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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 March 31, 2005
or
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ___ to ___.
COMMISSION FILE NUMBER 001-31924
- --------------------------------------------------------------------------------
NELNET, INC.
(Exact name of registrant as specified in its charter)
NEBRASKA 84-0748903
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
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 |X| No |_|
As of April 30, 2005, there were 39,727,864 and 13,983,454 shares of Class A
Common Stock and Class B Common Stock, par value $0.01 per share, outstanding,
respectively.
NELNET, INC.
FORM 10-Q
INDEX
March 31, 2005
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 .... 31
Item 4. Controls and Procedures ....................................... 34
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ............................................. 34
Item 6. Exhibits ...................................................... 35
Signatures .................................................................. 36
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
As of As of
March 31, 2005 December 31, 2004
-------------- -----------------
(unaudited)
(dollars in thousands,
except share data)
Assets:
Student loans receivable (net of allowance for loan losses of
$8,852 and $7,272, respectively) .................................. $ 14,540,316 13,461,814
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party ........... 13,118 4,854
Cash and cash equivalents - held at a related party ............... 29,941 35,135
------------ ------------
Total cash and cash equivalents ......................................... 43,059 39,989
Restricted cash ......................................................... 640,034 732,066
Restricted investments .................................................. 282,265 281,829
Restricted cash - due to loan program customers ......................... 28,536 249,070
Accrued interest receivable ............................................. 273,299 251,104
Accounts receivable, net ................................................ 24,287 27,156
Goodwill ................................................................ 18,632 8,522
Intangible assets, net .................................................. 24,165 11,987
Furniture, equipment, and leasehold improvements, net ................... 33,437 29,870
Other assets ............................................................ 75,298 66,598
Fair value of derivative instruments, net ............................... 48,223 --
------------ ------------
Total assets ...................................................... $ 16,031,551 15,160,005
============ ============
Liabilities:
Bonds and notes payable ................................................. $ 15,318,517 14,300,606
Accrued interest payable ................................................ 53,497 48,578
Fair value of derivative instruments, net ............................... -- 11,895
Other liabilities ....................................................... 105,690 93,681
Due to loan program customers ........................................... 28,536 249,070
------------ ------------
Total liabilities ................................................. 15,506,240 14,703,830
------------ ------------
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 39,727,864 shares as of March 31, 2005
and 39,687,037 shares as of December 31, 2004 ............... 397 397
Class B, $0.01 par value. Authorized 15,000,000 shares;
issued and outstanding 13,983,454 shares .................... 140 140
Additional paid-in capital .............................................. 209,259 207,915
Retained earnings ....................................................... 315,151 247,064
Unearned compensation ................................................... (64) (77)
Accumulated other comprehensive income, net of taxes .................... 428 736
------------ ------------
Total shareholders' equity ........................................ 525,311 456,175
------------ ------------
Commitments and contingencies
Total liabilities and shareholders' equity ........................ $ 16,031,551 15,160,005
============ ============
See accompanying notes to consolidated financial statements.
2
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three months ended March 31,
----------------------------
2005 2004
----------- -----------
(dollars in thousands,
except share data)
Interest income:
Loan interest .................................................... $ 184,325 88,727
Investment interest .............................................. 7,002 3,651
----------- -----------
Total interest income ...................................... 191,327 92,378
Interest expense:
Interest on bonds and notes payable .............................. 104,525 49,043
----------- -----------
Net interest income ........................................ 86,802 43,335
Less provision for loan losses ......................................... 2,031 3,115
----------- -----------
Net interest income after provision for loan losses ........ 84,771 40,220
----------- -----------
Other income:
Loan and guarantee servicing income .............................. 37,176 26,063
Other fee-based income ........................................... 3,356 1,889
Software services income ......................................... 2,206 1,892
Other income ..................................................... 1,400 1,443
Derivative market value adjustment and net settlements ........... 50,204 (3,741)
----------- -----------
Total other income ......................................... 94,342 27,546
----------- -----------
Operating expenses:
Salaries and benefits ............................................ 39,327 27,769
Other operating expenses:
Depreciation and amortization .............................. 4,466 4,408
Trustee and other debt related fees ........................ 2,328 2,614
Occupancy and communications ............................... 4,232 3,082
Advertising and marketing .................................. 3,138 2,323
Professional services ...................................... 5,776 4,460
Postage and distribution ................................... 4,306 3,848
Other ...................................................... 7,815 4,708
----------- -----------
Total other operating expenses ....................... 32,061 25,443
----------- -----------
Total operating expenses ............................. 71,388 53,212
----------- -----------
Income before income taxes ........................... 107,725 14,554
Income tax expense ..................................................... 39,638 5,433
----------- -----------
Net income ........................................... $ 68,087 9,121
=========== ===========
Earnings per share, basic and diluted ................ $ 1.27 0.17
=========== ===========
Weighted average shares outstanding, basic and diluted 53,682,569 53,635,631
=========== ===========
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 Common stock
stock ------------------------ Preferred ------------------------
shares Class A Class B stock Class A Class B
---------- ---------- ---------- ---------- ---------- ----------
(dollars in thousands, except share data)
Balance as of December 31, 2003 ...... -- 39,601,834 14,023,454 $ -- 396 140
Comprehensive income:
Net income ........................ -- -- -- -- -- --
Other comprehensive income, related
to cash flow hedge, net of tax . -- -- -- -- -- --
Total comprehensive income .....
Issuance of common stock ............ -- 22,409 -- -- -- --
---------- ---------- ---------- ---------- ---------- ----------
Balance as of March 31, 2004 ......... -- 39,624,243 14,023,454 $ -- 396 140
========== ========== ========== ========== ========== ==========
Balance as of December 31, 2004 ...... -- 39,687,037 13,983,454 $ -- 397 140
Comprehensive income:
Net income ....................... -- -- -- -- -- --
Other comprehensive income:
Cash flow hedge, net of tax .... -- -- -- -- -- --
Foreign currency translation ... -- -- -- -- -- --
Total comprehensive income .....
Issuance of common stock ............ -- 40,827 -- -- -- --
---------- ---------- ---------- ---------- ---------- ----------
Balance as of March 31, 2005 ......... -- 39,727,864 13,983,454 $ -- 397 140
========== ========== ========== ========== ========== ==========
Accumulated
Additional other Total
paid-in Retained Unearned comprehensive shareholders'
capital earnings compensation income (loss) equity
---------- ---------- ---------- ------------- -------------
Balance as of December 31, 2003 ...... 206,831 97,885 -- 237 305,489
Comprehensive income:
Net income ........................ -- 9,121 -- -- 9,121
Other comprehensive income, related
to cash flow hedge, net of tax . -- -- -- (501) (501)
----------
Total comprehensive income ..... 8,620
Issuance of common stock ............ 528 -- -- -- 528
---------- ---------- ---------- ---------- ----------
Balance as of March 31, 2004 ......... 207,359 107,006 -- (264) 314,637
========== ========== ========== ========== ==========
Balance as of December 31, 2004 ...... 207,915 247,064 (77) 736 456,175
Comprehensive income:
Net income ....................... -- 68,087 -- -- 68,087
Other comprehensive income:
Cash flow hedge, net of tax .... -- -- -- (105) (105)
Foreign currency translation ... -- -- -- (203) (203)
----------
Total comprehensive income ..... 67,779
Issuance of common stock ............ 1,344 -- 13 -- 1,357
---------- ---------- ---------- ---------- ----------
Balance as of March 31, 2005 ......... 209,259 315,151 (64) 428 525,311
========== ========== ========== ========== ==========
See accompanying notes to consolidated financial statements.
4
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Three months ended March 31,
----------------------------
2005 2004
----------- -----------
(dollars in thousands)
Net income .............................................................................. $ 68,087 9,121
Adjustments to reconcile net income to net cash provided by operating activities, net
of business acquisitions:
Depreciation and amortization, including loan premiums and deferred origination costs 22,130 25,788
Derivative market value adjustment .................................................. (60,290) 2,527
Ineffectiveness of cash flow hedge .................................................. 5 24
Non-cash compensation expense ....................................................... 136 528
Loss (income) from equity method investments ........................................ 112 (333)
Deferred income tax expense ......................................................... 23,184 1,308
Provision for loan losses ........................................................... 2,031 3,115
Increase in accrued interest receivable ............................................. (22,195) (13,572)
Decrease in accounts receivable ..................................................... 3,973 3,414
(Increase) decrease in other assets ................................................. (1,703) 20,747
Increase in accrued interest payable ................................................ 4,919 3,134
(Decrease) increase in other liabilities ............................................ (13,634) 15,255
----------- -----------
Net cash provided by operating activities ...................................... 26,755 71,056
----------- -----------
Cash flows from investing activities, net of business acquisitions:
Originations, purchases, and consolidations of student loans, including loan premiums
and deferred origination costs ................................................... (919,351) (1,253,316)
Purchases of student loans, including loan premiums, from a related party ........... (574,166) (124,853)
Net proceeds from student loan principal payments and loan consolidations ........... 397,202 604,070
Net purchases of furniture, equipment, and leasehold improvements ................... (6,337) (5,847)
Decrease (increase) in restricted cash .............................................. 92,032 (129,438)
Purchases of restricted investments ................................................. (247,652) (189,773)
Proceeds from maturities of restricted investments .................................. 247,216 169,145
Purchase of equity method investments ............................................... -- (5,250)
Purchase of loan origination rights ................................................. (260) (7,871)
Business acquisitions, net of cash acquired ......................................... (26,843) --
----------- -----------
Net cash used in investing activities .......................................... (1,038,159) (943,133)
----------- -----------
Cash flows from financing activities:
Payments on bonds and notes payable ................................................. (527,411) (507,197)
Proceeds from issuance of bonds and notes payable ................................... 1,545,237 1,281,500
Payments of debt issuance costs ..................................................... (3,718) (3,083)
Proceeds from issuance of common stock .............................................. 311 --
----------- -----------
Net cash provided by financing activities ...................................... 1,014,419 771,220
----------- -----------
Effect of exchange rate fluctuations on cash ............................................ 55 --
Net increase (decrease) in cash and cash equivalents ........................... 3,070 (100,857)
Cash and cash equivalents, beginning of period .......................................... 39,989 198,423
----------- -----------
Cash and cash equivalents, end of period ................................................ $ 43,059 97,566
=========== ===========
Supplemental disclosures of cash flow information:
Interest paid ....................................................................... $ 97,724 44,310
=========== ===========
Income taxes paid (received), net of refunds ........................................ $ 6,642 (2)
=========== ===========
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of March 31, 2005 and for the three months ended
March 31, 2005 and 2004 is unaudited)
1. Basis of Financial Reporting
The accompanying unaudited consolidated financial statements of Nelnet, Inc. and
subsidiaries (the "Company") as of March 31, 2005 and for the three months ended
March 31, 2005 and 2004 have been prepared on the same basis as the audited
consolidated financial statements for the year ended December 31, 2004 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 accounting principles generally accepted in the United States
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
months ended March 31, 2005 are not necessarily indicative of the results for
the year ending December 31, 2005. 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, 2004. Certain amounts from 2004 have
been reclassified to conform to the current period presentation.
2. Student Loans Receivable
Student loans receivable as of March 31, 2005 and December 31, 2004 consisted of
the following:
As of As of
March 31, December 31,
2005 2004
------------ ------------
(dollars in thousands)
Federally insured loans ........................................................................ $ 14,262,982 13,208,689
Non-federally insured loans .................................................................... 94,225 90,405
------------ ------------
14,357,207 13,299,094
Unamortized loan premiums and deferred origination costs ....................................... 191,961 169,992
Allowance for loan losses - federally insured loans ............................................ (99) (117)
Allowance for loan losses - non-federally insured loans ........................................ (8,753) (7,155)
------------ ------------
$ 14,540,316 13,461,814
============ ============
Federally insured allowance as a percentage of ending balance of federally insured loans ....... 0.00% 0.00%
Non-federally insured allowance as a percentage of ending balance of non-federally insured loans 9.29% 7.91%
Total allowance as a percentage of ending balance of total loans ............................... 0.06% 0.05%
A portion of the Company's Federal Family Education Loan Program ("FFELP" or
"FFEL Program") loan portfolio is comprised of loans financed prior to September
30, 2004 with tax-exempt obligations issued prior to October 1, 1993. Based upon
provisions of the Higher Education Act of 1965, as amended (the "Higher
Education Act"), and related interpretations by the U.S. Department of Education
(the "Department"), the Company is entitled to receive special allowance
payments on these loans 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 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. As of
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.
