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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 June 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 (I.R.S. Employer
of incorporation 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 July 31, 2004, there were 39,624,243 and 14,023,454 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
June 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 12
Item 3. Quantitative and Qualitative Disclosures about Market Risk........................... 34
Item 4. Controls and Procedures ............................................................. 34
Part II. OTHER INFORMATION
Item 1. Legal Proceedings ................................................................... 34
Item 2. Changes in Securities and Use of Proceeds ........................................... 35
Item 3. Defaults Upon Senior Securities ..................................................... 35
Item 4. Submission of Matters to a Vote of Security Holders ................................. 35
Item 5. Other Information ................................................................... 35
Item 6. Exhibits and Reports on Form 8-K .................................................... 36
Signatures ............................................................................................ 37
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30, 2004 December 31, 2003
------------- -----------------
(unaudited)
(dollars in thousands, except share data)
Assets:
Student loans receivable (net of allowance for loan losses of
$8,122 and $16,026, respectively).......................................... $12,194,097 10,455,442
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party.................... 24,617 188,272
Cash and cash equivalents - held at a related party........................ 36,816 10,151
----------- -----------
Total cash and cash equivalents................................................... 61,433 198,423
Restricted cash - held by trustee................................................. 528,446 634,263
Restricted investments - held by trustee.......................................... 294,579 180,688
Restricted cash - due to loan program customers................................... 15,529 141,841
Accrued interest receivable....................................................... 232,173 196,633
Accounts receivable, net.......................................................... 13,517 17,289
Goodwill.......................................................................... 16,533 2,551
Intangible assets, net............................................................ 12,821 9,079
Furniture, equipment, and leasehold improvements, net............................. 22,652 19,138
Other assets...................................................................... 67,799 76,162
----------- -----------
Total assets............................................................... $13,459,579 11,931,509
=========== ===========
Liabilities:
Bonds and notes payable........................................................... $12,844,539 11,366,458
Accrued interest payable.......................................................... 24,599 17,179
Other liabilities................................................................. 173,930 100,542
Due to loan program customers..................................................... 15,529 141,841
----------- -----------
Total liabilities.......................................................... 13,058,597 11,626,020
----------- -----------
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 39,624,243 shares at June 30, 2004
and 39,601,834 shares at December 31, 2003............................. 396 396
Class B, $0.01 par value. Authorized 15,000,000 shares;
issued and outstanding 14,023,454 shares............................... 140 140
Additional paid-in capital........................................................ 207,359 206,831
Retained earnings................................................................. 192,259 97,885
Accumulated other comprehensive income............................................ 828 237
----------- -----------
Total shareholders' equity................................................. 400,982 305,489
----------- -----------
Total liabilities and shareholders' equity................................. $13,459,579 11,931,509
=========== ===========
See accompanying notes to consolidated financial statements.
2
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three months ended Six months ended
June 30, June 30,
-------------------------- -------------------------
2004 2003 2004 2003
------------ ---------- ----------- ----------
(dollars in thousands, except share data)
Interest income:
Loan interest ..................................................... $ 224,399 92,673 313,126 182,355
Investment interest ............................................... 3,181 5,343 6,832 9,268
------------ ---------- ----------- ----------
Total interest income .......................................... 227,580 98,016 319,958 191,623
Interest expense:
Interest on bonds and notes payable ............................... 52,352 52,826 101,395 104,175
------------ ---------- ----------- ----------
Net interest income ............................................ 175,228 45,190 218,563 87,448
Less provision (recovery) for loan losses .............................. (6,421) 2,450 (3,306) 4,860
------------ ---------- ----------- ----------
Net interest income after provision (recovery) for loan losses . 181,649 42,740 221,869 82,588
------------ ---------- ----------- ----------
Other income:
Loan servicing and other fee income ............................... 22,512 24,400 48,221 50,237
Software services and other income ................................ 5,029 4,471 10,607 9,111
Derivative market value adjustment and net settlements ............ 1,357 -- (2,384) --
------------ ---------- ----------- ----------
Total other income ............................................. 28,898 28,871 56,444 59,348
------------ ---------- ----------- ----------
Operating expenses:
Salaries and benefits ............................................. 49,036 30,343 76,805 56,848
Other operating expenses:
Depreciation and amortization .................................. 4,677 6,031 9,085 11,867
Trustee and other debt related fees ............................ 2,851 3,787 5,465 7,459
Occupancy and communications ................................... 3,135 2,925 6,217 6,192
Advertising and marketing ...................................... 2,961 2,728 5,284 4,314
Professional services .......................................... 2,894 2,442 7,354 4,627
Consulting fees and support services to related parties ........ -- 450 -- 2,685
Postage and distribution ....................................... 3,220 3,035 7,068 6,788
Other .......................................................... 7,422 5,704 12,130 11,899
------------ ---------- ----------- ----------
Total other operating expenses .............................. 27,160 27,102 52,603 55,831
------------ ---------- ----------- ----------
Total operating expenses .................................... 76,196 57,445 129,408 112,679
------------ ---------- ----------- ----------
Income before income taxes and minority interest ............ 134,351 14,166 148,905 29,257
Income tax expense ..................................................... 49,098 5,840 54,531 11,462
------------ ---------- ----------- ----------
Income before minority interest ............................. 85,253 8,326 94,374 17,795
Minority interest in subsidiary loss ................................... -- -- -- 109
------------ ---------- ----------- ----------
Net income .................................................. $ 85,253 8,326 94,374 17,904
============ ========== =========== ==========
Earnings per share, basic and diluted ....................... $ 1.59 0.19 1.76 0.40
============ ========== =========== ==========
Weighted average shares outstanding, basic and diluted ...... 53,647,697 45,038,488 53,641,664 45,011,757
============ ========== =========== ==========
See accompanying notes to consolidated financial statements.
3
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(unaudited)
Preferred Common stock shares Class A Class B
stock ------------------------ Preferred common common
shares Class A Class B stock stock stock
----------- ----------- ---------- ------------ ---------- -----------
(dollars in thousands, except share data)
Balance at March 31, 2003 .................. -- 31,015,034 14,023,454 $ -- 310 140
Comprehensive income:
Net income ............................ -- -- -- -- -- --
Total comprehensive income .........
----------- ----------- ---------- ------------ ---------- -----------
Balance at June 30, 2003 ................... -- 31,015,034 14,023,454 $ -- 310 140
=========== =========== ========== ============ ========== ===========
Balance at March 31, 2004 .................. -- 39,624,243 14,023,454 $ -- 396 140
Comprehensive income:
Net income ............................ -- -- -- -- -- --
Other comprehensive income, net of tax,
related to cash flow hedge ......... -- -- -- -- -- --
Total comprehensive income .........
----------- ----------- ---------- ------------ ---------- -----------
Balance at June 30, 2004 ................... -- 39,624,243 14,023,454 $ -- 396 140
=========== =========== ========== ============ ========== ===========
Balance at December 31, 2002 ............... -- 30,947,834 14,023,454 $ -- 309 140
Comprehensive income:
Net income ............................ -- -- -- -- -- --
Total comprehensive income .........
Issuance of common stock ................... -- 331,800 -- -- 3 --
Redemption of common stock ................. -- (264,600) -- -- (2) --
----------- ----------- ---------- ------------ ---------- -----------
Balance at June 30, 2003 ................... -- 31,015,034 14,023,454 $ -- 310 140
=========== =========== ========== ============ ========== ===========
Balance at December 31, 2003 ............... -- 39,601,834 14,023,454 $ -- 396 140
Comprehensive income:
Net income ............................ -- -- -- -- -- --
Other comprehensive income, net of tax,
related to cash flow hedge ......... -- -- -- -- -- --
Total comprehensive income .........
Issuance of common stock ................... -- 22,409 -- -- -- --
----------- ----------- ---------- ------------ ---------- -----------
Balance at June 30, 2004 ................... -- 39,624,243 14,023,454 $ -- 396 140
=========== =========== ========== ============ ========== ===========
Accumulated
Additional other Total
paid-in Retained comprehensive shareholders'
capital earnings income (loss) equity
----------- ----------- ----------- -----------
Balance at March 31, 2003 .................. 38,053 80,360 -- 118,863
Comprehensive income:
Net income ............................ -- 8,326 -- 8,326
-----------
Total comprehensive income ......... 8,326
----------- ----------- ----------- -----------
Balance at June 30, 2003 ................... 38,053 88,686 -- 127,189
=========== =========== =========== ===========
Balance at March 31, 2004 .................. 207,359 107,006 (264) 314,637
Comprehensive income:
Net income ............................ -- 85,253 -- 85,253
Other comprehensive income, net of tax,
related to cash flow hedge ......... -- -- 1,092 1,092
-----------
Total comprehensive income ......... 86,345
----------- ----------- ----------- -----------
Balance at June 30, 2004 ................... 207,359 192,259 828 400,982
=========== =========== =========== ===========
Balance at December 31, 2002 ............... 37,891 70,782 -- 109,122
Comprehensive income:
Net income ............................ -- 17,904 -- 17,904
-----------
Total comprehensive income ......... 17,904
Issuance of common stock ................... 803 -- -- 806
Redemption of common stock ................. (641) -- -- (643)
----------- ----------- ----------- -----------
Balance at June 30, 2003 ................... 38,053 88,686 -- 127,189
=========== =========== =========== ===========
Balance at December 31, 2003 ............... 206,831 97,885 237 305,489
Comprehensive income:
Net income ............................ -- 94,374 -- 94,374
Other comprehensive income, net of tax,
related to cash flow hedge ......... -- -- 591 591
-----------
Total comprehensive income ......... 94,965
Issuance of common stock ................... 528 -- -- 528
----------- ----------- ----------- -----------
Balance at June 30, 2004 ................... 207,359 192,259 828 400,982
=========== =========== =========== ===========
See accompanying notes to consolidated financial statements.
