation loans, the Company must pay a 1.05% per year rebate fee
to the Department. Those consolidation loans that have variable interest rates
based on the SAP formula earn an annual yield less than that of a Stafford loan.
Those consolidation loans that have fixed interest rates less than the sum of
1.05% and the variable rate based on the SAP formula also earn an annual yield
less than that of a Stafford loan. As a result, as consolidation loans matching
these criteria become a larger portion of the Company's loan portfolio, there
will be a lower yield on the Company's loan portfolio in the short term.
However, due to the extended terms of consolidation loans, the Company expects
to earn the yield on these loans for a longer duration, making them beneficial
to the Company in the long term.
Because the Company generates the majority of its earnings from the spread
between the yield on its portfolio of student loans and the cost of financing
these loans, the interest rate sensitivity of the Company's balance sheet is
very important to its operations. The current and future interest rate
environment can and will affect the Company's interest earnings, net interest
income, and net income. The effects of changing interest rate environments are
further outlined in "-- Risks -- Market and Interest Rate Risk" below.
Investment interest income includes income from unrestricted interest-earning
deposits and funds in the Company's special purpose entities for its
asset-backed securitizations.
18
PROVISION FOR LOAN LOSSES
The allowance for loan losses is estimated and established through a
provision charged to expense. Losses are charged against the allowance when
management believes the collectibility of the loan principal is unlikely.
Recovery of amounts previously charged off is credited to the allowance for loan
losses. The Company maintains an allowance for loan losses associated with its
student loan portfolio at a level that is based on the performance
characteristics of the underlying loans. The Company analyzes the allowance
separately for its federally insured loans and its non-federally insured loans.
The allowance for the federally insured loan portfolio is based on periodic
evaluations of the Company's loan portfolios considering past experience, trends
in student loan claims rejected for payment by guarantors, changes to federal
student loan programs, current economic conditions, and other relevant factors.
The federal government guarantees 98 percent of principal and interest of
federally insured student loans, which limits the Company's loss exposure to two
percent of the outstanding balance of the Company's federally insured portfolio.
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company receives 100 percent reimbursement on all eligible FFEL Program
default claims submitted for reimbursement during the 12-month period following
the effective date of its designation. The Company is not subject to the two
percent risk sharing loss for eligible claims submitted during this 12-month
period. Only FFEL Program loans that are serviced by the Company, as well as
loans owned by the Company and serviced by other service providers designated as
Exceptional Performers by the Department, are subject to the 100 percent
reimbursement. In June 2004, the Company's allowance for loan losses balance was
reduced by $9.0 million and the provision for loan losses was similarly reduced
to account for the estimated effects of the Exceptional Performance designation.
As of September 30, 2004, service providers designated as an Exceptional
Performer serviced approximately 91 percent of the Company's federally insured
loans. Of this 91 percent, third parties service approximately one percent. With
an additional third- party service provider receiving the Exceptional
Performance designation in October 2004, more than 98 percent of the Company's
federally insured loans will be serviced by providers who have received such
designation. The Company is entitled to receive this benefit as long as it
and/or its other service providers continue to meet the required servicing
standards published by the Department. Compliance with such standards is
assessed on a quarterly basis.
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company charges off the loan when the
collection of principal and interest is 120 days past due.
The evaluation of the provision for loan losses is inherently subjective, as
it requires material estimates that may be subject to significant changes. The
provision for loan losses reflects the activity for the applicable period and
provides an allowance at a level that management believes is adequate to cover
probable losses inherent in the loan portfolio.
OTHER INCOME (EXPENSE)
The Company also earns fees and generates income from other sources,
including principally loan servicing, guarantee servicing, and licensing fees on
its software products. Loan servicing fees are determined according to
individual agreements with customers and are calculated based on the dollar
value or number of loans or accounts serviced for each customer. Guarantee
servicing fees are earned as a result of providing system software, hardware,
and telecommunication support, borrower and loan updates, default aversion
tracking services, claim processing services, and post-default collection
services to guaranty agencies. Guarantee servicing fees are calculated based on
the number of loans serviced or amounts collected. Software services income
includes software license and maintenance fees associated with student loan
software products as well as certain loan marketing fees. Other income also
includes the derivative market value adjustment and net settlements as further
discussed in "-- Risks -- Market and Interest Rate Risk". The Company's net
income included net settlements on derivatives of $16.0 million and $19.4
million during the three and nine months ended September 30, 2004, as compared
to $0.5 million during each of the comparable periods in 2003. The Company's net
income also included mark-to-market losses on derivative instruments of $40.2
million and $39.2 million during the three and nine months ended September 30,
2004, as compared to $5.1 million during each of the comparable periods in 2003.
19
OPERATING EXPENSES
Operating expenses include costs incurred to manage and administer the
Company's student loan portfolio and its financing transactions, costs incurred
to generate and acquire student loans, and general and administrative expenses,
which include corporate overhead. Operating expenses also include amortization
of intangible assets related to acquisitions. Operating expenses during the
three and nine months ended September 30, 2004 included $2.3 million and $6.4
million, respectively, of amortization of intangible assets resulting from
acquisitions as compared to $2.8 million and $10.0 million during the comparable
periods in 2003.
The Company does not believe inflation has a significant effect on its
operations.
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2003
THREE MONTHS ENDED
SEPTEMBER 30,
--------------------
2004 2003 $ CHANGE % CHANGE
--------- --------- ----------- -----------
(DOLLARS IN THOUSANDS)
INTEREST INCOME:
Loan interest.............................................$ 171,427 $ 104,998 $ 66,429 63.3 %
Amortization of loan premiums and
deferred origination costs............................... (18,395) (19,424) 1,029 5.3
Investment interest........................................ 4,918 2,716 2,202 81.1
--------- ----------- ---------- -----------
Total interest income.................................... 157,950 88,290 69,660 78.9
INTEREST EXPENSE:
Interest on bonds and notes payable......................... 68,545 47,309 21,236 44.9
--------- ----------- ---------- -----------
Net interest income...................................... 89,405 40,981 48,424 118.2
Less provision for loan losses................................. 2,300 4,015 (1,715) (42.7)
--------- ----------- ---------- -----------
Net interest income after provision for loan losses...... 87,105 36,966 50,139 135.6
--------- ----------- ---------- -----------
OTHER INCOME (EXPENSE):
Loan servicing and other fee income........................ 24,167 27,087 (2,920) (10.8)
Software services and other income......................... 8,391 4,565 3,826 83.8
Derivative settlements, net................................ (16,031) (524) (15,507) 2,959.4
Derivative market value adjustment......................... (40,183) (5,131) (35,052) 100.0
--------- ----------- ---------- -----------
Total other income (expense) ............................ (23,656) 25,997 (49,653) (191.0)
--------- ----------- ---------- -----------
OPERATING EXPENSES:
Salaries and benefits...................................... 25,060 35,901 (10,841) (30.2)
Other operating expenses:
Depreciation and amortization, excluding amortization
of intangible assets.................................. 2,676 2,472 204 8.3
Amortization of intangible assets........................ 2,275 2,785 (510) (18.3)
Trustee and other debt related fees...................... 2,752 3,339 (587) (17.6)
Occupancy and communications............................. 2,950 2,963 (13) (0.4)
Advertising and marketing................................ 2,916 2,379 537 22.6
Professional services.................................... 2,672 2,198 474 21.6
Consulting fees and support services to related parties.. -- 417 (417) (100.0)
Postage and distribution................................. 3,059 3,440 (381) (11.1)
Other.................................................... 7,142 6,375 767 12.0
--------- ----------- ---------- -----------
Total other operating expenses........................ 26,442 26,368 74 0.3
--------- ----------- ---------- -----------
Total operating expenses.............................. 51,502 62,269 (10,767) (17.3)
--------- ----------- ---------- -----------
Income before income taxes............................ 11,947 694 11,253 1,621.5
Income tax expense............................................. 4,310 1,827 2,483 135.9
--------- ----------- ---------- -----------
NET INCOME (LOSS)....................................$ 7,637 $ (1,133) $ 8,770 774.1 %
========= =========== ========== ===========
NET INTEREST INCOME. Total loan interest, including amortization of premiums
and deferred origination costs, increased as a result of an increase in the size
of the student loan portfolio and the special allowance yield adjustment, offset
by changes in the interest rate environment and in the pricing characteristics
of the Company's student loan assets. The special allowance yield adjustment of
$43.6 million, offset by lower average interest rates on loans, caused an
increase in the student loan net yield on the Company's student loan portfolio
to 5.05% from 3.65%. The weighted average interest rate on the student loan
portfolio increased due to the special allowance yield adjustment, offset by
lower interest rates on loans, and the increase in the number of lower yielding
consolidation loans, resulting in an increase in loan interest income of
approximately $30.7 million. Consolidation loan activity also increased the
consolidation rebate fee, offset slightly by a decrease in the amortization and
write-off of premiums and deferred origination costs, overall reducing loan
interest income approximately $6.1 million. There was no variable-rate floor
income during the three months ended September 30, 2004 and 2003. The increase
in loan interest income was also a result of an increase in the Company's
portfolio of student loans. The average student loan portfolio increased $2.7
billion, or 29.1%, during the nine months ended September 30, 2004, which
increased loan interest income by approximately $42.7 million.