3. 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. The Company evaluates the adequacy of the allowance for
loan losses on its federally insured loan portfolio separately from its
non-federally insured loan portfolio.
6
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% of principal and interest of federally
insured student loans, which limits the Company's loss exposure to 2% 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 FFELP loans. As a result of this designation, the Company receives
100% reimbursement on all eligible FFELP default claims submitted for
reimbursement during the 12-month period following the effective date of its
designation. The Company is not subject to the 2% risk sharing loss for eligible
claims submitted during this 12-month period. Only FFELP 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% reimbursement.
As of March 31, 2005, more than 99% of the Company's federally insured loans
were serviced by providers designated as an Exceptional Performer. Of this more
than 99%, the Company serviced approximately 91% and third parties serviced
approximately 8%. 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. If the Company or a third party servicer were to
lose its Exceptional Performance designation, either by the Department
discontinuing the program or the Company or third party servicer not meeting the
required servicing standards, loans serviced by the Company or third party would
become subject to the 2% risk sharing loss for all claims submitted after any
loss of the 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 these uninsured loans when the
collection of principal and interest is 120 days past due.
4. Related Party Transaction
On February 4, 2005, the Company entered into an agreement to amend certain
existing contracts with Union Bank and Trust Company ("UB&T"), an entity under
common control with the Company. Under the agreement, UB&T committed to transfer
to the Company substantially all of the remaining balance of UB&T's origination
rights in guaranteed student loans to be originated in the future, except for
student loans previously committed for sale to others. UB&T will continue to
originate student loans, and such guaranteed student loans not previously
committed for sale to others are to be sold by UB&T to the Company in the
future. UB&T also granted to the Company exclusive rights as marketing agent for
student loans on behalf of UB&T. As part of the agreement, UB&T also agreed to
sell the Company a portfolio of guaranteed student loans. During the first
quarter of 2005, the Company acquired approximately $500 million in loans from
UB&T under this agreement. During the second quarter of 2005, the Company will
fully complete the loan acquisition portion under this agreement by acquiring
approximately $150 million in loans that were not yet fully disbursed during the
first quarter. The Company agreed to pay the outstanding principal and accrued
interest with respect to the student loans purchased, together with a one-time
payment to UB&T in the amount of $20.0 million. The Company allocated the
consideration paid to UB&T to loan premiums except for approximately $260,000,
which was allocated to loan origination rights.
5. Acquisitions
The Company has positioned itself for growth by building a strong foundation
through acquisitions. Although the Company's assets, loan portfolios, and
fee-based revenues increase through such transactions, a key aspect of each
transaction is its impact on the Company's prospective organic growth and the
development of its integrated platform of services.
On December 1, 2004, the Company purchased 100% of the capital stock of EDULINX
Canada Corporation ("EDULINX") and its wholly owned subsidiary, Tricura Canada,
Inc., for $7.0 million. An additional payment of approximately $6.3 million is
to be paid by the Company if EDULINX obtains an extension or renewal of a
significant customer servicing contract that currently expires in February 2006.
This contingency payment is due following the date on which such extension or
renewal period of the servicing contract commences. The 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 purchase price allocation for EDULINX has not yet been finalized. The
preliminary allocation of the purchase price for EDULINX is shown below (dollars
in thousands):
Accounts receivable $ 11,273
Intangible assets 3,820
Furniture, equipment, and leasehold improvements 5,464
Other assets 1,180
Other liabilities (14,690)
--------
Total purchase price $ 7,047
========
Effective February 28, 2005, the Company purchased 100% of the capital stock of
Student Marketing Group, Inc. ("SMG") and 100% of the membership interests of
National Honor Roll, L.L.C. ("NHR"). The initial consideration paid by the
Company was $27.0 million. SMG and NHR were entities owned under common control.
SMG is a full service direct marketing agency providing a wide range of products
and services to help businesses reach the middle school, high school, college
bound high school, college, and young adult marketplace in a cost-effective
manner. In addition, SMG provides marketing services and college bound student
lists to college and university admissions offices nationwide. NHR recognizes
middle and high school students for exceptional academic success by providing
publication in the National Honor Roll Commemorative Edition, as well as
scholarships, a College Admissions Notification Service, and notice to local
newspapers and elected officials. In addition to the initial purchase price,
additional payments are to be paid by the Company based on the operating results
of SMG and NHR as defined in the purchase agreement. The contingent payments are
payable in annual installments through April 2008 and in total will range from a
minimum of $4.0 million to a maximum of $24.0 million. These acquisitions were
accounted for under purchase accounting and the results of operations have been
included in the consolidated financial statements from the effective date of the
acquisitions.
The purchase price allocation for SMG and NHR has not yet been finalized. The
preliminary allocation of the purchase price for SMG and NHR is show below
(dollars in thousands):
Cash and cash equivalents $ 157
Accounts receivable 1,212
Intangible assets 13,111
Furniture, equipment, and leasehold improvements 545
Other assets 5,355
Excess cost over fair value of net assets acquired 10,110
Other liabilities (3,490)
--------
Total purchase price $ 27,000
========
The pro forma information presenting the combined operations of the Company as
though these acquisitions occurred on January 1, 2004 is not significantly
different than actual results.
6. Intangible Assets and Goodwill
Intangible assets as of March 31, 2005 and December 31, 2004 consist of the
following:
As of As of
Useful March 31, December 31,
life 2005 2004
------------- ------------ -------------
(dollars in thousands)
Amortizable intangible assets:
Lender/customer relationships and loan origination rights (net of
accumulated amortization of $631 and $395, respectively)................... 36-120 months $ 9,502 7,505
Student lists (net of accumulated amortization of $171)....................... 48 months 8,026 --
Customer service contracts - EDULINX (net of accumulated amortization
of $247 and $61, respectively)............................................. 60 months 3,514 3,716
Other intangible assets (net of accumulated amortization of $9)............... 60-132 months 678 --
Servicing system software and other intellectual property (net of
accumulated amortization of $6,712 and $6,137, respectively)............... 36 months 191 766
------------ -------------
21,911 11,987
Unamortizable intangible assets - trade names................................... 2,254 --
------------ -------------
$ 24,165 11,987
============ =============
8
The Company recorded amortization expense on its intangible assets of $1.2
million and $2.1 million for the three months ended March 31, 2005 and 2004,
respectively. The Company will continue to amortize intangible assets over their
remaining useful lives and estimates it will record amortization expense as
follows (dollars in thousands):
2005 ........................................ $ 3,260
2006 ........................................ 4,079
2007 ........................................ 4,079
2008 ........................................ 4,000
2009 ........................................ 2,160
2010 and thereafter ......................... 4,333
-------
$21,911
=======
The change in the carrying amount of goodwill for the three months ended March
31, 2005 was as follows (dollars in thousands):
Balance as of January 1, 2005 ....................... $ 8,522
Goodwill acquired during the period .............. 10,110
-------
Balance as of March 31, 2005 ........................ $18,632
=======
7. Bonds and Notes Payable
On February 16, 2005 and April 19, 2005, the Company consummated debt offerings
of student loan asset-backed notes of $1.3 billion and $2.0 billion,
respectively, with final maturity dates ranging from 2011 through 2038. The
notes issued in these transactions have variable interest rates based on a
spread to LIBOR.
8. Derivative Financial Instruments
The Company maintains an overall interest rate risk management strategy that
incorporates the use of derivative instruments to minimize the economic effect
of interest rate volatility. The Company's goal is to manage interest rate
sensitivity by modifying the repricing or maturity characteristics of certain
balance sheet assets and liabilities so that the net interest margin is not, on
a material basis, adversely affected by movements in interest rates. The Company
views this strategy as a prudent management of interest rate sensitivity. The
Company accounts for derivative instruments under Statement of Financial
Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and
Hedging Activities ("SFAS No. 133"), which requires that every derivative
instrument be recorded on the balance sheet as either an asset or liability
measured at its fair value. Management has structured all of the Company's
derivative transactions with the intent that each is economically effective;
however, the majority do not qualify for hedge accounting under SFAS No. 133.
By using derivative instruments, the Company is exposed to credit and market
risk. If the counterparty fails to perform, credit risk is equal to the extent
of the fair value gain in a derivative. When the fair value of a derivative
contract is positive, this generally indicates that the counterparty owes the
Company. When the fair value of a derivative contract is negative, the Company
owes the counterparty and, therefore, it has no credit risk. The Company
minimizes the credit (or repayment) risk in derivative instruments by entering
into transactions with high-quality counterparties that are reviewed
periodically by the Company's risk committee. The Company also maintains a
policy of requiring that all derivative contracts be governed by an
International Swaps and Derivative Association Master Agreement.
Market risk is the adverse effect that a change in interest rates, or implied
volatility rates, has on the value of a financial instrument. The Company
manages market risk associated with interest rates by establishing and
monitoring limits as to the types and degree of risk that may be undertaken.
9
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of March 31, 2005:
Notional amounts by product type
--------------------------------------------------
Weighted
average
Fixed/ Floating/ fixed rate on
floating Basis fixed fixed/floating
Maturity swaps swaps swaps Total swaps
- ---------------------------------------- --------- --------- ---------- --------- --------------
(dollars in millions)
2005.................................... $ 1,187 1,000 210 2,397 2.20 %
2006.................................... 613 500 -- 1,113 2.99
2007.................................... 512 -- -- 512 3.42
2008.................................... 463 -- -- 463 3.76
2009.................................... 312 -- -- 312 4.01
2010.................................... 1,138 -- -- 1,138 4.25
--------- --------- --------- --------- ---------
Total.............................. $ 4,225 1,500 210 5,935 3.32 %
========= ========= ========= ========= =========
Fair value (in thousands)............... $ 52,189 (2,802) (1,164) 48,223
========= ========= ========= =========
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 March 31,
----------------------------
2005 2004
-------- --------
(dollars in thousands)
Change in fair value of derivative instruments ....... $ 60,290 (2,527)
Settlements, net ..................................... (10,086) (1,214)
-------- --------
Derivative market value adjustment and net settlements $ 50,204 (3,741)
======== ========
9. Accumulated Other Comprehensive Income
The following table shows the components of the change in accumulated other
comprehensive income, net of tax, related to one interest rate swap with a
notional amount of $150.0 million accounted for as a cash flow hedge:
Three months ended March 31,
----------------------------
2005 2004
--------- ---------
(dollars in thousands)
Balance at beginning of period .................... $ 736 237
Change in fair value of cash flow hedge ........ (109) (516)
Hedge ineffectiveness reclassified to earnings . 4 15
--------- ---------
Total change in unrealized loss on derivative (105) (501)
--------- ---------
Balance at end of period .......................... $ 631 (264)
========= =========
The Company's components of accumulated other comprehensive income at each
balance sheet date follow:
Foreign Accumulated
currency other
translation Cash flow comprehensive
adjustments hedge income (loss)
----------- ---------- -------------
(dollars in thousands)
Balance at December 31, 2004 .... $ -- 736 736
Fiscal 2005 year-to-date activity (203) (105) (308)
---------- ---------- ----------
Balance at March 31, 2005 ....... $ (203) 631 428
========== ========== ==========
10
10. Segment Reporting
The Company is a vertically integrated education finance organization that 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 and Guarantee Servicing, Servicing Software, and Direct
Marketing. The addition of Direct Marketing as an operating segment is a result
of the Company's acquisitions of SMG and NHR in 2005 (see note 5). The Asset
Management and Student Loan and Guarantee 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 Servicing Software
and Direct Marketing 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, 2004. SMG and NHR, which constitutes
the Direct Marketing segment, recognize revenue when the lists or products are
shipped.
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 education lending subsidiaries designed specifically for
this purpose.
The Student Loan and Guarantee Servicing segment provides for the servicing of
the Company's student loan portfolios and the portfolios of third parties and
servicing provided to guaranty agencies. The servicing activities include loan
origination activities, 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. The guarantee servicing
activities include providing systems software, hardware and telecommunications
support, borrower and loan updates, default aversion tracking services, claim
processing services, and post-default collection services to guaranty agencies.