4
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Six months ended
June 30,
--------------------------
2004 2003
----------- -----------
(dollars in thousands)
Net income .................................................................................. $ 94,374 17,904
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 ...... 47,033 47,871
Derivative market value adjustment ................................................... (548) --
Ineffectiveness of cash flow hedge ................................................... 30 --
Issuance of common stock to non-employee board members ............................... 528 --
Deferred income tax expense (benefit) ................................................ 7,441 (5,808)
Minority interest in subsidiary loss ................................................. -- (109)
Provision (recovery) for loan losses ................................................. (3,306) 4,860
Increase in accrued interest receivable .............................................. (31,461) (14,466)
Decrease in accounts receivable ...................................................... 3,796 73
Decrease in other assets ............................................................. 15,217 12,841
Increase in accrued interest payable ................................................. 4,509 676
Increase in other liabilities ........................................................ 72,721 393
----------- -----------
Net cash provided by operating activities ...................................... 210,334 64,235
----------- -----------
Cash flows from investing activities, net of business acquisition:
Originations, purchases, and consolidations of student loans, including premiums
and deferred origination costs ..................................................... (2,405,463) (1,382,536)
Purchases of student loans, including premiums, from a related party .................. (360,633) (379,825)
Net proceeds from student loan principal payments and loan consolidations ............. 1,137,987 820,096
Net purchases of furniture, equipment, and leasehold improvements ..................... (8,421) (6,245)
Purchases of investments .............................................................. (8,100) --
Decrease in restricted cash - held by trustee ......................................... 203,681 122,317
Purchases of restricted investments - held by trustee ................................. (415,380) (165,723)
Proceeds from maturities of restricted invesments - held by trustee ................... 301,489 207,903
Purchase of origination rights ........................................................ (7,898) --
Business acquisition, net of cash acquired ............................................ (10,829) --
Purchase of equity method investments ................................................. (10,110) --
----------- -----------
Net cash used in investing activities ........................................... (1,583,677) (784,013)
----------- -----------
Cash flows from financing activities:
Payments on bonds and notes payable ................................................... (953,134) (1,488,914)
Proceeds from issuance of bonds and notes payable ..................................... 2,195,562 2,221,077
Payments for debt issuance costs ...................................................... (6,075) (4,927)
Payments for redemption of common stock ............................................... -- (643)
Proceeds from issuance of common stock ................................................ -- 806
----------- -----------
Net cash provided by financing activities ....................................... 1,236,353 727,399
----------- -----------
Net (decrease) increase in cash and cash equivalents ............................ (136,990) 7,621
Cash and cash equivalents, beginning of period .............................................. 198,423 40,155
----------- -----------
Cash and cash equivalents, end of period .................................................... $ 61,433 47,776
=========== ===========
Supplemental disclosures of cash flow information:
Interest paid ......................................................................... $ 90,800 103,499
=========== ===========
Income taxes paid ..................................................................... $ 1,506 8,234
=========== ===========
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information at June 30, 2004 and for the three and six months ended
June 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 June 30, 2004 and for the three and
six months ended June 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 six
months ended June 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. Deferred Income
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 and March 31, 2004, the amount of deferred excess interest
income on these loans was $42.9 million and $78.8 million, respectively, and was
included in other liabilities on the Company's consolidated balance sheet. In
future periods, the Company will recognize the income from the special allowance
payments on these loans as it is earned.
3. Student Loans Receivable and Allowance for Loan Losses
Student loans receivable at June 30, 2004 and December 31, 2003 consisted
of the following:
As of As of
June 30, December 31,
2004 2003
------------ ------------
(dollars in thousands)
Federally insured loans ........................................................................ $ 11,938,890 10,222,547
Non-federally insured loans .................................................................... 94,439 92,327
------------ ------------
12,033,329 10,314,874
Unamortized premiums and deferred origination costs ............................................ 168,890 156,594
Less allowance for loan losses - Federally insured loans ....................................... (735) (9,755)
Less allowance for loan losses - Non-federally insured loans ................................... (7,387) (6,271)
------------ ------------
$ 12,194,097 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 7.82% 6.79%
Total allowance as a percentage of ending balance of total loans ............................... 0.07% 0.16%
6
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 beginning June 1, 2004, and the
Company is not subject to the two percent risk sharing loss for eligible claims
submitted after that date. 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 June 30, 2004, service providers designated as
an Exceptional Performer serviced approximately 90 percent of the Company's
federally insured loans. Of this 90 percent, less than one percent is serviced
by a third party. 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 June 2004, the Company's allowance for loan loss 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 Performer designation.
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 places a non-federally insured
loan on nonaccrual status and charges off the loan when the collection of
principal and interest is 120 days past due.
4. Acquisitions
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 6
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 5 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. At June 30, 2004, the investment in Premiere and
excess purchase price is included in other assets and intangible assets,
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. At June 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 million. The Company further agreed to
provide administrative services in connection with certain of the indentures
governing debt securities of RISLA for a ten-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. At June 30, 2004, this
goodwill is included in intangible assets on the consolidated balance sheet.
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.
7
The allocation of the purchase price for SLAAA is shown below (dollars in
thousands):
Cash and cash equivalents ........ $ 277
Restricted cash - held by trustee 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. At June 30, 2004, the investment in infiNET and excess purchase
price is included in other assets and intangible assets, respectively, on the
consolidated balance sheet.
Intangible assets at June 30, 2004 and December 31, 2003 consist of the
following:
As of As of
Useful June 30, December 31,
life 2004 2003
------------- ------- -------
(dollars in thousands)
Lender relationship and loan origination rights (net of accumulated
amortization of $10,259 and $9,613, respectively) .............. 36-120 months $ 8,544 1,292
Servicing system software and other intellectual property (net of
accumulated amortization of $16,784 and $13,273, respectively) . 36 months 4,277 7,787
------- -------
$12,821 9,079
======= =======
The Company recorded amortization expense on its intangible assets of $2.1
million and $3.5 million for the three months ended June 30, 2004 and 2003,
respectively, and $4.2 million and $7.2 million for the six months ended June
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 $5.7 million during the 12 months ending June 30, 2005 and $0.8
million for each of the 12 months ending June 30, 2006, 2007, 2008, and 2009,
respectively.
The change in the carrying amount of goodwill for the six months ended June
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 June 30, 2004 .......... $16,533
=======
5. Bonds and Notes Payable
On January 15, 2004, April 29, 2004, and July 20, 2004, the Company
consummated debt offerings of student loan asset-backed notes of $1.0 billion,
$1.0 billion, and $1.4 billion, respectively, with final maturity dates ranging
from 2009 through 2040. 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 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 6).
8
In July 2004, the Company redeemed a portion of its student loan interest
margin notes for $47.4 million, which includes a call-premium of $1.9 million.
The call-premium and write-off of the unamortized debt issue costs of $0.7
million will be expensed in the third quarter 2004.
6. 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 in 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 million that effectively converted debt with a
fixed rate to a variable rate (see note 5). These interest rate swaps do not
qualify for hedge accounting under SFAS No. 133.
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of June 30, 2004. The net fair
value of derivatives is included in other assets on the consolidated balance
sheet.
Notional amounts by product type
---------------------------------------
Fixed/ Floating/
floating Basis fixed
Maturity swaps swaps swaps Total
----------------------- ------- ------ ------ ------
(dollars in millions)
2004 .................. $ 7,000(a) -- -- 7,000
2005 .................. 400 1,000 210 1,610
2006 .................. -- 500 -- 500
------ ------ ------ ------
Total ............... $7,400 1,500 210 9,110
====== ====== ====== ======
Fair value (in thousands) $7,640 (4,967) (1,471) 1,202
====== ====== ====== ======
- ----------
(a) In July 2004, $4.0 billion of these interest rate swaps expired.
In July 2004, the Company 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 2.185% to 4.252% and the
weighted average is 3.512%. These interest rate swaps do not qualify for hedge
accounting under SFAS No. 133.