20
Interest expense on bonds and notes payable increased as average total debt
increased approximately $2.7 billion. Average variable-rate debt increased $2.9
billion, which increased interest expense by approximately $12.7 million. The
Company reduced average fixed-rate debt by $173.0 million, which decreased the
Company's overall interest expense by approximately $2.5 million. The increase
in interest rates, specifically LIBOR and auction rates, increased the Company's
average cost of funds to 2.05% from 1.78%, which increased interest expense
approximately $11.3 million.
Net interest income, excluding the effects of the special allowance yield
adjustment, increased approximately $4.8 million, or 11.8%, to approximately
$45.8 million from approximately $41.0 million.
PROVISION FOR LOAN LOSSES. The provision for loan losses for federally
insured student loans decreased $1.4 million from $1.5 million to $100,000
because of the Company's Exceptional Performer designation in June 2004. The
provision for loan losses for non-federally insured loans decreased $300,000
from $2.5 million to $2.2 million because of the decrease in the non-federally
insured loans and expected performance of the non-federally insured loan
portfolio.
OTHER INCOME (EXPENSE). Loan servicing and other fee income decreased due to
the reduction in the number and dollar amount of loans serviced for third
parties from $9.6 billion as of September 30, 2003 to $9.1 billion as of
September 30, 2004. Total average third-party loan servicing volume decreased
$525.4 million, or 5.5%, which resulted in a decrease in loan servicing income
of $1.5 million. The decrease in servicing volume is due to loan pay downs being
greater than loan additions within the third-party customer portfolios. In
addition, guarantee servicing income decreased $1.4 million due to a customer
that did not renew its servicing contract.
The increase in software services and other income was primarily due to a
one-time gain of $3.0 million recorded on the sale of a fixed asset.
The Company began utilizing derivative instruments in the third quarter of
2003 to provide economic hedges to protect against the impact of adverse changes
in interest rates. For the three months ended September 30, 2004, the derivative
market value adjustment losses were $40.2 million and net settlements
representing realized costs were $16.0 million as compared to $5.1 million and
$0.5 million for the comparative periods in 2003. See "-- Risks -- Market and
Interest Rate Risk."
OPERATING EXPENSES. The Company's compensation plans include various bonus
and incentive programs for its employee base. The Company recognizes costs
related to these plans when incurred in accordance with U.S. generally accepted
accounting principles ("GAAP"). The plans cover the majority of employees
including senior executive management. The incentive compensation plans are tied
to various performance targets and measures including loan volume, customer
satisfaction, and profitability. A significant portion of the incentive is based
on exceeding certain profitability targets and effectively "earning through" the
target to fund the incentive pool. Approximately 10% of GAAP net income before
taxes earned above the initial targets will add additional contributions to the
pool. In the third quarter of 2004, the recognition of the mark-to-market loss
on derivative products reduced the estimated amounts to be paid under the
various incentive programs. The Company's incentive and bonus compensation for
2004 is estimated to approximate 10% to 12% of net income before tax and other
certain costs associated with the plans. As such, the Company anticipates
additional costs will be incurred under the incentive plans in the fourth
quarter of 2004; however, the costs are not expected to exceed 10% of net income
before tax and other certain costs associated with the plans. Amounts due and
payable under the plans are subject to review and approval by the Company's
Compensation Committee of the Board of Directors. The Company anticipates
modifying the bonus and incentive programs for 2005.
In addition to a net reduction in the bonus and incentive compensation
expense in the third quarter 2004, salaries and benefits decreased because a
non-cash stock compensation charge of $5.2 million was recognized in the third
quarter of 2003 equal to the difference between the product of the estimated
initial public offering price and the number of shares issued in March 2003 and
the total price paid by the employees. In addition, salary expense of $3.9
million was recognized in the third quarter of 2003 associated with the
termination of consulting and employment agreements.
The decrease in the amortization of intangible assets is due to certain
intangible assets becoming fully amortized in 2003. The decrease in trustee and
other debt related fees relates to the reduced broker dealer fees from the
acquisition of Nelnet Capital LLC in August 2003. Advertising and marketing
expenses increased due to the expansion of the Company's marketing efforts,
especially in the consolidations area. Professional services increased due to
additional costs related to operations as a public company. No costs were
incurred in 2004 relating to consulting fees and support services to related
parties due to the termination of these agreements in July 2003. Other expenses
increased as the Company redeemed a portion of its student loan interest margin
notes in July 2004 and recognized a call-premium of $1.9 million on this
redemption.
21
INCOME TAX EXPENSE. Income tax expense increased due to the increase in
income before income taxes. The Company's effective tax rate was 36.1% and
263.3% during the three months ended September 30, 2004 and 2003, respectively.
The decrease in the effective tax rate in 2004 was principally a result of the
non-cash compensation expense recognized in the third quarter 2003 for financial
statement purposes that was not deductible for tax purposes.
NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2003
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------------
2004 2003 $ CHANGE % CHANGE
------------ ----------- ---------- ----------
(DOLLARS IN THOUSANDS)
INTEREST INCOME:
Loan interest, excluding variable-rate floor income....... $ 519,059 $ 304,989 $ 214,070 70.2 %
Variable-rate floor income................................. 348 12,700 (12,352) (97.3)
Amortization of loan premiums and deferred
origination costs........................................ (53,249) (49,760) (3,489) (7.0)
Investment interest........................................ 11,750 11,984 (234) (2.0)
------------ ----------- ---------- ----------
Total interest income.................................... 477,908 279,913 197,995 70.7
INTEREST EXPENSE:
Interest on bonds and notes payable........................ 169,940 151,484 18,456 12.2
------------ ----------- ---------- ----------
Net interest income...................................... 307,968 128,429 179,539 139.8
Less provision (recovery) for loan losses...................... (1,006) 8,875 (9,881) (111.3)
------------ ----------- ---------- ----------
Net interest income after provision (recovery)
for loan losses........................................ 308,974 119,554 189,420 158.4
------------ ----------- ---------- ----------
OTHER INCOME (EXPENSE):
Loan servicing and other fee income........................ 72,388 77,324 (4,936) (6.4)
Software services and other income......................... 18,998 13,676 5,322 38.9
Derivatives settlements, net............................... (19,389) (524) (18,865) (3,600.2)
Derivative market value adjustment......................... (39,209) (5,131) (34,078) (664.2)
------------ ----------- ---------- --------
Total other income (expense)............................. 32,788 85,345 (52,557) (61.6)
------------ ----------- ---------- --------
OPERATING EXPENSES:
Salaries and benefits...................................... 101,865 92,749 9,116 9.8
Other operating expenses:
Depreciation and amortization, excluding amortization
of intangible assets.................................. 7,604 7,143 461 6.5
Amortization of intangible assets........................ 6,432 9,981 (3,549) (35.6)
Trustee and other debt related fees...................... 8,217 10,798 (2,581) (23.9)
Occupancy and communications............................. 9,167 9,155 12 0.1
Advertising and marketing................................ 8,200 6,693 1,507 22.5
Professional services.................................... 10,026 6,825 3,201 46.9
Consulting fees and support services to related parties.. -- 3,102 (3,102) (100.0)
Postage and distribution................................. 10,127 10,228 (101) (1.0)
Other.................................................... 19,272 18,274 998 5.5
------------ ----------- ---------- ----------
Total other operating expenses........................ 79,045 82,199 (3,154) (3.8)
------------ ----------- ---------- ----------
Total operating expenses.............................. 180,910 174,948 5,962 3.4
------------ ----------- ---------- ----------
Income before income taxes and minority interest...... 160,852 29,951 130,901 437.1
Income tax expense............................................. 58,841 13,289 45,552 342.8
------------ ----------- ---------- ----------
Income before minority interest....................... 102,011 16,662 85,349 512.2
Minority interest in subsidiary loss........................... -- 109 (109) (100.0)
------------ ----------- ---------- ----------
NET INCOME........................................... $ 102,011 $ 16,771 $ 85,240 508.3 %
============ =========== ========== ==========
NET INTEREST INCOME. Total loan interest, including variable-rate floor
income and amortization of loan premiums and deferred origination costs,
increased as a result of an increase in the size of the student loan portfolio
and the special allowance yield adjustment, offset by changes in the interest
rate environment and in the pricing characteristics of the Company's student
loan assets. The special allowance yield adjustment of $167.9 million, offset by
lower average interest rates on loans, caused an increase in the student loan
net yield on the Company's student loan portfolio to 5.51% from 4.01%.
Variable-rate floor income decreased due to the timing and relative change in
interest rates during the periods. Essentially, prevailing interest rates
declined subsequent to the July 1, 2002 annual borrower interest rate reset date
compared to their less substantial decline following the reset of rates on July
1, 2003. Consequently, the Company realized approximately $348,000 of
variable-rate floor income during the nine months ended September 30, 2004 as
compared to $12.7 million. The weighted average interest rate on the student
loan portfolio increased due to the special allowance yield adjustment offset by
lower interest rates and the increase in the number of lower yielding
consolidation loans resulting in an increase in loan interest income of
approximately $113.7 million. Consolidation loan activity also increased the
amortization and write-off of premiums and deferred origination costs and the
consolidation rebate fee, reducing loan interest income approximately $23.1
million. The increase in loan interest income was also a result of an increase
in the Company's portfolio of student loans. The average student loan portfolio
increased $2.4 billion, or 26.9%, in the nine months ended September 30, 2004,
which increased loan interest income by approximately $120.3 million.
