UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 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 [ ]
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of October 31, 2005, there were 39,773,764 and 13,962,954 shares of Class A
Common Stock and Class B Common Stock, par value $0.01 per share, outstanding,
respectively.
NELNET, INC.
FORM 10-Q
INDEX
SEPTEMBER 30, 2005
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements...........................................2
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.........................15
Item 3. Quantitative and Qualitative Disclosures about Market Risk....40
Item 4. Controls and Procedures.......................................44
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.............................................44
Item 6. Exhibits......................................................45
SIGNATURES....................................................................46
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
As of As of
September 30, December 31,
2005 2004
------------- -------------
(unaudited)
(dollars in thousands,
except share data)
Assets:
Student loans receivable (net of allowance for loan losses of
$12,084 and $7,272, respectively)........................... $16,379,293 13,461,814
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party...... 29,384 4,854
Cash and cash equivalents - held at a related party.......... 48,344 35,135
------------ ------------
Total cash and cash equivalents................................... 77,728 39,989
Restricted cash................................................... 995,836 732,066
Restricted investments............................................ 156,146 281,829
Restricted cash - due to customers................................ 74,551 249,070
Accrued interest receivable....................................... 315,709 251,104
Accounts receivable, net.......................................... 28,638 27,156
Goodwill.......................................................... 67,942 8,522
Intangible assets, net............................................ 34,644 11,987
Furniture, equipment, and leasehold improvements, net............. 34,874 29,870
Other assets...................................................... 84,752 66,598
Fair value of derivative instruments, net......................... 61,212 --
------------ ------------
Total assets................................................ $18,311,325 15,160,005
============ ============
Liabilities:
Bonds and notes payable...........................................$17,418,652 14,300,606
Accrued interest payable.......................................... 82,931 48,578
Fair value of derivative instruments, net......................... -- 11,895
Other liabilities................................................. 138,100 93,681
Due to customers.................................................. 74,551 249,070
------------ ------------
Total liabilities............................................ 17,714,234 14,703,830
------------ ------------
Minority interest................................................. 274 --
------------ ------------
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 39,773,764 shares as
of September 30, 2005 and 39,687,037 shares
as of December 31, 2004................................... 398 397
Class B, $0.01 par value. Authorized 15,000,000 shares;
issued and outstanding 13,962,954 shares as
of September 30, 2005 and 13,983,454 shares
as of December 31, 2004................................... 140 140
Additional paid-in capital........................................ 210,341 207,915
Retained earnings................................................. 385,510 247,064
Unearned compensation............................................. (62) (77)
Accumulated other comprehensive income, net of taxes.............. 490 736
------------ ------------
Total shareholders' equity................................... 596,817 456,175
------------ ------------
Commitments and contingencies
Total liabilities and shareholders' equity.................. $18,311,325 15,160,005
============ ============
See accompanying notes to consolidated financial statements.
2
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
Three months ended Nine months ended
September 30, September 30,
----------------------- ------------------------
2005 2004 2005 2004
----------- ---------- ----------- ----------
(dollars in thousands, except share data)
Interest income:
Loan interest...............................................$ 227,750 153,032 619,219 466,158
Investment interest.......................................... 11,491 4,918 26,643 11,750
----------- ---------- ----------- ----------
Total interest income...................................... 239,241 157,950 645,862 477,908
Interest expense:
Interest on bonds and notes payable.......................... 160,243 68,545 398,045 169,940
----------- ---------- ----------- ----------
Net interest income........................................ 78,998 89,405 247,817 307,968
Less provision (recovery) for loan losses....................... 1,402 2,300 5,557 (1,006)
----------- ---------- ----------- ----------
Net interest income after provision (recovery)
for loan losses......................................... 77,596 87,105 242,260 308,974
----------- ---------- ----------- ----------
Other income (expense):
Loan and guarantee servicing income.......................... 37,459 24,513 109,313 73,422
Other fee-based income....................................... 10,503 1,840 22,886 5,359
Software services income..................................... 1,951 1,849 6,759 5,521
Other income................................................. 2,458 4,356 5,382 7,084
Derivative market value adjustment and net settlements....... 62,420 (56,214) 55,251 (58,598)
----------- ---------- ----------- ----------
Total other income (expense)............................... 114,791 (23,656) 199,591 32,788
----------- ---------- ----------- ----------
Operating expenses:
Salaries and benefits........................................ 44,311 25,060 123,615 101,865
Other operating expenses:
Depreciation and amortization.............................. 5,515 4,951 14,899 14,036
Trustee and other debt related fees........................ 1,945 2,752 6,394 8,217
Occupancy and communications............................... 4,704 2,950 13,280 9,167
Advertising and marketing................................... 4,112 2,916 11,860 8,200
Professional services...................................... 5,627 2,672 15,979 10,026
Postage and distribution................................... 4,288 3,059 13,673 10,127
Other...................................................... 8,433 7,142 24,502 19,272
----------- ---------- ----------- ----------
Total other operating expenses........................... 34,624 26,442 100,587 79,045
----------- ---------- ----------- ----------
Total operating expenses................................. 78,935 51,502 224,202 180,910
----------- ---------- ----------- ----------
Income before income taxes............................... 113,452 11,947 217,649 160,852
Income tax expense.............................................. 41,091 4,310 78,974 58,841
----------- ---------- ----------- ----------
Income before minority interest.......................... 72,361 7,637 138,675 102,011
Minority interest in net earnings of subsidiaries............... (229) -- (229) --
----------- ---------- ----------- ----------
Net income...............................................$ 72,132 7,637 138,446 102,011
=========== ========== =========== ==========
Earnings per share, basic and diluted....................$ 1.34 0.14 2.58 1.90
=========== ========== =========== ==========
Weighted average shares outstanding, basic and diluted... 53,734,218 53,648,788 53,709,801 53,644,056
=========== ========== =========== ==========
See accompanying notes to consolidated financial statements.
3
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
(unaudited)
ACCUMULATED
OTHER TOTAL
PREFERRED COMMON STOCK SHARES COMMON STOCK ADDITIONAL UNEARNED COMPRE- SHARE-
STOCK ------------------ PREFERRED --------------- PAID-IN RETAINED COMPEN- HENSIVES HOLDERS'
SHARES CLASS A CLASS B STOCK CLASS A CLASS B CAPITAL EARNINGS SATION INCOME EQUITY
------ ------- -------- ----- ------- ------- ------- -------- ----------- ------ ------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
BALANCE AS OF
JUNE 30, 2004......... -- 39,624,243 14,023,454 $ -- 396 140 207,359 192,259 -- 828 400,982
Comprehensive income:
Net income................ -- -- -- -- -- -- -- 7,637 -- -- 7,637
Other comprehensive
income, related
to cash flow hedge,
net of tax............ -- -- -- -- -- -- -- -- -- (234) (234)
Total comprehensive --------
income................ 7,403
Issuance of common stock.... -- 14,363 -- -- 1 -- 326 -- (97) -- 230
Conversion of common stock.. -- 40,000 (40,000) -- -- -- -- -- -- -- --
------ ---------- ----------- ------ ----- ------ -------- -------- ------- -------- --------
BALANCE AS OF
SEPTEMBER 30, 2004.......... -- 39,678,606 13,983,454 $ -- 397 140 207,685 199,896 (97) 594 408,615
====== ========== =========== ====== ===== ====== ======= ======== ======= ======== ========
BALANCE AS OF
JUNE 30, 2005............... -- 39,763,193 13,962,954 $ -- 398 140 209,949 313,378 (53) (142) 523,670
Comprehensive income:
Net income.............. -- -- -- -- -- -- -- 72,132 -- -- 72,132
Other comprehensive loss:
Cash flow hedge,
net of tax........... -- -- -- -- -- -- -- -- -- (296) (296)
Foreign currency
translation.......... -- -- -- -- -- -- -- -- -- 928 928
Total comprehensive --------
income.............. 72,764
Issuance of common stock.. -- 10,571 -- -- -- -- 392 -- (9) -- 383
------ ---------- ----------- ------ ----- ------ ------- -------- ------- -------- --------
BALANCE AS OF
SEPTEMBER 30, 2005......... -- 39,773,764 13,962,954 $ -- 398 140 210,341 385,510 (62) 490 596,817
====== ========== =========== ====== ===== ====== ======= ======== ======= ======== ========
BALANCE AS OF
DECEMBER 31, 2003.......... -- 39,601,834 14,023,454 $ -- 396 140 206,831 97,885 -- 237 305,489
Comprehensive income:
Net income.............. -- -- -- -- -- -- -- 102,011 -- -- 102,011
Other comprehensive
income, related to
cash flow hedge,
net of tax............. -- -- -- -- -- -- -- -- -- 357 357
Total comprehensive --------
income................ 102,368
Issuance of common stock.. -- 36,772 -- -- 1 -- 854 -- (97) -- 758
Conversion of common stock. -- 40,000 (40,000) -- -- -- -- -- -- -- --
------ ---------- ----------- ------ ----- ------ ------- -------- ------- -------- --------
BALANCE AS OF
SEPTEMBER 30, 2004......... -- 39,678,606 13,983,454 $ -- 397 140 207,685 199,896 (97) 594 408,615
====== ========== =========== ====== ===== ====== ======= ======== ======= ======== ========
BALANCE AS OF
DECEMBER 31, 2004.......... -- 39,687,037 13,983,454 $ -- 397 140 207,915 247,064 (77) 736 456,175
Comprehensive income:
Net income.............. -- -- -- -- -- -- -- 138,446 -- -- 138,446
Other comprehensive
income:
Cash flow hedge,
net of tax........... -- -- -- -- -- -- -- -- -- (736) (736
Foreign currency
translation.......... -- -- -- -- -- -- -- -- -- 490 490
Total comprehensive --------
income.............. 138,200
Issuance of common stock.. -- 66,227 -- -- 1 -- 2,426 -- 15 -- 2,442
Conversion of common stock -- 20,500 (20,500) -- -- -- -- -- -- -- --
------ ---------- ----------- ------ ----- ------ ------- -------- ------- -------- --------
BALANCE AS OF
SEPTEMBER 30, 2005......... -- 39,773,764 13,962,954 $ -- 398 140 210,341 385,510 (62) 490 596,817
====== ========== =========== ====== ===== ====== ======= ======== ======= ======== ========
See accompanying notes to consolidated financial statements.
4
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------
2005 2004
-------------- --------------
(DOLLARS IN THOUSANDS)
Net income...................................................... 138,446 102,011
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............. 72,991 72,601
Derivative market value adjustment......................... (74,300) 39,209
Ineffectiveness of cash flow hedge......................... 28 64
Non-cash compensation expense.............................. 1,728 610
Income from equity method investments...................... (1,068) (598)
Minority interest in net earnings of subsidiaries.......... 229 --
Gain on sale of fixed asset................................ -- (3,037)
Deferred income tax expense (benefit)...................... 36,305 (2,740)
Provision (recovery) for loan losses....................... 5,557 (1,006)
Increase in accrued interest receivable.................... (64,605) (49,655)
Decrease in accounts receivable............................ 300 3,117
(Increase) decrease in other assets........................ (2,420) 20,728
Increase in accrued interest payable....................... 34,353 9,658
Decrease in other liabilities.............................. (6,807) (21,624)
------------ ----------
Net cash provided by operating activities............. 140,737 169,338
------------ -----------
Cash flows from investing activities,
net of business acquisitions:
Originations, purchases, and consolidations
of student loans, including loan premiums
and deferred origination costs..........................(3,050,807) (2,600,335)
Purchases of student loans, including loan premiums,
from a related party....................................(1,022,700) (496,450)
Net proceeds from student loan principal payments.......... 1,098,101 848,374
Proceeds from sale of fixed asset.......................... -- 3,573
Net purchases of furniture, equipment, and
leasehold improvements.................................. (14,154) (14,292)
(Increase) decrease in restricted cash..................... (263,770) 146,884
Purchases of restricted investments........................ (640,384) (735,335)
Proceeds from maturities of restricted investments......... 766,067 644,309
Purchase of equity method investments...................... -- (10,110)
Purchase of loan origination rights........................ (260) (7,899)
Business acquisitions, net of cash acquired................ (78,612) (10,829)
Distributions from equity method investments............... 625 --
------------ ------------
Net cash used in investing activities.................(3,205,894) (2,232,110)
------------ ------------
Cash flows from financing activities:
Payments on bonds and notes payable........................(1,767,330) (3,479,226)
Proceeds from issuance of bonds and notes payable.......... 4,885,400 5,403,576
Payments of debt issuance costs............................ (16,184) (14,954)
Proceeds from issuance of common stock..................... 714 148
------------ ------------
Net cash provided by financing activities............. 3,102,600 1,909,544
------------ ------------
Effect of exchange rate fluctuations on cash.................... 296 --
------------ ------------
Net increase (decrease) in cash and cash equivalents.. 37,739 (153,228)
Cash and cash equivalents, beginning of period.................. 39,989 198,423
------------ ------------
Cash and cash equivalents, end of period.......................$ 77,728 45,195
============ =============
Supplemental disclosures of cash flow information:
Interest paid.............................................$ 354,090 151,856
============ =============
Income taxes paid, net of refunds.........................$ 47,589 43,975
============ =============
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF SEPTEMBER 30, 2005 AND FOR THE THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 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 September 30, 2005 and for the three and nine
months ended September 30, 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 for the
interim periods presented. 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 and nine
months ended September 30, 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 AND ALLOWANCE FOR LOAN LOSSES
Student loans receivable as of September 30, 2005 and December 31, 2004
consisted of the following:
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
2005 2004
------------- -------------
(DOLLARS IN THOUSANDS)
Federally insured loans.................................. $ 16,088,801 13,208,689
Non-federally insured loans.............................. 96,920 90,405
------------- -------------
16,185,721 13,299,094
Unamortized loan premiums and deferred origination costs.. 205,656 169,992
Allowance for loan losses - federally insured loans....... (98) (117)
Allowance for loan losses - non-federally insured loans... (11,986) (7,155)
------------- -------------
$ 16,379,293 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........ 12.37% 7.91%
Total allowance as a percentage of ending balance
of total loans.......................................... 0.07% 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 proceeds of tax-exempt obligations originally 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. 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, the amount of deferred excess interest income
on these loans was $42.9 million.