The Servicing Software segment provides software licenses and maintenance
associated with student loan software products. The Direct Marketing segment
provides marketing services, college bound student lists, and merchandise to
recognize middle and high school students.
Substantially all of the Company's revenues are earned from customers in the
United States except for revenue generated from servicing Canadian student
loans. For the three months ended March 31, 2005, the Company recognized $15.4
million from Canadian student loan servicing customers.
Costs excluded from segment net income before taxes primarily consist of
unallocated corporate expenses, net of miscellaneous revenues. Thus, net income
before taxes of the segments includes only the costs that are directly
attributable to the operations of the individual segment. Intersegment revenues
are charged by a segment to another segment that provides the product or
service. The amount of intersegment revenue is based on comparable fees charged
in the market.
Segment data is as follows:
Three months ended March 31,
-----------------------------------------------------------------------------------------------
2005 2004
--------------------------------------------- -----------------------------------------------
Student Student
loan and loan and
Asset guarantee Total Asset guarantee Total
management servicing Other segments management servicing Other segments
---------- --------- -------- -------- ---------- --------- -------- --------
(dollars in thousands)
Net interest income .......... $ 86,070 678 15 86,763 42,689 261 2 42,952
Other income (expense) ....... 52,429 37,166 3,429 93,024 (893) 25,802 1,893 26,802
Intersegment revenues ........ -- 26,102 1,304 27,406 -- 19,016 979 19,995
-------- -------- -------- -------- -------- -------- -------- --------
Total revenue ............. 138,499 63,946 4,748 207,193 41,796 45,079 2,874 89,749
Provision for loan losses .... 2,031 -- -- 2,031 3,115 -- -- 3,115
Depreciation and amortization 26 919 799 1,744 334 126 1,763 2,223
Net income (loss) before taxes $100,217 18,663 2,025 120,905 6,685 13,375 (564) 19,496
======== ======== ======== ======== ======== ======== ======== ========
11
As of As of
March 31, December 31,
2005 2004
----------- ------------
(dollars in thousands)
Asset management ................... $15,861,254 14,808,684
Student loan and guarantee servicing 152,467 334,181
Other .............................. 35,656 5,934
----------- -----------
Total segment assets ............ $16,049,377 15,148,799
=========== ===========
Reconciliation of segment data to the consolidated financial statements is as
follows:
Three months ended March 31,
----------------------------
2005 2004
--------- ---------
(dollars in thousands)
Total segment revenues ...................... $ 207,193 89,749
Elimination of intersegment revenues ........ (27,406) (19,995)
Corporate activities revenues, net .......... 1,357 1,127
--------- ---------
Total consolidated revenues .............. $ 181,144 70,881
========= =========
Total net income before taxes of segments ... $ 120,905 19,496
Corporate activities expenses, net .......... (13,180) (4,942)
--------- ---------
Total consolidated net income before taxes $ 107,725 14,554
========= =========
As of As of
March 31, December 31,
2005 2004
------------ ------------
(dollars in thousands)
Total segment assets ............... $ 16,049,377 15,148,799
Elimination of intercompany assets . (54,255) (39,213)
Assets of other operating activities 36,429 50,419
------------ ------------
Total consolidated assets ....... $ 16,031,551 15,160,005
============ ============
Net corporate revenues included in the previous tables are from activities that
are not related to the four identified operating segments, such as investment
earnings. The net corporate expenses include expenses for marketing and other
unallocated support services. The net corporate revenues and expenses are not
associated with an ongoing business activity as defined by SFAS No. 131 and,
therefore, have not been included within the operating segments.
The assets held at the corporate level are not identified with any of the
operating segments. Accordingly, these assets are included in the reconciliation
of segment assets to total consolidated assets. These assets consist primarily
of cash, investments, furniture, equipment, leasehold improvements, and other
assets.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion and analysis 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 included in the Company's Annual Report on Form 10-K for
the year ended December 31, 2004.
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," and
"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, the risks and uncertainties set
forth in "Risk Factors" and elsewhere in this Form 10-Q and changes in the terms
of student loans and the educational credit marketplace arising from the
implementation of, or changes in, applicable laws and regulations, which may
reduce the volume, average term, and costs of yields on student loans under the
FFEL Program of the Department or result in loans being originated or refinanced
under non-FFELP
12
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. Although the
Company may from time to time voluntarily update its prior forward-looking
statements, it disclaims any commitment to do so except as required by
securities laws.
Overview
The Company is one of the leading education finance companies in the United
States and is focused on providing quality products and services to students and
schools nationwide. The Company ranks among the nation's leaders in terms of
total net student loan assets with $14.5 billion as of March 31, 2005.
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 student loan marketing, originations, acquisitions,
and portfolio management. The Company owns a large portfolio of student
loan assets through a series of education lending subsidiaries. The
Company obtains loans through direct origination or through acquisition of
loans. The Company also provides marketing, sales, managerial, and
administrative support related to its asset generation activities.
o Student Loan and Guarantee Servicing. The Company services its student
loan portfolio and the portfolios of third parties. Servicing activities
include loan origination activities, application processing, borrower
updates, payment processing, due diligence procedures, and claim
processing. The following table summarizes the Company's loan servicing
volumes as of March 31, 2005:
Company Percent Third party Percent Total
------- ------- ----------- ------- -------
(dollars in millions)
FFELP and private loans .. $13,116 59.7% $ 8,868 40.3% $21,984
Canadian loans (in U.S. $) -- -- 7,337 100.0 7,337
------- ------- ------- ------- -------
Total ...... $13,116 44.7% $16,205 55.3% $29,321
======= ======= ======= ======= =======
The Company also 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 uses internally developed loan servicing
software and also provides this software to third-party student loan
holders and servicers.
o Direct Marketing. The Company provides a wide range of direct marketing
products and services to help businesses reach the middle school, high
school, college bound high school, college, and young adult market place
in a cost-effective manner. The Company also provides marketing services
and college bound student lists to college and university admissions
offices nationwide. The Company also recognizes middle and high school
students for exceptional academic success by providing publications and
scholarships.
The Company's education lending subsidiaries under the Asset Management service
offering are engaged in the securitization of education finance assets. These
education lending subsidiaries hold beneficial interests in eligible loans,
subject to creditors with specific interests. The liabilities of the Company's
education lending subsidiaries are not the obligations of the Company or any of
its other subsidiaries and cannot be consolidated in the event of bankruptcy.
The transfers of student loans to the eligible lender trusts do not qualify for
sales under the provisions of SFAS No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, as the trusts
continue to be under the effective control of the Company. Accordingly, all the
financial activities and related assets and liabilities, including debt, of the
securitizations are reflected in the Company's consolidated financial
statements.
13
The Company's Asset Management and Student Loan and Guarantee Servicing
offerings constitute reportable operating segments according to the provisions
of SFAS No. 131. The Servicing Software and Direct Marketing 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
before taxes for each of the Company's reportable segments:
Three months ended March 31,
--------------------------------------------------------------------------
2005 2004
---------------------------------- -----------------------------------
Student Student
loan and loan and
Asset guarantee Other Asset guarantee Other
management servicing segments management servicing segments
---------- --------- -------- ---------- --------- --------
Segment revenue ................ 77.0% 21.1% 1.9% 59.9% 37.4% 2.7%
Segment net income (loss) before
taxes ....................... 82.9% 15.4% 1.7% 34.3% 68.6% (2.9%)
The Company's derivative market value adjustment and net settlements are
included in the Asset Management segment. Because the majority of the Company's
derivatives do not qualify for hedge accounting under SFAS No. 133, the
derivative market value adjustment can cause the percent of revenue and net
income before taxes to fluctuate from period to period between segments.
The Company's student loan portfolio has grown significantly through
originations and acquisitions. The Company originated or acquired $1.5 billion
of student loans during the three months ended March 31, 2005 through student
loan acquisition 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 38.7% of the student loans added to the Company's loan
portfolio through a student loan channel during the three months ended
March 31, 2005;
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 46.3% of the student loans added to the Company's loan
portfolio through a student loan channel during the three months ended
March 31, 2005; 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 12.9% of the student loans
added to the Company's loan portfolio through a student loan channel
during the three months ended March 31, 2005.
In addition, the Company also acquires student loans through spot purchases,
which accounted for 2.1% of student loans added to the Company's loan portfolio
through a student loan channel during the three months ended March 31, 2005.
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. 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
14
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. Based upon
provisions of the Higher Education Act, and related interpretations by the
Department, loans financed prior to September 30, 2004 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 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. As of
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. As of
March 31, 2005, the Company holds $3.3 billion in loans that are receiving
special allowance payments based upon the minimum 9.5% rate.
The Company currently recognizes the income from the special allowance payments,
referred to as the special allowance yield adjustment, on these loans as it is
earned and would expect its net interest income to increase over historical
periods accordingly; however, since the portfolio subject to the 9.5% floor is
not expected to increase, amounts recognized will decrease as compared to the
current period. In addition, if interest rates rise, the normal yield on the
portfolio of loans earning this special allowance will increase, thereby
reducing the special allowance yield adjustment. The Company entered into $3.7
billion in notional amount of interest rate swaps in July 2004 to reduce the
risk of rising interest rates on this portfolio.
Net interest income increased $43.5 million, or 100.3%, during the three months
ended March 31, 2005 as compared to the comparable period in 2004. Net interest
income, excluding the effects of variable-rate floor income and the special
allowance yield adjustment, increased approximately $14.1 million, or 32.7%,
during the three months ended March 31, 2005 as compared to the comparable
period in 2004, due to portfolio growth. Net student loans receivable increased
$3.3 billion, or 29.7%, to $14.5 billion as of March 31, 2005 as compared to
$11.2 billion as of March 31, 2004.
Interest income is also dependent upon the relative level of interest rates. The
Company maintains an overall interest rate risk management strategy that
incorporates the use of interest rate derivative instruments to reduce the
economic effect of interest rate volatility. The Company's management has
structured all of its derivative instruments with the intent that each is
economically effective. However, most of the Company's derivative instruments do
not qualify for hedge accounting under SFAS No. 133 and thus may adversely
impact earnings. In addition, the mark-to-market adjustment recorded through
earnings in the Company's consolidated statements of income may fluctuate from
period to period. See Item 3, "Quantitative and Qualitative Disclosures About
Market Risk - Interest Rate Risk."
Competition for the supply channel of education financing in the student loan
industry has caused the cost of acquisition (or loan 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 paid from the purchase of student loans over the average
useful life of the assets. When the Company's loans are consolidated, the
Company may accelerate recognition of unamortized premiums if the consolidated
loan is considered a new loan. 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 the percent of consolidation loans continues to increase
as a percent of the Company's overall loan portfolio, the Company will continue
to experience reduced yields. If these trends continue, the Company could
continue to see an increase in consolidation rebate fees and amortization costs
and a reduction in yield. See "-- Student Loan Portfolio--Student Loan Spread
Analysis." Although the Company's short-term yields may be reduced if this trend
continues, the Company will have been successful in protecting its assets and
stabilizing its balance sheet for long-term growth. Conversely, a reduction in
consolidation of the Company's own loans or the loans of third parties could
positively impact the effect of amortization on the Company's student loan yield
from period to period. Also, as the Company's portfolio of consolidation loans
grows both in nominal dollars and as a percent of the total portfolio, the
impact of premium amortization as a percent of student loan yield should
decrease, unless the cost of acquisition of consolidation loans or underlying
loans increases substantially in the future.
Net interest income includes $15.8 million, or 46 basis points, in yield
reduction due to the amortization of loan premiums and deferred origination
costs during the three months ended March 31, 2005 as compared to $19.8 million,
or 76 basis points, during the comparable period in 2004. This decrease is due
to a slight decease in consolidation activity in 2005 compared to 2004. The
Company's unamortized loan premiums and deferred origination costs, as a percent
of student loans, remained unchanged at 1.3%
15
as of March 31, 2005 and December 31, 2004. Net interest income also includes
$21.8 million, or 63 basis points, in yield reduction due to consolidation
rebate fees during the three months ended March 31, 2005 as compared to $14.5
million, or 55 basis points, during the comparable period in 2004. The increase
in the consolidation loan rebate fee, combined with the lower lender yield of
the consolidation loans the Company is originating, has resulted in student loan
interest spread compression, excluding the effects of the variable-rate floor
income and special allowance yield adjustment, net of settlements on
derivatives, from 1.66% during the three months ended March 31, 2004 to 1.64%
during the three months ended March 31, 2005.