Interest expense on bonds and notes payable increased as average total debt
increased approximately $2.3 billion. Average variable-rate debt increased $2.5
billion, which increased interest expense by approximately $27.6 million. The
22
Company reduced average fixed-rate debt by $188.2, which decreased the Company's
overall interest expense by approximately $8.3 million. The nominal average
increase in interest rates, specifically LIBOR and auction rates, increased
interest expense approximately $2.3 million. Interest expense for the nine
months ended September 30, 2003, includes $2.6 million due to the write off of
debt issuance costs incurred as a result of refinancing certain debt
transactions. The nominal average increase in interest rates was offset by
improved pricing on the large LIBOR based securitizations and decrease in the
auction rate debt financings. Therefore, these improved pricings on debt
securitizations, coupled with the decreases in fixed-rate debt and the write off
of debt issuance costs in 2003 resulted in the decrease in the Company's average
cost of funds to 1.82% from 1.99%.
Net interest income, excluding the effects of variable-rate floor income and
the special allowance yield adjustment, increased approximately $24.0 million,
or 20.8%, to approximately $139.7 million from approximately $115.7 million.
PROVISION FOR LOAN LOSSES. The provision for loan losses for federally
insured student loans decreased $10.1 million from an expense of $2.9 million to
a recovery of $7.2 million because of the Company's Exceptional Performer
designation. The provision for loan losses on non-federally insured loans
increased $240,000 from $6.0 million to $6.2 million because of the change in
the composition of the non-federally insured loans and expected performance of
the non-federally insured loan portfolio.
OTHER INCOME (EXPENSE). Loan servicing and other fee income decreased
primarily due to the reduction in the number and dollar amount of loans the
Company serviced for third parties from $9.6 billion as of September 30, 2003 to
$9.1 billion as of September 30, 2004. Total average third-party loan servicing
volume decreased $855.3 million, or 8.4%, which resulted in a decrease in loan
servicing income of $4.1 million. The decrease in servicing volume is due to
loan pay downs being greater than loan additions within the third-party customer
portfolios. In addition, guarantee servicing income decreased $0.9 million due
to a customer that did not renew its servicing contract.
The software services and other income increased $1.6 million due to the
acquisition of Nelnet Capital LLC (formerly UFS Securities, LLC) in August 2003
and the broker dealer fee income generated from this subsidiary's activities. In
addition, other income included a one-time gain of $3.0 million recorded on the
sale of a fixed asset.
The Company began utilizing derivative instruments in the third quarter of
2003 to provide economic hedges to protect against the impact of adverse changes
in interest rates. For the nine months ended September 30, 2004, the derivative
market value adjustment losses were $39.2 million and net settlements
representing realized interest costs were $19.4 million as compared to $5.1
million and $0.5 million for the comparative periods in 2003. See "-- Risks --
Market and Interest Rate Risk."
OPERATING EXPENSES. The Company's compensation plans include various bonus
and incentive programs for its employee base. The Company recognizes costs
related to these plans when incurred in accordance with GAAP. The plans cover
the majority of employees including senior executive management. The incentive
compensation plans are tied to various performance targets and measures
including loan volume, customer satisfaction, and profitability. A significant
portion of the incentive is based on exceeding certain profitability targets and
effectively "earning through" the target to fund the incentive pool.
Approximately 10% of GAAP net income before taxes earned above the initial
targets will add additional contributions to the pool. The recognition of
significant income in the second quarter of 2004 triggered recognition of
expenses under the programs based on the likelihood of the Company exceeding
certain pre-established goals and targets. In the third quarter of 2004, the
recognition of the mark-to-market loss on derivative products reduced the
estimated amounts to be paid under the various incentive programs. The Company's
incentive and bonus compensation for 2004 is estimated to approximate 10% to 12%
of net income before tax and other certain costs associated with the plans.
Amounts due and payable under the plans are subject to review and approval by
the Company's Compensation Committee of the Board of Directors.
For the nine months ended September 30, 2004, the Company incurred expenses
related to the various incentive compensation plans of approximately $22 million
or 12% of net income before tax and other certain costs associated with the
plans. The Company anticipates additional costs will be incurred under the
incentive plans in the fourth quarter of 2004; however, the costs are not
expected to exceed 10% of net income before tax and other certain costs
associated with the plans. The Company anticipates modifying the bonus and
incentive plans for 2005.
23
Salaries and benefits increased due to the recognition of approximately $22
million of incentive expenses in 2004 as a result of the Company meeting the
pre-established goals and targets generated primarily by the financial impact
related to the special allowance yield adjustment and the Exceptional
Performance designation, offset by the mark-to-market loss on its derivative
products.
The decrease in the amortization of intangible assets is due to certain
intangible assets becoming fully amortized in 2003. The decrease in trustee and
other debt related fees relates to the reduced broker dealer fees from the
acquisition of Nelnet Capital LLC in August 2003. Advertising and marketing
expenses increased due to the expansion of the Company's marketing efforts,
especially in the consolidations area. Professional services increased due to
additional costs related to operations as a public company. No costs were
incurred in 2004 relating to consulting fees and support services to related
parties due to the termination of these agreements in July 2003.
INCOME TAX EXPENSE. Income tax expense increased due to the increase in
income before income taxes. The Company's effective tax rate was 36.6% and 44.4%
during the nine months ended September 30, 2004 and 2003, respectively. The
decrease in the effective tax rate in 2004 was principally a result of the
non-cash compensation expense recognized in the third quarter 2003 for financial
statement purposes that was not deductible for tax purposes.
FINANCIAL CONDITION
AS OF SEPTEMBER 30, 2004 COMPARED TO DECEMBER 31, 2003
AS OF AS OF
SEPTEMBER 30, 2004 DECEMBER 31, 2003 $ CHANGE % CHANGE
------------------ ------------------ ------------ -----------
(DOLLARS IN THOUSANDS)
ASSETS:
Student loans receivable, net..................... $ 12,793,704 $ 10,455,442 $ 2,338,262 22.4 %
Other assets...................................... 1,321,092 1,476,744 (155,652) (10.5)
------------------ ------------------ ------------- -----------
Total assets................................ $ 14,114,796 $ 11,932,186 $ 2,182,610 18.3 %
================== ================== ============= ===========
LIABILITIES:
Bonds and notes payable........................... $ 13,526,343 $ 11,366,458 $ 2,159,885 19.0 %
Fair value of derivative instruments, net......... 39,386 677 38,709 5,717.7
Other liabilities................................. 140,452 259,562 (119,110) (45.9)
------------------ ------------------ ------------- -----------
Total liabilities........................... 13,706,181 11,626,697 2,079,484 17.9
SHAREHOLDERS' EQUITY:
Shareholders' equity.............................. 408,615 305,489 103,126 33.8
------------------ ------------------ ------------- -----------
Total liabilities and shareholders' equity.. $ 14,114,796 $ 11,932,186 $ 2,182,610 18.3 %
================== ================== ============= ===========
Total assets increased primarily because of an increase in student loans
receivable. The Company originated and acquired $3.3 billion of student loans
during the nine months ended September 30, 2004, offset by repayments of
approximately $1.0 billion. Other assets declined because of a $110.7 million
decrease in restricted cash due to loan program customers, which reflects timing
of disbursements on loans and reduced lockbox volume. Total liabilities
increased primarily because of an increase in bonds and notes payable, resulting
from additional borrowings to fund growth in student loans. The fair value of
derivatives instruments increased due to the larger notional amounts and change
in market conditions on the Company's derivative instruments. Other liabilities
include restricted cash due to loan program customers that decreased $110.7
million as a result of timing of disbursements on loans and reduced lockbox
volume. Shareholders' equity increased primarily as a result of net income of
$102.0 million during the nine months ended September 30, 2004.
LIQUIDITY AND CAPITAL RESOURCES
The Company utilizes operating cash flow, operating lines of credit, and
secured financing transactions to fund operations and student loan acquisitions.
In addition, in December 2003, the Company consummated an initial public
offering of its Class A common stock that yielded the Company net proceeds of
$163.7 million. Operating activities provided net cash of $169.3 million during
the nine months ended September 30, 2004, an increase of $82.6 million from the
net cash provided by operating activities of $86.7 million during the comparable
period in 2003. Operating cash flows are driven by net income adjusted for
various non-cash items such as the provision (recovery) for loan losses,
depreciation and amortization, deferred income taxes, and the derivative market
value adjustment. These non-cash items resulted in an increase in cash provided
by operating activities of $26.9 million during the nine months ended September
30, 2004 as compared to the comparable period in 2003. In addition, the special
allowance yield adjustment recognized in 2004, reduced by the change in
settlement costs on derivative instruments and related operating expenses and
taxes, increased cash provided by operating activities in 2004 over 2003.
24
As of September 30, 2004, the Company had a $35.0 million operating line of
credit and a $50.0 million commercial paper commitment under two separate
facilities from a group of six large regional and national financial
institutions that expire in September 2005. The Company uses these facilities
primarily for general operating purposes and had $10.0 million borrowed under
these facilities at September 30, 2004. The Company believes these facilities,
the growth in the cash flow from operating activities, and the initial public
stock offering indicate a favorable trend in its available capital resources.
Due to the proceeds received from the initial public offering, a $30.0 million
operating line of credit with a national financial institution was not renewed
in February 2004.