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 Six months ended
June 30, June 30,
-------------------- -------------------
2004 2003 2004 2003
------- ------ ------ ------
(dollars in thousands)
Change in fair value of derivative instruments ....... $ 3,075 -- 548 --
Settlements, net ..................................... (1,718) -- (2,932) --
------- ------ ------ ------
Derivative market value adjustment and net settlements $ 1,357 -- (2,384) --
======= ====== ====== ======
9
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 million accounted for as a cash flow hedge:
Three months ended Six months ended
June 30, June 30,
----------------------- ------------------
2004 2003 2004 2003
------- ------- ------- -------
(dollars in thousands)
Accumulated other comprehensive income (loss), net:
Balance at beginning of period ............................................ $ (264) -- 237 --
Change in fair value of cash flow hedge ................................ 1,088 -- 572 --
Hedge ineffectiveness reclassified to earnings ......................... 4 -- 19 --
------- ------- ------- -------
Total change in unrealized gain on derivative ............... 1,092 -- 591 --
------- ------- ------- -------
Balance at end of period .................................................. $ 828 -- 828 --
======= ======= ======= =======
7. Stock Plans
On February 19, 2004, the Company issued 22,409 shares of its Class A
common stock under the Nelnet, Inc. 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 via
payroll deductions at a 15 percent discount from fair market value. The Company
will recognize compensation expense equal to the intrinsic value on the date
stock is issued to the employee.
8. 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.
10
Segment data is as follows:
Three months ended June 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 ................ $ 176,797 68 1 176,866 45,634 156 2 45,792
Other income (expense) ............. (536) 20,017 7,502 26,983 716 19,418 7,665 27,799
Intersegment revenues .............. -- 19,659 824 20,483 -- 15,369 461 15,830
--------- --------- --------- --------- --------- --------- --------- ---------
Total revenue .................. 176,261 39,744 8,327 224,332 46,350 34,943 8,128 89,421
Provision (recovery) for loan losses (6,421) -- -- (6,421) 2,450 -- -- 2,450
Depreciation and amortization ...... -- -- 1,769 1,769 537 322 1,784 2,643
Income tax expense (benefit) ....... 53,418 5,043 (36) 58,425 2,944 2,798 271 6,013
Net income (loss) .................. $ 100,916 8,308 271 109,495 12,795 3,594 (214) 16,175
========= ========= ========= ========= ========= ========= ========= =========
Six months ended June 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 ................ $ 221,348 346 4 221,698 89,019 500 5 89,524
Other income (expense) ............. (319) 37,443 15,214 52,338 1,587 40,345 15,711 57,643
Intersegment revenues .............. -- 38,622 1,803 40,425 -- 30,228 839 31,067
--------- --------- --------- --------- --------- --------- --------- ---------
Total revenue .................. 221,029 76,411 17,021 314,461 90,606 71,073 16,555 178,234
Provision (recovery) for loan losses (3,306) -- -- (3,306) 4,860 -- -- 4,860
Depreciation and amortization ...... -- -- 3,532 3,532 1,073 806 3,567 5,446
Income tax expense (benefit) ....... 56,527 8,865 (567) 64,825 4,960 5,973 728 11,661
Net income ......................... $ 110,602 12,744 2,662 126,008 23,990 9,252 24 33,266
========= ========= ========= ========= ========= ========= ========= =========
Segment - Total Assets
------------------------------
As of As of
June 30, December 31,
2004 2003
----------- -----------
(dollars in thousands)
Asset management ..... $13,214,177 11,497,693
Student loan servicing 202,641 339,286
Other ................ 26,514 23,918
----------- -----------
Total segments .. $13,443,332 11,860,897
=========== ===========
11
Reconciliation of segment data to the consolidated financial statements is
as follows:
Three months ended Six months ended
June 30, June 30,
------------------------ ------------------------
2004 2003 2004 2003
--------- --------- --------- ---------
(dollars in thousands)
Total segment revenues ............. $ 224,332 89,421 314,461 178,234
Elimination of intersegment revenues (20,483) (15,830) (40,425) (31,067)
Corporate revenues (expenses), net . 277 470 971 (371)
--------- --------- --------- ---------
Total consolidated revenues ... $ 204,126 74,061 275,007 146,796
========= ========= ========= =========
Total net income of segments ....... $ 109,495 16,175 126,008 33,266
Corporate expenses, net ............ (24,242) (7,849) (31,634) (15,362)
--------- --------- --------- ---------
Total consolidated net income . $ 85,253 8,326 94,374 17,904
========= ========= ========= =========
As of As of
June 30, December 31,
2004 2003
------------ ------------
(dollars in thousands)
Total segment assets ............... $ 13,443,332 11,860,897
Elimination of intercompany assets . (13,998) (30,140)
Assets of other operating activities 30,245 100,752
------------ ------------
Total consolidated assets ..... $ 13,459,579 11,931,509
============ ============
Net corporate revenues included in the above table relate to activities
that are not related to the four identified operating segments, such as
investment earnings and nonrecurring revenue for marketing services. The net
corporate expenses include expenses for marketing, capital markets, and other
unallocated support services, including income taxes. 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 deferred
assets.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis provides 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 for the year ended December 31, 2003 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.
12
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 $13.5
billion in total assets as of June 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.
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. The servicing activities provided
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.
In accordance with U.S. generally accepted accounting principles, 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 intersegment
revenue) and net income of each of the Company's reportable segments for the
three and six months ended June 30, 2004 and 2003:
Three months ended June 30,
--------------------------------------------------------------------------
2004 2003
-------------------------------- ------------------------------------
Student Student
Asset Loan Other Asset Loan Other
Management Servicing Segments Management Servicing Segments
---------- --------- -------- ---------- --------- --------
Segment revenue 86.5% 9.9% 3.6% 63.0% 26.6% 10.4%
Segment net income 92.2% 7.6% 0.2% 79.1% 22.2% (1.3%)
Six months ended June 30,
--------------------------------------------------------------------------
2004 2003
-------------------------------- ------------------------------------
Student Student
Asset Loan Other Asset Loan Other
Management Servicing Segments Management Servicing Segments
---------- --------- -------- ---------- --------- --------
Segment revenue 80.7% 13.8% 5.5% 61.6% 27.8% 10.6%
Segment net income 87.8% 10.1% 2.1% 72.1% 27.8% 0.1%
13
The Company's student loan portfolio has grown significantly through
originations and acquisitions. The Company originated or acquired $1.2 billion
and $2.2 billion of student loans during the three and six months ended June 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 28.4% and 41.3% of the student loans originated or
acquired during the three and six months ended June 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 31.0% and 32.5% of the student loans
originated or acquired during the three and six months ended June 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 31.2% and 20.3% of
the student loans originated or acquired during the three and six months
ended June 30, 2004, respectively.
In addition, the Company also acquires student loans through spot purchases,
which accounted for 9.4% and 5.9% of student loans originated or acquired during
the three and six months ended June 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 and March 31, 2004, the amount
of deferred excess interest income on these loans was $42.9 million and $78.8
million, respectively. In future periods, the Company will recognize 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.
14
Net interest income increased by $130.0 million and $131.1 million, or
287.8% and 149.9%, respectively, during the three and six months ended June 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 of $124.3 million in 2004, increased approximately $12.6
million and $19.2 million, or 33.0% and 25.7%, respectively, during the three
and six months ended June 30, 2004 as compared to the comparable periods in 2003
due to portfolio growth. Net student loans receivable increased by $2.7 billion,
or 28.4%, to $12.2 billion at June 30, 2004 as compared to $9.5 billion at June
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 Statement of Financial Accounting
Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging
Activities ("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 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
2.185% to 4.252% and the weighted average is 3.512%. Since these swaps were not
in place during the second quarter of 2004, the net settlements and any mark to
market adjustment will impact future periods accordingly and could have a
negative impact if rates were to remain at the current historic 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 amortization costs and consolidation rebate fees 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 consolidations of the
Company's own loans or of the loans of third parties could positively impact the
effect of amortization on the Company's student loan yield from period to
period.
Net interest income includes $15.0 million and $34.9 million, or 53 basis
points and 64 basis points, respectively, in yield reduction due to the
amortization of premiums and deferred origination costs during the three and six
months ended June 30, 2004, as compared to $14.2 million and $30.3 million, or
64 basis points and 70 basis points, respectively, during the comparable periods
in 2003. As a result, the Company's unamortized premiums and deferred
origination costs, as a percent of student loans, decreased from 1.7% at June
30, 2003 to 1.4% at June 30, 2004. Net interest income also includes $16.0
million and $30.5 million, or 57 basis points and 56 basis points, respectively,
in yield reduction due to consolidation rebate fees during the three and six
months ended June 30, 2004, as compared to $9.3 million and $17.8 million, or 42
basis points and 41 basis points, respectively, during the comparable periods in
2003. This, combined with the lower borrower rates associated with the
consolidation loans the Company is originating, has resulted in student loan
interest spread compression, excluding the effects of the recognition of special
allowance yield adjustment and variable-rate floor income, from 1.83% during the
six months ended June 30, 2003 to 1.77% during the six months ended June 30,
2004. Consolidation activity slowed in the second 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. As a result,
excluding the effects of the recognition of the special allowance yield
adjustment and variable rate floor income, the Company's student loan interest
spread increased from 1.77% during the three months ended June 30, 2003 to 1.86%
during the three months ended June 30, 2004.