Acquisitions
The Company has positioned itself for growth by building a strong foundation
through acquisitions. Although the Company's assets, loan portfolios, and
fee-based revenues increase through such transactions, a key aspect of each
transaction is its impact on the Company's prospective organic growth and the
development of its integrated platform of services. As a result of these
acquisitions and the Company's rapid organic growth, the period-to-period
comparability of the Company's results of operations may be difficult. A summary
of 2004 and 2005 acquisitions follows:
In January 2004, the Company acquired 50% of the membership interests in
Premiere Credit of North America, LLC ("Premiere"), a collection services
company that specializes in collection of educational debt. This investment is
being accounted for under the equity method of accounting.
In March 2004, the Company acquired rights, title, and interest in certain
assets of the Rhode Island Student Loan Authority ("RISLA"), including the right
to originate student loans in RISLA's name without competition from RISLA for a
period of ten years. The Company further agreed to provide administrative
services in connection with certain of the indentures governing debt securities
of RISLA for a 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% of the stock of infiNET Integrated
Solutions, Inc. ("infiNET"), an ecommerce services provider for colleges,
universities, and healthcare organizations. InfiNET provides customer-focused
electronic transactions, information sharing, and account and bill presentment.
This investment is being accounted for under the equity method of accounting.
In December 2004, the Company purchased 100% of the stock of EDULINX. EDULINX is
a Canadian corporation that engages in the servicing of student loans in Canada.
Effective February 28, 2005, the Company acquired 100% of the capital stock of
SMG, a full service direct marketing agency, and 100% of the membership
interests of NHR, a company which provides publications and scholarships for
middle and high school students achieving exceptional academic success.
Net Interest Income
The Company generates the majority of its earnings from the spread, referred to
as its student loan spread, between the yield the Company receives on its
student loan portfolio and the cost of funding these loans. This spread income
is reported on the Company's income statement as net interest income. The
amortization of loan premiums, including capitalized costs of origination, the
consolidation loan rebate fee, and yield adjustments from borrower benefit
programs, are netted against loan interest income on the Company's income
statement. The amortization and write-offs of debt issuance costs are included
in interest expense on the Company's income statement.
The Company's portfolio of FFELP loans generally earns interest at the higher of
a variable rate based on the special allowance payment, or SAP, formula set by
the Department and the borrower rate, which is fixed over a period of time. The
SAP formula is based on an applicable index plus a fixed spread that is
dependent upon when the loan was originated, the loan's repayment status, and
funding sources for the loan. Depending on the type of student loan and when the
loan was originated, the borrower rate is either fixed to term or is reset to a
market rate each July 1. The larger the reduction in rates subsequent to the
July 1 annual borrower interest rate reset date, the greater the Company's
opportunity to earn variable-rate floor income. In declining interest rate
environments, the Company can earn significant amounts of such income.
Conversely, as the decline in rates abates, or in environments where interest
rates are rising, the Company's opportunity to earn variable-rate floor income
can be reduced, in some cases substantially. Since the borrower rates are reset
annually, the Company views earnings on variable-rate floor income as temporary
and not necessarily sustainable. The Company's ability to earn variable-rate
floor income in future periods is dependent upon the interest rate environment
following the annual reset of borrower rates, and the Company cannot assure the
nature of such environment in the future. The Company recorded no variable-rate
floor income during the three months ended March 31, 2005 as compared to
approximately $348,000 during the comparable period in 2004.
16
On those FFELP loans with fixed-term borrower rates, primarily consolidation
loans, the Company earns interest at the greater of the borrower rate or a
variable rate based on the SAP formula. Since the Company finances the majority
of its student loan portfolio with variable-rate debt, the Company may earn
excess spread on these loans for an extended period of time.
On most consolidation loans, the Company must pay a 1.05% per year rebate fee to
the Department. Those consolidation loans that have variable interest rates
based on the SAP formula earn an annual yield less than that of a Stafford loan.
Those consolidation loans that have fixed interest rates less than the sum of
1.05% and the variable rate based on the SAP formula also earn an annual yield
less than that of a Stafford loan. As a result, as consolidation loans matching
these criteria become a larger portion of the Company's loan portfolio, there
will be a lower yield on the Company's loan portfolio in the short term.
However, due to the extended terms of consolidation loans, the Company expects
to earn the yield on these loans for a longer duration, making them beneficial
to the Company in the long term.
Because the Company generates the majority of its earnings from its student loan
spread, 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 Item 3, "Quantitative and Qualitative Disclosures about Market Risk
- -- Interest Rate Risk."
Investment interest income includes income from unrestricted interest-earning
deposits and funds in the Company's special purpose entities for its
asset-backed securitizations.
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% of principal and interest of federally
insured student loans, which limits the Company's loss exposure to 2% 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 FFELP loans. As a result of this designation, the Company receives
100% reimbursement on all eligible FFELP default claims submitted for
reimbursement during the 12-month period following the effective date of its
designation. The Company is not subject to the 2% risk sharing loss for eligible
claims submitted during this 12-month period. Only FFELP 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% reimbursement.
As of March 31, 2005, more than 99% of the Company's federally insured loans
were serviced by providers designated as an Exceptional Performer. Of this more
than 99%, the Company serviced approximately 91% and third parties serviced
approximately 8%. The Company is entitled to receive this benefit as long as it
and/or its other service providers continue to meet the required servicing
standards published by the Department. Compliance with such standards is
assessed on a quarterly basis.
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company charges off these uninsured
loans when the collection of principal and interest is 120 days past due.
The evaluation of the provision for loan losses is inherently subjective, as it
requires material estimates that may be subject to significant changes. The
provision for loan losses reflects the activity for the applicable period and
provides an allowance at a level that management believes is adequate to cover
probable losses inherent in the loan portfolio.
17
Other Income
The Company also earns fees and generates income from other sources, including
principally loan and guarantee servicing income, licensing fees on its software
products, and fee-based revenue from direct marketing activities. Loan servicing
fees are determined according to individual agreements with customers and are
calculated based on the dollar value or number of loans serviced for each
customer. 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.
Other fee-based income includes income from the sale of lists and student
publications and is recognized when the lists or products are shipped.
Other income also includes the derivative market value adjustment and net
settlements as further discussed in Item 3, "Quantitative and Qualitative
Disclosures About Market Risk -- Interest Rate Risk."
Operating Expenses
Operating expenses include indirect costs incurred to generate and acquire
student loans, costs incurred to manage and administer the Company's student
loan portfolio and its financing transactions, costs incurred to service the
Company's student loan portfolio and the portfolios of third parties, costs
incurred to provide software and direct marketing services to third parties, and
other general and administrative expenses. Operating expenses also includes the
depreciation and amortization of capital assets and intangible assets.
The Company does not believe inflation has a significant effect on its
operations.
Results of Operations
Three months ended March 31, 2005 compared to the three months ended March 31,
2004
Three months ended March 31, Change
---------------------------- ----------------------------
2005 2004 Dollars Percent
--------- --------- --------- ---------
(dollars in thousands)
Interest income:
Loan interest, excluding variable-rate floor income . $ 200,107 $ 108,196 $ 91,911 84.9%
Variable-rate floor income .......................... -- 348 (348) (100.0)
Amortization of loan premiums and deferred .......... (15,782) (19,817) 4,035 20.4
origination costs
Investment interest ................................. 7,002 3,651 3,351 91.8
--------- --------- --------- ---------
Total interest income ............................. 191,327 92,378 98,949 107.1
Interest expense:
Interest on bonds and notes payable ................. 104,525 49,043 55,482 113.1
--------- --------- --------- ---------
Net interest income ............................... 86,802 43,335 43,467 100.3
Less provision for loan losses ......................... 2,031 3,115 (1,084) (34.8)
--------- --------- --------- ---------
Net interest income after provision for loan losses 84,771 40,220 44,551 110.8
--------- --------- --------- ---------
Other income:
Loan and guarantee servicing income ................. 37,176 26,063 11,113 42.6
Other fee-based income .............................. 3,356 1,889 1,467 77.7
Software services income ............................ 2,206 1,892 314 16.6
Other income ........................................ 1,400 1,443 (43) (3.0)
Derivative market value adjustment .................. 60,290 (2,527) 62,817 100.0
Derivative settlements, net ......................... (10,086) (1,214) (8,872) (730.8)
--------- --------- --------- ---------
Total other income ................................ 94,342 27,546 66,796 242.5
--------- --------- --------- ---------
Operating expenses:
Salaries and benefits ............................... 39,327 27,769 11,558 41.6
Other operating expenses:
Depreciation and amortization, excluding
amortization of intangible assets .............. 3,293 2,330 963 41.3
Amortization of intangible assets ................. 1,173 2,078 (905) (43.6)
Trustee and other debt related fees ............... 2,328 2,614 (286) (10.9)
Occupancy and communications ...................... 4,232 3,082 1,150 37.3
Advertising and marketing ......................... 3,138 2,323 815 35.1
Professional services ............................. 5,776 4,460 1,316 29.5
Postage and distribution .......................... 4,306 3,848 458 11.9
Other ............................................. 7,815 4,708 3,107 66.0
--------- --------- --------- ---------
Total other operating expenses ................. 32,061 25,443 6,618 26.0
--------- --------- --------- ---------
Total operating expenses ....................... 71,388 53,212 18,176 34.2
--------- --------- --------- ---------
Income before income taxes ..................... 107,725 14,554 93,171 640.2
Income tax expense ..................................... 39,638 5,433 34,205 629.6
--------- --------- --------- ---------
Net income ..................................... $ 68,087 $ 9,121 $ 58,966 646.5%
========= ========= ========= =========
18
Net interest income. Total loan interest, including amortization of loan
premiums and deferred origination costs, increased as a result of an increase in
the size of the student loan portfolio, changes in the interest rate
environment, and the special allowance yield adjustment, offset by changes in
the pricing characteristics of the Company's student loan assets. The special
allowance yield adjustment of $29.7 million and higher average interest rates on
loans caused an increase in the student loan net yield on the Company's student
loan portfolio to 5.37% from 3.40% (when excluding the special allowance yield
adjustment, the student loan yield during the three months ended March 31, 2005
was 4.51%.) Variable-rate floor income decreased due to the relative change in
interest rates during the periods subsequent to the annual borrower interest
rate reset date on July 1 of each year. Consequently, the Company realized no
variable-rate floor income during the three months ended March 31, 2005 as
compared to approximately $348,000 during the comparable period in 2004. The
weighted average interest rate on the student loan portfolio increased due to
the special allowance yield adjustment and higher interest rates on loans,
offset by the increase in the number of lower yielding consolidation loans,
resulting in an increase in loan interest income of approximately $46.1 million.
Consolidation loan activity also increased the consolidation rebate fee expense,
offset by a decrease in the amortization and write-off of loan premiums and
deferred origination costs, overall decreasing loan interest income
approximately $3.3 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 $3.3 billion, or 31.5%, during the three months
ended March 31, 2005 compared to the same period in 2004, which increased loan
interest income by approximately $53.1 million.
Interest expense on bonds and notes payable increased as average total debt
increased approximately $3.0 billion. Average variable-rate debt increased $3.3
billion, which increased interest expense by approximately $21.3 million. The
Company reduced average fixed-rate debt by $218.0 million, which decreased the
Company's overall interest expense by approximately $3.4 million. The increase
in interest rates, specifically LIBOR and auction rates, increased the Company's
average cost of funds (excluding derivative settlement costs) to 2.85% from
1.69%, which increased interest expense approximately $37.4 million.
Net interest income, excluding the effects of the special allowance yield
adjustment and variable-rate floor income, increased approximately $14.1
million, or 32.7%, to approximately $57.1 million from approximately $43.0
million.