The Company's secured financing instruments include commercial paper lines,
short-term student loan warehouse programs, variable-rate tax-exempt bonds,
fixed-rate bonds, fixed-rate tax-exempt bonds, and various asset-backed
securities. Of the $13.5 billion of debt outstanding as of September 30, 2004,
$12.0 billion was issued under securitization transactions. On January 15, 2004,
April 22, 2004, July 20, 2004, and September 29, 2004, the Company completed
asset-backed securities transactions totaling $1.0 billion, $1.0 billion, $1.4
billion, and $2.0 billion, respectively. The proceeds from the September 2004
issuance were used to redeem $1.7 billion of student loan asset-backed auction
rate notes. Depending on market conditions, the Company anticipates continuing
to access the asset-backed securities market in 2005 and subsequent years.
Securities issued in the securitization transactions are generally priced off a
spread to LIBOR or set under an auction procedure related to the bonds and
notes. The student loans financed are generally priced on a spread to commercial
paper or Treasury bills.
The Company's warehouse facilities allow for expansion of liquidity and
capacity for student loan growth and should provide adequate liquidity to fund
the Company's student loan operations for the foreseeable future. As of
September 30, 2004, the Company had a loan warehousing capacity of $2.7 billion,
of which $1.5 billion was outstanding, through 364-day commercial paper conduit
programs. These conduit programs mature in 2004 through 2009; however, they must
be renewed annually by underlying liquidity providers. Historically, the Company
has been able to renew its commercial paper conduit programs, including the
underlying liquidity agreements, and therefore does not believe the renewal of
these contracts present a significant risk to its liquidity. Because the Company
continues to grow its loan portfolio and acquisition channels, the loan
warehousing capacity was increased by $800.0 million in October 2004. In
November 2004, the loan warehousing capacity was decreased $50.0 million due to
the expiration of one warehouse facility. The Company's warehouse capacity as of
November 15, 2004 is $3.45 billion.
The Company is limited in the amounts of funds that can be transferred from
its subsidiaries through intercompany loans, advances, or cash dividends. These
limitations result from the restrictions contained in trust indentures under
debt financing arrangements to which the Company's education lending
subsidiaries are parties. The Company does not believe these limitations will
affect its operating cash needs. The amounts of cash and investments restricted
in the respective reserve accounts of the education lending subsidiaries are
shown on the balance sheets as restricted cash and investments.
The following table summarizes the Company's bonds and notes outstanding as
of September 30, 2004:
LINE OF INTEREST RATE
CARRYING PERCENT CREDIT RANGE ON CARRYING FINAL
AMOUNT OF TOTAL AMOUINT AMOUNT MATURITY
-------------- ----------- ------------- ----------------- ------------------
(DOLLARS IN THOUSANDS)
Variable rate bonds and notes (a):
Bond and notes based on indices.........$ 7,634,731 56.4 % $ 7,634,731 1.69% - 2.65% 11/25/09 - 01/25/41
Bond and notes based on auction......... 3,623,620 26.8 3,623,620 1.40% - 2.10% 07/01/05 - 07/01/43
------------- ---------- -------------
Total variable rate bonds and notes.. 11,258,351 83.2 11,258,351
Commerical paper and other.................. 1,453,981 10.8 2,700,000 1.55% - 1.76% 05/13/05 - 09/02/09
Fixed-rate bonds and notes (a).............. 789,011 5.8 789,011 5.20% - 7.63% 05/01/05 - 05/01/29
Other borrowings............................ 25,000 0.2 100,000 2.05% - 6.00% 09/23/05 - 11/01/05
------------- ---------- -------------
Total...................................$ 13,526,343 100.0 % $ 14,847,362
============= ========== =============
(a) Issued in securitization transactions.
Total unused commitments under various commercial paper, warehouse, and
operating line of credit agreements totaled $1.3 billion as of September 30,
2004.
25
The Company is committed under noncancelable operating leases for certain
office and warehouse space and equipment. The Company's contractual obligations
as of September 30, 2004 were as follows:
LESS THAN MORE THAN
TOTAL 1 YEAR 1 TO 3 YEARS 3 TO 5 YEARS 5 YEARS
------------- ----------- ------------- ------------- -----------
(DOLLARS IN THOUSANDS)
Bonds and notes payable...... $ 13,526,343 218,020 243,057 451,698 12,613,568
Operating lease obligations.. 13,960 4,919 6,950 1,723 368
------------- ----------- ------------- ------------- ------------
Total..................... $ 13,540,303 222,939 250,007 453,421 12,613,936
============= =========== ============= ============= ============
The Company has commitments with its branding partners and forward flow
lenders which obligate the Company to purchase loans originated under specific
criteria, although the branding partners and forward flow lenders are not
obligated to provide the Company with a minimum amount of loans. Branding
partners are from whom the Company acquires student loans and to whom the
Company provides marketing and origination services. Forward flow lenders are
from whom the Company acquires student loans and to whom the Company provides
origination services. These commitments generally run for periods ranging from
one to five years and are generally renewable. The Company is obligated to
purchase student loans at current market rates at the respective sellers'
requests under various agreements. As of September 30, 2004, $317.7 million of
student loans were originated under these agreements, which the Company was
committed to purchase.
STUDENT LOAN PORTFOLIO
The table below describes the components of the Company's loan portfolio:
AS OF SEPTEMBER 30, 2004 AS OF DECEMBER 31, 2003
------------------------ --------------------------
DOLLARS PERCENT DOLLARS PERCENT
------------- ---------- -------------- ----------
(DOLLARS IN THOUSANDS)
Federally insured:
Stafford......................................... $ 5,218,535 40.8 % $ 4,900,249 46.9 %
PLUS/SLS (a)..................................... 263,118 2.1 249,217 2.4
Consolidation.................................... 7,056,556 55.2 5,073,081 48.5
Non-federally insured................................ 92,247 0.7 92,327 0.9
-------------- --------- -------------- ----------
Total....................................... 12,630,456 98.8 10,314,874 98.7
Unamortized premiums and deferred origination costs... 171,694 1.3 156,594 1.5
Allowance for loan losses:
Allowance - federally insured.................... (706) (0.0) (9,755) (0.1)
Allowance - non-federally insured................ (7,740) (0.1) (6,271) (0.1)
-------------- --------- -------------- ----------
Net.........................................$ 12,793,704 100.0 % $ 10,455,442 100.0 %
============== ========= ============== ==========
----------
(a) Supplemental Loans for Students, or SLS, are the predecessor to
unsubsidized Stafford loans.
26
ACTIVITY IN THE ALLOWANCE FOR LOAN LOSSES
The provision for loan losses represents the periodic expense of maintaining
an allowance sufficient to absorb losses, net of recoveries, inherent in the
portfolio of student loans. An analysis of the Company's allowance for loan
losses is presented in the following table:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- -----------------------------
2004 2003 2004 2003
------------- ------------- -------------- -------------
(DOLLARS IN THOUSANDS)
Balance at beginning of period...................................... $ 8,122 $ 13,750 $ 16,026 $ 12,000
Provision (recovery) for loan losses:
Federally insured loans........................................ 100 1,515 (7,216) 2,905
Non-federally insured loans.................................... 2,200 2,500 6,210 5,970
------------- ------------ ------------- ------------
Total provision (recovery) for loan losses................ 2,300 4,015 (1,006) 8,875
Charge-offs:
Federally insured loans........................................ (129) (936) (1,833) (2,271)
Non-federally insured loans.................................... (1,945) (1,117) (5,050) (2,937)
------------- ------------ ------------- ------------
Total charge-offs......................................... (2,074) (2,053) (6,883) (5,208)
Recoveries, non-federally insured loans............................. 98 12 309 57
------------- ------------ ------------- ------------
Net charge-offs..................................................... (1,976) (2,041) (6,574) (5,151)
------------- ------------ ------------- ------------
Balance at end of period............................................ $ 8,446 $ 15,724 $ 8,446 $ 15,724
============= ============ ============= ============
Allocation of the allowance for loan losses:
Federally insured loans........................................ $ 706 $ 10,004 $ 706 $ 10,004
Non-federally insured loans.................................... 7,740 5,720 7,740 5,720
------------- ------------ ------------- ------------
Total allowance for loan losses........................... $ 8,446 $ 15,724 $ 8,446 $ 15,724
============= ============ ============= ============
Net loan charge-offs as a percentage of average student loans....... 0.065 % 0.087 % 0.078 % 0.077 %
Total allowance as a percentage of average student loans............ 0.070 % 0.168 % 0.075 % 0.177 %
Total allowance as a percentage of ending balance of student loans.. 0.067 % 0.159 % 0.067 % 0.159 %
Non-federally insured allowance as a percentage of the ending
balance of non-federally insured loans......................... 8.391 % 6.168 % 8.391 % 6.168 %
Average student loans............................................... $ 12,108,981 $ 9,377,746 $ 11,282,561 $ 8,891,773
Ending balance of student loans..................................... $ 12,630,456 $ 9,913,870 $ 12,630,456 $ 9,913,870
Ending balance of non-federally insured loans....................... $ 92,247 $ 92,744 $ 92,247 $ 92,744
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company receives 100 percent reimbursement on all eligible FFEL Program
default claims submitted for reimbursement during the 12-month period following
the effective date of its designation. The Company is not subject to the two
percent risk sharing loss for eligible claims submitted during this 12-month
period. Only FFEL Program loans that are serviced by the Company, as well as
loans owned by the Company and serviced by other service providers designated as
Exceptional Performers by the Department, are subject to the 100 percent
reimbursement. In June 2004, the Company's allowance for loan losses balance was
reduced by $9.0 million and the provision for loan losses was similarly reduced
to account for the estimated effects of the Exceptional Performance designation.