The allowance for loan losses represents management's estimate of probable
losses on student loans. This evaluation process is subject to 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 currently guarantees 98% of the principal of and the
interest on federally insured student loans, which limits the Company's loss
exposure to 2% of the outstanding balance of the Company's federally insured
portfolio.
In September 2005, the Company was re-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 a 12-month period (June 1, 2005 through May 31, 2006). The
Company is not subject to the 2% risk sharing on 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 eligible for the
100% reimbursement. The Company is entitled to receive this benefit as long as
it and/or its service providers continue to meet the required servicing
standards published by the Department. Compliance with such standards is
assessed on a quarterly basis. In addition, service providers must apply for
redesignation as an Exceptional Performer with the Department on an annual
basis. The Company first earned its Exceptional Performer designation effective
June 1, 2004.
As of September 30, 2005, more than 99% of the Company's federally insured loans
were serviced by providers designated as Exceptional Performers. Of this
portion, the Company serviced approximately 93% and third parties serviced
approximately 7%. If the Company or a third party servicer were to lose its
Exceptional Performer designation, either by the Department discontinuing the
program or the Company or third party servicer not meeting the required
servicing standards or failing to get re-designated during the annual
application process, loans serviced by the Company or such third party would
become subject to the 2% risk sharing for all claims submitted after loss of the
designation.
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. The
current provisions of the Higher Education Act are scheduled to expire on
December 31, 2005. Historically, the United States Congress makes changes to the
provisions of the Higher Education Act during the reauthorization process. One
of the changes to the Higher Education Act that is included in the House's
reauthorization proposal is to the guarantee rates on FFELP loans, including
proposals for a decrease in insurance and reinsurance on portfolios receiving
the benefit of Exceptional Performance designation by up to 2%, from 100% to 98%
of principal and accrued interest, and a decrease in insurance and reinsurance
on portfolios not subject to the Exceptional Performance designation by up to
2%, from 98% to 96% of principal and accrued interest. The Senate's
reauthorization proposal includes a provision to end the Exceptional Performer
program and to decrease the insurance and reinsurance on FFELP loans from 98% to
97% of principal and accrued interest. If the insurance and reinsurance decrease
during reauthorization, the Company would have to establish a provision for loan
losses related to the new risk sharing amounts. This provision would be
recognized by the Company upon the effective date of the new provisions of the
Higher Education Act, which is estimated to be October 1, 2006. See Item 2,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Risks - Political/Regulatory Risk."
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company places a non-federally insured
loan on nonaccrual status and charges off the loan when the collection of
principal and interest is 120 days past due.
3. 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 $630.8 million in guaranteed student loans. 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 $260,000, which was allocated to loan
origination rights.
4. ACQUISITIONS
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 $7.4 million, including $0.4 million of direct acquisition costs. 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 March 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 allocation of the purchase price for EDULINX is shown below (dollars in
thousands):
Cash and cash equivalents........................... $ --
Accounts receivable................................. 11,273
Intangible assets................................... 7,246
Furniture, equipment, and leasehold improvements.... 5,464
Other assets........................................ 1,180
Excess cost over fair value of net assets acquired.. 2,996
Other liabilities................................... (20,731)
----------
Total purchase price $ 7,428
==========
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, scholarships, a
College Admissions Notification Service, and notices 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 $24.0 million. These acquisitions were accounted
for under purchase accounting and the results of operations have been included
in the consolidated financial statements from the effective date of the
acquisitions.
The Company is in the process of obtaining third-party valuations of certain
intangible assets; thus, the allocation of the purchase price is subject to
refinement. The preliminary allocation of the purchase price for SMG and NHR is
shown below (dollars in thousands):
Cash and cash equivalents............................$ 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
=========
Effective June 1, 2005, the Company purchased 80% of the capital stock of FACTS
Management Co. and American Card Services, Inc. (collectively, "FACTS") for
$56.0 million. FACTS Management Co. and American Card Services, Inc. were
entities owned under common control. FACTS provides automated tuition payment
solutions, online payment processing, detailed information reporting, and data
integration services to educational institutions, families, and students. In
addition, FACTS provides financial needs analysis for students applying for aid
in private and parochial K-12 schools. Included in the FACTS purchase agreement
is a "call" option that allows the Company to purchase the remaining 20% of the
capital stock of FACTS at a price as determined in the agreement. The Company
can exercise this option anytime after June 1, 2008. In addition, the minority
shareholder has a "put" option that if exercised requires the Company to
purchase the remaining 20% of the capital stock of FACTS at a price as
determined in the agreement. The put option can be exercised at anytime during
the period from June 1, 2007 through June 1, 2010. The acquisition of FACTS was
accounted for under purchase accounting and the results of operations have been
included in the consolidated financial statements from the effective date of the
acquisition.
8
The Company is in the process of obtaining third-party valuations of certain
intangible assets; thus, the allocation of the purchase price is subject to
refinement. The preliminary allocation of the purchase price for FACTS is shown
below (dollars in thousands):
Cash and cash equivalents........................... $ 2,466
Restricted cash - due to customers.................. 11,034
Accounts receivable................................. 55
Intangible assets................................... 10,250
Furniture, equipment, and leasehold improvements.... 360
Other assets........................................ 24
Excess cost over fair value of net assets acquired.. 45,569
Due to customers.................................... (11,034)
Other liabilities................................... (2,679)
Minority interests' ownership in net assetsacquired. (45)
----------
Total purchase price $ 56,000
==========
Effective July 1, 2005, the Company purchased 100% of the capital stock of
Foresite Solutions, Inc. ("Foresite") for approximately $735,000, net of cash
acquired of approximately $15,000. Approximately $668,000 of the consideration
paid was allocated by the Company as excess cost over fair value of net assets
acquired during the allocation of purchase price. Foresite develops
complementary Web-based software applications that improve the administration of
financial aid offices and work-study programs at colleges and universities. The
acquisition was accounted for under purchase accounting and the results of
operations have been included in the consolidated financial statements from the
date of acquisition.
The following pro forma information presents the combined results of the Company
as though the SMG, NHR, FACTS, and Foresite acquisitions occurred as of the
beginning of each reporting period. The pro forma information does not
necessarily reflect the results of operations if the acquisitions had been in
effect at the beginning of the period or that may be attained in the future. In
addition, the pro forma information reflects the results of operations based on
the Company's preliminary allocation of purchase price.
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------- ------------------------------
2005 2004 2005 2004
-------------- -------------- -------------- --------------
(DOLLARS IN THOUSANDS, (DOLLARS IN THOUSANDS,
EXCEPT SHARE DATA) EXCEPT SHARE DATA)
Net interest income......................$ 78,998 89,554 248,325 308,168
Other income (expense)................... 114,791 (16,609) 212,542 59,291
Net income............................... 72,132 7,303 139,290 104,084
Weighted average shares outstanding,
basic and diluted..................... 53,734,218 53,648,788 53,709,801 53,644,056
Earnings per share, basic and diluted....$ 1.34 0.14 2.59 1.94
On October 24, 2005, the Company purchased 100% of the capital stock of LoanSTAR
Funding Group, Inc. ("LoanSTAR") and servicing assets from LoanSTAR Systems,
Inc. for approximately $169 million. LoanSTAR and LoanSTAR Systems, Inc. were
entities owned under common control. LoanSTAR is a Texas-based secondary market
and loan originator. The acquisition includes LoanSTAR's FFELP student loan
portfolio of approximately $864 million and related debt, as well as LoanSTAR's
sales and marketing operations. The Company will account for these acquisitions
under purchase accounting and the results of operations will be included in the
consolidated financial statements from the effective date of these acquisitions.
On October 25, 2005, the Company acquired approximately $2.2 billion of FFELP
loans from Chela Education Financing, Inc. ("Chela") in a cash transaction for
approximately $109 million over the par value of the student loan portfolio and
related accrued interest. As part of this asset purchase, the Company also
acquired certain servicing and origination assets and the rights to the Chela
brand. The portfolio of student loans and related accrued interest acquired by
the Company were financed through existing student loan warehousing facilities.
On October 31, 2005, the Company entered into an agreement to amend an existing
contract with the State of Colorado, Department of Higher Education, College
Access Network. College Access Network is the Colorado state-designated
guarantor of FFELP student loans. Under the agreement, the Company will provide
student loan servicing and guarantee operations and will assume the operational
expenses and employment of approximately 140 College Access Network employees.
College Access Network will pay the Company a portion of the gross servicing and
guarantee fees as consideration for the Company providing these services on
behalf of College Access Network. The agreement terminates November 1, 2015 and
can be extended for an additional 10-year period upon mutual agreement. The
Company paid $41.2 million as consideration to enter into this outsourcing
contract. This payment will create an intangible asset that will be amortized
over the term of the contract.
9
On November 8, 2005, the Company entered into an agreement with the shareholders
of 5280 Solutions, Inc. and FirstMark Services LLC that provides for the Company
to purchase the remaining 50% interest in these entities for total consideration
of approximately $12 million. The Company currently owns 50% of each of these
entities and accounts for them under the equity method of accounting. The
Company intends to pay approximately 80% of the purchase price through the
issuance of restricted shares of Class A common stock. The transaction is
expected to close during November, with an effective date of November 1, 2005.
The agreement is subject to certain regulatory approvals and closing conditions.
5. INTANGIBLE ASSETS AND GOODWILL
Intangible assets as of September 30, 2005 and December 31, 2004 consist of the
following (dollars in thousands):
WEIGHTED
AVERAGE AS OF AS OF
USEFUL SEPTEMBER 30, DECEMBER 31,
LIFE 2005 2004
------------- ------------- -------------
Amortizable intangible assets:
Covenants not to compete (net of accumulated amortization of $854)... 61 months $ 9,809 --
Student lists (net of accumulated amortization of $1,195)............ 48 months 7,002 --
Loan origination rights (net of accumulated amortization of $1,045
and $395, respectively)........................................... 118 months 7,114 7,505
Customer relationships (net of accumulated amortization of
$933 and $61, respectively)....................................... 84 months 7,493 3,716
Servicing system software (net of accumulated amortization of
$7,240 and $6,137, respectively)..................................... 61 months 777 766
Trade name (net of accumulated amortization of $27).................. 84 months 195 --
----------- ---------- ---------
Total - amortizable intangible assets.......................... 76 months 32,390 11,987
===========
Unamortizable intangible assets - trade names............................ 2,254 --
---------- ---------
$ 34,644 11,987
========== =========
The Company recorded amortization expense on its intangible assets of $1.9
million and $2.3 million for the three months ended September 30, 2005 and 2004,
respectively, and $4.7 million and $6.4 million for the nine months ended
September 30, 2005 and 2004, respectively. The Company will continue to amortize
intangible assets over their remaining useful lives. As disclosed in note 4, the
Company is in the process of obtaining third party valuations of certain
intangible assets, however, as of September 30, 2005 the Company estimates it
will record amortization expense as follows (dollars in thousands):
2005..............................$ 1,765
2006.............................. 6,789
2007.............................. 6,261
2008.............................. 6,167
2009.............................. 3,956
2010 and thereafter............... 7,452
----------
$ 32,390
==========
10
The change in the carrying amount of goodwill by segment was as follows (dollars
in thousands):
STUDENT LOAN PAYMENT
ASSET AND GUARANTEE SOFTWARE DIRECT MANAGEMENT
MANAGEMENT SERVICING SERVICES MARKETING SERVICES TOTAL
----------- ------------- --------- --------- ---------- --------
Balance as of January 1, 2005.............. $ 5,971 -- 2,551 -- -- 8,522
Goodwill acquired during the period........ -- -- -- 10,110 -- 10,110
----------- -------------- ---------- --------- ---------- --------
Balance as of March 31, 2005............... $ 5,971 -- 2,551 10,110 -- 18,632
Goodwill acquired during the period........ -- -- -- -- 45,569 45,569
Goodwill from prior period acquisition
allocated during the current period........ -- 1,958 -- -- -- 1,958
Effect of foreign currency fluctuations -- (320) -- -- -- (320)
----------- -------------- --------- -------- ---------- ---------
Balance as of June 30, 2005................ $ 5,971 1,638 2,551 10,110 45,569 65,839
Goodwill acquired during the period........ -- -- 668 -- -- 668
Goodwill from prior period acquisition
allocated during the current period........ -- 1,358 -- -- -- 1,358
Effect of foreign currency fluctuations -- 77 -- -- -- 77
----------- -------------- --------- --------- --------- ---------
Balance as of September 30, 2005........... $ 5,971 3,073 3,219 10,110 45,569 67,942
=========== ============== ========= ========= ========= =========
6. BONDS AND NOTES PAYABLE
On February 16, 2005, April 19, 2005, and July 22, 2005, the Company consummated
debt offerings of student loan asset-backed notes of $1.3 billion, $2.0 billion,
and $1.3 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.
On May 25, 2005, the Company consummated a debt offering consisting of $275.0
million in aggregate principal amount of Senior Notes due June 1, 2010 (the
"Notes"). The Notes are unsecured obligations of the Company. Interest on the
Notes is 5.125%, payable semiannually. At the Company's option, the Notes are
redeemable in whole at any time or in part from time to time at the redemption
price described in its prospectus supplement.
On August 19, 2005, the Company entered into a credit agreement for a $500.0
million unsecured line of credit. Concurrently with entry into this agreement,
the Company terminated its existing $35.0 million operating line of credit and
$50.0 million commercial paper operating line of credit. The $500.0 million line
of credit terminates on August 19, 2010.
7. NONEMPLOYEE DIRECTORS COMPENSATION PLAN
The Company has a compensation plan for nonemployee directors pursuant to which
nonemployee directors can elect to receive their annual retainer fees in the
form of cash or Class A common stock. If a nonemployee director elects to
receive Class A common stock, the number of shares of Class A common stock that
are awarded is equal to the amount of the annual retainer fee otherwise payable
in cash divided by 85% of the fair market value of a share of Class A common
stock on the date the fee is payable. Nonemployee directors who choose to
receive Class A common stock may also elect to defer receipt of the Class A
common stock until termination of their service on the board of directors.