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, the Company's rapid
organic growth, the development of its platform, and changes in operations,
period-to-period comparability of the Company's results of operations may be
difficult.
15
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.
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 ten-year period.
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.
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 bond 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 more drastic 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 the three months ended June 30, 2004 and
recorded approximately $348,000 of variable-rate floor income during the six
months ended June 30, 2004, as compared to $6.9 million and $12.7 million during
the comparable periods in 2003. 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.
On those FFELP loans with fixed to 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 the Company receives 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.
16
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 beginning June 1, 2004, and the
Company is not subject to the two percent risk sharing loss for eligible claims
submitted after that date. 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 June 30, 2004, service providers designated as
an Exceptional Performer serviced approximately 90 percent of the Company's
federally insured loans. Of this 90 percent, less than one percent is serviced
by a third party. 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 June 2004, the Company's allowance for loan
loss 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
Performer designation. The Company anticipates lower provision expense for loan
losses compared to historical periods as a result of the Exceptional Performer
designation.
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 places a non-federally insured
loan on nonaccrual status and charges off the loan when the collection of
principal and interest is 120 days past due. During the second quarter 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.
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
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" below. The Company's
net income included net settlements on derivatives of $1.7 million and $2.9
million and mark-to-market gains on derivative instruments of $3.1 million and
$0.5 million during the three and six months ended June 30, 2004, respectively.
There were no derivatives outstanding during the first six months of 2003.
17
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 six months ended June 30, 2004 included $2.1 million and $4.2 million,
respectively, of amortization of intangible assets resulting from acquisitions
as compared to $3.5 million and $7.2 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 June 30, 2004 compared to the three months ended June 30,
2003
Three months ended
June 30,
------------------------
2004 2003 $ Change % Change
--------- --------- --------- --------
(dollars in thousands)
Interest income:
Loan interest, excluding variable-rate floor income ............ $ 239,436 $ 99,982 $ 139,454 139.5%
Variable-rate floor income ..................................... -- 6,900 (6,900) (100.0)
Amortization of loan premiums and deferred origination costs ... (15,037) (14,209) (828) (5.8)
Investment interest ............................................ 3,181 5,343 (2,162) (40.5)
--------- --------- --------- --------
Total interest income ........................................ 227,580 98,016 129,564 132.2
Interest expense:
Interest on bonds and notes payable ............................ 52,352 52,826 (474) (0.9)
--------- --------- --------- --------
Net interest income .......................................... 175,228 45,190 130,038 287.8
Less provision (recovery) for loan losses ........................... (6,421) 2,450 (8,871) (362.1)
--------- --------- --------- --------
Net interest income after provision (recovery) for loan losses 181,649 42,740 138,909 325.0
--------- --------- --------- --------
Other income:
Loan servicing and other fee income ............................ 22,512 24,400 (1,888) (7.7)
Software services and other income ............................. 5,029 4,471 558 12.5
Derivative market value adjustment and net settlements ......... 1,357 -- 1,357 100.0
--------- --------- --------- --------
Total other income ........................................... 28,898 28,871 27 0.1
--------- --------- --------- --------
Operating expenses:
Salaries and benefits .......................................... 49,036 30,343 18,693 61.6
Other operating expenses:
Depreciation and amortization, excluding amortization
of intangible assets ...................................... 2,598 2,531 67 2.6
Amortization of intangible assets ............................ 2,079 3,500 (1,421) (40.6)
Trustee and other debt related fees .......................... 2,851 3,787 (936) (24.7)
Occupancy and communications ................................. 3,135 2,925 210 7.2
Advertising and marketing .................................... 2,961 2,728 233 8.5
Professional services ........................................ 2,894 2,442 452 18.5
Consulting fees and support services to related parties ...... -- 450 (450) (100.0)
Postage and distribution ..................................... 3,220 3,035 185 6.1
Othe ......................................................... 7,422 5,704 1,718 30.1
--------- --------- --------- --------
Total other operating expenses ............................ 27,160 27,102 58 0.2
--------- --------- --------- --------
Total operating expenses .................................. 76,196 57,445 18,751 32.6
--------- --------- --------- --------
Income before income taxes ................................ 134,351 14,166 120,185 848.4
Income tax expense .................................................. 49,098 5,840 43,258 740.7
--------- --------- --------- --------
Net income ................................................ $ 85,253 $ 8,326 $ 76,927 923.9%
========= ========= ========= ========
Net interest income. Total loan interest, including variable-rate floor
income and amortization of premiums and deferred origination costs, increased as
a result of an increase in the size of the student loan portfolio and
recognition of 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. Recognition of the special allowance yield adjustment of
$124.3 million, offset by lower interest rates during the three months ended
June 30, 2004, caused an increase in the student loan net yield on the Company's
student loan portfolio to 7.96% from 4.16% for the comparable period in 2003.
Variable-rate floor income decreased due to the timing and relative change in
interest rates during the periods. Essentially, prevailing interest rates
declined drastically 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 no variable-rate
floor income during the three months ended June 30, 2004 as compared to $6.9
million during the comparable period in 2003. The weighted average interest rate
on the student loan portfolio increased during the three months ended June 30,
2004 due to the recognition of the special allowance yield adjustment, offset by
lower
18
interest rates and the increase in the number of lower yielding consolidation
loans. The higher weighted average loan interest rate resulted in an increase in
loan interest income of approximately $92.3 million. Consolidation loan activity
also increased the amortization and write-off of premiums and deferred
origination costs and increased the consolidation rebate fee, reducing loan
interest income approximately $7.4 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 26.8%, at June 30,
2004 as compared to the comparable period in 2003, which increased loan interest
income by approximately $54.0 million.
Interest expense on bonds and notes payable decreased despite an increase in
average total debt of approximately $2.2 billion. Average variable-rate debt
during the three months ended June 30, 2004 increased $2.4 billion over the
comparable period in 2003, which increased interest expense by approximately
$6.9 million. The Company reduced average fixed-rate debt by $181.5 million
during the three months ended June 30, 2004 as compared to the comparable period
in 2003, which decreased the Company's overall interest expense by approximately
$2.7 million. The reduction in interest rates, specifically LIBOR and auction
rates, decreased the Company's average cost of funds to 1.69% during the three
months ended June 30, 2004 from 2.08% during the comparable period in 2003,
which decreased interest expense approximately $2.5 million. Interest expense
for the three months ended June 30, 2003 includes $2.2 million due to the write
off of bond issuance costs incurred as a result of refinancing certain debt
transactions.
Net interest income, excluding the effects of variable-rate floor income and
recognition of the special allowance yield adjustment, increased approximately
$12.6 million, or 33.0%, to approximately $50.9 million during the three months
ended June 30, 2004 from approximately $38.3 million during the comparable
period in 2003.
Provision for loan losses. The provision for loan losses for federally
insured student loans decreased $9.6 million from an expense of $0.8 million
during the three months ended June 30, 2003 to a recovery of $8.8 million during
the three months ended June 30, 2004 as a result of the Company's Exceptional
Performer designation. The provision for loan losses for non-federally insured
loans increased $770,000 from $1.6 million during the three months ended June
30, 2003 to $2.3 million during the three months ended June 30, 2004 due to the
increase in the non-federally insured loans and expected performance of the
non-federally insured loan portfolio.
Other income. Loan servicing and other fee income decreased due to the
reduction in the number and dollar amount of loans the Company serviced for
third parties. Total average third-party loan servicing volume decreased $922.9
million, or 9.2%, during the three months ended June 30, 2004 as compared to the
comparable period in 2003, which resulted in a decrease in loan servicing income
of $2.1 million. The decrease in servicing volume is due to loan pay downs being
greater than loan additions within the third-party customer portfolios. This
decrease in income was offset by an increase of approximately $564,000 in
guarantee servicing income during the six months ended June 30, 2004 due to
special conversion fees received from a customer that did not renew its
servicing contract.
The increase in software services and other income was primarily 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.
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 June 30, 2004, the derivative
market value adjustment gain was $3.1 million and net settlements representing
realized interest costs were $1.7 million. See "-- Risks -- Market and Interest
Rate Risk."
Operating expenses. Salaries and benefits increased during the three months
ended June 30, 2004 due to the recognition of incentive expenses as a result of
the Company meeting certain pre-established goals and targets generated
primarily by the financial impact related to the recognition of the special
allowance yield adjustment and the Exceptional Performer designation. The
Company recognized approximately $20.7 million of expense in June 2004 related
to these incentive plans. 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.
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 due to an additional $2.0 million of
charitable contribution expenses.
Income tax expense. Income tax expense increased due to the increase in
income before income taxes. The Company's effective tax rate was 36.5% and 41.2%
during the three months ended June 30, 2004 and 2003, respectively. The decrease
in the effective tax rate in 2004 was related to certain items not deductible
for tax purposes that contributed more positively as a percentage of pre-tax
income in 2004 than in 2003.