Provision for loan losses. The provision for loan losses for federally insured
student loans decreased $1.4 million from $1.5 million to $81,000 because of the
Company's Exceptional Performer designation in June 2004. The provision for loan
losses for non-federally insured loans increased $280,000 from $1.7 million to
$2.0 million because of the increase in the non-federally insured loans and
expected performance of the non-federally insured loan portfolio.
Other income. Loan and guarantee servicing income increased due to the
acquisition of EDULINX in December 2004, which recognized $15.4 million of
servicing income during the three months ended March 31, 2005. This increase was
offset by the reduction in the number and dollar amount of loans serviced for
third parties in the Company's U.S. servicing operations from $9.4 billion as of
March 31, 2004 to $8.9 billion as of March 31, 2005. Total average U.S.
third-party loan servicing volume decreased $127.7 million, or 1.4%, which
resulted in a decrease in loan servicing income of approximately $2.7 million.
The decrease in the Company's U.S. servicing volume is due to loan pay downs
being greater than loan additions within the third-party customer portfolios. In
addition, guarantee servicing income decreased $1.6 million due to a customer
that did not renew its servicing contract in April 2004. Other fee-based income
increased due to the acquisitions of SMG and NHR effective February 28, 2005.
Software services income increased due to additional system maintenance and
enhancement work performed for clients.
The Company utilizes derivative instruments to provide economic hedges to
protect against the impact of adverse changes in interest rates. During the
three months ended March 31, 2005, the derivative market value adjustment gains
were $60.3 million and net settlements representing realized costs were $10.1
million as compared to derivative market adjustment losses of $2.5 million and
net settlements of $1.2 million for the comparable period in 2004. This
increase, in addition to the changes in interest rates and fluctuations in the
forward yield curve, is the result of the Company entering into $3.7 billion in
notional amount of derivatives in July 2004. See Item 3, "Quantitative and
Qualitative Disclosures about Market Risk -- Interest Rate Risk."
Operating expenses. Salaries and benefits increased $7.5 million due to the
acquisitions of EDULINX, SMG, and NHR. In addition, the 2005 incentive plan
expense increased approximately $3.0 million due to a change in terms of the
Company's incentive plan.
The increase in depreciation and amortization is due to an approximately
$600,000 increase as a result of the acquisition of EDULINX. The decrease in the
amortization of intangible assets is due to certain intangible assets becoming
fully amortized in 2004, offset by the amortization of acquired intangible
assets related to recent acquisitions. The decrease in trustee and other debt
related fees relates to the improved efficiencies in the Company's debt
transactions. Occupancy and communications, professional services, postage and
distribution, and other operating expenses increased due to the acquisition of
EDULINX, SMG, and NHR. Advertising and marketing expenses increased
approximately $340,000 due to the acquisitions of EDULINX and SMG and
approximately $475,000 due to the expansion of the Company's marketing efforts,
especially in the consolidations area.
19
Income tax expense. Income tax expense increased due to the increase in income
before income taxes. The Company's effective tax rate was 36.8% and 37.3% during
the three months ended March 31, 2005 and 2004, respectively.
Financial Condition
As of March 31, 2005 compared to December 31, 2004
Change
As of As of -------------------------------
March 31, 2005 December 31, 2004 Dollars Percent
-------------- ----------------- ----------- -----------
(dollars in thousands)
Assets:
Student loans receivable, net ................. $14,540,316 $13,461,814 $ 1,078,502 8.0%
Other assets .................................. 1,443,012 1,698,191 (255,179) (15.0)
Fair value of derivative instruments, net ..... 48,223 -- 48,223 100.0
----------- ----------- ----------- -----------
Total assets ............................. $16,031,551 $15,160,005 $ 871,546 5.7%
=========== =========== =========== ===========
Liabilities:
Bonds and notes payable ....................... $15,318,517 $14,300,606 $ 1,017,911 7.1%
Fair value of derivative instruments, net ..... -- 11,895 (11,895) (100.0)
Other liabilities ............................. 187,723 391,329 (203,606) (52.0)
----------- ----------- ----------- -----------
Total liabilities ........................ 15,506,240 14,703,830 802,410 5.5
Shareholders' equity:
Shareholders' equity .......................... 525,311 456,175 69,136 15.2
----------- ----------- ----------- -----------
Total liabilities and shareholders' equity $16,031,551 $15,160,005 $ 871,546 5.7%
=========== =========== =========== ===========
Total assets increased primarily due to an increase in student loans receivable.
The Company originated and acquired $1.5 billion of student loans during the
three months ended March 31, 2005, offset by repayments of approximately $0.4
billion. Other assets declined primarily because of a $220.5 million decrease in
restricted cash due to loan program customers, which reflects timing of
disbursements on loans and reduced lockbox volume. The fair value of derivatives
instruments changed from a net liability as of December 31, 2004 to a net asset
as of March 31, 2005 due to the change in market conditions on the Company's
derivative instruments. Total liabilities increased primarily because of an
increase in bonds and notes payable, resulting from additional borrowings to
fund growth in student loans. Other liabilities include restricted cash amounts
due to loan program customers that decreased $220.5 million as a result of
timing of disbursements on loans and reduced lockbox volume. Shareholders'
equity increased primarily as a result of net income of $68.1 million during the
three months ended March 31, 2005.
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, on April 13, 2005, the Company filed a universal shelf registration
statement with the Securities and Exchange Commission ("SEC"). When declared
effective, this will allow the Company to sell up to $750 million of securities
that may consist of common stock, preferred stock, unsecured debt securities,
warrants, stock purchase contracts, and stock purchase units. The terms of any
securities would be established at the time of the offering. As of the date of
this report, the registration statement has not yet become effective, and
securities may not be sold under the registration statement nor may offers to
buy be accepted before the registration statement becomes effective. The
information in this report with respect to the universal shelf registration
statement shall not constitute an offer to sell or solicitation of an offer to
buy the securities.
Operating activities provided net cash of $26.8 million during the three months
ended March 31, 2005, a decrease of $44.3 million from the net cash provided by
operating activities of $71.1 million during the comparable period in 2004.
Operating cash flows are driven by net income adjusted for various non-cash
items such as the provision for loan losses, depreciation and amortization,
deferred income taxes, the derivative market value adjustment, non-cash
compensation expense, and income (losses) from equity method investments. These
non-cash items resulted in a decrease in cash provided by operating activities
of $45.6 million during the three months ended March 31, 2005 as compared to the
comparable period in 2004.
As of March 31, 2005, the Company had a $35.0 million operating line of credit
and a $50.0 million commercial paper commitment under two separate facilities
from a group of six large regional and national financial institutions that
expire in September 2005. The Company uses these facilities primarily for
general operating purposes and had $23.9 million borrowed under these facilities
as of March 31, 2005. The Company had $61.1 million available to borrow under
these operating lines as of March 31, 2005. The Company believes these
facilities and the universal shelf registration indicate a favorable trend in
its available capital resources.
20
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 $15.3 billion of debt outstanding as of March 31, 2005, $12.5
billion was issued under securitization transactions. On February 16, 2005 and
April 19, 2005, the Company completed asset-backed securities transactions
totaling $1.3 billion and $2.0 billion, respectively. Depending on market
conditions, the Company anticipates continuing to access the asset-backed
securities market in 2005 and subsequent years. Securities issued in the
securitization transactions are generally priced off a spread to LIBOR or set
under an auction procedure. The student loans financed are generally priced on a
spread to commercial paper or U.S. Treasury bills.
The Company's warehouse facilities allow for expansion of liquidity and capacity
for student loan growth and should provide adequate liquidity to fund the
Company's student loan operations for the foreseeable future. As of March 31,
2005, the Company had a loan warehousing capacity of $4.4 billion, of which $2.8
billion was outstanding, through 364-day commercial paper conduit programs. The
Company had $1.6 billion in warehouse capacity available under its warehouse
facilities as of March 31, 2005. These conduit programs mature in 2005 through
2009; however, they must be renewed annually by underlying liquidity providers.
Historically, the Company has been able to renew its commercial paper conduit
programs, including the underlying liquidity agreements, and therefore the
Company 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
significantly 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
March 31, 2005:
Interest rate
range on
Carrying Percent carrying Final
amount of total amount maturity
----------- ----------- ------------- -------------------
(dollars in
thousands)
Variable rate bonds and notes (a):
Bond and notes based on indices ...... $ 8,289,473 54.1% 1.84% - 3.79% 11/25/09 - 01/25/41
Bond and notes based on auction ...... 3,542,470 23.1 1.85% - 3.20% 11/01/09 - 07/01/43
----------- -----------
Total variable rate bonds and notes 11,831,943 77.2
Commerical paper and other .............. 2,786,767 18.2 2.65% - 2.80% 05/13/05 - 09/02/09
Fixed-rate bonds and notes (a) .......... 660,943 4.3 5.20% - 6.68% 05/01/05 - 05/01/29
Other borrowings ........................ 38,864 0.3 2.95% - 6.00% 09/23/05 - 11/01/05
----------- -----------
Total ................................ $15,318,517 100.0%
=========== ===========
- ----------
(a) Issued in securitization transactions.
The Company is committed under noncancelable operating leases for certain office
and warehouse space and equipment. The Company's contractual obligations as of
March 31, 2005 were as follows:
Less than More than
Total 1 year 1 to 3 years 3 to 5 years 5 years
----------- ----------- ------------ ------------ -----------
(dollars in thousands)
Bonds and notes payable ... $15,318,517 2,533,986 203,001 779,227 11,802,303
Operating lease obligations 19,859 5,815 9,001 3,208 1,835
----------- ----------- ----------- ----------- -----------
Total .................. $15,338,376 2,539,801 212,002 782,435 11,804,138
=========== =========== =========== =========== ===========
The Company has commitments with its branding partners and forward flow lenders
which obligate the Company to purchase loans originated under specific criteria,
although the branding partners and forward flow lenders are not obligated to
provide the Company with a minimum amount of loans. Branding partners are those
entities from whom the Company acquires student loans and provides marketing and
origination services. Forward flow lenders are those entities from whom the
Company acquires student loans and provides origination services. These
commitments generally run for periods ranging from one to five years and are
generally renewable. As of March 31, 2005, the Company was committed to extend
credit or was obligated to purchase $372.8 million of student loans at current
market rates at the respective sellers' requests under various agreements.
21
On December 1, 2004, the Company purchased EDULINX in a business combination for
$7.0 million. An additional payment of approximately $6.3 million is to be paid
by the Company if EDULINX obtains an extension or renewal of a significant
customer servicing contract that currently expires in February 2006. This
contingency payment is due following the date on which such extension or renewal
period of the servicing contract commences.
Effective February 28, 2005, the Company purchased 100% of the capital stock of
SMG and 100% of the membership interests of NHR. The initial consideration paid
by the Company was $27.0 million. In addition to the initial purchase price,
additional payments are to be paid by the Company based on the operating results
of SMG and NHR as defined in the purchase agreement. The contingent payments are
payable in annual installments through April 2008 and in total will range from a
minimum of $4.0 million to a maximum of $24.0 million.