As of September 30, 2004, service providers designated as an Exceptional
Performer serviced approximately 91 percent of the Company's federally insured
loans. Of this 91 percent, third parties service approximately one percent. With
an additional third-party service provider receiving the Exceptional Performance
designation in October 2004, more than 98 percent of the Company's federally
insured loans will be serviced by providers who have received such designation.
The Company is entitled to receive this benefit as long as it and/or its other
service providers continue to meet the required servicing standards published by
the Department. Compliance with such standards is assessed on a quarterly basis.
27
Delinquencies have the potential to adversely impact the Company's earnings
through increased servicing and collection costs and account charge-offs. The
table below shows the student loan delinquency amounts:
AS OF SEPTEMBER 30, 2004 AS OF DECEMBER 31, 2003
-------------------------- --------------------------
DOLLARS PERCENT DOLLARS PERCENT
------------ ----------- -------------- -----------
(DOLLARS IN THOUSANDS)
FEDERALLY INSURED LOANS:
Loans in-school/grace/deferment(1)..........$ 3,935,224 $ 2,940,193
Loans in forebearance(2).................... 1,619,072 1,362,335
Loans in repayment status:
Loans current........................... 6,247,906 89.4 % 5,245,316 88.6 %
Loans delinquent 31-60 days(3).......... 278,424 4.0 279,435 4.7
Loans delinquent 61-90 days(3).......... 160,530 2.3 130,339 2.2
Loans delinquent 91 days or greater(4).. 297,053 4.3 264,929 4.5
------------ -------- ------------- ---------
Total loans in repayment............. 6,983,913 100.0 % 5,920,019 100.0 %
------------ ======== ------------- =========
Total federally insured loans........$12,538,209 $10,222,547
============ =============
NON-FEDERALLY INSURED LOANS:
Loans in-school/grace/deferment(1)..........$ 23,549 $ 25,537
Loans in forebearance(2).................... 3,866 14,776
Loans in repayment status:
Loans current........................... 57,393 88.5 % 45,554 87.5 %
Loans delinquent 31-60 days(3).......... 2,323 3.6 2,531 4.9
Loans delinquent 61-90 days(3).......... 1,970 3.0 1,556 3.0
Loans delinquent 91 days or greater(4).. 3,146 4.9 2,373 4.6
------------ -------- ------------- ---------
Total loans in repayment............ 64,832 100.0 % 52,014 100.0 %
------------ ======== ------------- =========
Total non-federally insured loans....$ 92,247 $ 92,327
============ =============
- ----------
(1) Loans for borrowers who still may be attending school or engaging in other
permitted educational activities and are not yet required to make payments
on the loans, E.G., residency periods for medical students or a grace period
for bar exam preparation for law students.
(2) Loans for borrowers who have temporarily ceased making full payments due to
hardship or other factors, according to a schedule approved by the servicer
consistent with the established loan program servicing procedures and
policies.
(3) The period of delinquency is based on the number of days scheduled payments
are contractually past due and relate to repayment loans, that is,
receivables not charged off, and not in school, grace, deferment, or
forbearance.
(4) Loans delinquent 91 days or greater include loans in claim status, which are
loans which have gone into default and have been submitted to the guaranty
agency for FFELP loans, or the insurer for non-federally insured loans, to
process the claim for payment.
During the second quarter of 2004, the Company reclassified FFELP loans and
the related allowance that have been rejected for reimbursement by the guarantor
to the non-federally insured loan portfolio, because these loans are effectively
uninsured. In the above tables, the reclassification is reflected for all
periods presented.
ORIGINATION AND ACQUISITION
The Company's student loan portfolio increases through various channels,
including originations through the direct channel and acquisitions through the
branding partner channel, the forward flow channel, and spot purchases. The
Company's portfolio also increases with the addition of portfolios acquired
through business acquisitions.
One of the Company's primary objectives is to focus on originations through
the direct channel and acquisitions through the branding partner channel. The
Company has extensive and growing relationships with many large financial and
educational institutions that are active in the education finance industry. The
Company's branding relationships and forward flow relationships include Union
Bank, an affiliate of the Company, as well as many schools and national and
regional financial institutions. Loss of a strong relationship, like that with a
significant branding partner, such as Union Bank, or with schools from which the
Company directly or indirectly acquires a significant volume of student loans,
could result in an adverse effect on the volume derived from the branding
partner channel.
28
The table below sets forth the activity of loans originated or acquired
through each of the Company's channels:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- -----------------------------
2004 2003 2004 2003
-------------- ------------- -------------- -------------
(DOLLARS IN THOUSANDS)
Beginning balance....................................$ 12,033,329 9,317,847 10,314,874 8,404,388
Direct channel:
Consolidation loan originations.................. 857,456 732,954 2,169,374 1,469,624
Less consolidation of existing portfolio......... (370,792) (407,000) (893,800) (759,000)
-------------- ------------- -------------- -------------
Net consolidation loan originations......... 486,664 325,954 1,275,574 710,624
Stafford/PLUS loan originations.................. 102,203 71,819 222,515 188,695
Branding partner channel............................. 91,446 112,283 806,653 723,023
Forward flow channel................................. 174,922 177,332 623,014 485,334
Other channels....................................... 73,279 242,984 204,062 306,650
-------------- ------------- -------------- -------------
Total channel acquisitions....................... 928,514 930,372 3,131,818 2,414,326
Loans acquired in business acquisition............... -- -- 136,138 --
Repayments, claims, capitalized interest, and other.. (331,387) (334,349) (952,374) (904,844)
-------------- ------------- -------------- -------------
Ending balance......................................$ 12,630,456 9,913,870 12,630,456 9,913,870
============== ============= ============== =============
STUDENT LOAN SPREAD ANALYSIS
Maintenance of the spread on assets is a key factor in maintaining and
growing the Company's income. The following table analyzes the student loan
spread on the Company's portfolio of student loans and represents the spread on
assets earned in conjunction with the liabilities used to fund the assets:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ -----------------------
2004 2003 2004 2003
------------ ---------- ----------- ----------
Student loan yield...................................... 6.25 % 4.94 % 6.71 % 5.19 %
Consolidation rebate fees............................... (0.59) (0.46) (0.57) (0.43)
Premium and deferred origination costs amortization..... (0.61) (0.83) (0.63) (0.75)
------------ ---------- ----------- ----------
Student loan net yield.................................. 5.05 3.65 5.51 4.01
Student loan cost of funds.............................. (2.05) (1.78) (1.82) (1.99)
------------ ---------- ----------- ----------
Student loan spread..................................... 3.00 1.87 3.69 2.02
Variable-rate floor income.............................. -- -- -- (0.19)
Special allowance yield adjustment (a).................. (1.44) -- (1.98) --
------------ ---------- ----------- ----------
Core student loan spread................................ 1.56 % 1.87 % 1.71 % 1.83 %
============ ========== =========== ==========
Average balance of student loans (in thousands) $12,108,981 $9,377,746 $11,282,561 $8,891,773
----------
(a) On June 30, 2004, the Company recognized $124.3 million of excess
interest income that had previously been deferred. At December 31, 2003, the
amount of deferred excess interest income on these loans was $42.9 million.
The increase in lower yielding consolidation loans coupled with a slightly
higher interest rate environment has caused some compression in the Company's
loan spread when excluding the special allowance yield adjustment.
RISKS
POLITICAL/REGULATORY RISK
Pursuant to the terms of the Higher Education Act, the FFEL Program is
periodically amended, and the Higher Education Act is generally reauthorized by
Congress every five to six years in order to prevent sunset of that Act. Changes
in the Higher Education Act made in the two most recent reauthorizations have
included reductions in the student loan yields paid to lenders, increased fees
paid by lenders, and a decreased level of federal guarantee. Future changes
could result in further negative impacts on the Company's business. Moreover,
there can be no assurance that the provisions of the Higher Education Act, which
is scheduled to expire on September 30, 2005, will be reauthorized. While
Congress has consistently extended the effective date of the Higher Education
Act, it may elect not to reauthorize the Department's ability to provide
interest subsidies, special allowance payments, and federal guarantees for
student loans. Such a failure to reauthorize would reduce the number of
federally insured student loans available for the Company to originate and/or
acquire in the future.
29
Specific proposed legislation that could have a material effect on the
Company's operations, if enacted, in no particular order, include:
o allowing for increased borrower limits, which may provide opportunities
for increasing the average size of the Company's future loan
originations;
o changes to the single holder rule and other FFEL Program rates and terms
as discussed under "-- Risk Related to Consolidation Loans;"
o eliminating variable-rate floor income as well as the 9.5% floor
interest rate on loans refinanced with funds from pre-1993 tax-exempt
financings;
o restrictions limiting/preventing a FFELP lender from making a
consolidation loan consisting of only Federal Direct Lending ("FDL")
loans; and
o initiatives aimed at supporting the FDL program to the detriment of the
FFEL program.
In addition, the Department oversees and implements the Higher Education Act
and periodically issues regulations and interpretations of that Act. Changes in
such regulations and interpretations could negatively impact the Company's
business.
See "-- Overview-- Recent Developments" for additional disclosures concerning
political and regulatory risks.