19
Six months ended June 30, 2004 compared to the six months ended June 30, 2003
Six months ended
June 30,
----------------------
2004 2003 $ Change % Change
--------- --------- --------- ----------
(dollars in thousands)
Interest income:
Loan interest, excluding variable-rate floor income ............. $ 347,632 $ 199,991 $ 147,641 73.8%
Variable-rate floor income ...................................... 348 12,700 (12,352) (97.3)
Amortization of loan premiums and deferred origination costs .... (34,854) (30,336) (4,518) (14.9)
Investment interest ............................................. 6,832 9,268 (2,436) (26.3)
--------- --------- --------- ------
Total interest income ......................................... 319,958 191,623 128,335 67.0
Interest expense:
Interest on bonds and notes payable ............................. 101,395 104,175 (2,780) (2.7)
--------- --------- --------- ------
Net interest income ........................................... 218,563 87,448 131,115 149.9
Less provision (recovery) for loan losses ........................... (3,306) 4,860 (8,166) (168.0)
--------- --------- --------- ------
Net interest income after provision (recovery) for loan losses 221,869 82,588 139,281 168.6
--------- --------- --------- ------
Other income:
Loan servicing and other fee income ............................. 48,221 50,237 (2,016) (4.0)
Software services and other income .............................. 10,607 9,111 1,496 16.4
Derivative market value adjustment and net settlements .......... (2,384) -- (2,384) (100.0)
--------- --------- --------- ------
Total other income ............................................ 56,444 59,348 (2,904) (4.9)
--------- --------- --------- ------
Operating expenses:
Salaries and benefits ........................................... 76,805 56,848 19,957 35.1
Other operating expenses:
Depreciation and amortization, excluding amortization
of intangible assets ....................................... 4,928 4,671 257 5.5
Amortization of intangible assets ............................. 4,157 7,196 (3,039) (42.2)
Trustee and other debt related fees ........................... 5,465 7,459 (1,994) (26.7)
Occupancy and communications .................................. 6,217 6,192 25 0.4
Advertising and marketing ..................................... 5,284 4,314 970 22.5
Professional services ......................................... 7,354 4,627 2,727 58.9
Consulting fees and support services to related parties ....... -- 2,685 (2,685) (100.0)
Postage and distribution ...................................... 7,068 6,788 280 4.1
Other ......................................................... 12,130 11,899 231 1.9
--------- --------- --------- ------
Total other operating expenses ............................. 52,603 55,831 (3,228) (5.8)
--------- --------- --------- ------
Total operating expenses ................................... 129,408 112,679 16,729 14.8
--------- --------- --------- ------
Income before income taxes and minority interest ........... 148,905 29,257 119,648 409.0
Income tax expense .................................................. 54,531 11,462 43,069 375.8
--------- --------- --------- ------
Income before minority interest ............................ 94,374 17,795 76,579 430.3
--------- --------- --------- ------
Minority interest in subsidiary loss ................................ -- 109 (109) (100.0)
--------- --------- --------- ------
Net income ................................................. $ 94,374 $ 17,904 $ 76,470 427.1%
========= ========= ========= ======
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 recognition of 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. Recognition of the special allowance yield
adjustment of $124.3 million, offset by lower interest rates during the six
months ended June 30, 2004, caused an increase in the student loan net yield on
the Company's student loan portfolio to 5.76% from 4.22% for the comparable
period in 2003. Variable-rate floor income decreased due to the timing and
relative change in interest rates during the periods. Essentially, prevailing
interest rates declined drastically 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 six months ended
June 30, 2004 as compared to $12.7 million during the comparable period in 2003.
The weighted average interest rate on the student loan portfolio increased
during the six months ended June 30, 2004 due to the recognition of the special
allowance yield adjustment offset by lower interest rates and the increase in
the number of lower yielding consolidation loans. The higher weighted average
loan interest rate resulted in an increase in loan interest income of
approximately $82.8 million. Consolidation loan activity also increased the
amortization and write-off of premiums and deferred origination costs and
increased the consolidation rebate fee, reducing loan interest income
approximately $17.2 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 $2.2 billion, or 25.7%, at June 30, 2004 as
compared to the comparable period in 2003, which increased loan interest income
by approximately $77.3 million.
Interest expense on bonds and notes payable decreased despite an increase in
average total debt of approximately $2.1 billion. Average variable-rate debt
during the six months ended June 30, 2004 increased $2.3 billion over the
comparable period in 2003, which increased interest expense by approximately
$13.6 million. The Company reduced average fixed-rate debt by $196.0 million
during the six months ended June 30, 2004 as compared to the comparable period
in 2003, which decreased the Company's overall
20
interest expense by approximately $5.8 million. The reduction in interest rates,
specifically LIBOR and auction rates, decreased the Company's average cost of
funds to 1.69% during the six months ended June 30, 2004 from 2.10% during the
comparable period in 2003, which decreased interest expense approximately $8.1
million. Interest expense for the six months ended June 30, 2003 includes $2.5
million due to the write off of bond issuance costs incurred as a result of
refinancing certain debt transactions.
Net interest income, excluding the effects of variable-rate floor income and
recognition of the special allowance yield adjustment, increased approximately
$19.2 million, or 25.7%, to approximately $93.9 million during the six months
ended June 30, 2004 from approximately $74.7 million during the comparable
period in 2003.
Provision for loan losses. The provision for loan losses for federally
insured student loans decreased $8.7 million from an expense of $1.4 million
during the six months ended June 30, 2003 to a recovery of $7.3 million during
the six months ended June 30, 2004, as a result of the Company's Exceptional
Performer designation. The provision for loan losses on non-federally insured
loans increased $540,000 from $3.5 million during the six months ended June 30,
2003 to $4.0 million during the six months ended June 30, 2004, due to the
increase in the non-federally insured loans and expected performance of the
non-federally insured loan portfolio.
Other income. 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. Total average third-party loan servicing volume decreased $1.0
billion, or 9.8%, during the six months ended June 30, 2004 as compared to the
comparable period in 2003, which resulted in a decrease in loan servicing income
of $2.6 million. The decrease in servicing volume is due to loan pay downs being
greater than loan additions within the third-party customer portfolios. This
decrease in income was offset by an increase of approximately $564,000 in
guarantee servicing income during the six months ended June 30, 2004 due to
special conversion fees received from a customer that did not renew its
servicing contract.
The increase in software services and other income was primarily 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.
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 six months ended June 30, 2004, the derivative market
value adjustment gain was $548,000 and net settlements representing realized
interest costs were $2.9 million. See "-- Risks -- Market and Interest Rate
Risk."
Operating expenses. Salaries and benefits increased during the six months
ended June 30, 2004 due to the recognition of incentive expenses as a result of
the Company meeting certain pre-established goals and targets generated
primarily by the financial impact related to the recognition of the special
allowance yield adjustment and the Exceptional Performer designation. The
Company recognized approximately $20.7 million of expense in June 2004 related
to these incentive plans. 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 39.2%
during the six months ended June 30, 2004 and 2003, respectively. The decrease
in the effective tax rate in 2004 was related to certain items not deductible
for tax purposes that contributed more positively as a percentage of pre-tax
income in 2004 than in 2003.
21
Financial Condition
At June 30, 2004 compared to December 31, 2003
As of
-------------------------
June 30, December 31,
2004 2003 $ Change % Change
----------- ----------- ----------- --------
(dollars in thousands)
Assets:
Student loans receivable, net ............................... $12,194,097 $10,455,442 $ 1,738,655 16.6%
Other assets ................................................ 1,265,482 1,476,067 (210,585) (14.3)
----------- ----------- ----------- ----
Total assets .......................................... $13,459,579 $11,931,509 $ 1,528,070 12.8%
=========== =========== =========== =====
Liabilities:
Bonds and notes payable ..................................... $12,844,539 $11,366,458 $ 1,478,081 13.0%
Other liabilities ........................................... 214,058 259,562 (45,504) (17.5)
----------- ----------- ----------- ----
Total liabilities ..................................... 13,058,597 11,626,020 1,432,577 12.3
Shareholders' equity:
Shareholders' equity ........................................ 400,982 305,489 95,493 31.3
----------- ----------- ----------- ----
Total liabilities and shareholders' equity ............ $13,459,579 $11,931,509 $ 1,528,070 12.8%
=========== =========== =========== ====
Total assets increased primarily due to an increase in student loans
receivable. This increase was the result of the Company originating and
acquiring $2.3 billion of student loans during the six months ended June 30,
2004, offset by repayments of approximately $0.6 billion. Total liabilities
increased primarily as a result of an increase in bonds and notes payable. The
increase in bonds and notes payable resulted from additional borrowings to fund
the Company's growth in student loans. Shareholders' equity increased primarily
as a result of net income of $94.4 million during the six months ended June 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 $210.3 million during
the six months ended June 30, 2004, an increase of $146.1 million from the net
cash provided by operating activities of $64.2 million during the comparable
period in 2003. Of this increase, $124.3 million is due to the special allowance
yield adjustment recognized in 2004. Operating cash flows are also 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 $3.7 million during the six months
ended June 30, 2004 as compared to the comparable period in 2003.