On June 27, 2005, the Company issued 8,222 shares of its Class A common stock
under the plan. These shares were issued to directors that elected to receive
shares and did not defer receipt of the shares. In addition, there were
directors that for 2005 elected to receive shares and defer receipt of the
shares. Included in the Company's weighted average shares outstanding is 6,727
shares that will be issued to these directors upon their termination from the
board of directors.
8. DERIVATIVE FINANCIAL INSTRUMENTS
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.
11
By using derivative instruments, the Company is exposed to credit and market
risk. When the fair value of a derivative contract is positive, this generally
indicates that the counterparty owes the Company. 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 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 Derivatives Association, Inc. 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.
The following table summarizes the notional values and fair values of the
Company's outstanding derivative instruments as of September 30, 2005:
NOTIONAL AMOUNTS BY PRODUCT TYPE
---------------------------------------------
FIXED/ BASIS FLOATING/
MATURITY FLOATING SWAPS SWAPS FIXED SWAPS TOTAL
- --------------------------- -------------- ------- ----------- ---------
(DOLLARS IN MILLIONS)
2005...................... $ 600 -- 800 1,400
2006...................... 613 500 -- 1,113
2007...................... 512 -- -- 512
2008...................... 463 -- -- 463
2009...................... 312 -- -- 312
2010 and thereafter....... 1,938 -- -- 1,938
-------------- ------- ----------- --------
Total................ $ 4,438 500 800 5,738
============== ======= =========== ========
Fair value (in thousands). $ 62,406 (320) (874) 61,212
============== ======= =========== ========
The following is a summary of the amounts included in derivative market value
adjustment and net settlements on the consolidated statements of operations:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -----------------------
2005 2004 2005 2004
----------- ----------- ----------- ----------
(DOLLARS IN THOUSANDS)
Change in fair value of derivative instruments.. $ 65,382 (39,757) 74,300 (39,209)
Settlements, net................................ (2,962) (16,457) (19,049) (19,389)
----------- ----------- ----------- ----------
Derivative market value adjustment and
net settlements............................... $ 62,420 (56,214) 55,251 (58,598)
=========== =========== =========== ==========
9. ACCUMULATED OTHER COMPREHENSIVE INCOME
The Company's components of accumulated other comprehensive income, net of tax,
at each balance sheet date follow:
FOREIGN ACCUMULATED
CURRENCY OTHER
TRANSLATION CASH FLOW COMPREHENSIVE
ADJUSTMENT HEDGE INCOME
------------ ----------- -------------
(DOLLARS IN THOUSANDS)
Balance as of December 31, 2004... $ -- 736 736
Current period activity........... 490 (736) (246)
------------ ------------ --------------
Balance as of September 30, 2005.. $ 490 -- 490
============ ============ ==============
12
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, which expired in September 2005, accounted
for as a cash flow hedge:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- -------------------
2005 2004 2005 2004
--------- ----------- --------- --------
(DOLLARS IN THOUSANDS)
Balance at beginning of period..................... $ 296 828 736 237
Change in fair value of cash flow hedge......... (304) (255) (753) 317
Hedge ineffectiveness reclassified to earnings.. 8 21 17 40
-------- ---------- -------- --------
Total change in unrealized loss on derivative (296) (234) (736) 357
-------- ---------- -------- --------
Balance at end of period.......................... $ -- 594 -- 594
======== ========== ======== ========
10. SEGMENT REPORTING
The Company is a vertically integrated education finance organization that has
five 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, Software Services, Direct
Marketing, and Payment Management Services. The addition of Direct Marketing and
Payment Management Services as operating segments is a result of the Company's
acquisitions of SMG, NHR, and FACTS in 2005 (see note 4). 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 Software Services,
Direct Marketing, and Payment Management Services 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 constitute the Direct Marketing segment, recognize
revenue when lists or products are shipped. FACTS, which constitutes the Payment
Management Services segment, recognizes revenue over the period in which it
provides services to its customers.
The Asset Management segment includes the acquisition, management, and ownership
of the student loan assets. Revenues are primarily generated from 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 Software Services segment provides software licenses and maintenance
associated with student loan servicing and other software products to both the
Company and third-party customers.
The Direct Marketing segment provides marketing products and services and
college bound student lists and recognizes middle and high school students for
academic success by providing publications, scholarships, and various
notifications.
The Payment Management Services segment provides automated tuition payment
solutions, online payment processing, detailed information reporting, and data
integration services to educational institutions, families, and students. In
addition, this segment provides financial needs analysis for students applying
for aid in private and parochial K-12 schools.
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 and nine months ended September 30, 2005, the Company
recognized $14.9 million and $43.3 million, respectively, from Canadian student
loan servicing customers.
Costs excluded from segment net income before taxes primarily consist of
unallocated corporate expenses, net of miscellaneous revenues. Thus, net income
before taxes of the segments includes only the costs that are directly
attributable to the operations of the individual segment. Intersegment revenues
are charged by a segment to another segment that provides the product or
service. The amount of intersegment revenue is based on comparable fees charged
in the market.
13
Segment data is as follows:
THREE MONTHS ENDED SEPTEMBER 30,
---------------------------------------------------------------------------------------------
2005 2004
------------------------------------------------ --------------------------------------------
STUDENT LOAN STUDENT LOAN
ASSET AND GUARANTEE TOTAL ASSET AND GUARANTEE TOTAL
MANAGEMENT SERVICING OTHER SEGMENTS MANAGEMENT SERVICING OTHER SEGMENTS
----------- ------------- --------- ---------- ------------ ------------- -------- --------
(DOLLARS IN THOUSANDS)
Net interest income....................$ 80,363 1,275 555 82,193 88,910 354 3 89,267
Other income (expense)................. 64,800 37,455 10,257 112,512 (54,210) 24,513 1,848 (27,849)
Intersegment revenues.................. -- 29,681 716 30,397 -- 23,876 925 24,801
------------ ------------- --------- -------- --------- --------- --------- -------
Total revenue...................... 145,163 68,411 11,528 225,102 34,700 48,743 2,776 86,219
Provision for loan losses.............. 1,402 -- -- 1,402 2,300 -- -- 2,300
Depreciation and amortization.......... 32 1,153 1,306 2,491 334 126 1,769 2,229
Net income (loss) before taxes......... 112,823 22,432 2,946 138,201 3,902 18,719 (487) 22,134
NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------------------------------------------------------------------
2005 2004
----------------------------------------------- ---------------------------------------------
STUDENT LOAN STUDENT LOAN
ASSET AND GUARANTEE TOTAL ASSET AND GUARANTEE TOTAL
MANAGEMENT SERVICING OTHER SEGMENTS MANAGEMENT SERVICING OTHER SEGMENTS
------------ ------------- ---------- --------- ------------ ------------- -------- --------
(DOLLARS IN THOUSANDS)
Net interest income....................$ 248,979 2,706 680 252,365 306,653 808 6 307,467
Other income (expense)................. 62,214 109,298 23,293 194,805 (51,779) 73,213 5,522 26,956
Intersegment revenues.................. -- 82,613 2,901 85,514 -- 62,498 2,728 65,226
------------ ---------- -------- --------- ----------- --------- -------- --------
Total revenue...................... 311,193 194,617 26,874 532,684 254,874 136,519 8,256 399,649
Provision (recovery) for loan losses... 5,557 -- -- 5,557 (1,006) -- -- (1,006)
Depreciation and amortization.......... 90 3,023 3,160 6,273 1,003 378 5,301 6,682
Net income (loss) before taxes......... 216,046 60,501 9,557 286,104 180,769 44,875 (1,683) 223,961
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
2005 2004
-------------- ---------------
(DOLLARS IN THOUSANDS)
Asset management..................... $17,952,639 14,808,684
Student loan and guarantee servicing. 236,274 334,181
Other................................ 128,518 5,934
-------------- ---------------
Total segment assets............. $18,317,431 15,148,799
============== ===============
14
Reconciliation of segment data to the consolidated financial statements is as
follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ -----------------------
2005 2004 2005 2004
------------ ---------- ----------- ----------
(DOLLARS IN THOUSANDS)
Total segment revenues............................... $ 225,102 86,219 532,684 399,649
Elimination of intersegment revenues.................. (30,397) (24,801) (85,514) (65,226)
Interest expense on unsecured debt.................... (3,696) (97) (5,595) (255)
Corporate activities' revenues, net................... 2,780 4,428 5,833 6,588
------------ ---------- ----------- ----------
Total consolidated revenues.......................$ 193,789 65,749 447,408 340,756
============ ========== =========== ==========
Total net income before taxes of segments.............$ 138,201 22,134 286,104 223,961
Corporate activities' expenses, net................... (24,749) (10,187) (68,455) (63,109)
------------ ---------- ----------- ----------
Total consolidated net income before taxes and
minority interest..............................$ 113,452 11,947 217,649 160,852
============ ========== =========== ==========
Net corporate revenues included in the previous table are from activities that
are not related to the five identified operating segments. 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.
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
2005 2004
------------- --------------
(DOLLARS IN THOUSANDS)
Total segment assets................ 18,317,431 15,148,799
Elimination of intercompany assets.. (40,377) (39,213)
Corporate assets.................... 34,271 50,419
------------- -------------
Total consolidated assets... $ 18,311,325 15,160,005
============= =============
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 Quarterly Report on 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 or result in loans being originated or
refinanced under non-FFEL 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
15
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 $16.4 billion as of September 30, 2005.
The Company's business is comprised of five 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 services. 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. In
December 2004, the Company purchased EDULINX Canada Corporation, or EDULINX.
EDULINX is a Canadian corporation that engages in servicing student loans in
Canada. The following table summarizes the Company's loan servicing volumes
as of September 30, 2005:
COMPANY PERCENT THIRD PARTY PERCENT TOTAL
---------- --------- ----------- ---------- ----------
(DOLLARS IN MILLIONS)
FFELP and private loans $ 14,700 63.5% $ 8,458 36.5% $ 23,158
Canadian loans (in U.S. $) -- -- 8,118 100.0% 8,118
---------- --------- ----------- ---------- ----------
Total $ 14,700 47.0% $ 16,576 53.0% $ 31,276
========== ========= =========== ========== ==========
The Company also provides servicing support to guaranty agencies, which
includes system software, hardware and telecommunications support, borrower
and loan updates, default aversion tracking services, claim processing
services, and post-default collection services.
o SOFTWARE SERVICES. 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 places 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.
o PAYMENT MANAGEMENT SERVICES. The Company provides automated tuition payment
solutions, online payment processing, detailed information reporting, and
data integration services to educational institutions, families, and
students. In addition, the Company provides financial needs analysis for
students applying for aid in private and parochial K-12 schools.
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 as
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.
16
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 Software Services, Direct Marketing, and Payment Management
Services 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 percentage of total segment revenue (excluding
intersegment revenue) and net income (loss) before taxes for each of the
Company's reportable segments:
THREE MONTHS ENDED SEPTEMBER 30,
----------------------------------------------------------------
2005 2004
-------------------------------- -------------------------------
STUDENT STUDENT
LOAN AND LOAN AND
ASSET GUARANTEE OTHER ASSET GUARANTEE OTHER
MANAGEMENT SERVICING SEGMENTS MANAGEMENT SERVICING SEGMENTS
---------- --------- -------- ---------- --------- --------
Segment
revenues................. 74.6% 19.9% 5.5% 56.5% 40.5% 3.0%
Segment net income
(loss) before
taxes................ 81.6% 16.2% 2.2% 17.6% 84.6% (2.2)%
NINE MONTHS ENDED SEPTEMBER 30,
----------------------------------------------------------------
2005 2004
-------------------------------- -------------------------------
STUDENT STUDENT
LOAN AND LOAN AND
ASSET GUARANTEE OTHER ASSET GUARANTEE OTHER
MANAGEMENT SERVICING SEGMENTS MANAGEMENT SERVICING SEGMENTS
---------- --------- -------- ---------- --------- --------
Segment
revenues................ 69.6% 25.0% 5.4% 76.2% 22.1% 1.7%
Segment net income
(loss) before
taxes............... 75.5% 21.1% 3.4% 80.7% 20.0% (0.7)%
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 (loss) 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 $1.1 billion
and $4.0 billion of student loans during the three and nine months ended
September 30, 2005, respectively, 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
71.6% and 48.1% of the student loans added to the Company's loan portfolio
through a student loan channel during the three and nine months ended
September 30, 2005, respectively;
o the branding partner channel, in which the Company acquires student loans
from lenders to whom it provides marketing and origination services, which
accounted for 4.0% and 28.3% of the student loans added to the Company's loan
portfolio through a student loan channel during the three and nine months
ended September 30, 2005, respectively; and
o the forward flow channel, in which the Company acquires student loans from
lenders to whom it provides origination services, but provides no marketing
services, or who have agreed to sell loans to the Company under forward sale
commitments, which accounted for 23.9% and 22.6% of the student loans added
to the Company's loan portfolio through a student loan channel during the
three and nine months ended September 30, 2005, respectively.
In addition, the Company also acquires student loans through spot purchases,
which accounted for 0.5% and 1.0% of student loans added to the Company's loan
portfolio through a student loan channel during the three and nine months ended
September 30, 2005, respectively.
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;
17
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 the Company's income and is primarily
impacted by the size of the portfolio and the net yield of the assets in the
portfolio. 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. Based upon provisions of the Higher
Education Act, and related interpretations by the Departme1nt, loans financed
prior to September 30, 2004 with tax-exempt obligations originally 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. 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, the amount of deferred
excess interest income on these loans was $42.9 million.
Of the $3.1 billion in loans held by the Company as of September 30, 2005 that
are receiving the 9.5% minimum rate of return, approximately $2.8 billion in
loans were refinanced prior to September 30, 2004 with proceeds of tax-exempt
obligations originally issued prior to October 1, 1993 and then subsequently
refinanced with the proceeds of taxable obligations, without retiring the
tax-exempt obligations. Interest income that is generated from this $2.8 billion
portfolio in excess of income based upon standard special allowance rates is
referred to by the Company as the special allowance yield adjustment. Since the
$2.8 billion portfolio of student loans will decrease as borrowers make payments
on these loans, the special allowance yield adjustment will decrease as compared
to historical periods. 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.