LIQUIDITY RISK
The Company's primary funding needs are those required to finance the student
loan portfolio and satisfy the Company's cash requirements for new student loan
originations and acquisitions, operating expenses, and technological
development. The Company's operating and warehouse financings are provided by
third parties. The term of each conduit facility is less than one year and each
facility is renewable at the option of the lender and may be terminated at any
time for cause. There can be no assurance that the Company will be able to
maintain such conduit facilities, find alternative funding, or increase the
commitment level of such facilities, if necessary. While the Company's conduit
facilities have historically been renewed for successive terms, there can be no
assurance that this will continue in the future.
In addition, the Company has historically relied upon, and expects to
continue to rely upon, asset-backed securitizations as the Company's most
significant source of funding for student loans on a long-term basis. A major
disruption in the auction markets, such as insufficient potential bid orders to
purchase all the notes offered for sale or being repriced, could subject the
Company to interest costs substantially above the anticipated and historical
rates paid on these types of securities. A change in the capital markets could
limit the Company's ability to raise funds or significantly increase the cost of
those funds, affecting its ability to acquire student loans.
CREDIT RISK
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company receives 100 percent reimbursement on all eligible FFEL Program
default claims submitted for reimbursement during the 12-month period following
the effective date of its designation. The Company is not subject to the two
percent risk sharing loss for eligible claims submitted during this 12-month
period. Only FFEL Program loans that are serviced by the Company, as well as
loans owned by the Company and serviced by other service providers designated as
Exceptional Performers by the Department, are subject to the 100 percent
reimbursement. As of September 30, 2004, service providers designated as an
Exceptional Performer serviced approximately 91 percent of the Company's
federally insured loans. Of this 91 percent, third parties service approximately
one percent. With an additional third-party service provider receiving the
Exceptional Performance designation in October 2004, more than 98 percent of the
Company's federally insured loans will be serviced by providers who have
received such designation. The Company is entitled to receive this benefit as
long as it and/or its other service providers continue to meet the required
servicing standards published by the Department. Compliance with such standards
is assessed on a quarterly basis. The Company bears full risk of losses
experienced with respect to the unguaranteed portion of its federally insured
loans (those loans not serviced by a service provider designated as an
Exceptional Performer). If the Company or a third party service provider were to
lose its Exceptional Performance designation, either by the Department
discontinuing the program or the Company or third party not meeting the required
servicing standards, loans serviced by the Company or third-party would become
subject to the two percent risk sharing loss for all claims submitted after any
loss of the Exceptional Performance designation.
30
Losses on the non-federally insured loans will be borne by the Company. The
loan loss pattern on the Company's non-federally insured loan portfolio is not
as developed as that on its FFELP loan portfolio. The performance of student
loans in the portfolio is affected by the economy, and a prolonged economic
downturn may have an adverse effect on the credit performance of these loans. In
addition, the Company's non-federally insured loans are underwritten and priced
according to risk, using credit-scoring systems. The Company has defined
underwriting and collection policies, as well as ongoing risk monitoring and
review processes for all non-federally insured loans.
Management believes the Company has provided sufficient allowances to cover
the losses that may be experienced in both its federally insured and
non-federally insured loan portfolios. There is, however, no guarantee that such
allowances are sufficient enough to account for actual losses.
OPERATIONAL RISK
Operational risk can result from regulatory compliance errors, technology
failures, breaches of internal control systems, and the risk of fraud or
unauthorized transactions. Operational risk includes failure to comply with
regulatory requirements of the Higher Education Act, rules and regulations of
the agencies that act as guarantors on the student loans, and federal and state
consumer protection laws and regulations on the Company's non-federally insured
loans. Such failure to comply, irrespective of the reason, could subject the
Company to loss of the federal guarantee on FFELP loans, costs of curing
servicing deficiencies or remedial servicing, suspension or termination of the
Company's right to participate in the FFEL program or to participate as a
servicer, negative publicity, and potential legal claims or actions brought by
the Company's servicing customers and borrowers.
The Company has the ability to cure servicing deficiencies and the Company's
historical losses have been minimal. However, the Company's servicing and
guarantee servicing activities are highly dependent on its information systems,
and the Company faces the risk of business disruption should there be extended
failures of its systems. The Company has well-developed and tested business
recovery plans to mitigate this risk. The Company also manages operational risk
through its risk management and internal control processes covering its product
and service offerings. These internal control processes are documented and
tested regularly.
RISK RELATED TO CONSOLIDATION LOANS
The Company's student loan origination and lending activities could be
significantly impacted by the reauthorization of the Higher Education Act
relative to the single holder rule. For example, if the single holder rule,
which generally restricts a competitor from consolidating loans away from a
holder that owns all of a student's loans, were abolished, a substantial portion
of the Company's non-consolidated portfolio would be at risk of being
consolidated away by a competitor. On the other hand, abolition of the rule
would also open up a portion of the rest of the market and provide the Company
with the potential to gain market share. The portion of the rest of the market
that would be opened up to the Company, as measured in aggregate principal
amount of student loans, would be greater than the portion of the Company's
non-consolidated portfolio that would be at risk of being consolidated by a
competitor. Other potential changes to the Higher Education Act relating to
consolidation loans that could impact the Company include, without limitation:
o allowing refinancing of consolidation loans, which would open
approximately 55% of the Company's portfolio to such refinancing; and
o allowing for variable-rate consolidation loans and extended repayment
terms of Stafford loans, which would lead to fewer loans lost through
consolidation of the Company's portfolio, but would also decrease
consolidation opportunities.
31
MARKET AND INTEREST RATE RISK
The Company's primary market risk exposure arises from fluctuations in its
borrowing and lending rates, the spread between which could impact the Company
due to shifts in market interest rates. Because the Company generates the
majority of its earnings from the spread between the yield on the portfolio of
student loans and the cost of funding these loans, the interest sensitivity of
the balance sheet is a key profitability driver. The majority of student loans
have variable-rate characteristics in certain interest rate environments. Some
of the student loans include fixed-rate components depending upon the rate reset
provisions, or, in the case of consolidation loans, are fixed at the weighted
average interest rate of the underlying loans at the time of consolidation. The
following table sets forth the Company's loan assets and debt instruments by
rate characteristics:
AS OF SEPTEMBER 30, 2004 AS OF DECEMBER 31, 2003
-------------------------- --------------------------
DOLLARS PERCENT DOLLARS PERCENT
-------------- ---------- -------------- -----------
(DOLLARS IN THOUSANDS)
Fixed-rate loan assets............ $ 5,875,564 46.5 % $ 5,532,497 53.6 %
Variable-rate loan assets......... 6,754,892 53.5 4,782,377 46.4
-------------- ---------- -------------- -----------
Total.......................... $ 12,630,456 100.0 % $ 10,314,874 100.0 %
============== ========== ============== ===========
Fixed-rate debt instruments........$ 789,011 5.8 % $ 927,694 8.2 %
Variable-rate debt instruments..... 12,737,332 94.2 10,438,764 91.8
-------------- ---------- -------------- -----------
Total...........................$ 13,526,343 100.0 % $ 11,366,458 100.0 %
============== ========== ============== ===========
Historically, the Company has followed a policy of funding the majority of
its student loan portfolio with variable-rate debt. In a low interest rate
environment, the FFELP loan portfolio yields excess income primarily due to the
reduction in interest rates on the variable-rate liabilities that fund student
loans at a fixed borrower rate and also due to consolidation loans earning
interest at a fixed rate to the borrower. Therefore, absent utilizing derivative
instruments, in a low interest rate environment, a rise in interest rates will
have an adverse effect on earnings. In higher interest rate environments, where
the interest rate rises above the borrower rate and the fixed-rate loans become
variable rate and are effectively matched with variable-rate debt, the impact of
rate fluctuations is substantially reduced.
The Company attempts to match the interest rate characteristics of pools of
loan assets with debt instruments of substantially similar characteristics,
particularly in rising interest rate environments. Due to the variability in
duration of the Company's assets and varying market conditions, the Company does
not attempt to perfectly match the interest rate characteristics of the entire
loan portfolio with the underlying debt instruments. The Company has adopted a
policy of periodically reviewing the mismatch related to the interest rate
characteristics of its assets and liabilities and the Company's opinion as to
current and future market conditions. Based on those factors, the Company will
periodically use derivative instruments as part of its overall risk management
strategy to manage risk arising from its fixed-rate and variable-rate financial
instruments.
32
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of September 30, 2004:
NOTIONAL AMOUNTS BY PRODUCT TYPE
--------------------------------------------------------
FIXED/FLOATING BASIS FLOATING/FIXED
MATURITY SWAPS (a) SWAPS (b ) SWAPS (c) TOTAL
- --------------------------------- --------------- ------------- ------------ ------------
(DOLLARS IN MILLIONS)
2004............................. $ 3,000 (d) -- -- 3,000
2005............................. 1,062 1,000 210 2,272
2006............................. 613 500 -- 1,113
2007............................. 512 -- -- 512
2008............................. 463 -- -- 463
2009 and thereafter.............. 1,450 -- -- 1,450
-------------- ------------ ------------ -----------
Total.......................... $ 7,100 1,500 210 8,810
============== ============ ============ ===========
Weighted average rate............ 2.43%
==============
Fair value (e) (in thousands).... $ (34,637) (3,743) (1,006) (39,386)
============== ============ ============ ===========
- ----------
(a) A fixed/floating swap is an interest rate swap in which the Company agrees
to pay a fixed rate in exchange for a floating rate. The interest rate swap
converts a portion of the Company's variable-rate debt (equal to the
notional amount of the swap) to a fixed rate for a period of time fixing the
relative spread between a portion of the Company's student loan assets and
the converted fixed-rate liability.