The Company has a $35.0 million operating line of credit and a $35.0 million
commercial paper facility under two separate facilities from a group of six
large regional and national financial institutions. The Company uses these
facilities primarily for general operating purposes. The Company did not have
any borrowings under these facilities at June 30, 2004. These facilities expire
in September 2004. The Company intends to renew these facilities through
September 2005. The Company believes these facilities, the growth in the cash
flow from operating activities, and the initial public stock offering indicates
a favorable trend in the Company's available capital resources. Due to the
proceeds received from the initial public offering, a $30 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 $12.8 billion of debt outstanding as of June 30, 2004, $10.8
billion was issued under securitization transactions. On January 15, 2004, April
22, 2004, and July 20, 2004, the Company completed asset-backed securities
transactions totaling $1.0 billion, $1.0 billion, and $1.4 billion,
respectively. Depending on market conditions, the Company anticipates continuing
to access the asset-backed securities markets in 2004 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. In July 2004, the Company redeemed a portion of its
student loan interest margin notes for $47.4 million, which includes a
call-premium of $1.9 million. The call-premium and write-off of the unamortized
debt issue costs of $0.7 million will be expensed in the third quarter 2004.
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. At June 30,
2004, the Company had a
22
loan warehousing capacity of $2.8 billion, of which $2.0 billion was outstanding
at June 30, 2004, through 364-day commercial paper conduit programs. These
conduit programs mature in 2004 through 2009, however, 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.
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 June 30, 2004:
As of June 30, 2004
--------------------------------------------------------
Interest rate
range on
Carrying Percent of Line of credit carrying
amount total amount amount Final maturity
----------- ---------- -------------- ------------- -------------------
(dollars in thousands)
Variable rate bonds and notes (a):
Bond and notes based on indices .......... $ 4,499,954 35.1% $ 4,499,954 1.22% - 1.84% 11/25/09 - 02/25/39
Bond and notes based on auction .......... 5,398,670 42.0 5,398,670 1.10% - 1.60% 07/01/05 - 07/01/43
----------- ----- -----------
Total variable rate bonds and notes ... 9,898,624 77.1 9,898,624
Commerical paper and other ................... 2,049,878 16.0 2,800,000 1.09% - 1.20% 05/14/04 - 09/02/09
Fixed-rate bonds and notes (a) ............... 881,037 6.9 881,037 5.20% - 7.63% 05/01/05 - 05/01/29
Other borrowings ............................. 15,000 0.1 85,000 6.00% 11/1/2005
----------- ----- -----------
Total .................................... $12,844,539 100.0% $13,664,661
=========== ===== ===========
- ----------
(a) Issued in securitization transactions.
Total unused commitments under various commercial paper, warehouse, and
operating line of credit agreements totaled $820.1 million as of June 30, 2004.
The Company is committed under noncancelable operating leases for certain
office and warehouse space and equipment. The Company's contractual obligations
as of June 30, 2004 were as follows:
As of June 30, 2004
-------------------------------------------------------------------
Less than More than
Total 1 year 1 to 3 years 3 to 5 years 5 years
----------- --------- ------------ ------------ -----------
(dollars in thousands)
Bonds and notes payable ... $12,844,539 218,917 277,582 165,138 12,182,902
Operating lease obligations 14,660 4,921 7,177 2,122 440
----------- ------- ------- ------- ----------
Total .................. $12,859,199 223,838 284,759 167,260 12,183,342
=========== ======= ======= ======= ==========
The Company has commitments with its branding partners, from whom the
Company acquires student loans and to whom the Company provides marketing and
origination services, and forward flow lenders, from whom the Company acquires
student loans and to whom the Company provides origination services only, 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. 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 June 30, 2004,
$199.2 million of student loans were originated under these agreements, which
the Company was committed to purchase.
On July 1, 2004, the Company implemented its employee share purchase plan
pursuant to which employees are entitled to purchase Class A common stock via
payroll deductions at a 15 percent discount from fair market value. The Company
will recognize compensation expense equal to the intrinsic value on the date
stock is issued to the employee.
23
Student Loan Portfolio
The table below describes the components of the Company's loan portfolio as
of June 30, 2004 and December 31, 2003:
As of June 30, 2004 As of December 31, 2003
--------------------- -----------------------
Dollars Percent Dollars Percent
----------- ------- ----------- -------
(dollars in thousands)
Federally insured:
Stafford ................................................. $ 5,319,123 43.6% $ 4,900,249 46.9%
PLUS/SLS (a) ............................................. 290,398 2.4 249,217 2.4
Consolidation ............................................ 6,329,369 51.9 5,073,081 48.5
Non-federally insured ......................................... 94,439 0.8 92,327 0.9
----------- ----- ----------- -----
Total ............................................... 12,033,329 98.7 10,314,874 98.7
Unamortized premiums and deferred origination costs ........... 168,890 1.4 156,594 1.5
Allowance for loan losses:
Allowance - federally insured ............................ (735) (0.0) (9,755) (0.1)
Allowance - non-federally insured ........................ (7,387) (0.1) (6,271) (0.1)
----------- ----- ----------- -----
Net ................................................. $12,194,097 100.0% $10,455,442 100.0%
=========== ===== =========== =====
- ----------
(a) Supplemental Loans for Students, or SLS, are the predecessor to unsubsidized
Stafford loans.
Activity in the Allowance for Loan Losses
The provision for loan losses represents the periodic expense of maintaining
an allowance sufficient to absorb losses, net of recoveries, inherent in the
portfolio of student loans.
An analysis of the Company's allowance for loan losses is presented in the
following table:
Three months ended Six months ended
June 30, June 30,
-------------------------- --------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
(dollars in thousands)
Balance at beginning of period .....................................$ 16,623 $ 13,222 $ 16,026 $ 12,000
Provision (recovery) for loan losses:
Federally insured loans ....................................... (8,761) 880 (7,316) 1,390
Non-federally insured loans ................................... 2,340 1,570 4,010 3,470
----------- ----------- ----------- -----------
Total provision (recovery) for loan losses ............... (6,421) 2,450 (3,306) 4,860
Charge-offs:
Federally insured loans ....................................... (719) (797) (1,704) (1,335)
Non-federally insured loans ................................... (1,476) (1,153) (3,105) (1,820)
----------- ----------- ----------- -----------
Total charge-offs ........................................ (2,195) (1,950) (4,809) (3,155)
Recoveries, non-federally insured loans ............................ 115 28 211 45
----------- ----------- ----------- -----------
Net charge-offs .................................................... (2,080) (1,922) (4,598) (3,110)
----------- ----------- ----------- -----------
Balance at end of period ...........................................$ 8,122 $ 13,750 $ 8,122 $ 13,750
=========== =========== =========== ===========
Allocation of the allowance for loan losses:
Federally insured loans .......................................$ 735 $ 9,425 $ 735 $ 9,425
Non-federally insured loans ................................... 7,387 4,325 7,387 4,325
----------- ----------- ----------- -----------
Total allowance for loan losses ..........................$ 8,122 $ 13,750 $ 8,122 $ 13,750
=========== =========== =========== ===========
Net loan charge-offs as a percentage of average student loans ...... 0.074% 0.086% 0.085% 0.072%
Total allowance as a percentage of average student loans ........... 0.072% 0.155% 0.075% 0.159%
Total allowance as a percentage of ending balance of student loans . 0.067% 0.148% 0.067% 0.148%
Non-federally insured allowance as a percentage of the ending
balance of non-federally insured loans ........................ 7.822% 4.923% 7.822% 4.923%
Average student loans ..............................................$11,284,576 $ 8,899,049 $10,869,351 $ 8,648,786
Ending balance of student loans ....................................$12,033,329 $ 9,317,847 $12,033,329 $ 9,317,847
Ending balance of non-federally insured loans ......................$ 94,439 $ 87,851 $ 94,439 $ 87,851
24
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 beginning June 1, 2004, and the
Company is not subject to the two percent risk sharing loss for eligible claims
submitted after that date. 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 June 30, 2004, service providers designated as
an Exceptional Performer serviced approximately 90 percent of the Company's
federally insured loans. Of this 90 percent, less than one percent is serviced
by a third party. 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 June 2004, the Company's allowance for loan
loss 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
Performer designation.