Student Loan Portfolio
The table below describes the components of the Company's loan portfolio:
As of March 31, 2005 As of December 31, 2004
---------------------------- ----------------------------
Dollars Percent Dollars Percent
------------ ------------ ------------ ------------
(dollars in thousands)
Federally insured:
Stafford .............................................. $ 5,340,328 36.7% $ 5,047,487 37.5%
PLUS/SLS .............................................. 329,765 2.3 252,910 1.9
Consolidation ......................................... 8,592,889 59.1 7,908,292 58.7
Non-federally insured .................................... 94,225 0.7 90,405 0.7
------------ ------------ ------------ ------------
Total .............................................. 14,357,207 98.8 13,299,094 98.8
Unamortized loan premiums and deferred origination costs . 191,961 1.3 169,992 1.3
Allowance for loan losses:
Allowance - federally insured ......................... (99) (0.0) (117) (0.0)
Allowance - non-federally insured ..................... (8,753) (0.1) (7,155) (0.1)
------------ ------------ ------------ ------------
Net ................................................ $ 14,540,316 100.0% $ 13,461,814 100.0 %
============ ============ ============ ============
22
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 March 31,
--------------------------------
2005 2004
------------ ------------
(dollars in thousands)
Balance at beginning of period ..................................... $ 7,272 $ 16,026
Provision for loan losses:
Federally insured loans ......................................... 81 1,445
Non-federally insured loans ..................................... 1,950 1,670
------------ ------------
Total provision for loan losses .............................. 2,031 3,115
Charge-offs:
Federally insured loans ......................................... (99) (985)
Non-federally insured loans ..................................... (503) (1,629)
------------ ------------
Total charge-offs ............................................ (602) (2,614)
Recoveries, non-federally insured loans ............................ 151 96
------------ ------------
Net charge-offs .................................................... (451) (2,518)
------------ ------------
Balance at end of period ........................................... $ 8,852 $ 16,623
============ ============
Allocation of the allowance for loan losses:
Federally insured loans ......................................... $ 99 $ 10,215
Non-federally insured loans ..................................... 8,753 6,408
------------ ------------
Total allowance for loan losses .............................. $ 8,852 $ 16,623
============ ============
Net loan charge-offs as a percentage of average student loans ...... 0.013% 0.096%
Total allowance as a percentage of average student loans ........... 0.064% 0.159%
Total allowance as a percentage of ending balance of student loans . 0.062% 0.150%
Non-federally insured allowance as a percentage of the ending
balance of non-federally insured loans .......................... 9.289% 6.923%
Average student loans .............................................. $ 13,742,362 $ 10,453,826
Ending balance of student loans .................................... $ 14,357,207 $ 11,065,865
Ending balance of non-federally insured loans ...................... $ 94,225 $ 92,567
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 March 31, 2005 As of December 31, 2004
---------------------------- ----------------------------
Dollars Percent Dollars Percent
----------- ----------- ----------- -----------
(dollars in thousands)
Federally Insured Loans:
Loans in-school/grace/deferment(1) ...... $ 4,204,056 $ 3,584,260
Loans in forebearance(2) ................ 1,718,915 1,654,158
Loans in repayment status:
Loans current ........................ 7,500,158 89.9% 7,142,808 89.6%
Loans delinquent 31-60 days(3) ....... 291,673 3.5 338,434 4.3
Loans delinquent 61-90 days(3) ....... 173,859 2.1 154,477 1.9
Loans delinquent 91 days or greater(4) 374,321 4.5 334,552 4.2
----------- ----------- ----------- -----------
Total loans in repayment .......... 8,340,011 100.0% 7,970,271 100.0%
----------- =========== ----------- ===========
Total federally insured loans ..... $14,262,982 $13,208,689
=========== ===========
Non-Federally Insured Loans:
Loans in-school/grace/deferment(1) ...... $ 25,500 $ 23,106
Loans in forebearance(2) ................ 2,338 2,110
Loans in repayment status:
Loans current ........................ 61,069 92.0% 58,606 89.9%
Loans delinquent 31-60 days(3) ....... 1,953 2.9 2,559 3.9
Loans delinquent 61-90 days(3) ....... 1,643 2.5 1,495 2.3
Loans delinquent 91 days or greater(4) 1,722 2.6 2,529 3.9
----------- ----------- ----------- -----------
Total loans in repayment .......... 66,387 100.0% 65,189 100.0%
----------- =========== ----------- ===========
Total non-federally insured loans . $ 94,225 $ 90,405
=========== ===========
- ----------
(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.
23
(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.
Origination and Acquisition
The Company's student loan portfolio increases through various channels,
including originations through the direct channel and acquisitions through the
branding partner channel, the forward flow channel, and spot purchases. The
Company's portfolio also increases with the addition of portfolios acquired
through business acquisitions.
One of the Company's primary objectives is to focus on originations through the
direct channel and acquisitions through the branding partner channel. The
Company has extensive and growing relationships with many large financial and
educational institutions that are active in the education finance industry. Loss
of a strong relationship with an institution that 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 of loans originated or acquired through
each of the Company's channels:
Three months ended March 31,
-------------------------------
2005 2004
------------ ------------
(dollars in thousands)
Beginning balance ................................. $ 13,299,094 10,314,874
Direct channel:
Consolidation loan originations ................ 745,090 806,565
Less consolidation of existing portfolio ....... (337,100) (368,400)
------------ ------------
Net consolidation loan originations ......... 407,990 438,165
Stafford/PLUS loan originations ................ 155,023 92,927
Branding partner channel .......................... 673,841 354,503
Forward flow channel .............................. 187,163 85,204
Other channels .................................... 31,688 20,996
------------ ------------
Total channel acquisitions ..................... 1,455,705 991,795
Repayments, claims, capitalized interest, and other (397,592) (240,804)
------------ ------------
Ending balance .................................... $ 14,357,207 11,065,865
============ ============
24
Student Loan Spread Analysis
Maintenance of the spread on assets is a key factor in maintaining and growing
the Company's income. The following table analyzes the student loan spread on
the Company's portfolio of student loans and represents the spread on assets
earned in conjunction with the liabilities used to fund the assets:
Three months ended March 31,
------------------------------------
2005 2004
-------------- --------------
Student loan yield ................................ 6.46% 4.71%
Consolidation rebate fees ......................... (0.63) (0.55)
Premium and deferred origination costs amortization (0.46) (0.76)
-------------- --------------
Student loan net yield ............................ 5.37 3.40
Student loan cost of funds (a) .................... (3.12) (1.73)
-------------- --------------
Student loan spread ............................... 2.25 1.67
Variable-rate floor income ........................ -- (0.01)
Special allowance yield adjustment, net of
settlements on derivatives (b) ................. (0.61) --
-------------- --------------
Core student loan spread .......................... 1.64% 1.66%
============== ==============
Average balance of student loans (in thousands) ... $ 13,742,362 $ 10,453,826
Average balance of debt outstanding (in thousands) 14,677,213 11,631,648
- ----------
(a) The student loan cost of funds includes the effects of the net settlement
costs on the Company's derivative instruments of $10.1 million and $1.2
million for the three months ended March 31, 2005 and 2004, respectively.
(b) The special allowance yield adjustment of approximately $29.7 million for
the three months ended March 31, 2005 represents the impact of net spread
had loans earned at statutorily defined rates under a taxable financing.
This special allowance yield adjustment has been reduced by net
settlements on derivative instruments that were used to hedge this loan
portfolio earning the excess yield, which was $8.9 million for the three
months ended March 31, 2005.
The increase in lower yielding consolidation loans coupled with a slightly
higher interest rate environment has caused some compression in the Company's
loan spread when excluding the special allowance yield adjustment, net of
settlements on derivatives.
Risks
If any of the following risks actually occurs, the Company's business, financial
condition, and results of operations could be materially and adversely affected.
See also the risk factors under the heading "Risk Factors" in Part I, Item I,
"Business" in the Company's Annual Report on Form 10-K for the year ended
December 31, 2004.
Political/Regulatory Risk
Following the Company's disclosures related to recognition of the special
allowance yield adjustment on its 9.5% loan portfolio ("9.5% Floor"), a United
States Senator, by letter to the Secretary of Education dated August 26, 2004,
requested information as to whether the Department had approved of the Company's
receipt of the 9.5% Floor income and, if not, why the Department had not sought
to recover claimed subsidies under the 9.5% Floor. By letter dated September 10,
2004, the Company furnished to the Department certain background information
concerning the growth of the 9.5% Floor loans in its portfolio, which
information had been requested by the Department. The Senator, in a second
letter to the SEC dated September 21, 2004, requested that the SEC investigate
the Company's activities related to the 9.5% Floor. More specifically, the
individual raised concerns about the Company's disclosures in connection with
its decision to recognize the previously deferred income, and trading of Company
securities by Company executives following such disclosures. On September 27,
2004, the Company voluntarily contacted the SEC to request a meeting with the
SEC Staff. The Company's request was granted, and representatives of the Company
met with representatives of the SEC Staff on October 12, 2004. Company
representatives offered to provide to the SEC information that the SEC Staff
wished to have relating to the issues raised in the Senator's letter. By letter
dated October 14, 2004, the SEC Staff requested that, in connection with an
informal investigation, the Company provide certain identified information. The
Company has furnished to the SEC Staff the information it has requested and is
fully cooperating with the SEC Staff in its informal investigation. The Company
continues to believe that the concerns expressed to the SEC by the Senator are
entirely unfounded, but it is not appropriate or feasible to determine or
predict the ultimate outcome of the SEC's informal investigation. The Company's
costs related to the SEC's informal investigation are being expensed as
incurred. Additional costs, if any, associated with an adverse outcome or
resolution of that matter, in a manner that is currently indeterminate and
inherently unpredictable, could adversely affect the Company's financial
condition and results of operations. Although it is possible that an adverse
outcome in certain circumstances could have a material adverse effect, based on
information currently known by the Company's management, in its opinion, the
outcome of such pending informal investigation is not likely to have such an
effect.
25
Pursuant to the terms of the Higher Education Act, the FFEL Program is
periodically amended, and the Higher Education Act is generally reauthorized by
Congress every five to six years in order to prevent sunset of that Act. Changes
in the Higher Education Act made in the two most recent reauthorizations have
included reductions in the student loan yields paid to lenders, increased fees
paid by lenders, and a decreased level of federal guarantee. Future changes
could result in further negative impacts on the Company's business. Moreover,
there can be no assurance that the provisions of the Higher Education Act, which
is scheduled to expire on September 30, 2005, will be reauthorized. While
Congress has consistently extended the effective date of the Higher Education
Act, it may elect not to reauthorize the Department's ability to provide
interest subsidies, special allowance payments, and federal guarantees for
student loans. Such a failure to reauthorize would reduce the number of
federally insured student loans available for the Company to originate and/or
acquire in the future. With respect to EDULINX, changes in the Canada Student
Loans Program, or the CSLP, which governs the majority of the loans serviced by
EDULINX, could result in a similar negative impact on EDULINX' business.
Some of the highlights of specific proposed legislation and President Bush's
fiscal year 2006 budget proposals that, if enacted, could have a material effect
on the Company's operations, in no particular order, include:
o allowing refinancing of consolidation loans, which would open
approximately 59% of the Company's portfolio to such refinancing;
o increasing origination fees paid by lenders in connection with making or
holding loans;
o allowing for variable-rate consolidation loans and extended repayment
terms of Stafford loans, which would lead to fewer loans lost through
consolidation of the Company's portfolio, but would also decrease
consolidation opportunities;
o changes to the FFEL Program guarantee rates and terms, including proposals
for a decrease in insurance on portfolios receiving the benefit of the
Exceptional Performance designation from 100% to 97% or greater of
principal and accrued interest, and a decrease in insurance on portfolios
not subject to the Exceptional Performance designation from 98% to 95% of
principal and accrued interest;
o eliminating variable-rate floor income, including prospectively and
permanently eliminating the 9.5% floor interest rate on loans refinanced
with funds from pre-1993 tax-exempt financings and eliminating rebate of
excess earnings on loans where the borrower rate is in excess of the
lender rate;
o limiting and/or preventing a FFEL Program lender from making a
consolidation loan consisting of only Federal Direct Lending ("FDL")
loans; and
o initiatives aimed at promoting the FDL Program to the detriment of the
FFEL Program.
In addition, in October 2004, Congress passed and President Bush signed into law
the Taxpayer-Teacher Protection Act of 2004 (the "October Act"), which
prospectively suspended eligibility for the 9.5% Floor on any loans refinanced
with proceeds of taxable obligations between September 30, 2004 and January 1,
2006. The Company's FFELP loans, which have been refinanced with proceeds of
taxable obligations and are receiving special allowance payments under the 9.5%
Floor, were all refinanced with proceeds of taxable obligations well before
September 30, 2004. The Company had ceased adding to its portfolio of loans
receiving special allowance payments subject to the 9.5% Floor in May 2004, and
thus the language in the October Act is not expected to have an effect upon the
eligibility of such loans for the 9.5% Floor, nor is it expected to have a
material effect upon the Company's financial condition or results of operation.