(b) A basis swap is an interest rate swap agreement in which the Company agrees
to pay a floating rate in exchange for another floating rate, based upon
different market indices. The Company has employed basis swaps to limit its
sensitivity to dramatic fluctuations in the underlying indices used to price
a portion of its variable-rate assets and variable-rate debt.
(c) A floating/fixed swap is an interest rate swap in which the Company agrees
to pay a floating rate in exchange for a fixed rate. The interest rate swap
converts a portion of the Company's fixed-rate debt (equal to the notional
amount of the swap) to a floating rate for a period of time.
(d) These interest rate swaps, carrying a 1.20% weighted average rate, expired
in October 2004.
(e) Fair value is determined from market quotes from independent security
brokers. Fair value indicates an estimated amount the Company would receive
(pay) if the contracts were cancelled or transferred to other parties.
Derivative instruments that are currently used as part of the Company's
interest rate risk management strategy include interest rate swaps and basis
swaps. The Company accounts for its derivative instruments in accordance with
SFAS No. 133. SFAS No. 133 requires that changes in the fair value of derivative
instruments be recognized currently in earnings unless specific hedge accounting
criteria as specified by SFAS No. 133 are met. Management has structured all of
the Company's derivative transactions with the intent that each is economically
effective. However, the majority of the Company's derivative instruments do not
qualify for hedge accounting under SFAS No. 133; consequently, the change in
fair value of these derivative instruments is included in the Company's
statement of income. At September 30, 2004, the Company accounted for one
interest rate swap with a notional amount of $150 million as a cash flow hedge
in accordance with SFAS No. 133. Gains and losses on the effective portion of
this qualifying hedge are accumulated in other comprehensive income and
reclassified to current period earnings over the period in which the stated
hedged transactions impact earnings. Ineffectiveness is recorded to earnings.
The following is a summary of the amounts included in derivative market value
adjustment and net settlements on the consolidated income statements:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- --------------------
2004 2003 2004 2003
---------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
Change in fair value of derivative instruments.........$ 40,183) (5,131) (39,209) (5,131)
Settlements, net........................................ (16,031) (524) (19,389) (524)
---------- --------- --------- ---------
Derivative market value adjustment and net settlements.$ (56,214) (5,655) (58,598) (5,655)
========== ========= ========= =========
The following tables summarize the effect on the Company's earnings, based
upon a sensitivity analysis performed by the Company assuming a hypothetical
increase and decrease in interest rates of 100 basis points and an increase in
interest rates of 200 basis points while funding spreads remain constant. The
effect on earnings was performed on the Company's variable-rate assets and
liabilities. For the three and nine months ended September 30, 2004 and 2003,
the analysis includes the effects of the derivative instruments in existence
during these periods.
33
As a result of the Company's interest rate management activities, the Company
expects the change in pre-tax net income resulting from 100 basis point and 200
basis point increases in interest rates will not result in a proportional
decrease in net income due to the effective switch of some variable-rate loans
to fixed-rate loans. The results of the Company's interest rate management
activities initiated in 2004 can be seen in the following tables:
THREE MONTHS ENDED SEPTEMBER 30, 2004
-----------------------------------------------------------------------
CHANGE FROM DECREASE CHANGE FROM INCREASE CHANGE FROM INCREASE
OF 100 BASIS POINTS OF 100 BASIS POINTS OF 200 BASIS POINTS
--------------------- --------------------- -----------------------
DOLLAR PERCENT DOLLAR PERCENT DOLLAR PERCENT
---------- --------- ---------- --------- ---------- -----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Effect on earnings:
Increase (decrease) in pre-tax
net income before
impact of derivative settlements.......$ 18,782 157.2 % $(12,438) (104.1)% $ (23,776) (199.0)%
Impact of derivative settlements.......... (15,662) (131.1) 15,662 131.1 31,324 262.2
---------- --------- ---------- --------- ---------- ----------
Increase in net income before taxes.......$ 3,120 26.1 % $ 3,224 27.0% $ 7,548 63.2 %
========== ========= ========== ========= ========== ==========
Increase in basic and diluted
earning per share......................$ 0.04 $ 0.04 $ 0.09
========== ========== ==========
THREE MONTHS ENDED SEPTEMBER 30, 2003
-----------------------------------------------------------------------
CHANGE FROM DECREASE CHANGE FROM INCREASE CHANGE FROM INCREASE
OF 100 BASIS POINTS OF 100 BASIS POINTS OF 200 BASIS POINTS
--------------------- --------------------- -----------------------
DOLLAR PERCENT DOLLAR PERCENT DOLLAR PERCENT
---------- --------- ---------- --------- ---------- -----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Effect on earnings:
Increase (decrease) in pre-tax
net income before
impact of derivative settlements.......$ 60,502 8,717.9 % $(13,636) (1,964.8)% $ (21,403) (3,083.9)%
Impact of derivative settlements.......... (4,410) (635.4) 2,997 431.8 6,715 967.5
---------- --------- ---------- --------- ---------- ----------
Increase in net income before taxes.......$ 56,092 8,082.5 % $(10,639) (1,533.0)% $ (14,688) (2,116.4) %
========== ========= ========== ========= ========== ==========
Increase in basic and diluted
earning per share......................$ 0.77 $ (0.15) $ (0.20)
========== ========== ==========
NINE MONTHS ENDED SEPTEMBER 30, 2004
-----------------------------------------------------------------------
CHANGE FROM DECREASE CHANGE FROM INCREASE CHANGE FROM INCREASE
OF 100 BASIS POINTS OF 100 BASIS POINTS OF 200 BASIS POINTS
--------------------- --------------------- -----------------------
DOLLAR PERCENT DOLLAR PERCENT DOLLAR PERCENT
---------- --------- ---------- --------- ---------- -----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Effect on earnings:
Increase (decrease) in pre-tax
net income before
impact of derivative settlements.......$ 65,878 41.0 % $(32,411) (20.01)% $ (59,626) (37.1)%
Impact of derivative settlements.......... (29,306) (18.2) 29,306 18.2 58,613 36.4
---------- --------- ---------- --------- ---------- ----------
Increase (decrease) in net income
before taxes...........................$ 36,572 22.8 % $ (3,105) (1.9)% $ (1,013) (0.7) %
========== ========= ========== ========= ========== ==========
Increase (decrease)in basic and diluted
earning per share......................$ 0.42 $ (0.04) $ (0.01)
========== ========== ==========
NINE MONTHS ENDED SEPTEMBER 30, 2003
-----------------------------------------------------------------------
CHANGE FROM DECREASE CHANGE FROM INCREASE CHANGE FROM INCREASE
OF 100 BASIS POINTS OF 100 BASIS POINTS OF 200 BASIS POINTS
--------------------- --------------------- -----------------------
DOLLAR PERCENT DOLLAR PERCENT DOLLAR PERCENT
---------- --------- ---------- --------- ---------- -----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Effect on earnings:
Increase (decrease) in pre-tax
net income before
impact of derivative settlements.......$ 27,650 92.3 % $(23,369) (78.0)% $ (38,604) (128.9)%
Impact of derivative settlements.......... (11,700) (39.1) 9,375 31.3 20,625 68.9
---------- --------- ---------- --------- ---------- ----------
Increase (decrease) in net income
before taxes............................$ 15,950 53.2 % $(13,994) (43.7)% $ (17,979) (60.0) %
========== ========= ========== ========= ========== ==========
Increase (decrease) in basic and diluted
earning per share......................$ 0.23 $ 0.20 $ (0.26)
========== ========== ==========
34
The following tables set forth the Company's variable-rate assets and
liabilities categorized by the reset date of the underlying index. Fixed-rate
assets and liabilities are categorized based on their maturity dates. An
interest rate gap is the difference between volumes of assets and volumes of
liabilities maturing or repricing during specific future time intervals. The
following gap analysis reflects the Company's interest rate-sensitive positions
and is not necessarily reflective of the positions that existed throughout the
period:
AS OF SEPTEMBER 30, 2004
-------------------------------------------------------------------------------
INTEREST RATE SENSITIVITY PERIOD
------------------------------------------------------------------------------
3 MONTHS 3 MONTHS 6 MONTHS 1 TO 2 2 TO 5 OVER
OR LESS TO 6 MONTHS TO 1 YEAR YEARS YEARS 5 YEARS
----------- -------------- ---------- ----------- ---------- ----------
(DOLLARS IN THOUSANDS)
Interest-sensitive assets:
Student loans..................$ 12,793,704 $ -- $ -- $ -- $ -- $ --
Cash and investments........... 933,271 -- -- -- -- --
------------ ------------ ---------- ----------- ---------- ----------
Total interest-sensitive
assets..................... 13,726,975 -- -- -- -- --
------------ ------------ ---------- ----------- ---------- ----------
Interest-sensitive liabilities:
Short-term borrowings........... 12,737,332 -- -- -- -- --
Long-term notes................. 56,135 51,783 100,102 116,389 253,973 210,629
------------ ------------ ---------- ----------- ---------- ----------
Total interest-sensitive
liabilities................. 12,793,467 51,783 100,102 116,389 253,973 210,629
------------ ------------ ---------- ----------- ---------- ----------
Period gap.......................... 933,508 (51,783) (100,102) (116,389) (253,973) (210,629)
Cumulative gap...................... 933,508 881,725 781,623 665,234 411,261 200,632
Ratio of interest-sensitive
assets to interest-sensitive
liabilities..................... 107.3 % -- % -- % -- % -- % -- %
============ ============ ========== =========== ========== ==========
Ratio of cumulative gap to
total interest-sensitive assets. 6.8 % 6.4 % 5.7 % 4.8 % 3.0 % 1.5 %
============ ============ ========== =========== ========== ==========
AS OF DECEMBER 31, 2003
-------------------------------------------------------------------------------
INTEREST RATE SENSITIVITY PERIOD
------------------------------------------------------------------------------
3 MONTHS 3 MONTHS 6 MONTHS 1 TO 2 2 TO 5 OVER
OR LESS TO 6 MONTHS TO 1 YEAR YEARS YEARS 5 YEARS
----------- -------------- ---------- ----------- ---------- ----------
(DOLLARS IN THOUSANDS)
Interest-sensitive assets:
Student loans...................$ 10,455,442 $ - $ - $ - $ - $ -
Cash and investments............ 1,155,215 - - - - -
------------ ----------- ---------- ----------- ---------- ----------
Total interest-sensitive
assets...................... 11,610,657 - - - - -
------------ ----------- ---------- ----------- ---------- ----------
Interest-sensitive liabilities:
Short-term borrowings........... 10,438,764 - - - - -
Long-term notes................. 61,237 54,355 108,167 206,484 311,588 185,863
------------ ----------- ---------- ----------- ---------- ----------
Total interest-sensitive
liabilities................. 10,500,001 54,355 108,167 206,484 311,588 185,863
------------ ----------- ---------- ----------- ---------- ----------
Period gap.......................... 1,110,656 (54,355) (108,167) (206,484) (311,588) (185,863)
Cumulative gap...................... 1,110,656 1,056,301 948,134 741,650 430,062 244,199
Ratio of interest-sensitive
assets to interest-sensitive
liabilities..................... 110.6 % - % - % - % - % - %
============ =========== ========== =========== ========== ==========
Ratio of cumulative gap to
total interst-sensitive assets.. 9.6 % 9.1 % 8.2 % 6.4 % 3.7 % 2.1 %
============ =========== ========== =========== ========== ==========
35
CRITICAL ACCOUNTING POLICIES
This Management's Discussion and Analysis of Financial Condition and Results
of Operations discusses the unaudited consolidated financial statements, which
have been prepared in accordance with U.S. generally accepted accounting
principles, or GAAP. The preparation of these financial statements requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the reported amounts of income and expenses during
the reporting periods. The Company bases its estimates and judgments on
historical experience and on various other factors that the Company believes are
reasonable under the circumstances. Actual results may differ from these
estimates under varying assumptions or conditions. Note 3 of the consolidated
financial statements included in the Company's Annual Report on Form 10-K for
the year ended December 31, 2003 includes a summary of the significant
accounting policies and methods used in the preparation of the consolidated
financial statements.