Interest income is also dependent upon the relative level of interest rates. The
current and future interest rate environment can and will affect interest
earnings, net interest income, and net income. 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 the change in the market value on the derivative
instruments is recognized in the statement of operations each reporting period.
This mark-to-market adjustment may fluctuate from period to period and adversely
impact earnings.
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
its existing portfolio through consolidation efforts. The Company will amortize
its premiums paid on 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 percentage of consolidation loans continues to increase as a
percentage of the Company's overall loan portfolio, the Company will continue to
experience an increase in consolidation rebate fees and amortization costs and
reduced yields. 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 percentage of the total portfolio, the impact of
premium amortization as a percent of student loan yield should decrease.
However, this decrease may be offset by increased costs to originate and acquire
student loans in the future due to increased competition in the student loan
industry. Beginning January 1, 2006, the Company will begin to offer a 3%
origination fee buy-down to its borrowers on the majority of Stafford loans
originated through its direct channel. Similar borrower incentives offered by
the Company's brand partners and forward flow lenders will increase the cost of
loans acquired by the Company through these channels.
18
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, 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., a student loan
secondary market. This acquisition was accounted for under purchase accounting
and the results of operations have been included in the consolidated financial
statements from the date of acquisition.
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.
This acquisition was accounted for under purchase accounting and the results of
operations have been included in the consolidated financial statements from the
date of acquisition.
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. These
acquisitions were accounted for under purchase accounting and the results of
operations have been included in the consolidated financial statements from the
date of acquisition.
Effective June 1, 2005, the Company purchased 80% of the capital stock of FACTS.
FACTS provides automated tuition payment solutions, online payment processing,
detailed information reporting, and data integration services to educational
institutions, families, and students. In addition, FACTS provides financial
needs analysis for students applying for aid in private and parochial K-12
schools. This acquisition was accounted for under purchase accounting and the
results of operations have been included in the consolidated financial
statements from the date of acquisition.
Effective July 1, 2005, the Company purchased 100% of the capital stock of
Foresite, a company which develops complementary Web-based software applications
that improve the administration of financial aid offices and work-study programs
at colleges and universities. This acquisition was accounted for under purchase
accounting and the results of operations have been included in the consolidated
financial statements from the date of acquisition.
Effective October 24, 2005, the Company purchased 100% of the capital stock of
LoanSTAR and servicing assets from LoanSTAR Systems, Inc. LoanSTAR is a
Texas-based secondary market and loan originator.
Effective October 25, 2005, the Company purchased from Chela a portfolio of
approximately $2.2 billion of student loans originated under the FFEL Program
and the rights to the Chela brand. The Company also acquired certain servicing
and origination assets.
On October 31, 2005, the Company entered into an agreement to amend an existing
contract with College Access Network. College Access Network is the Colorado
state-designated guarantor of FFELP student loans. Under the agreement, the
Company will provide student loan servicing and guarantee operations and will
assume the operational expenses and employment of certain College Access Network
employees. College Access Network will pay the Company a portion of the gross
servicing and guarantee fees as consideration for the Company providing these
services on behalf of College Access Network. The agreement terminates November
1, 2015 and can be extended for an additional 10-year period upon mutual
agreement.
19
On November 8, 2005, the Company entered into an agreement to purchase the
remaining 50% interest in 5280 Solutions, Inc. and FirstMark Services LLC. The
Company currently owns 50% of these entities and accounts for them under the
equity method of accounting. The transaction is expected to close during
November, with an effective date of November 1, 2005. The agreement is subject
to certain regulatory approvals and closing conditions.
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 statement of operations 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 statement of
operations. The amortization of debt issuance costs is included in interest
expense on the Company's statement of operations.
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
annual July 1 borrower interest rate reset, 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 and nine months ended September 30, 2005 and three
months ended September 30, 2004 and approximately $348,000 during the nine
months ended September 30, 2004.
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 those loans with higher borrower interest rates 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, which is a component of net interest income,
includes income from unrestricted interest-earning deposits and funds in the
Company's special purpose entities which are utilized 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
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.
The Company analyzes the allowance separately for its federally insured loans
and its non-federally insured loans.
20
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 currently guarantees 98% of the principal of and the
interest on federally insured student loans, which limits the Company's loss
exposure to 2% of the outstanding balance of the Company's federally insured
portfolio.
In September 2005, the Company was re-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 a 12-month period (June 1, 2005 through May 31, 2006). The
Company is not subject to the 2% risk sharing on 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 eligible for the
100% reimbursement. The Company is entitled to receive this benefit as long as
it and/or its service providers continue to meet the required servicing
standards published by the Department. Compliance with such standards is
assessed on a quarterly basis. In addition, service providers must apply for
redesignation as an Exceptional Performer with the Department on an annual
basis. The Company first earned its Exceptional Performer designation effective
June 1, 2004.
As of September 30, 2005, more than 99% of the Company's federally insured loans
were serviced by providers designated as Exceptional Performers. Of this
portion, the Company serviced approximately 93% and third parties serviced
approximately 7%. If the Company or a third party servicer were to lose its
Exceptional Performer designation, either by the Department discontinuing the
program or the Company or third party servicer not meeting the required
servicing standards or failing to get re-designated during the annual
application process, loans serviced by the Company or such third party would
become subject to the 2% risk sharing for all claims submitted after loss of the
designation.
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. The
current provisions of the Higher Education Act are scheduled to expire on
December 31, 2005. Historically, the United States Congress makes changes to the
provisions of the Higher Education Act during the reauthorization process. One
of the changes to the Higher Education Act that is included in the House's
reauthorization proposal is to the guarantee rates on FFELP loans, including
proposals for a decrease in insurance and reinsurance on portfolios receiving
the benefit of Exceptional Performance designation by up to 2%, from 100% to 98%
of principal and accrued interest, and a decrease in insurance and reinsurance
on portfolios not subject to the Exceptional Performance designation by up to
2%, from 98% to 96% of principal and accrued interest. The Senate's
reauthorization proposal includes a provision to end the Exceptional Performer
program and to decrease the insurance and reinsurance on FFELP loans from 98% to
97% of principal and accrued interest. If the insurance and reinsurance decrease
during reauthorization, the Company would have to establish a provision for loan
losses related to the new risk sharing amounts. This provision would be
recognized by the Company upon the effective date of the new provisions of the
Higher Education Act, which is estimated to be October 1, 2006. "See "- Risks -
Political/Regulatory Risk."
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company places a non-federally insured
loan on nonaccrual status and charges off the loan when the collection of
principal and interest is 120 days past due.
OTHER INCOME
The Company also earns fees and generates income from other sources, including
principally loan and guarantee servicing income, fee-based revenue from direct
marketing and payment management activities, and licensing fees on its software
products. Loan servicing fees are determined according to individual agreements
with customers and are calculated based on the dollar value or number of loans
serviced for each customer. Guarantee servicing fees are calculated based on the
number of loans serviced or amounts collected. Fee-based income is determined by
the volume of sales of lists and student publications. Fee-based income also
includes annual fees for providing payment management services to schools and/or
students. Software services income is determined from individual agreements with
customers and includes license and maintenance fees associated with student loan
software products.
Other income also includes the derivative market value adjustment and net
settlements from the Company's derivative instruments as further discussed in
Item 3, "Quantitative and Qualitative Disclosures About Market Risk -- Interest
Rate Risk."
21
OPERATING EXPENSES
Operating expenses includes 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 direct marketing, payment management, and software 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.
22
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2004
THREE MONTHS ENDED
SEPTEMBER 30, CHANGE
----------------------- --------------------
2005 2004 DOLLARS PERCENT
---------- ----------- --------- ---------
(DOLLARS IN THOUSANDS)
INTEREST INCOME:
Loan interest.......................... $ 247,791 171,427 76,364 44.5 %
Amortization of loan premiums and
deferred origination costs........... (20,041) (18,395) (1,646) (8.9)
Investment interest.................... 11,491 4,918 6,573 133.7
---------- ----------- --------- ---------
Total interest income................ 239,241 157,950 81,291 51.5
INTEREST EXPENSE:
Interest on bonds and notes payable.... 160,243 68,545 91,698 133.8
---------- ----------- --------- ---------
Net interest income.................. 78,998 89,405 (10,407) (11.6)
Less provision for loan losses............. 1,402 2,300 (898) (39.0)
---------- ----------- --------- ---------
Net interest income after provision
for loanlosses..................... 77,596 87,105 (9,509) (10.9)
---------- ----------- --------- ---------
OTHER INCOME (EXPENSE):
Loan and guarantee servicing income.... 37,459 24,513 12,946 52.8
Other fee-based income................. 10,503 1,840 8,663 470.8
Software services income............... 1,951 1,849 102 5.5
Other income........................... 2,458 4,356 (1,898) (43.6)
Derivative market value adjustment..... 65,382 (39,757) 105,139 264.5
Derivative settlements, net............ (2,962) (16,457) 13,495 82.0
---------- ----------- --------- ---------
Total other income (expense)......... 114,791 (23,656) 138,447 585.3
---------- ----------- --------- ---------
OPERATING EXPENSES:
Salaries and benefits.................. 44,311 25,060 19,251 76.8
Other operating expenses:
Depreciation and amortization,
excluding amortization
of intangible assets............... 3,596 2,676 920 34.4
Amortization of intangible assets.... 1,919 2,275 (356) (15.6)
Trustee and other debt related fees.. 1,945 2,752 (807) (29.3)
Occupancy and communications......... 4,704 2,950 1,754 59.5
Advertising and marketing............ 4,112 2,916 1,196 41.0
Professional services................ 5,627 2,672 2,955 110.6
Postage and distribution............. 4,288 3,059 1,229 40.2
Other................................ 8,433 7,142 1,291 18.1
---------- ----------- --------- ---------
Total other operating expenses..... 34,624 26,442 8,182 30.9
---------- ----------- --------- ---------
Total operating expenses........... 78,935 51,502 27,433 53.3
---------- ----------- --------- ---------
Income before income taxes......... 113,452 11,947 101,505 849.6
Income tax expense..................... 41,091 4,310 36,781 853.4
---------- ----------- --------- ---------
Income before minority interest.... 72,361 7,637 64,724 847.5
Minority interest in net
earnings of subsidiarie (229) -- (229) (100.0)
---------- ----------- --------- ---------
Net income.........................$ 72,132 7,637 64,495 844.5 %
========== =========== ========= =========
NET INTEREST INCOME. Total loan interest increased as a result of growth of the
student loan portfolio and an increase in interest rates. These increases were
offset by an increase in lower yielding consolidation loans and a decrease in
the special allowance yield adjustment. The average student loan portfolio
increased $3.5 billion, or 29.1%, during the three months ended September 30,
2005 compared to the same period in 2004, which resulted in an increase of loan
interest income by approximately $56.2 million. Overall, the student loan yield
increased to 6.94% in 2005 from 6.25% in 2004. When excluding the special
allowance yield adjustment, the student loan yield increased to 6.39% in 2005
from 4.81% in 2004 as a result of the rising interest rate environment offset by
an increase in lower yielding consolidation loans held by the Company. The
impact of the rising interest rates offset by increased lower yielding
consolidation loans resulted in an increase in interest income of approximately
$47.8 million. The special allowance yield adjustment, which reflects interest
income in excess of special allowance payments had loans earned at statutorily
defined rates under a taxable financing, decreased $21.8 million to
approximately $21.8 million for the three months ended September 30, 2005 from
approximately $43.6 million for the three months ended September 30, 2004. This
decrease is due to an increase in interest rates, which decreases the excess
special allowance payments over the statutorily defined rates under a taxable
financing, and a decrease in the portfolio of loans earning the special
allowance yield adjustment. An increase in the Company's consolidation loan
portfolio resulted in higher consolidation rebate fees and decreased loan
interest by $7.7 million.
23
Interest expense on bonds and notes payable increased as a result of the
increase in average variable-rate debt, the issuance of unsecured fixed-rate
debt in May 2005, and an increase in interest rates. These increases were offset
by a reduction in the average asset-backed fixed-rate bonds and notes
outstanding. Overall, the student loan cost of funds (excluding net settlements
on derivatives) increased to 3.76% in 2005 from 2.05% in 2004. Average
variable-rate debt increased $3.5 billion, which resulted in an increase of
interest expense of approximately $30.5 million. In addition, the increase in
interest rates, specifically LIBOR and auction rates, increased the Company's
average cost of funds on variable-rate debt which increased interest expense
approximately $61.5 million. The Company also issued $275 million of unsecured
debt in May 2005 which increased interest expense by $3.5 million. The increase
in interest expense was reduced as average fixed-rate bonds and notes decreased
by $261.7 million, which decreased the Company's overall interest expense by
approximately $3.9 million.
Net interest income, excluding the effects of the special allowance yield
adjustment, increased approximately $11.4 million, or 24.9%, to approximately
$57.2 million from approximately $45.8 million. This increase, when factoring
the decrease in the Company's student loan spread, is consistent with the
average student loan increase of 29.1%.
PROVISION FOR LOAN LOSSES. The provision for loan losses for federally insured
student loans decreased approximately $98,000 from approximately $100,000 in
2004 to approximately $2,000 in 2005 due to an additional service provider
obtaining the Exceptional Performer designation during 2005. The provision for
loan losses for non-federally insured loans decreased $0.8 million from $2.2
million in 2004 to $1.4 million in 2005 because of the 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. EDULINX recognized $14.9 million of
servicing income during the three months ended September 30, 2005. This increase
was offset by a decrease in loan servicing income from the Company's U.S.
servicing operations of approximately $1.4 million. This decrease was the result
of a decrease in the average dollar amount of loans serviced for third parties
in the Company's U.S. servicing operations from $9.0 billion for the three
months ended September 30, 2004 to $8.4 billion for the three months ended
September 30, 2005. 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, loan servicing income from loans originated on
behalf of the Company's U.S. customers decreased due to the acquisition of
origination rights from UB&T on February 4, 2005.
Other fee-based income increased $8.2 million due to the acquisitions of SMG and
NHR in February 2005 and FACTS in June 2005. Income from borrower late fees,
which is also classified as other fee-based income, increased $0.2 million as a
result of the increase in the size of the Company's student loan portfolio.