There are proponents of legislation which could act to retroactively remove
eligibility for the 9.5% Floor from FFELP loans that have, prior to September
30, 2004, been refinanced with proceeds of taxable obligations. The Company
cannot predict whether such legislation will be advanced in the future. If such
retroactive legislation were to be enacted and withstand legal challenge, it
would have a material adverse effect upon the Company's financial condition and
results of operations. Retroactive legislation was called for during
congressional debate in October 2004. However, the Department has indicated that
receipt of the 9.5% Floor income is permissible under current law and previous
interpretations thereof. The Company cannot predict whether the Department will
maintain its position in the future on the permissibility of the 9.5% Floor.
The Company cannot predict whether the above legislative or budget proposals
will be enacted into law, but they may form some of the framework utilized by
Congress in negotiating the fiscal year 2006 budget resolution and
reauthorization of the Higher Education Act. 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.
26
Liquidity Risk
The Company's primary funding needs are those required to finance its student
loan portfolio and satisfy its cash requirements for new student loan
originations and acquisitions, operating expenses, and technological
development. The Company's operating and warehouse financings are substantially
provided by third parties, over which it has no control. Unavailability of such
financing sources may subject the Company to the risk that it may be unable to
meet its financial commitments to creditors, branding partners, forward flow
lenders, or borrowers when due unless it finds alternative funding mechanisms.
The Company relies upon conduit warehouse loan financing vehicles to support its
funding needs on a short-term basis. There can be no assurance that the Company
will be able to maintain such warehouse financing in the future. As of March 31,
2005, the Company had a student loan warehousing capacity of $4.4 billion, of
which $2.8 billion was outstanding, through 364-day commercial paper conduit
programs. These conduit programs mature in 2005 through 2009; however, they must
be renewed annually by underlying liquidity providers and may be terminated at
any time for cause. There can be no assurance 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. The Company's has two general
operating lines of credit that are for terms of less than one year each, are
renewable at the option of the lenders, and may be terminated at any time for
cause. In addition, the Company has a credit facility agreement with a Canadian
financial institution that is cancelable by either party upon demand.
The Company has historically relied upon, and expects to continue to rely upon,
asset-backed securitizations as its most significant source of funding for
student loans on a long-term basis. As of March 31, 2005, $12.5 billion of the
Company's student loans were funded by long-term asset-backed securitizations.
The net cash flow the Company receives from the securitized student loans
generally represents the excess amounts, if any, generated by the underlying
student loans over the amounts required to be paid to the bondholders, after
deducting servicing fees and any other expenses relating to the securitizations.
In addition, some of the residual interests in these securitizations have been
pledged to secure additional bond obligations. The Company's rights to cash flow
from securitized student loans are subordinate to bondholder interests, and
these loans may fail to generate any cash flow beyond what is due to pay
bondholders.
The interest rates on certain of the Company's asset-backed securities are set
and periodically reset via a "dutch auction" utilizing remarketing agents for
varying intervals ranging from seven to 91 days. Investors and potential
investors submit orders through a broker-dealer as to the principal amount of
notes they wish to buy, hold, or sell at various interest rates. The
broker-dealers submit their clients' orders to the auction agent or remarketing
agent, who determines the interest rate for the upcoming period. If there are
insufficient potential bid orders to purchase all of the notes offered for sale
or being repriced, the Company could be subject to interest costs substantially
above the anticipated and historical rates paid on these types of securities. A
failed auction or remarketing could also reduce the investor base of the
Company's other financing and debt instruments.
In addition, rising interest rates existing at the time the Company's
asset-backed securities are remarketed may cause other competing investments to
become more attractive to investors than the Company's securities, which may
decrease the Company's liquidity.
Credit Risk
As of March 31, 2005, 99% of the Company's student loan portfolio was comprised
of federally insured loans. These loans benefit from a federal guarantee of
between 98% and 100% of their principal balance and accrued interest.
In June 2004, the Company was designated as an Exceptional Performer by the
Department in recognition of its exceptional level of performance in servicing
FFELP loans. As a result of this designation, the Company is not subject to the
2% risk sharing loss for eligible claims submitted during a 12-month period. The
Company is entitled to receive this benefit as long as it and/or its other
service providers designated as Exceptional Performers continue to meet the
required servicing standards published by the Department. Compliance with such
standards is assessed on a quarterly basis. The Company bears full risk of
losses experienced with respect to the unguaranteed portion of its federally
insured loans (those loans not serviced by a service provider designated as an
Exceptional Performer). If the Company or a third party service provider were to
lose its Exceptional Performance designation, either by the Department
discontinuing the program or the Company or third party not meeting the required
servicing standards, loans serviced by the Company or third-party would become
subject to the 2% risk sharing loss for all claims submitted after any loss of
the Exceptional Performance designation. If the Department discontinued the
program, the Company would have to establish a provision for loan losses related
27
to the 2% risk sharing. Based on the balance of federally insured loans
outstanding as of March 31, 2005, this provision would be approximately $10.0
million. In addition, President Bush's fiscal year 2006 budget proposals provide
for a decrease in insurance (i) under the Exceptional Performer designation from
100% to 97% or greater and (ii) on portfolios not subject to the Exceptional
Performer designation from 98% to 95% of principal and accrued interest. The
Company cannot predict whether the budget proposals will be enacted into law,
but they may form some of the framework for Congress as it negotiates the fiscal
year 2006 budget resolution.
Losses on the Company's non-federally insured loans are borne by the Company,
with the exception of certain privately insured loans. Privately insured loans
constitute a minority of the Company's non-federally insured loan portfolio. The
loan loss pattern on the Company's non-federally insured loan portfolio is not
as developed as that on its federally insured loan portfolio. As of March 31,
2005, the aggregate principal balance of non-federally insured loans comprised
1% of the Company's entire student loan portfolio; however, it is expected to
increase to between 3% and 5% over the next three to five years. There can be no
assurance that this percentage will not further increase over the long term. 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.
While the Company has provided allowances estimated to cover losses that may be
experienced in both its federally insured and non-federally insured loan
portfolios, there can be no assurance that such allowances will be sufficient to
cover actual losses in the future.
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. In addition, Canadian laws and regulations govern the Company's Canadian
loan servicing operations. 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 portfolio of federally insured loans is subject to refinancing
through the use of consolidation loans, which are expressly permitted by the
Higher Education Act. Consolidation loan activity may result in three
detrimental effects. First, when the Company consolidates loans in its
portfolio, the new consolidation loans have a lower yield than the loans being
refinanced due to the statutorily mandated consolidation loan rebate fee of
1.05% per year. Although consolidation loans generally feature higher average
balances, longer average lives, and slightly higher special allowance payments,
such attributes may not be sufficient to counterbalance the cost of the rebate
fees. Second, and more significantly, the Company may lose student loans in its
portfolio that are consolidated away by competing lenders. Increased
consolidations of student loans by the Company's competitors may result in a
negative return on loans, when considering the origination costs or acquisition
premiums paid with respect to these loans. Additionally, consolidation of loans
away by competing lenders can result in a decrease of the Company's servicing
portfolio, thereby decreasing fee-based servicing income. Third, increased
consolidations of the Company's own student loans create cash flow risk because
the Company incurs upfront consolidation costs, which are in addition to the
origination or acquisition costs incurred in connection with the underlying
student loans, while extending the repayment schedule of the consolidated 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. Other potential changes to the Higher
Education Act relating to consolidation loans that could adversely impact the
Company include allowing refinancing of consolidation loans, which would open
approximately 59% of the Company's portfolio to such refinancing, and increasing
origination fees paid by lenders in connection with making consolidation loans.
28
Competitive Risks
Under the FDL Program, the Department makes loans directly to student borrowers
through the educational institutions they attend. The volume of student loans
made under the FFEL Program and available for the Company to originate or
acquire may be reduced to the extent loans are made to students under the FDL
Program. In addition, if the FDL Program expands, to the extent the volume of
loans serviced by the Company is reduced, the Company may experience reduced
economies of scale, which could adversely affect earnings. Loan volume
reductions could further reduce amounts received by the guaranty agencies
available to pay claims on defaulted student loans.
In the FFEL Program market, the Company faces significant competition from SLM
Corporation, the parent company of Sallie Mae. SLM Corporation services nearly
half of all outstanding federally insured loans and is the largest holder of
student loans. The Company also faces intense competition from other existing
lenders and servicers. As the Company expands its student loan origination and
acquisition activities, that expansion may result in increased competition with
some of its servicing customers. This has in the past resulted in servicing
customers terminating their contractual relationships with the Company, and the
Company could in the future lose more servicing customers as a result. As the
Company seeks to further expand its business, the Company will face numerous
other competitors, many of which will be well established in the markets the
Company seeks to penetrate. Some of the Company's competitors are much larger
than the Company, have better name recognition, and have greater financial and
other resources. In addition, several competitors have large market
capitalizations or cash reserves and are better positioned to acquire companies
or portfolios in order to gain market share. Furthermore, many of the
institutions with which the Company competes have significantly more equity
relative to their asset bases. Consequently, such competitors may have more
flexibility to address the risks inherent in the student loan business. Finally,
some of the Company's competitors are tax-exempt organizations that do not pay
federal or state income taxes and which generally receive floor income on
certain tax-exempt obligations on a greater percentage of their student loan
portfolio because they have financed a greater percentage of their student loans
with tax-exempt obligations issued prior to October 1, 1993. These factors could
give the Company's competitors a strategic advantage.
The Company's student loan originations generally are limited to students
attending eligible educational institutions in the United States. Volumes of
originations are greater at some schools than others, and the Company's ability
to remain an active lender at a particular school with concentrated volumes is
subject to a variety of risks, including the fact that each school has the
option to remove the Company from its "preferred lender" list or to add other
lenders to its "preferred lender" list, the risk that a school may enter the FDL
Program, or the risk that a school may begin making student loans itself. The
Company acquires student loans through forward flow commitments with other
student loan lenders, but each of these commitments has a finite term. There can
be no assurance that these lenders will renew or extend their existing forward
flow commitments on terms that are favorable to the Company, if at all,
following their expiration.
In addition, as of March 31, 2005, third parties owned approximately 55% of the
loans the Company serviced. To the extent that third-party servicing clients
reduce the volume of student loans that the Company processes on their behalf,
the Company's income would be reduced, and, to the extent the related costs
could not be reduced correspondingly, net income could be materially adversely
affected. Such volume reductions occur for a variety of reasons, including if
third-party servicing clients commence or increase internal servicing
activities, shift volume to another service provider, perhaps because such other
service provider does not compete with the client in student loan originations
and acquisitions, or exit the FFEL Program completely.
The Company's inability to maintain strong relationships with significant
schools, branding partners, servicing customers, guaranty agencies, and software
licensees could result in loss of:
o loan origination volume with borrowers attending certain schools;
o loan origination volume generated by some of the Company's branding
partners;
o loan and guarantee servicing volume generated by some of the Company's
loan servicing customers and guaranty agencies; and
o software licensing volume generated by some of the Company's licensees.
The Company cannot assure that its forward flow channel lenders or its branding
partners will continue their relationships with the Company. Loss of a strong
relationship with a significant branding partner or with schools, from which a
significant volume of student loans is directly or indirectly acquired, could
result in an adverse effect on the Company's business.
The business of servicing Canadian student loans by EDULINX is limited to a
small group of servicing customers and the agreement with the largest of such
customers is currently scheduled to expire in February 2006. EDULINX cannot
guarantee that it will obtain a renewal of this largest servicing agreement or
that it will maintain its other servicing agreements and the termination of any
such servicing agreements could result in an adverse effect on its business.
29
Prepayment Risk
Pursuant to the Higher Education Act, borrowers may prepay loans made under the
FFEL Program at any time. Prepayments may result from consolidating student
loans, which tends to occur more frequently in low interest rate environments,
from borrower defaults, which will result in the receipt of a guarantee payment,
and from voluntary full or partial prepayments, among other things. High
prepayment rates will have the most impact on the Company's asset-backed
securitization transactions priced in relation to LIBOR. The rate of prepayments
of student loans may be influenced by a variety of economic, social, and other
factors affecting borrowers, including interest rates and the availability of
alternative financing. The Company's profits could be adversely affected by
higher prepayments, which would reduce the amount of interest the Company
receives and expose the Company to reinvestment risk.
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 accounting principles generally accepted in the
United States. 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 2 of the consolidated financial statements,
which are included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2004 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. Management has determined the only critical accounting policy is
determining the level of the allowance for loan losses.