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 June 30, 2004 and
December 31, 2003:
As of June 30, 2004 As of December 31, 2003
---------------------- -----------------------
Balance Percent Balance Percent
------------ ------- ------------ -------
(dollars in thousands)
Federally Insured Student Loan Portfolio:
Loans in-school/grace/deferment(1) ....................... $ 3,581,605 $ 2,940,193
Loans in forebearance(2) ................................. 1,630,044 1,362,335
Loans in repayment status:
Loans current ........................................ 6,039,860 89.8% 5,245,316 88.6%
Loans delinquent 31-60 days(3) ....................... 269,297 4.0 279,435 4.7
Loans delinquent 61-90 days(3) ....................... 142,298 2.1 130,339 2.2
Loans delinquent 91 days or greater(4) ............... 275,786 4.1 264,929 4.5
------------ ----- ------------ -----
Total loans in repayment .......................... 6,727,241 100.0% 5,920,019 100.0%
------------ ===== ------------ =====
Total federally insured student loan portfolio .... $ 11,938,890 $ 10,222,547
============ ============
Non-Federally Insured Student Loan Portfolio:
Loans in-school/grace/deferment(1) ....................... $ 24,718 $ 25,537
Loans in forebearance(2) ................................. 6,070 14,776
Loans in repayment status:
Loans current ........................................ 57,318 90.1% 45,554 87.6%
Loans delinquent 31-60 days(3) ....................... 2,297 3.6 2,531 4.9
Loans delinquent 61-90 days(3) ....................... 1,727 2.7 1,556 2.9
Loans delinquent 91 days or greater(4) ............... 2,309 3.6 2,373 4.6
------------ ----- ------------ -----
Total loans in repayment .......................... 63,651 100.0% 52,014 100.0%
------------ ===== ------------ =====
Total private student loan portfolio .............. $ 94,439 $ 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
25
institutions which 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.
The table below sets forth the activity during the three and six months
ended June 30, 2004 and 2003 of loans originated or acquired through each of the
Company's channels:
Three months ended Six months ended
June 30, June 30,
---------------------------- ----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
(dollars in thousands)
Beginning balance ................................................ $ 11,065,865 $ 8,881,560 $ 10,314,874 $ 8,404,388
Direct channel:
Consolidation loan originations .............................. 505,353 292,446 1,311,918 736,670
Less consolidation of existing portfolio ..................... (201,999) (117,000) (523,008) (352,000)
------------ ------------ ------------ ------------
Net consolidation loan originations ..................... 303,354 175,446 788,910 384,670
Stafford/PLUS loan originations .............................. 27,385 30,760 120,312 116,876
Branding partner channel ......................................... 360,704 244,418 715,207 610,740
Forward flow channel ............................................. 362,888 167,395 448,092 308,002
Other channels ................................................... 109,787 35,046 130,783 63,666
------------ ------------ ------------ ------------
Total channel acquisitions ................................... 1,164,118 653,065 2,203,304 1,483,954
Loans acquired in business acquisition ........................... 136,138 -- 136,138 --
Repayments, claims, capitalized interest, and other .............. (332,792) (216,778) (620,987) (570,495)
------------ ------------ ------------ ------------
Ending balance ................................................... $ 12,033,329 $ 9,317,847 $ 12,033,329 $ 9,317,847
============ ============ ============ ============
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 during the three and six
months ended June 30, 2004 and 2003, and represents the spread on assets earned
in conjunction with the liabilities used to fund the assets:
Three months ended Six months ended
June 30, June 30,
--------------------------- ----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
(dollars in thousands) (dollars in thousands)
Student loan yield ........................................... 9.06% 5.22% 6.96% 5.33%
Consolidation rebate fees .................................... (0.57) (0.42) (0.56) (0.41)
Premium and deferred origination costs amortization .......... (0.53) (0.64) (0.64) (0.70)
------------ ------------ ------------ ------------
Student loan net yield ....................................... 7.96 4.16 5.76 4.22
Student loan cost of funds ................................... (1.69) (2.08) (1.69) (2.10)
------------ ------------ ------------ ------------
Student loan spread .......................................... 6.27 2.08 4.07 2.12
Variable-rate floor income ................................... -- (0.31) (0.01) (0.29)
Special allowance yield adjustment (a) ....................... (4.41) -- (2.29) --
------------ ------------ ------------ ------------
Core student loan spread ..................................... 1.86% 1.77% 1.77% 1.83%
============ ============ ============ ============
Average balance of student loans (in thousands) .............. $ 11,284,876 $ 8,899,049 $ 10,869,351 $ 8,648,786
----------
(a) On June 30, 2004, the Company recognized $124.3 million of excess interest
income that had previously been deferred. At December 31, 2003 and March 31,
2004, the amount of deferred excess interest income on these loans was $42.9
million and $78.8 million, respectively. In future periods, the Company will
recognize the income from the special allowance payments on these loans as it is
earned.
26
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, 2004, 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.
Specific proposed legislation that could have a material effect on the
Company's operations, if enacted, include:
o initiatives aimed at supporting the Federal Direct Lending ("FDL")
program to the detriment of the FFEL program;
o restrictions limiting/preventing a FFELP lender from making a
consolidation loan consisting of only FDL Loans;
o allowing for increased borrower limits, which may provide opportunities
for increasing the average size of the Company's future loan
originations;
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; and
o changes to the single holder rule and other FFEL Program rates and terms
as discussed under "-- Risk Related to Consolidation Loans."
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.
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 beginning June 1, 2004, and the
Company is not subject to the two percent risk sharing loss for eligible claims
submitted after that date. 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 June 30, 2004, service providers designated as
an Exceptional Performer serviced approximately 90 percent of the Company's
federally insured loans. Of this 90 percent, less than one percent is serviced
by a third party. The Company is entitled to receive this benefit as long as it
and/or its
27
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 were to lose its Exceptional Performer designation, either by the
Department discontinuing the program or the Company not meeting the required
servicing standards, loans serviced by the Company would become subject to the
two percent risk sharing loss for all claims submitted after any loss of the
Exceptional Performer designation.
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 almost 52%
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 less loans lost through
consolidation of the Company's portfolio, but would also decrease
consolidation opportunities.
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 Company's 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
28
the time of consolidation. The following table sets forth the Company's loan
assets and debt instruments by rate characteristics:
As of June 30, 2004 As of December 31, 2003
--------------------- -----------------------
Dollars Percent Dollars Percent
----------- ------- ----------- -------
(dollars in thousands)
Fixed-rate loan assets ........................ $ 6,315,496 52.5% $ 5,532,497 53.6%
Variable-rate loan assets ..................... 5,717,833 47.5 4,782,377 46.4
----------- ----- ----------- -----
Total ...................................... $12,033,329 100.0% $10,314,874 100.0%
=========== ===== =========== =====
Fixed-rate debt instruments ................... $ 881,037 6.9% $ 927,694 8.2%
Variable-rate debt instruments ................ 11,963,502 93.1 10,438,764 91.8
----------- ----- ----------- -----
Total ...................................... $12,844,539 100.0% $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 overall risk management
strategy to manage risk arising from its fixed-rate and variable-rate financial
instruments.
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of June 30, 2004:
Notional amounts by product type
--------------------------------------
Fixed/ Floating/
floating Basis fixed
Maturity swaps (a) swaps (b) swaps (c) Total
- ------------------------------------------- --------- -------- --------- -----
(dollars in millions)
2004 ...................................... $ 7,000(d) -- -- 7,000
2005 ...................................... 400 1,000 210 1,610
2006 ...................................... -- 500 -- 500
------ ------ ------ -----
Total ................................... $7,400 1,500 210 9,110
====== ====== ====== =====
Fair value (e) (dollars in thousands) ..... $7,640 (4,967) (1,471) 1,202
====== ====== ====== =====
- ----------
(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) In July 2004, $4.0 billion of these interest rate swaps expired.
(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.
29
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 are included in the Company's
statement of income. At June 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 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 Six months ended
June 30, June 30,
------------------ ----------------
2004 2003 2004 2003
------- ------ ------- -------
(dollars in thousands)
Change in fair value of derivative instruments ............. $ 3,075 -- $ 548 --
Settlements, net ........................................... (1,718) -- (2,932) --
------- --- ------- ---
Derivative market value adjustment and net settlements ..... $ 1,357 -- $(2,384) --
======= === ======= ===
In July 2004, the Company 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 2.185% to 4.252% and the
weighted average is 3.512%. These interest rate swaps do not qualify for hedge
accounting under SFAS No. 133.
The following tables summarize the effect on the Company's earnings during
the three and six months ended June 30, 2004 and 2003, 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, and for the
three and six months ended June 30, 2004, includes the effects of the derivative
instruments in existence during these periods. The following tables do not
include the effects of the derivative instruments entered into by the Company in
July 2004.