Other income decreased due to a one-time gain of $3.0 million recorded on the
sale of a fixed asset during the three months ended September 30, 2004. This was
offset by an increase in income from an investment the Company accounts for on
the equity-method basis of accounting.
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 September 30, 2005, the derivative market value adjustment
net gains were $65.4 million and net settlements representing realized costs
were $3.0 million as compared to derivative market value adjustment net losses
of $39.8 million and net settlements representing realized costs of $16.5
million for the comparable period in 2004. The change in the derivative market
value adjustment is the result of changes in interest rates and fluctuations in
the forward yield curve. See Item 3, "Quantitative and Qualitative Disclosures
about Market Risk -- Interest Rate Risk."
OPERATING EXPENSES Salaries and benefits increased $11.7 million due to the
acquisitions of EDULINX, SMG, NHR, and FACTS. Incentive plan compensation
increased $5.0 million due to a change in terms in the Company's 2005 incentive
plan from 2004. The Company also incurred additional costs as a result of the
increased volume in the Company's consolidations area.
Depreciation and amortization, excluding amortization of intangible assets,
increased $0.9 million primarily 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 and advertising and marketing
expenses increased $1.4 million and $0.9 million, respectively, due to the
acquisitions of EDULINX, SMG, NHR, and FACTS. The Company also incurred
additional costs due to expansion of the Company's marketing efforts, especially
in the consolidations area. Professional services expenses increased $2.2
million due to the acquisition of EDULINX and FACTS. Postage and distribution
expense increased $0.7 million due to the acquisitions of EDULINX, NHR, and
FACTS and $0.4 million due to the Company's direct marketing efforts, especially
in the consolidations area. Other expenses increased $1.8 million due to recent
acquisitions described above. In addition, there was an increase in charitable
contribution expense in 2005. These increases were offset by a decrease in other
expenses as the result of $1.9 million paid for a call-premium on the redemption
of debt during July 2004.
INCOME TAX EXPENSE. Income tax expense increased due to the increase in income
before income taxes. The Company's effective tax rate was 36.2% and 36.1% during
the three months ended September 30, 2005 and 2004, respectively.
24
NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2004
NINE MONTHS
ENDED SEPTEMBER 30, CHANGE
--------------------------- ----------------------
2005 2004 DOLLARS PERCENT
------------ ------------ ---------- ----------
(DOLLARS IN THOUSANDS)
INTEREST INCOME:
Loan interest, excluding variable-rate floor income... $ 671,589 519,059 152,530 29.4 %
Variable-rate floor income............................ -- 348 (348) (100.0)
Amortization of loan premiums and deferred
origination costs.................................... (52,370) (53,249) 879 1.7
Investment interest.................................... 26,643 11,750 14,893 126.7
------------ ------------ ---------- ----------
Total interest income................................ 645,862 477,908 167,954 35.1
INTEREST EXPENSE:
Interest on bonds and notes payable................... 398,045 169,940 228,105 134.2
------------ ------------ ---------- ----------
Net interest income................................ 247,817 307,968 (60,151) (19.5)
Less provision (recovery) for loan losses................ 5,557 (1,006) 6,563 652.4
------------ ------------ ---------- ----------
Net interest income after provision (recovery)
for loan losses 242,260 308,974 (66,714) (21.6)
------------ ------------ ---------- ----------
OTHER INCOME:
Loan and guarantee servicing income.................. 109,313 73,422 35,891 48.9
Other fee-based income............................... 22,886 5,359 17,527 327.1
Software services income............................. 6,759 5,521 1,238 22.4
Other income......................................... 5,382 7,084 (1,702) (24.0)
Derivative market value adjustment................... 74,300 (39,209) 113,509 289.5
Derivative settlements, net.......................... (19,049) (19,389) 340 1.8
------------ ------------ ---------- ----------
Total other income................................. 199,591 32,788 166,803 508.7
------------ ------------ ---------- ----------
OPERATING EXPENSES:
Salaries and benefits................................ 123,615 101,865 21,750 21.4
Other operating expenses:
Depreciation and amortization, excluding
amortization of intangible assets................ 10,248 7,604 2,644 34.8
Amortization of intangible assets.................. 4,651 6,432 (1,781) (27.7)
Trustee and other debt related fees................ 6,394 8,217 (1,823) (22.2)
Occupancy and communications....................... 13,280 9,167 4,113 44.9
Advertising and marketing.......................... 11,860 8,200 3,660 44.6
Professional services.............................. 15,979 10,026 5,953 59.4
Postage and distribution........................... 13,673 10,127 3,546 35.0
Other.............................................. 24,502 19,272 5,230 27.1
------------ ------------ ---------- ----------
Total other operating expenses................... 100,587 79,045 21,542 27.3
------------ ------------ ---------- ----------
Total operating expenses......................... 224,202 180,910 43,292 23.9
------------ ------------ ---------- ----------
Income before income taxes....................... 217,649 160,852 56,797 35.3
Income tax expense................................... 78,974 58,841 20,133 34.2
------------ ------------ ---------- ----------
Income before minority interest................. 138,675 102,011 36,664 35.9
Minority interest in net earnings of subsidiaries.... (229) -- (229) (100.0)
------------ ------------ ---------- ----------
Net income...................................... $ 138,446 102,011 36,435 35.7 %
============ ============ ========== ==========
NET INTEREST INCOME. Total loan interest increased as a result of growth of the
student loan portfolio and an increase in interest rates. These increases were
offset by an increase in lower yielding consolidation loans and a decrease in
the special allowance yield adjustment. The average student loan portfolio
increased $3.5 billion, or 30.9%, during the nine months ended September 30,
2005 compared to the same period in 2004, which resulted in an increase of loan
interest income by approximately $157.3 million. Overall, the student loan yield
increased to 6.72% in 2005 from 6.71% in 2004. When excluding the special
allowance yield adjustment, the student loan yield increased to 6.02% in 2005
from 4.73% in 2004 as a result of the rising interest rate environment offset by
an increase in lower yielding consolidation loans held by the Company. The
impact of the rising interest rates offset by increased lower yielding
consolidation loans resulted in an increase in interest income of approximately
$109.2 million. The special allowance yield adjustment, which reflects interest
income in excess of special allowance payments had loans earned at statutorily
defined rates under a taxable financing, decreased $90.5 million to
approximately $77.4 million for the nine months ended September 30, 2005 from
approximately $167.9 million for the nine months ended September 30, 2004. This
decrease is due to an increase in interest rates, which decreases the excess
special allowance payments over the statutorily defined rates under a taxable
financing, and a decrease in the portfolio of loans earning the special
allowance yield adjustment. In addition, the 2004 special yield adjustment
included approximately $42.9 million that was previously deferred. An increase
in the Company's consolidation loan portfolio resulted in higher consolidation
rebate fees and decreased loan interest by $22.4 million.
25
Interest expense on bonds and notes payable increased as a result of the
increase in average variable-rate debt, the issuance of unsecured fixed-rate
debt in May 2005, and an increase in interest rates. These increases were offset
by a reduction in the average asset-backed fixed-rate bonds and notes
outstanding. Overall, the student loan cost of funds (excluding net settlements
on derivatives) increased to 3.36% in 2005 from 1.82% in 2004. Average
variable-rate debt increased $3.4 billion, which resulted in an increase of
interest expense of approximately $81.4 million. In addition, the increase in
interest rates, specifically LIBOR and auction rates, increased the Company's
average cost of funds on variable-rate debt which increased interest expense
approximately $151.4 million. The Company also issued $275 million of unsecured
debt in May 2005 which increased interest expense by $5.0 million. The increase
in interest expense was reduced as average fixed-rate bonds and notes decreased
by $243.4 million, which decreased the Company's overall interest expense by
approximately $10.8 million.
Net interest income, excluding the effects of the special allowance yield
adjustment and variable-rate floor income, increased approximately $30.6
million, or 21.9%, to approximately $170.4 million from approximately $139.8
million. This increase, when factoring the decrease in the Company's student
loan spread, is consistent with the average student loan increase of 30.9%.
PROVISION FOR LOAN LOSSES. The provision for loan losses for federally insured
student loans increased $7.4 million from a recovery of $7.2 million in 2004 to
an expense of $0.2 million in 2005 as a result of the Company's Exceptional
Performer designation in June 2004. The provision for loan losses for
non-federally insured loans decreased $0.8 million from $6.2 million in 2004 to
$5.4 million in 2005 because of the 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. EDULINX recognized $43.3 million of
servicing income during the nine months ended September 30, 2005. This increase
was offset by a decrease in loan servicing income from the Company's U.S.
servicing operations of approximately $4.7 million. This decrease was the result
of a decrease in the average dollar amount of loans serviced for third parties
in the Company's U.S. servicing operations from $9.3 billion for the nine months
ended September 30, 2004 to $8.7 billion for the nine months ended September 30,
2005. 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. Loan servicing income from loans originated on behalf of the
Company's U.S. customers also decreased due to the acquisition of origination
rights from UB&T on February 4, 2005. Guarantee servicing income decreased $2.5
million due to a customer that did not renew its servicing contract in 2004.
Other fee-based income increased $16.4 million due to the acquisitions of SMG
and NHR in February 2005 and FACTS in June 2005. Income from borrower late fees,
which is also classified as other fee-based income, increased $0.8 million as a
result of the increase in the size of the Company's student loan portfolio.
Software services income increased due to additional system maintenance and
enhancement work performed for third-party customers. Other income decreased due
to a one-time gain of $3.0 million recorded on the sale of a fixed asset during
the three months ended September 30, 2004. This was offset by an increase in
income from an investment the Company accounts for on the equity-method basis of
accounting.
The Company utilizes derivative instruments to provide economic hedges to
protect against the impact of adverse changes in interest rates. During the nine
months ended September 30, 2005, the derivative market value adjustment net
gains were $74.3 million and net settlements representing realized costs were
$19.0 million as compared to derivative market value adjustment net losses of
$39.2 million and net settlements representing realized costs of $19.4 million
for the comparable period in 2004. The change in the derivative market value
adjustment is the result of changes in interest rates and fluctuations in the
forward yield curve. See Item 3, "Quantitative and Qualitative Disclosures about
Market Risk -- Interest Rate Risk."
OPERATING EXPENSES. Salaries and benefits increased $27.6 million due to the
acquisitions of EDULINX, SMG, NHR, and FACTS. This increase is offset by the
Company recognizing approximately $9.7 million less in incentive plan
compensation in 2005 compared to 2004 due to a change in terms of the Company's
incentive plan for 2005. The Company also incurred additional costs as a result
of the increased volume in the Company's consolidations area.
Depreciation and amortization, excluding amortization of intangible assets,
increased $2.0 million as a result of the acquisitions of EDULINX, SMG, and
FACTS. There was also an increase in depreciation expense due to computer
software and hardware additions. 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 and advertising and marketing expenses increased $3.9 million and
$2.4 million, respectively, due to the acquisitions of EDULINX, SMG, NHR, and
FACTS. In addition, marketing expenses increased $1.3 million due to expansion
of the Company's marketing efforts, especially in the consolidations area.
Professional services expenses increased $5.2 million due to the acquisitions of
EDULINX, SMG, NHR and FACTS. Postage and distribution expense increased $2.3
million due to the acquisitions of EDULINX, NHR, and FACTS and $1.4 million due
to the Company's direct marketing efforts, especially in the consolidations
area. Other expenses increased $4.8 million due to recent acquisitions described
above. Other miscellaneous expenses also increased as a result of growth of the
Company. The costs were offset by a decrease in other expenses as the result of
$1.9 million paid for a call-premium on the redemption of debt during July 2004.
26
INCOME TAX EXPENSE. Income tax expense increased due to the increase in income
before income taxes. The Company's effective tax rate was 36.3% and 36.6% during
the nine months ended September 30, 2005 and 2004, respectively.
FINANCIAL CONDITION
AS OF SEPTEMBER 30, 2005 COMPARED TO DECEMBER 31, 2004
AS OF AS OF CHANGE
SEPTEMBER 30, DECEMBER 31, ------------------------
2005 2004 DOLLARS PERCENT
--------------- --------------- ------------- ---------
(DOLLARS IN THOUSANDS)
ASSETS:
Student loans receivable, net.................... $ 16,379,293 13,461,814 2,917,479 21.7 %
Cash, cash equivalents, and restricted cash and
investments.................................... 1,304,261 1,302,954 1,307 0.1
Goodwill......................................... 67,942 8,522 59,420 697.3
Intangible assets................................ 34,644 11,987 22,657 189.0
Fair value of derivative instruments, net........ 61,212 -- 61,212 100.0
Other assets..................................... 463,973 374,728 89,245 23.8
--------------- --------------- ------------- ---------
Total assets................................ $ 18,311,325 15,160,005 3,151,320 20.8 %
=============== =============== ============= =========
LIABILITIES:
Bonds and notes payable.......................... $ 17,418,652 14,300,606 3,118,046 21.8 %
Fair value of derivative instruments, net........ -- 11,895 (11,895) (100.0)
Other liabilities................................ 295,582 391,329 (95,747) (24.5)
--------------- --------------- ------------- ---------
Total liabilities........................... 17,714,234 14,703,830 3,010,404 20.5
Minority interest................................ 274 -- 274 100.0
Shareholders' equity............................. 596,817 456,175 140,642 30.8
--------------- --------------- ------------- ---------
Total liabilities and shareholders' equity..$ 18,311,325 15,160,005 3,151,320 20.8 %
=============== =============== ============= =========
Total assets increased primarily due to an increase in student loans receivable.
The Company originated and acquired $4.0 billion of student loans during the
nine months ended September 30, 2005, offset by repayments of approximately $1.1
billion. Fair value of derivative instruments, net changed from a liability to
an asset due to the change in the fair value of the Company's derivative
instruments as a result of a change in the forward yield curve. Goodwill,
intangible assets, and other assets increased primarily due to the acquisitions
of SMG, NHR, FACTS, and Foresite during 2005. In addition, accrued interest
receivable is included in other assets and increased as a result of the increase
in student loans receivable. 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 includes restricted cash amounts
due to loan program customers that decreased $174.5 million as a result of
timing of disbursements on loans and reduced lockbox volume. This is offset by
increases due to the acquisitions of SMG, NHR, and FACTS and an increase in
accrued interest on bonds and notes payable as a result of increased interest
rates and additional borrowings. Shareholders' equity increased primarily as a
result of net income of $138.4 million during the nine months ended September
30, 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") which was declared
effective on May 12, 2005. This facility allows 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 are established at the time of the
offering. On May 25, 2005, the Company consummated a debt offering under this
universal shelf consisting of $275.0 million in aggregate principal amount of
Senior Notes due June 1, 2010 (the "Notes"). The Notes are unsecured obligations
of the Company. Interest on the Notes is 5.125%, payable semiannually. At the
Company's option, the Notes are redeemable in whole at any time or in part from
time to time at the redemption price described in its prospectus supplement.