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. The Company evaluates the adequacy of the allowance for
loan losses on its federally insured loan portfolio separately from its
non-federally insured loan portfolio.
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% of principal and interest of federally
insured student loans, which limits the Company's loss exposure to 2% 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 FFELP loans. As a result of this designation, the Company receives
100% reimbursement on all eligible FFELP default claims submitted for
reimbursement during the 12-month period following the effective date of its
designation. The Company is not subject to the 2% risk sharing loss for eligible
claims submitted during this 12-month period. Only FFELP 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% reimbursement. As of March 31, 2005, more than 99% of the
Company's federally insured loans were serviced by providers designated as an
Exceptional Performer. Of this more than 99%, the Company serviced approximately
91% and third parties serviced approximately 8%. The Company is entitled to
receive this benefit as long as it and/or its other service providers continue
to meet the required servicing standards published by the Department. Compliance
with such standards is assessed on a quarterly basis.
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company charges off these uninsured
loans when the collection of principal and interest is 120 days past due.
The allowance for federally insured and non-federally insured loans is
maintained at a level management believes is adequate to provide for estimated
probable credit losses inherent in the loan portfolio. This evaluation is
inherently subjective because it requires estimates that may be susceptible to
significant changes.
30
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
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 its student loan spread, the interest sensitivity
of the balance sheet is a key profitability driver. The majority of student
loans have variable-rate characteristics in certain interest rate environments.
Some of the student loans include fixed-rate components depending upon the rate
reset provisions, or, in the case of consolidation loans, are fixed at the
weighted average interest rate of the underlying loans at the time of
consolidation. The following table sets forth the Company's loan assets and debt
instruments by rate characteristics:
As of March 31, 2005 As of December 31, 2004
----------- ----------- ----------- -----------
Dollars Percent Dollars Percent
----------- ----------- ----------- -----------
(dollars in thousands)
Fixed-rate loan assets ....... $ 5,393,697 37.6% $ 5,559,748 41.8%
Variable-rate loan assets .... 8,963,510 62.4 7,739,346 58.2
----------- ----------- ----------- -----------
Total ..................... $14,357,207 100.0% $13,299,094 100.0%
=========== =========== =========== ===========
Fixed-rate debt instruments .. $ 660,943 4.3% $ 712,641 5.0%
Variable-rate debt instruments 14,657,574 95.7 13,587,965 95.0
----------- ----------- ----------- -----------
Total ..................... $15,318,517 100.0% $14,300,606 100.0%
=========== =========== =========== ===========
The following table shows the Company's student loan assets currently earning at
a fixed-rate as of March 31, 2005:
Borrower/ Estimated
lender variable Current
Fixed interest weighted conversion balance of
rate range average yield rate (a) fixed rate assets
---------- ------------- -------- -----------------
(dollars in thousands)
5.5 - 6.0% 5.69% 3.05% $ 160,003
6.0 - 6.5 6.21 3.57 299,487
6.5 - 7.0 6.71 4.07 359,426
7.0 - 8.0 7.52 4.88 315,462
> 8.0 8.56 5.92 977,817
9.5 floor yield 9.50 6.86 3,281,502
-----------
$ 5,393,697
===========
- ----------
(a) The estimated variable conversion rate is the estimated short-term
interest rate at which loans would convert to variable rate.
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 outlook as to
current and future market conditions. Based on those factors, the Company will
periodically use derivative instruments as part of its overall risk management
strategy to manage risk arising from its fixed-rate and variable-rate financial
instruments.
31
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of March 31, 2005:
Notional amounts by product type
---------------------------------------------------------------
Weighted
average
fixed rate
Fixed/ Floating/ on fixed/
floating Basis fixed floating
Maturity swaps (a) swaps (b) swaps (c) Total swaps
- ----------------------------------------- ----------- ----------- ---------- ----------- ----------
(dollars in millions)
2005..................................... $ 1,187 1,000 210 2,397 2.20 %
2006..................................... 613 500 -- 1,113 2.99
2007..................................... 512 -- -- 512 3.42
2008..................................... 463 -- -- 463 3.76
2009..................................... 312 -- -- 312 4.01
2010..................................... 1,138 -- -- 1,138 4.25
----------- ----------- ---------- ----------- ----------
Total.................................. $ 4,225 1,500 210 5,935 3.32 %
=========== =========== ========== =========== ==========
Fair value (d) (in thousands)............ $ 52,189 (2,802) (1,164) 48,223
=========== =========== ========== ===========
(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) 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.
The Company accounts for its derivative instruments in accordance with SFAS No.
133. SFAS No. 133 requires that changes in the fair value of derivative
instruments be recognized currently in earnings unless specific hedge accounting
criteria as specified by SFAS No. 133 are met. Management has structured all of
the Company's derivative transactions with the intent that each is economically
effective. However, the majority of the Company's derivative instruments do not
qualify for hedge accounting under SFAS No. 133; consequently, the change in
fair value of these derivative instruments is included in the Company's
operating results. Changes or shifts in the forward yield curve can
significantly impact the valuation of the Company's derivatives. Accordingly,
changes or shifts to the forward yield curve will impact the financial position,
results of operations, and cash flows of the Company. As of March 31, 2005, the
Company accounted for one interest rate swap with a notional amount of $150
million as a cash flow hedge in accordance with SFAS No. 133. Gains and losses
on the effective portion of this qualifying hedge are accumulated in other
comprehensive income and reclassified to current period earnings over the period
in which the stated hedged transactions impact earnings. Ineffectiveness is
recorded to earnings through interest expense.
The following is a summary of the amounts included in derivative market value
adjustment and net settlements on the consolidated income statements related to
those derivative instruments that do not qualify for hedge accounting:
Three months ended March 31,
-----------------------------
2005 2004
-------- --------
(dollars in thousands)
Change in fair value of derivative instruments ....... $ 60,290 (2,527)
Settlements, net ..................................... (10,086) (1,214)
-------- --------
Derivative market value adjustment and net settlements $ 50,204 (3,741)
======== ========
The increase in the derivative market value adjustment and net settlements
during the three months ended March 31, 2005, in addition to the changes in
interest rates and fluctuations in the forward yield curve, is the result of the
Company entering into $3.7 billion in notional amount of derivatives in July
2004.
32
The following tables summarize the effect on the Company's earnings, based upon
a sensitivity analysis performed by the Company assuming a hypothetical increase
and decrease in interest rates of 100 basis points and an increase in interest
rates of 200 basis points while funding spreads remain constant. The effect on
earnings was performed on the Company's variable-rate assets and liabilities.
The analysis includes the effects of the derivative instruments in existence
during the periods presented.
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.
Three months ended March 31, 2005
--------------------------------------------------------------------------
Change from decrease Change from increase Change from increase
of 100 basis points of 100 basis points of 200 basis points
-------------------- -------------------- --------------------
Dollar Percent Dollar Percent Dollar Percent
-------- ------- -------- ------- -------- -------
(dollars in thousands, except share data)
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements ......... $ 11,623 10.8% $(10,808) (10.0)% $(19,529) (18.1)%
Impact of derivative settlements ............... (9,900) (9.2) 9,900 9.2 19,800 18.4
-------- ------ -------- ------ -------- ------
Increase (decrease) in net income before taxes . $ 1,723 1.6% $ (908) (0.8)% $ 271 0.3%
======== ====== ======== ====== ======== ======
Increase (decrease) in basic and diluted
earning per share ........................ $ 0.02 $ (0.01) $ 0.00
======== ======== ========
Three months ended March 31, 2004
--------------------------------------------------------------------------
Change from decrease Change from increase Change from increase
of 100 basis points of 100 basis points of 200 basis points
-------------------- -------------------- --------------------
Dollar Percent Dollar Percent Dollar Percent
-------- ------- -------- ------- -------- -------
(dollars in thousands, except share data)
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements ......... $ 21,808 149.8% $ (4,484) (30.8)% $ (7,123) (48.9)%
Impact of derivative settlements ............... (17,033) (117.0) 12,934 88.9 27,917 191.8
-------- ------ -------- ------ -------- ------
Increase in net income before taxes ............ $ 4,775 32.8% $ 8,450 58.1% $ 20,794 142.9%
======== ====== ======== ====== ======== ======
Increase in basic and diluted
earning per share ........................ $ 0.06 $ 0.10 $ 0.24
======== ======== ========
Developing an effective strategy for dealing with movements in interest rates is
complex, and no strategy can completely insulate the Company from risks
associated with such fluctuations. In addition, a counterparty to a derivative
instrument could default on its obligation, thereby exposing the Company to
credit risk. When the fair value of a derivative instrument is negative, the
Company owes the counterparty and, therefore, has no credit risk. However, if
the value of derivatives with a counterparty exceeds a specified threshold, the
Company may have to pay a collateral deposit to the counterparty. If interest
rates move materially differently from management's expectations, the Company
could be required to deposit a significant amount of collateral with its
derivative instrument counterparties. The collateral deposits, if significant,
could negatively impact the Company's capital resources. The Company manages
market risks associated with interest rates by establishing and monitoring
limits as to the types and degree of risk that may be undertaken. Further, the
Company may have to repay certain costs, such as transaction fees or brokerage
costs, if the Company terminates a derivative instrument. Finally, the Company's
interest rate risk management activities could expose the Company to substantial
losses if interest rates move materially differently from management's
expectations. As a result, the Company cannot assure that its economic hedging
activities will effectively manage its interest rate sensitivity or have the
desired beneficial impact on its results of operations or financial condition.
Foreign Currency Exchange Risk
The Company purchased EDULINX in December 2004. EDULINX is a Canadian
corporation that engages in servicing Canadian student loans. As a result of
this acquisition, the Company is exposed to market risk related to fluctuations
in foreign currency exchange rates between the U.S. and Canadian dollars. The
Company has not entered into any foreign currency derivative instruments to
hedge this risk. However, the Company does not believe fluctuations in foreign
currency exchange rates will have a significant effect on the financial
position, results of operations, or cash flows of the Company.
33
ITEM 4. CONTROLS AND PROCEDURES
Disclosure 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. 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.
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.
Changes in Internal Control over Financial Reporting
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.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to various claims, lawsuits, and proceedings that arise
in the normal course of business. These matters principally consist of claims by
borrowers disputing the manner in which their loans have been processed. On the
basis of present information, anticipated insurance coverage, and advice
received from counsel, it is the opinion of the Company's management that the
disposition or ultimate determination of these claims, lawsuits, and proceedings
will not have a material adverse effect on the Company's business, financial
position, or results of operations.
In addition to such legal proceedings that arise in the ordinary course of
business, the Company has furnished to the SEC Staff information it has
requested pursuant to an informal investigation and the Company is fully
cooperating with the SEC on such informal investigation. See Part I, Item 2,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" under the heading "Risks -- Political/Regulatory Risks."
34
ITEM 6. EXHIBITS
4.1 Indenture of Trust dated as of April 1, 2005, between Nelnet
Student Loan Trust 2005-2 and Zions First National Bank, as
trustee and as eligible lender trustee, filed as Exhibit 4.1
to Nelnet Student Loan Trust 2002-2's Current Report on Form
8-K filed on April 29, 2005 and incorporated herein by
reference.
10.1* Amended Nelnet, Inc. Executive Officers' Bonus Plan.
10.2* Amended Nelnet, Inc. Employee Share Purchase Plan.
10.3* Summary of Named Executive Officer Compensation.
10.4* Summary of Non-Employee Director Compensation.
10.5 Amendment of Agreements dated as of February 4, 2005, by and
between Union Bank and Trust Company and National Education
Loan Network, Inc. (filed as Exhibit 10.1 to the
registrant's Current Report on Form 8-K filed on February
10, 2005 and incorporated herein by reference).
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
35
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: May 10, 2005 By: /s/ Michael S. Dunlap
-----------------------------------------------
Name: Michael S. Dunlap
Title: Chairman and Co-Chief Executive Officer
By: /s/ Stephen F. Butterfield
-----------------------------------------------
Name: Stephen F. Butterfield
Title: Vice-Chairman and Co-Chief Executive Officer
By: /s/ Terry J. Heimes
-----------------------------------------------
Name: Terry J. Heimes
Title: Chief Financial Officer
36