On an on-going basis, management evaluates its estimates and judgments,
particularly as they relate to accounting policies that management believes are
most "critical" -- that is, they are most important to the portrayal of the
Company's financial condition and results of operations and they require
management's most difficult, subjective or complex judgments, often as a result
of the need to make estimates about the effect of matters that are inherently
uncertain. These accounting policies include securitization accounting and
determining the level of the allowance for loan losses.
SECURITIZATION ACCOUNTING
The Company uses the issuance of asset-backed securities, commonly called
securitization transactions, as a key component of its financing strategy. In
conjunction with these transactions, the Company transfers student loans to
trusts, which issue bonds backed by the student loans. The Company's
securitization transactions do not qualify for sale treatment under SFAS No.
140, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENTS OF LIABILITIES-A REPLACEMENT OF SFAS NO. 125, as the trusts
continue to be under the Company's effective control and as such the Company
does not record or recognize gain on sale in conjunction with the transaction,
but rather treat the transfers as secured borrowings. All of the financial
activities and related assets and liabilities, including debt, of the trusts are
reflected and consolidated in the Company's financial statements. Servicing,
administrative support services, and other intercompany activities have been
eliminated in accordance with GAAP.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses represents management's estimate of probable
losses on student loans. This evaluation process is subject to numerous
estimates and judgments. In making such estimates and judgments, management
considers such things as the value and character of loans outstanding, past loan
loss experience, and general economic conditions. The Company evaluates the
adequacy of the allowance for loan losses on its federally insured loan
portfolio separately from its non-federally insured loan portfolio. Historical
delinquencies and credit loss experience are also considered when reviewing the
current aging of the portfolios, together with analyses that reflect current
trends and conditions.
The allowance for the federally insured loan portfolio is based on periodic
evaluations of the Company's loan portfolios considering past experience, trends
in student loan claims rejected for payment by guarantors, changes to federal
student loan programs, current economic conditions, and other relevant factors.
The federal government guarantees 98 percent of principal and interest of
federally insured student loans, which limits the Company's loss exposure to two
percent of the outstanding balance of the Company's federally insured portfolio.
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company receives 100 percent reimbursement on all eligible FFEL Program
default claims submitted for reimbursement during the 12-month period following
the effective date of its designation. The Company is not subject to the two
percent risk sharing loss for eligible claims submitted during this 12-month
period. Only FFEL Program loans that are serviced by the Company, as well as
loans owned by the Company and serviced by other service providers designated as
Exceptional Performers by the Department, are subject to the 100 percent
reimbursement. At September 30, 2004, service providers designated as an
Exceptional Performer serviced approximately 91 percent of the Company's
federally insured loans. Of this 91 percent, third parties service approximately
one percent. With an additional third-party service provider receiving the
Exceptional Performance designation in October 2004, more than 98 percent of the
Company's federally insured loans will be serviced by providers who have
received such designation. The Company is entitled to receive this benefit as
long as it and/or its other service providers continue to meet the required
servicing standards published by the Department. Compliance with such standards
is assessed on a quarterly basis.
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company charges off the loan when the
collection of principal and interest is 120 days past due.
36
The allowance for federally insured and non-federally insured loans is
maintained at a level management believes is adequate to provide for estimated
probable credit losses inherent in the loan portfolio. This evaluation is
inherently subjective because it requires estimates that may be susceptible to
significant changes.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Included within Item 2, "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
ITEM 4. CONTROLS AND PROCEDURES
Under supervision and with the participation of certain members of the
Company's management, including the co-chief executive officers and the chief
financial officer, the Company completed an evaluation of the effectiveness of
the design and operation of its disclosure controls and procedures (as defined
in Rules 13a-15(e) and 15d-15(e) to the Securities Exchange Act of 1934, as
amended (the "Exchange Act"). Based on this evaluation, the Company's co-chief
executive officers and chief financial officer believe that the disclosure
controls and procedures were effective as of the end of the period covered by
this Quarterly Report on Form 10-Q with respect to timely communication to them
and other members of management responsible for preparing periodic reports and
material information required to be disclosed in this Quarterly Report on Form
10-Q as it relates to the Company and its consolidated subsidiaries.
There was no change in the Company's internal control over financial
reporting during the Company's last fiscal quarter that has materially affected,
or is reasonably likely to materially affect, the Company's internal control
over financial reporting.
The effectiveness of the Company's or any system of disclosure controls and
procedures is subject to certain limitations, including the exercise of judgment
in designing, implementing, and evaluating the controls and procedures, the
assumptions used in identifying the likelihood of future events, and the
inability to eliminate misconduct completely. As a result, there can be no
assurance that the Company's disclosure controls and procedures will prevent all
errors or fraud or ensure that all material information will be made known to
appropriate management in a timely fashion. By their nature, the Company's or
any system of disclosure controls and procedures can provide only reasonable
assurance regarding management's control objectives.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to various claims, lawsuits, and proceedings that
arise in the normal course of business. These matters principally consist of
claims by borrowers disputing the manner in which their loans have been
processed. On the basis of present information, anticipated insurance coverage,
and advice received from counsel, it is the opinion of the Company's management
that the disposition or ultimate determination of these claims, lawsuits, and
proceedings will not have a material adverse effect on the Company's business,
financial position, or results of operations.
In addition to such legal proceedings that arise in the ordinary course of
business, the Company is furnishing to the SEC Staff information it has
requested pursuant to an informal investigation and the Company is fully
cooperating with the SEC on such informal investigation. See "Recent
Developments."
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Nothing to report.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Nothing to report.
37
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Nothing to report.
ITEM 5. OTHER INFORMATION
Nothing to report.
ITEM 6. EXHIBITS
4.16* Indenture of Trust dated as of September 1, 2004, between
Nelnet Student Loan Trust 2004-4 and Zions First National
Bank, as eligible lender trustee and as indenture trustee.
21.1* Subsidiaries of Nelnet, Inc.
31.1* Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 of Co-Chief Executive Officer Michael S. Dunlap.
31.2* Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 of Co-Chief Executive Officer Stephen F. Butterfield.
31.3* Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002 of Chief Financial Officer Terry J. Heimes.
32.** Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- ----------
* Filed herewith
** Furnished herewith
38
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NELNET, INC.
Date: November 15, 2004 By: /s/ Michael S. Dunlap
---------------------------------------
Name: Michael S. Dunlap
Title: Chairman and Co-Chief
Executive Officer
By: /s/ Stephen F. Butterfield
---------------------------------------
Name: Stephen F. Butterfield
Title: Vice-Chairman and Co-Chief
Executive Officer
By: /s/ Terry J. Heimes
---------------------------------------
Name: Terry J. Heimes
Title: Chief Financial Officer
39