On August 19, 2005, the Company entered into a credit agreement for a $500.0
million unsecured line of credit. Concurrently with entry into this agreement,
the Company terminated its existing $35.0 million operating line of credit and
$50.0 million commercial paper operating line of credit. The $500.0 million line
of credit terminates on August 19, 2010. The Company had no outstanding
borrowings under this facility as of September 30, 2005.
27
The Company's secured financing instruments include short-term student loan
warehouse programs, variable-rate tax-exempt bonds, fixed-rate tax-exempt bonds,
fixed-rate bonds, and various asset-backed securities. Of the $17.4 billion of
debt outstanding as of September 30, 2005, $14.6 billion was issued under
securitization transactions. On February 16, 2005, April 19, 2005, and July 22,
2005, the Company completed asset-backed securities transactions totaling $1.3
billion, $2.0 billion, and $1.3 billion, respectively Depending on market
conditions, the Company anticipates continuing to access the asset-backed
securities market for the remainder of 2005 and subsequent years. Securities
issued in the securitization transactions are generally priced based upon a
spread to LIBOR or set under an auction procedure. The interest rate on student
loans being financed is generally set based upon 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 September
30, 2005, the Company had a loan warehousing capacity of $4.5 billion, of which
$2.6 billion was outstanding, through 364-day commercial paper conduit programs.
The Company had $1.9 billion in warehouse capacity available under its warehouse
facilities as of September 30, 2005. These conduit programs mature in 2006
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.
On October 24, 2005, the Company purchased 100% of the capital stock of LoanSTAR
and servicing assets from LoanSTAR Systems, Inc. for approximately $169 million.
On October 31, 2005, the Company entered into an agreement to amend an existing
contract with College Access Network for total consideration of $41.2 million.
The Company used operating cash and its unsecured line of credit to fund these
acquisitions.
On October 25, 2005, the Company acquired $2.2 billion of FFELP loans from Chela
in a cash transaction for approximately $109 million over the par value of the
student loan portfolio and related accrued interest. Subsequent to September 30,
2005, the Company increased its capacity on its warehouse facilities by $2.1
billion from $4.5 billion to $6.6 billion in order to fund this student loan
portfolio acquisition.
The Company is limited in the amounts of funds that can be transferred from its
subsidiaries through intercompany loans, advances, or cash dividends. These
limitations result from the restrictions contained in trust indentures under
debt financing arrangements to which the Company's education lending
subsidiaries are parties. The Company does not believe these limitations will
significantly affect its operating cash needs. The amounts of cash and
investments restricted in the respective reserve accounts of the education
lending subsidiaries are shown on the balance sheets as restricted cash and
investments.
The following table summarizes the Company's bonds and notes outstanding as of
September 30, 2005:
INTEREST RATE
RANGE ON
CARRYING PERCENT OF CARRYING FINAL
AMOUNT TOTAL AMOUNT MATURITY
------------- ----------- -------------- -------------
(DOLLARS IN THOUSANDS)
Variable rate bonds and notes (a):
Bonds and notes based on
indices...............................$ 10,812,241 62.1 % 3.63% - 4.66% 11/25/2009 - 01/25/2041
Bonds and notes based on
auction............................... 3,200,670 18.4 2.40% - 3.90% 11/01/2009 - 07/01/2043
------------- ---------
Total variable rate bonds and notes. 14,012,911 80.5
Commerical paper and other................ 2,555,009 14.6 3.50% - 3.71% 05/12/2006 - 09/02/2009
Fixed-rate bonds and notes (a)............ 560,732 3.2 5.20% - 6.68% 12/01/2005 - 05/01/2029
Unsecured fixed rate debt................. 275,000 1.6 5.13% 06/01/2010
Other borrowings.......................... 15,000 0.1 6.00% 11/01/2005
------------- ---------
Total.................................$ 17,418,652 100.0 %
============= =========
- -----------
(a) Issued in securitization transactions.
28
The Company is committed under noncancelable operating leases for certain office
and warehouse space and equipment. The Company's contractual obligations as of
September 30, 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..........$ 17,418,652 2,204,244 192,923 992,774 14,028,711
Student loan purchase obligation (a)2,201,900 2,201,900 -- -- --
Operating lease obligations...... 18,126 6,135 8,586 3,021 384
Other............................ 2,500 2,500 -- -- --
------------- ------------ ------------ ------------- ------------
Total........................$ 19,641,178 4,414,779 201,509 995,795 14,029,095
============= ============ ============ ============= ============
- ---------
(a) On September 27, 2005, the Company entered into an agreement with Chela
that provided for the acquisition of assets from Chela, including an
approximate $2.2 billion student loan portfolio, related servicing and
origination assets, and rights to the Chela brand. On October 25, 2005, the
Company completed this acquisition and paid approximately $109 million in
cash over the par value of the student loan portfolio and related accrued
interest.
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 September 30, 2005, the Company was committed to
extend credit or was obligated to purchase $208.0 million of student loans at
current market rates at the respective sellers' requests under or pursuant to
the terms of various agreements.
On December 1, 2004, the Company purchased EDULINX in a business combination for
$7.4 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 March 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.
On November 8, 2005, the Company entered into an agreement with the shareholders
of 5280 Solutions, Inc. and FirstMark Services LLC that provides for the Company
to purchase the remaining 50% interest in these entities for total consideration
of approximately $12 million. The Company intends to pay approximately 80% of
the purchase price through the issuance of restricted shares of Class A common
stock. The transaction is expected to close during November, with an effective
date of November 1, 2005. The agreement is subject to certain regulatory
approvals and closing conditions.
STUDENT LOAN PORTFOLIO
The table below describes the components of the Company's loan portfolio:
AS OF SEPTEMBER 30, 2005 AS OF DECEMBER 31, 2004
-------------------------- --------------------------
DOLLARS PERCENT DOLLARS PERCENT
-------------- ---------- -------------- ----------
(DOLLARS IN THOUSANDS)
Federally insured:
Stafford.............................................$ 5,623,229 34.3 % $ 5,047,487 37.5 %
PLUS/SLS............................................. 294,888 1.8 252,910 1.9
Consolidation........................................ 10,170,684 62.1 7,908,292 58.7
Non-federally insured.................................... 96,920 0.6 90,405 0.7
------------- --------- -------------- ----------
Total............................................ 16,185,721 98.8 13,299,094 98.8
Unamortized loan premiums and deferred origination costs. 205,656 1.3 169,992 1.3
Allowance for loan losses:
Allowance - federally insured........................ (98) -- (117) --
Allowance - non-federally insured.................... (11,986) (0.1) (7,155) (0.1)
------------- --------- -------------- ----------
Net..............................................$ 16,379,293 100.0 % $ 13,461,814 100.0 %
============= ========= ============== ==========
29
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 SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- ------------------------------
2005 2004 2005 2004
----------------- ------------- -------------- --------------
(DOLLARS IN THOUSANDS)
Balance at beginning of period.................................$ 10,689 8,122 7,272 16,026
Provision (recovery) for loan losses:
Federally insured loans................................... 2 100 207 (7,216)
Non-federally insured loans............................... 1,400 2,200 5,350 6,210
----------------- -------------- ------------- -------------
Total provision (recovery) for loan losses............. 1,402 2,300 5,557 (1,006)
Charge-offs:
Federally insured loans................................... (3) (129) (226) (1,833)
Non-federally insured loans............................... (166) (1,945) (1,044) (5,050)
----------------- -------------- ------------- -------------
Total charge-offs...................................... (169) (2,074) (1,270) (6,883)
Recoveries, non-federally insured loans........................ 162 98 525 309
----------------- -------------- ------------- -------------
Net charge-offs............................................... (7) (1,976) (745) (6,574)
----------------- -------------- ------------- -------------
Balance at end of period.......................................$ 12,084 8,446 12,084 8,446
================= ============== ============= =============
Allocation of the allowance for loan losses:
Federally insured loans...................................$ 98 706 98 706
Non-federally insured loans............................... 11,986 7,740 11,986 7,740
----------------- -------------- ------------- -------------
Total allowance for loan losses........................$ 12,084 8,446 12,084 8,446
================= ============== ============= =============
Net loan charge-offs as a percentage of average student loans.. 0.000 % 0.065 % 0.007 % 0.078 %
Total allowance as a percentage of average student loans....... 0.077 %. 0.070 % 0.082 % 0.075 %
Total allowance as a percentage of ending balance of
student loans............................................. 0.075 % 0.067 % 0.075 % 0.067 %
Non-federally insured allowance as a percentage of the ending
balance of non-federally insured loans.................... 12.367 % 8.391 % 12.367 % 8.391 %
Average student loans..........................................$ 15,628,420 12,108,981 14,766,024 11,282,561
Ending balance of student loans................................ 16,185,721 12,630,456 16,185,721 12,630,456
Ending balance of non-federally insured loans.................. 96,920 92,247 96,920 92,247
Delinquencies have the potential to adversely impact the Company's earnings
through increased servicing and collection costs and account charge-offs. The
table below shows the student loan delinquency amounts:
AS OF SEPTEMBER 30, 2005 AS OF DECEMBER 31, 2004
------------------------ -------------------------
DOLLARS PERCENT DOLLARS PERCENT
------------ --------- ------------- ---------
(dollars in thousands)
Federally Insured Loans:
Loans in-school/grace/deferment(1)..........$ 5,049,704 $ 3,584,260
Loans in forebearance(2).................... 1,800,907 1,654,158
Loans in repayment status:
Loans current............................ 8,214,269 88.9 % 7,142,808 89.6 %
Loans delinquent 31-60 days(3)........... 376,681 4.1 338,434 4.3
Loans delinquent 61-90 days(3)........... 201,497 2.2 154,477 1.9
Loans delinquent 91 days or greater(4)... 445,743 4.8 334,552 4.2
-------------- ------- --------------- -------
Total loans in repayment............... 9,238,190 100.0 % 7,970,271 100.0 %
-------------- ======= --------------- =======
Total federally insured loans..........$ 16,088,801 $ 13,208,689
============== ===============
NON-FEDERALLY INSURED LOANS:
Loans in-school/grace/deferment(1)......... $ 28,735 $ 23,106
Loans in forebearance(2)................... 2,288 2,110
Loans in repayment status:
Loans current........................... 60,665 92.1 % 58,606 89.9 %
Loans delinquent 31-60 days(3).......... 2,373 3.6 2,559 3.9
Loans delinquent 61-90 days(3).......... 1,282 1.9 1,495 2.3
Loans delinquent 91 days or greater(4).. 1,577 2.4 2,529 3.9
-------------- ------- --------------- -------
Total loans in repayment.............. 65,897 100.0 % 65,189 100.0 %
-------------- ======= --------------- =======
Total non-federally insured loans..... $ 96,920 $ 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.
(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.
30
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 and forward flow
channels. 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 relationship with an institution from which the Company
directly or indirectly acquires a significant volume of student loans could
result in an adverse effect on the volume derived from its various channels.
The table below sets forth the activity of loans originated or acquired through
each of the Company's channels:
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- --------------------------------
2005 2004 2005 2004
---------------- --------------- -------------- ----------------
(DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS)
Beginning balance.................................... $ 15,469,689 12,033,329 13,299,094 10,314,874
Direct channel:
Consolidation loan originations.................. 1,097,436 857,456 2,624,106 2,169,374
Less consolidation of existing portfolio......... (559,700) (404,500) (1,274,100) (997,800)
--------------- --------------- ------------ -------------
Net consolidation loan originations........... 537,736 452,956 1,350,006 1,171,574
Stafford/PLUS loan originations.................. 239,927 102,203 567,549 222,515
Branding partner channel............................. 43,934 91,446 1,126,788 806,653
Forward flow channel................................. 260,072 174,922 901,185 623,014
Other channels....................................... 5,015 73,279 39,200 204,062
--------------- --------------- ------------- -------------
Total channel acquisitions....................... 1,086,684 894,806 3,984,728 3,027,818
Loans acquired in business acquisition............... -- -- -- 136,138
Repayments, claims, capitalized interest, and other.. (370,652) (297,679) (1,098,101) (848,374)
--------------- --------------- ------------- -------------
Ending balance....................................... $ 16,185,721 12,630,456 16,185,721 12,630,456
=============== =============== ============= =============
Included in the branding partner channel acquisitions for the nine months ended
September 30, 2005 is $630.8 million of student loans purchased from UB&T, an
entity under common control with the Company. This acquisition was made by the
Company as part of an agreement with UB&T entered into on February 4, 2005. As
part of this agreement, UB&T also committed to transfer to the Company
substantially all of the remaining balance of UB&T's origination rights in
guaranteed student loans. As such, beginning in the second quarter of 2005, all
loans originated by UB&T on behalf of the Company are presented in the table
above as direct channel originations. Branding partner channel acquisitions from
UB&T were approximately $51.9 million and $197.0 million for the three and nine
month periods ended September 30, 2004, respectively.
In March 2004, the Company acquired rights, title, and interest in certain
assets of RISLA, including the right to originate student loans in RISLA's name
without competition from RISLA. The Company also purchased certain assets,
including a portfolio of federally insured loans with an aggregate outstanding
balance of $175.1 million. This loan acquisition is included in the branding
partner channel acquisitions for the nine months ended September 30, 2004.
Originations made subsequent to this acquisition are presented in the table
above as direct channel originations.