30
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 June 30, 2004
--------------------------------------------------------------------------
Change from decrease of Change from increase of Change from increase of
100 basis points 100 basis points 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 ......... $ 22,235 16.5% $ (4,461) (3.3)% $ (8,034) (6.0)%
Impact of derivative settlements ............... (18,804) (14.0) 15,706 11.7 32,962 24.5
-------- ----- -------- ----- -------- ------
Increase in net income before taxes ............ $ 3,431 2.5% $ 11,245 8.4% $ 24,928 18.5%
======== ===== ======== ===== ======== ======
Increase in basic and diluted
earning per share ........................ $ 0.04 $ 0.13 $ 0.29
======== ======== ========
Three months ended June 30, 2003
--------------------------------------------------------------------------
Change from decrease of Change from increase of Change from increase of
100 basis points 100 basis points 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 ......... $ 19,953 140.9% $(12,502) (88.3)% $(15,928) (112.4)%
Impact of derivative settlements ............... -- -- -- -- -- --
-------- ----- -------- ----- -------- ------
Increase (decrease) in net income before taxes . $ 19,953 140.9% $(12,502) (88.3)% $(15,928) (112.4)%
======== ===== ======== ===== ======== ======
Increase (decrease) in basic and diluted
earning per share ........................ $ 0.27 $ (0.17) $ (0.22)
======== ======== ========
Six months ended June 30, 2004
--------------------------------------------------------------------------
Change from decrease of Change from increase of Change from increase of
100 basis points 100 basis points 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 ......... $ 44,101 29.6% $ (7,468) (5.0)% $(12,714) (8.5)%
Impact of derivative settlements ............... (35,871) (24.1) 28,892 19.4 61,274 41.1
-------- ----- -------- ----- -------- ------
Increase in net income before taxes ............ $ 8,230 5.5% $ 21,424 14.4% $ 48,560 32.6%
======== ===== ======== ===== ======== ======
Increase in basic and diluted
earning per share ........................ $ 0.10 $ 0.25 $ 0.56
======== ======== ========
Six months ended June 30, 2003
--------------------------------------------------------------------------
Change from decrease of Change from increase of Change from increase of
100 basis points 100 basis points 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 ......... $ 38,797 132.6% $(22,733) (77.7)% $(28,810) (98.5)%
Impact of derivative settlements ............... -- -- -- -- -- --
-------- ----- -------- ----- -------- ------
Increase (decrease) in net income before taxes . $ 38,797 132.6% $(22,733) (77.7)% $(28,810) (98.5)%
======== ===== ======== ===== ======== ======
Increase (decrease) in basic and diluted
earning per share ........................ $ 0.53 $ (0.31) $ (0.40)
======== ======== ========
31
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
as of June 30, 2004 and December 31, 2003 and is not necessarily reflective of
the positions that existed throughout the period:
As of June 30, 2004
-------------------------------------------------------------------------------------
Interest rate sensitivity period
-------------------------------------------------------------------------------------
3 months 3 months 6 months 1 to 2 2 to 5 Over 5
or less to 6 months to 1 year years years years
----------- ----------- ----------- ----------- ----------- -----------
(dollars in thousands)
Interest-sensitive assets:
Student loans ................. $12,194,097 $ -- $ -- $ -- $ -- $ --
Cash and investments .......... 892,558 -- -- -- -- --
----------- ----------- ----------- ----------- ----------- -----------
Total interest-sensitive
assets ................ 13,086,655 -- -- -- -- --
----------- ----------- ----------- ----------- ----------- -----------
Interest-sensitive liabilities:
Short-term borrowings ......... 11,963,502 -- -- -- -- --
Long-term notes ............... 52,352 56,135 110,429 152,822 292,098 217,201
----------- ----------- ----------- ----------- ----------- -----------
Total interest-sensitive
liabilities ........... 12,015,854 56,135 110,429 152,822 292,098 217,201
----------- ----------- ----------- ----------- ----------- -----------
Period gap .......................... 1,070,801 (56,135) (110,429) (152,822) (292,098) (217,201)
Cumulative gap ...................... 1,070,801 1,014,666 904,237 751,415 459,317 242,116
Ratio of interest-sensitive
assets to interest-sensitive
liabilities ................... 108.9% --% --% --% --% --%
=========== =========== =========== =========== =========== ===========
Ratio of cumulative gap to
total interest-sensitive assets 8.2% 7.8% 6.9% 5.7% 3.5% 1.9%
=========== =========== =========== =========== =========== ===========
As of December 31, 2003
-------------------------------------------------------------------------------------
Interest rate sensitivity period
-------------------------------------------------------------------------------------
3 months 3 months 6 months 1 to 2 2 to 5 Over 5
or less to 6 months to 1 year years years 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 interest-sensitive assets 9.6% 9.1% 8.2% 6.4% 3.7% 2.1%
=========== =========== =========== =========== =========== ===========
32
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 issues 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 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 portfolio, 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 beginning June 1, 2004, and the
Company is not subject to the two percent risk sharing loss for eligible claims
submitted after that date. 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 June 30, 2004, service providers designated as
an Exceptional Performer serviced approximately 90 percent of the Company's
federally insured loans. Of this 90 percent, less than one percent is serviced
by a third party. 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 places a non-federally insured
loan on nonaccrual status and charges off the loan when the collection of
principal and interest is 120 days past due.
33
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, as it requires estimates that may be susceptible to
significant changes.
Recent Accounting Pronouncements
Consolidation of Variable Interest Entities
In January 2003, the Financial Accounting Standards Board issued FIN No. 46,
Consolidation of Variable Interest Entities ("FIN No. 46"). FIN No. 46 clarifies
the application of Accounting Research Bulletin No. 51, Consolidated Financial
Statements, to certain entities in which equity investors do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties, which are referred to as
variable interest entities. Variable interest entities are required to be
consolidated by their primary beneficiaries. The primary beneficiary of a
variable interest entity is the party that absorbs a majority of the entity's
expected losses, receives a majority of its expected residual returns, or both,
as a result of holding variable interests. FIN No. 46 also requires new
disclosures about variable interest entities. The implementation date was
deferred until December 31, 2003 for calendar year companies. In December 2003,
the FASB issued revised interpretation No. 46 ("FIN 46R"), which addresses how a
business enterprise should evaluate whether it has a controlling financial
interest in an entity through means other than voting rights and accordingly
should consolidate this entity. The clarifications and modifications applies to
periods ending after December 31, 2003. FIN No. 46 and FIN 46R did not have an
effect on the Company's financial statements.
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.
34
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Nothing to report.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Nothing to report.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's annual meeting of shareholders held on May 27, 2004, the
following proposals were approved by the margins indicated:
1. To elect nine directors to serve on the Company's Board of Directors
for one-year terms or until their successors are elected and qualified.
Number of Shares
-------------------------------
Votes For Votes Withheld
----------- --------------
James P. Abel .................................. 147,789,389 53,930
Don R. Bouc .................................... 147,218,544 624,775
Stephen F. Butterfield ......................... 147,430,014 413,305
Michael S. Dunlap .............................. 147,427,980 415,339
Thomas E. Henning .............................. 147,523,239 320,080
Arturo R. Moreno ............................... 147,219,371 623,948
Brian J. O'Connor .............................. 147,502,939 340,380
Michael D. Reardon ............................. 147,523,139 320,180
James H. Van Horn .............................. 147,394,863 448,456
2. To ratify the appointment of KPMG LLP as independent auditors for 2004.
Number of Shares
----------------------------------------
Votes For Votes Against Abstain
----------- ------------- -------
147,770,934 49,905 22,480
ITEM 5. OTHER INFORMATION
Nothing to report.
35
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits
4.15* Indenture of Trust dated as of July 1, 2004, between Nelnet
Student Loan Trust 2004-3 and Zions First National Bank, as
eligible lender trustee and as indenture trustee.
10.76* Line of Credit Agreement dated as of June 15, 2004, between
National Education Loan Network, Inc. and Premiere Credit of
North America, LLC.
10.77* Promissory Note dated as of June 15, 2004, and executed by
Premiere Credit of North America, LLC, in favor of National
Education Loan Network, Inc.
10.78* Security Agreement dated as of June 15, 2004, between National
Education Loan Network, Inc. and Premiere Credit of North
America, LLC.
10.79* Real Estate Mortgage dated as of June 15, 2004, and executed by
Premiere Credit of North America, LLC, in favor of National
Education Loan Network, Inc.
10.80* First Amendment to Amended and Restated Warehouse Note Purchase
and Security Agreement dated as of June 29, 2004, by and among
NHELP-III, Inc., Delaware Funding Company, LLC, Park Avenue
Receivables Corporation, Three Rivers Funding Corporation,
JPMorgan Chase Bank, and Mellon Bank, N.A.
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
(b) Reports on Form 8-K.
On February 5, 2004, the Company furnished a current report on Form 8-K
announcing its financial results for the quarter and year ended December 31,
2003.
On April 28, 2004, the Company furnished a current report on Form 8-K
announcing its financial results for the quarter ended March 31, 2004.
On May 27, 2004, the Company furnished a current report on Form 8-K
announcing that the Company would provide a Web cast and conference call of its
2004 annual shareholders' meeting scheduled for May 27, 2004 and announcing that
the Company had been awarded Exceptional Performer status as a student loan
servicer for the Federal Family Education Loan Program.
On July 2, 2004, the Company filed a current report on Form 8-K announcing
that effective June 30, 2004, it will begin to recognize income related to
student loan portfolios funded from the proceeds of tax-exempt bonds, including
amounts previously deferred through that date.
On July 29, 2004, the Company filed a current report on Form 8-K announcing
its financial results for the quarter ended June 30, 2004.
36
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: August 16, 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. Hermes
Title: Chief Financial Officer
37