31
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 SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------- ---------------------------------
2005 2004 2005 2004
-------------- -------------- ---------------- --------------
Student loan yield.................................. 6.94 % 6.25 % 6.72 % 6.71 %
Consolidation rebate fees........................... (0.65) (0.59) (0.64) (0.57)
Premium and deferred origination costs amortization. (0.51) (0.61) (0.47) (0.63)
-------------- ------------- ---------------- --------------
Student loan net yield.............................. 5.78 5.05 5.61 5.51
Student loan cost of funds (a)...................... (3.83) (2.53) (3.52) (2.02)
-------------- ------------- ---------------- --------------
Student loan spread................................. 1.95 2.52 2.09 3.49
Special allowance yield adjustment, net of
settlements on derivatives (b)................. (0.49) (0.87) (0.55) (1.78)
-------------- ------------- ---------------- --------------
Core student loan spread............................ 1.46 % 1.65 % 1.54 % 1.71 %
============== ============= ================ ==============
Average balance of student loans (in thousands)..... $ 15,628,420 12,108,981 14,766,024 11,282,561
Average balance of debt outstanding (in thousands).. 16,564,494 13,363,469 15,669,656 12,475,490
----------
(a) The student loan cost of funds includes the effects of the net settlement
costs on the Company's derivative instruments.
(b) The special allowance yield adjustment of $21.8 million and $43.6 million
for the three months ended September 30, 2005 and September 30, 2004,
respectively, and $77.4 million and $167.9 million for the nine months ended
September 30, 2005 and September 30, 2004, respectively, represent the
impact on net spread had loans earned at statutorily defined rates under a
taxable financing. The 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 $2.6 million and $17.2
million for the three months ended September 30, 2005 and September 30,
2004, respectively, and $17.0 million and $17.2 million for the nine months
ended September 30, 2005 and September 30, 2004, respectively.
The compression of the Company's core student loan spread during 2005 has been
due to the following items:
o an increase in lower yielding consolidation loans;
o an increase in consolidation rebate fees due to the growth of the Company's
consolidation loan portfolio;
o an increase in in-school loans, which have a lower yield than loans in
repayment;
o rising interest rates which compressed the margins on the Company's fixed
rate loans that were not hedged; and
o interest rate spreads in the bond market which widened during the second and
third quarters of 2005, resulting in increased funding costs on the Company's
auction rate notes.
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
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, increases in
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 December 31, 2005, will be reauthorized.
32
Legislatively, the relevant committees of the House and Senate have each passed
bills to reauthorize the Higher Education Act. The Company anticipates that each
of these bills will eventually be moved to the floor of each body for approval,
with a House/Senate conference then negotiating the terms of the final law.
Depending on whether the current budget reconciliation process stands, final
passage of the Higher Education Act reauthorization could take place as part of
budget reconciliation, or as a stand-alone bill.
The House Education and the Workforce Committee originally reported its Higher
Education Act reauthorization bill in July. The July mark-up took place in the
context of a reconciliation budget instruction to the Committee of $12.6 billion
in savings for all areas in its jurisdiction, which was part of an overall
entitlement savings goal of $35 billion. In October, the House leadership stated
its intent to raise the overall budget reconciliation target from $35 billion to
$50 billion. If this higher target is approved by the House, it could result in
the Committee on Education and the Workforce seeking additional savings from its
bill before it is moved to the floor. Some of the key provisions of the House's
bill include:
o requiring lenders to return to the federal government floor income for loans
disbursed after July 1, 2006;
o phasing out origination fees in the FFEL Program and mandating a 1%
guarantee fee;
o increasing loan limits for first-year and second-year students from $2,625 to
$3,500 and from $3,500 to $4,500, respectively, while maintaining existing
aggregate undergraduate borrowing limits;
o increasing graduate unsubsidized annual borrowing limits from $10,000 to
$12,000;
o preserving the current variable interest rate formula on Stafford and
Unsubsidized Stafford loans beyond July 1, 2006;
o providing consolidation borrowers with a choice of interest rates between the
current variable rate or a higher fixed rate. Borrowers would also be
required to pay an origination fee of 0.5% to secure the fixed-rate option;
o repealing the single holder rule on consolidation loans;
o reducing lender default insurance from 98% to 96% on loans disbursed after
July 1, 2006. The bill also provides that risk sharing under Exceptional
Performer be reduced from 100% to 98%; and
o providing that no new loans will receive a 9.5% special allowance payment
rate after enactment.
The Senate Committee on Health, Education, Labor and Pensions marked up its own
Higher Education Act bill in October. The Senate bill shared some provisions
with the House bill, but also differed in a number of important ways. Some of
the key provisions of the Senate bill that are similar to the House bill
include:
o lender rebate of floor income;
o mandate a 1% guarantee fee;
o provisions on loan limit increases; and
o repeal of the single holder rule on consolidation loans.
Other provisions of the Senate bill include:
o Borrower interest rates would shift from the current variable-rate structure
to fixed rates. New Stafford loans would be fixed at 6.8%, PLUS at 8.5%; and
consolidation fixed at the average of the underlying rates. The basic lender
special allowance payment rate would remain unchanged. This contrasts with
the House bill, which would maintain a variable-rate structure on Stafford
and PLUS loans.
o reduces the 3% lender origination fee to 2.5% in 2007;
o increases lender origination fee on consolidation loans to 1%;
o reduces lender default insurance on new loans from 98% to 97%;
o ends the Exceptional Performer program;
33
o makes permanent the existing ban on "refinancing" and "refunding" practices
on loans in order to earn a minimum 9.5% floor interest rate. However, it
does not end "recycling" as the House bill does;
o expands the PLUS student loan to graduate and professional students; and
o allows no new schools to participate in the school-as-lender program (if not
participating as of August 31, 2005) and places new restrictions on existing
participants, including holding loans to grace.
The Company cannot predict whether any of 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
the 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.
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.
A portion of the Company's FFEL Program loan portfolio is comprised of loans
currently financed or financed prior to September 30, 2004 with proceeds of
tax-exempt obligations originally issued prior to October 1, 1993. Based upon
provisions of the Higher Education Act, and regulations and guidance of the
Department and related interpretations, the Company is entitled to receive
special allowance payments on these loans equal to a 9.5% minimum rate of return
("the 9.5% Floor"). As of September 30, 2005, the Company had $3.1 billion of
FFELP loans that were receiving special allowance payments based upon the 9.5%
Floor.
In May 2003, the Company sought confirmation from the Department regarding
whether it was allowed to receive the special allowance payments based on the
9.5% Floor on loans being acquired with funds obtained from the proceeds of
tax-exempt obligations originally issued prior to October 1, 1993 and then
subsequently refinanced with proceeds of taxable obligations without retiring
the tax-exempt obligations. Pending satisfactory resolution of this issue, the
Company deferred recognition of that portion of the 9.5% Floor income generated
by these loans which exceeded statutorily defined special allowance rates under
a taxable financing. In June 2004, after consideration of certain clarifying
information received in connection with the guidance it had sought and based on
written and verbal communications with the Department, management concluded that
the earnings process had been completed and recognized the previously deferred
income of $124.3 million on this portfolio. The Company is currently recognizing
the 9.5% Floor income on these loans as it is earned.
In October 2004, Congress passed and President Bush signed into law the
Taxpayer-Teacher Protection Act of 2004 (the "October 2004 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 loans in the Company's student loan portfolio that 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 before September 30, 2004. In April 2004, the Company ceased
adding to its portfolio of loans receiving special allowance payments subject to
the 9.5% Floor, and thus the provisions of the October 2004 Act do not have an
effect upon the eligibility of such loans to receive the 9.5% Floor.
On May 24, 2005, the Office of Inspector General of the Department ("OIG")
publicly released a Final Audit Report on Special Allowance Payments to New
Mexico Educational Assistance Foundation for Loans Funded by Tax-Exempt
Obligations (the "NMEAF Audit Report"). In the NMEAF Audit Report, the OIG
indicated it had determined that the New Mexico Educational Assistance
Foundation ("NMEAF"), an entity unrelated to the Company, received what the OIG
deemed to be improper special allowance payments under the 9.5% Floor
calculation for loans that were transferred as security for new debt obligations
("refunded bonds") after the prior tax-exempt obligation was retired. The OIG
recommended that the Chief Operating Officer for Federal Student Aid of the
Department calculate and require repayment by NMEAF of the special allowance
payments described in the NMEAF Audit Report. However, as discussed below, the
Department subsequently determined that NMEAF complied with applicable laws,
regulations, and Department guidance with respect to such special allowance
payments.
In June 2005, the OIG commenced an audit of the portion of its student loan
portfolio receiving 9.5% Floor special allowance payments. The Company is fully
cooperating with the OIG in connection with this audit. The Company also
understands that the Department, as part of a nationwide project, is separately
conducting a review of lenders related to student loans financed with the
proceeds of tax-exempt bonds that are eligible for the 9.5% Floor. On June 30,
2005, the Company provided information to the Department that it requested as
part of this project.
On July 8, 2005, the Secretary of the Department announced that the Department
had completed its review of the NMEAF Audit Report and determined that NMEAF
complied with applicable laws, regulations, and Department guidance with respect
to NMEAF's receipt of 9.5% Floor special allowance payments discussed in the
NMEAF Audit Report and effectively indicated it disagreed with the OIG's
conclusions.
34
Although retroactive changes to the Higher Education Act are extremely uncommon,
if Congress were to enact legislation that applied retroactively to remove FFELP
loans that have been refinanced with proceeds of taxable obligations from
eligibility for the 9.5% Floor, and if such legislation were to withstand legal
challenge, it could have a material adverse effect upon the Company's financial
condition and results of operations. Of the $3.1 billion in loans held by the
Company as of September 30, 2005 that are receiving 9.5% Floor payments,
approximately $2.8 billion in loans were financed prior to September 30, 2004
with proceeds of tax-exempt obligations originally issued prior to October 1,
1993 and then subsequently refinanced with the proceeds of taxable obligations,
without retiring the tax-exempt obligations.
On October 24, 2005, Nelnet acquired LoanSTAR, including its student loan
portfolio of approximately $864 million. Included in LoanSTAR's portfolio of
student loans was approximately $412 million of student loans receiving the 9.5%
Floor payments, of which approximately $250 million in loans were financed prior
to September 30, 2004 with proceeds of tax-exempt obligations originally issued
prior to October 1, 1993 and then subsequently refinanced with the proceeds of
taxable obligations, without retiring the tax-exempt obligations.
The guidance issued by the Department has indicated that receipt of the 9.5%
Floor income on loans such as those held by the Company is permissible under
current law and previous interpretations thereof. However, the Company cannot
predict whether the Department will maintain its position in the future on the
permissibility of the 9.5% Floor. Likewise, although management believes that it
has complied in all material respects with the rules and regulations with
respect to the proper categorization of these loans as being eligible for the
9.5% Floor special allowance payments, the Company cannot predict the outcome of
the OIG audit. Costs, if any, associated with an adverse outcome of the OIG
audit or resolution of findings or recommendations arising out of the OIG audit,
a potential Department review of its position on the permissibility of the 9.5%
Floor, or legislation which would retroactively remove eligibility for the 9.5%
Floor could adversely affect the Company's financial condition and results of
operations. However, it is the opinion of the Company's management, based on
information currently known, that any adverse outcome or resolution of findings
or recommendations arising out of the OIG audit, a potential Department review
of its permissibility of the 9.5% Floor, or legislation which would
retroactively remove eligibility for the 9.5% Floor would not have a material
adverse effect on the Company's operations.
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, technological development,
and business acquisitions. 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 or fund opportunistic
business acquisitions 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 September
30, 2005, the Company had a student loan warehousing capacity of $4.5 billion,
of which $2.6 billion was outstanding, through 364-day commercial paper conduit
programs. These conduit programs mature in 2006 through 2009; however, they must
be renewed annually by underlying liquidity providers and may be terminated at
any time for cause. Subsequent to September 30, 2005, the Company increased its
capacity on its warehouse facilities by $2.1 billion from $4.5 billion to $6.6
billion in order to fund a student loan portfolio acquisition of approximately
$2.2 billion from Chela on October 25, 2005. 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.
On August 19, 2005, the Company entered into a credit agreement for a $500.0
million unsecured line of credit. Concurrently with entry into this agreement,
the Company terminated its existing $35.0 million operating line of credit and
$50.0 million commercial paper operating line of credit. The $500.0 million line
of credit terminates on August 19, 2010. In addition, the Company has a credit
facility agreement with a Canadian financial institution that is cancelable by
either party upon notice.
35
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 September 30, 2005, $14.6 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 September 30, 2005, 99% of the Company's student loan portfolio was
comprised of federally insured loans. These loans currently benefit from a
federal guarantee of between 98% and 100% of their principal balance and accrued
interest.
In September 2005, the Company was re-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 a 12-month period (June 1, 2005 through May 31, 2006). The
Company is not subject to the 2% risk sharing on 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 eligible for the
100% reimbursement. The Company is entitled to receive this benefit as long as
it and/or its service providers continue to meet the required servicing
standards published by the Department. Compliance with such standards is
assessed on a quarterly basis. In addition, service providers must apply for
redesignation as an Exceptional Performer with the Department on an annual
basis. The Company first earned its Exceptional Performer designation effective
June 1, 2004.
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 Performer designation,
either by the Department or Congress (via reauthorization) 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 Performer designation. If the Department discontinued the program or
Congress eliminates the program through reauthorization, the Company would have
to establish a provision for loan losses related to the 2% risk sharing. Based
on the balance of federally insured loans outstanding as of September 30, 2005,
this provision would be approximately $11.0 million. In addition, current House
and Senate proposals related to the Higher Education Act reauthorization process
include provisions to decrease insurance and reinsurance on FFELP student loans.
If the insurance and reinsurance decrease during reauthorization, the Company
would have to establish a provision for loan losses related to the new risk
sharing amounts. This provision would be recognized by the Company upon the
effective date of the new provisions of the Higher Education Act, which is
estimated to be October 1, 2006.
Losses on the Company's non-federally insured loans are borne by the Company.
The loan loss pattern on the Company's non-federally insured loan portfolio is
not as developed as that on its federally insured loan portfolio. As of
September 30, 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 increase further 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
36
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 in this area have been minimal. However, the Company's loan
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 borrower'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 62% of the Company's portfolio to such refinancing, and increasing
origination fees paid by lenders in connection with making consolidation loans.
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 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 occasionally 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 than the Company 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.
37
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 September 30, 2005, third parties owned approximately 53% 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 and forward flow 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 and
forward flow 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 March 2006. EDULINX cannot
guarantee that it will obtain a renewal of the servicing agreement with this
largest customer 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.
PREPAYMENT RISK
Pursuant to the Higher Education Act, borrowers may voluntarily prepay loans
made under the FFEL Program at any time in full or in part. Prepayments may also
result from consolidating student loans, which tends to occur more frequently in
low interest rate environments, and from borrower defaults, which will result in
the receipt of a guarantee payment. 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.
38
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.
In September 2005, the Company was re-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 a 12-month period (June 1, 2005 through May 31, 2006). The
Company is not subject to the 2% risk sharing on 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 eligible for the
100% reimbursement. The Company is entitled to receive this benefit as long as
it and/or its service providers continue to meet the required servicing
standards published by the Department. Compliance with such standards is
assessed on a quarterly basis. In addition, service providers must apply for
redesignation as an Exceptional Performer with the Department on an annual
basis. The Company first earned its Exceptional Performer designation effective
June 1, 2004.
As of September 30, 2005, more than 99% of the Company's federally insured loans
were serviced by providers designated as Exceptional Performers. Of this
portion, the Company serviced approximately 93% and third parties serviced
approximately 7%. If the Company or a third party servicer were to lose its
Exceptional Performer designation, either by the Department discontinuing the
program or the Company or third party servicer not meeting the required
servicing standards or failing to get re-designated during the annual
application process, loans serviced by the Company or such third party would
become subject to the 2% risk sharing for all claims submitted after loss of the
designation.
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. The
current provisions of the Higher Education Act are scheduled to expire on
December 31, 2005. Historically, the United States Congress makes changes to the
provisions of the Higher Education Act during the reauthorization process. One
of the changes to the Higher Education Act that is included in the House's
reauthorization proposal is to the guarantee rates on FFELP loans, including
proposals for a decrease in insurance and reinsurance on portfolios receiving
the benefit of Exceptional Performance designation by up to 2%, from 100% to 98%
of principal and accrued interest, and a decrease in insurance and reinsurance
on portfolios not subject to the Exceptional Performance designation by up to
2%, from 98% to 96% of principal and accrued interest. The Senate's
reauthorization proposal includes a provision to end the Exceptional Performer
program and to decrease the insurance and reinsurance on FFELP loans from 98% to
97% of principal and accrued interest. If the insurance and reinsurance decrease
during reauthorization, the Company would have to establish a provision for loan
losses related to the new risk sharing amounts. This provision would be
recognized by the Company upon the effective date of the new provisions of the
Higher Education Act, which is estimated to be October 1, 2006. See, " - Risks -
Political/Regulatory Risk."
In determining the adequacy of the allowance for loan losses on the
non-federally insured loans, the Company considers several factors including:
loans in repayment versus those in a nonpaying status, months in repayment,
delinquency status, type of program, and trends in defaults in the portfolio
based on Company and industry data. The Company places a non-federally insured
loan on nonaccrual status and charges off the loan when the collection of
principal and interest is 120 days past due.
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.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2005, the Financial Accounting Standards Board ("FASB") issued SFAS No.
154, REPORTING ACCOUNTING CHANGES AND ERROR CORRECTIONS ("SFAS No. 154"). SFAS
No. 154 requires retrospective application for voluntary changes in accounting
principle unless it is impracticable to do so. SFAS No. 154's retrospective
application requirement replaces Accounting Principles Board Opinion 20's
requirement to recognize most voluntary changes in accounting principle by
39
including in net income of the period of the change the cumulative effect of
changing to the new accounting principle. If the cumulative effect of the change
in accounting principle can be determined, but it is impracticable to determine
the specific effects of an accounting change on one or more prior periods
presented, the change in accounting policy will have to be applied to balances
of assets and liabilities as of the beginning of the earliest period for which
retrospective application is practicable, with a corresponding adjustment made
to the opening balance of retained earnings or other components of equity (e.g.,
accumulated other comprehensive income) for that period. If it is impracticable
to determine the cumulative effect of applying a change in accounting principle,
the new accounting principle is to be applied prospectively from the earliest
date practicable. If retrospective application for all prior periods is
impracticable, the method used to report the change and the reason that
retrospective application is impracticable are to be disclosed. The requirements
of SFAS No. 154 are effective for accounting changes made in fiscal years
beginning after December 15, 2005. As of the filing of this report, management
believes that SFAS No. 154 will not have a significant effect on the financial
position, results of operations, and cash flows of the Company.
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 to the
borrower at the weighted average interest rate of the underlying loans at the
time of consolidation. The following table sets forth the Company's loan assets
and debt instruments by rate characteristics:
AS OF SEPTEMBER 30, 2005 AS OF DECEMBER 31, 2004
------------------------- -------------------------
DOLLARS PERCENT DOLLARS PERCENT
-------------- --------- --------------- --------
(DOLLARS IN THOUSANDS)
Fixed-rate loan assets........... $ 4,714,036 29.1 % $ 5,559,748 41.8 %
Variable-rate loan assets........ 11,471,685 70.9 7,739,346 58.2
-------------- --------- --------------- --------
Total........................ $16,185,721 100.0 % $ 13,299,094 100.0 %
============== ========= =============== ========
Fixed-rate debt instruments...... $ 850,732 4.9 % $ 712,641 5.0%
Variable-rate debt instruments... 16,567,920 95.1 13,587,965 95.0
-------------- --------- --------------- --------
Total......................... $17,418,652 100.0 % $ 14,300,606 100.0 %
============== ========= =============== ========
The following table shows the Company's student loan assets currently earning at
a fixed rate as of September 30, 2005:
BORROWER/ ESTIMATED
LENDER VARIABLE BALANCE OF
FIXED INTEREST WEIGHTED CONVERSION FIXED-RATE
RATE RANGE AVERAGE YIELD RATE (a) LOAN ASSETS
-------------- ---------------- -------------- --------------
(DOLLARS IN THOUSANDS)
6.5 - 7.0% 6.71% 4.07% $ 355,993
7.0 - 8.0 7.51 4.87 321,057
> 8.0 8.55 5.91 935,846
9.5 floor yield 9.50 6.86 3,101,140
--------------
$ 4,714,036
==============
- ----------
(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.
40
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 relationship between 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.
The following table summarizes the notional values and weighted average interest
rates of the Company's outstanding derivative instruments used to hedge the
fixed-rate student loan portfolio as of September 30, 2005 (dollars in
millions):
FIXED/ WEIGHTED FLOATING/ WEIGHTED
FLOATING SWAPS AVERAGE FIXED FIXED AVERAGE FIXED NET NOTIONAL
MATURITY (a)(b) RATE (a)(b) SWAPS (c) SWAPS (c) AMOUNT
- ------------------------- ------------- ------------- ------------- ------------- ------------
2005..................... $ 600 2.23 % $ 800 3.58 % $ (200)
2006..................... 613 2.99 -- -- 613
2007..................... 512 3.42 -- -- 512
2008..................... 463 3.76 -- -- 463
2009..................... 312 4.01 -- -- 312
2010 and thereafter...... 1,938 4.29 -- -- 1,938
------------ ------------ ----------- ------------ ------------
Total.................. $ 4,438 3.66 % $ 800 3.58 % $ 3,638
============ ============ =========== ============ ============
- ----------
(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. The weighted average fixed rate is
the rate paid by the Company on these interest rate swaps.
(b) Includes an interest rate swap with a notional amount of $250 million that
expired on October 3, 2005 with a fixed rate of 1.75%.
(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. The weighted
average fixed rate is the rate received by the Company on these interest
rate swaps.
In addition to the interest rate swaps summarized above, as of September 30,
2005, the Company had $561 million of fixed-rate debt (excluding certain of the
Company's fixed-rate unsecured debt of $290 million) that was used to hedge the
fixed-rate student loan portfolio.
Subsequent to September 30, 2005, the Company acquired approximately $690
million in additional fixed-rate student loan assets earning at a rate greater
than 6.5% as a result of the business acquisition of LoanSTAR and student loan
portfolio acquisition from Chela. The Company's risk committee will assess the
additional interest rate risk exposure as a result of these acquisitions as part
of its overall risk management strategy.
The Company also has one basis swap with a notional amount of $500 million that
matures in August 2006. 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.
41
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. During 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. This swap expired in September
2005.
The following is a summary of the amounts included in derivative market value
adjustment and net settlements on the consolidated statements of operations
related to those derivative instruments that do not qualify for hedge
accounting:
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------- ------------------------------
2005 2004 2005 2004
------------- ---------------- -------------- --------------
(DOLLARS IN THOUSANDS)
Change in fair value of derivative instruments.. $65,382 (39,757) 74,300 (39,209)
Settlements, net................................ (2,962) (16,457) (19,049) (19,389)
------------ -------------- ------------ ------------
Derivative market value adjustment and
net settlements 62,420 (56,214) 55,251 (58,598)
============ ============== ============ ============
42
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 SEPTEMBER 30, 2005
---------------------------------------------------------------------------
CHANGE FROM DECREASE OF CHANGE FROM INCREASE OF CHANGE FROM INCREASE OF
100 BASIS POINTS 100 BASIS POINTS 200 BASIS POINTS
----------------------- ------------------------ ------------------------
Dollars Percent Dollars Percent Dollars Percent
----------- ---------- ------------ ---------- ------------ ----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements.............. $14,264 12.6 % $ (9,730) (8.6)% $ (17,781) (15.7)%
Impact of derivative settlements.................. (9,134) (8.1) 9,134 8.1 18,269 16.1
----------- ---------- ------------ ---------- ------------ ----------
Increase (decrease) in net income before taxes.... $ 5,130 4.5 $ (596) (0.5)% $ 488 0.4%
=========== ========== ============ ========== ============ ==========
Increase (decrease) in basic and diluted
earning per share............................. $ 0.06 $ (0.01) $ 0.01
=========== ============ ============
THREE MONTHS ENDED SEPTEMBER 30, 2004
---------------------------------------------------------------------------
CHANGE FROM DECREASE OF CHANGE FROM INCREASE OF CHANGE FROM INCREASE OF
100 BASIS POINTS 100 BASIS POINTS 200 BASIS POINTS
----------------------- ------------------------ ------------------------
Dollars Percent Dollars Percent Dollars Percent
----------- ---------- ------------ ---------- ------------ ----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements.............. $.18,782 157.2 % $ (12,438) (104.1)% $ (23,776) (199.0)%
Impact of derivative settlements.................. (15,662) (131.1) 15,662 131.1 31,324 262.2
----------- ---------- ------------ ---------- ------------ ----------
Increase in net income before taxes............... $ 3,120 26.1 % $ 3,224 27.0 % $ 7,548 63.2%
=========== ========== ============ ========== ============ ==========
Increase in basic and diluted
earning per share............................. $ 0.04 $ 0.04 $ 0.09
=========== ============ ============
NINE MONTHS ENDED SEPTEMBER 30, 2005
---------------------------------------------------------------------------
CHANGE FROM DECREASE OF CHANGE FROM INCREASE OF CHANGE FROM INCREASE OF
100 BASIS POINTS 100 BASIS POINTS 200 BASIS POINTS
----------------------- ------------------------ ------------------------
Dollars Percent Dollars Percent Dollars Percent
----------- ---------- ------------ ---------- ------------ ----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements.............. $58,620 26.9 % $ (26,852) (12.3)% $ (46,971) (21.6)%
Impact of derivative settlements.................. (29,044) (13.3) 29,044 13.3 58,089 26.7
----------- ---------- ------------ ---------- ------------ ----------
Increase in net income before taxes............... $ 29,576 13.6 % $ 2,192 1.0 % $ 11,118 5.1 %
=========== ========== ============ ========== ============ ==========
Increase in basic and diluted
earning per share............................. $ 0.35 $ 0.03 $ 0.13
=========== ============ ============
NINE MONTHS ENDED SEPTEMBER 30, 2004
---------------------------------------------------------------------------
CHANGE FROM DECREASE OF CHANGE FROM INCREASE OF CHANGE FROM INCREASE OF
100 BASIS POINTS 100 BASIS POINTS 200 BASIS POINTS
----------------------- ------------------------ ------------------------
Dollars Percent Dollars Percent Dollars Percent
----------- ---------- ------------ ---------- ------------ ----------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements.............. $ 65,878 41.0 % $ (32,411) (20.1)% $ (59,626) (37.1)%
Impact of derivative settlements.................. (29,306) (18.2) 29,306 18.2 58,613 36.4
----------- ---------- ------------ ---------- ------------ ----------
Increase (decrease) in net income before taxes.... $ 36,572 22.8 % $ (3,105) (1.9)% $ (1,013) (0.7)%
=========== ========== ============ ========== ============ ==========
Increase (decrease) in basic and diluted
earning per share............................. $ 0.42 $ (0.04) $ (0.01)
=========== ============ ============
43
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.
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 SEC Rules
13a-15(e) and 15d-15(e) under 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 and
disputes with other business entities. 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.
44
ITEM 6. EXHIBITS
2.1 Stock and Asset Purchase Agreement dated as of October 3, 2005
among Nelnet, Inc., NNI Acquisition Servicing Limited
Partnership, Greater Texas Foundation, and LoanSTAR Systems,
Inc., filed as Exhibit 2.1 to Nelnet, Inc.'s Current Report on
Form 8-K filed on October 3, 2005 and incorporated herein by
reference.
2.2 Asset Purchase Agreement dated as of September 27, 2005, among
Nelnet, Inc., Chela Education Financing, Inc. and The Education
Financing Foundation of California, filed as Exhibit 2.2 to
Nelnet, Inc.'s Current Report on Form 8-K filed on October 26,
2005 and incorporated herein by reference.
10.1* Amended Nelnet, Inc. Employee Share Purchase Plan.
10.2 Credit Agreement dated August 19, 2005, among Nelnet, Inc.,
JPMorgan Chase Bank, N.A. individually and as Administrative
Agent, Citibank, N.A. individually and as Syndication Agent and
various lender parties thereto, filed as Exhibit 99.1 to Nelnet,
Inc.'s Current Report on Form 8-K filed on August 25, 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
45
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NELNET, INC.
Date: November 9, 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
46