Nelnet, Inc. (NNI) is one of the leading education finance companies in the U.S., with more than $26 billion in student loans outstanding at September 30, 2007. NNI offers a broad range of student loan and financial services, along with technology-based products designed to simplify the student loan process by automating financial aid delivery, loan processing, and funds disbursement. Student loans are originated and acquired through a variety of methods, including the direct channel and the branding partner / forward flow channels (in which NNI acquires student loans from other lenders), as well as through spot purchases and whole-company acquisitions and other channels. Direct-channel loans are typically the most profitable due to lower acquisition costs and generally longer retention periods.
Ninety-nine percent of NNI's portfolio is made up of federally insured loans, which are in large part guaranteed by the U.S. government. As NNI currently earlier operated under the Department of Education s (DOE) "Exceptional Performer" designation, the guarantee is typically 99%, depending on several factors. It is also worth noting that all provisions relating to Exceptional Performer status, and the monetary benefit associated with it have been eliminated effective October 1, 2007, per new legislation. Less than 1% of loans are private loans, where NNI assumes the credit risk. The majority of revenues traditionally have been generated as spread income on student loans and investments, with the minority coming from loan and guarantee servicing, software and other fee-based sources. Management has clearly been pushing to grow this latter group rapidly, however, and fee-based revenue accounted for 50% of total revenue in 2006 and 54% in the third quarter of 2007.
On September 27, 2007, the President signed into law the College Cost Reduction and Access Act of 2007 (the "Act"). This legislation contains provisions with significant implications for participants in the Federal Family Education Loan Program ("FFEL Program or "FFELP") by cutting funding to the FFEL Program by $20 billion over the next five years as estimated by the Congressional Budget Office. Among other things, the Act:
Reduces special allowance payments to for-profit lenders and not-for-profit lenders by 0.55 percentage points and 0.40 percentage points, respectively, for both Stafford and Consolidation Loans disbursed on or after October 1, 2007
Reduces special allowance payments to for-profit lenders and not-for-profit lenders by 0.85 percentage points and 0.70 percentage points, respectively, for PLUS loans disbursed on or after October 1, 2007
Increases origination fees paid by lenders on all FFELP loan types, from 0.5 percent to 1.0 percent, for all loans first disbursed on or after October 1, 2007
Eliminates all provisions relating to Exceptional Performer status, and the monetary benefit associated with it, effective October 1, 2007 and
For loans disbursed on or after October 1, 2012, reduces default insurance to 95 percent of the unpaid principal of such loans.
Update on the 9.5% SAP audit
On January 19, NNI came to an agreement with the Department of Education, resolving the audit of the part of NNI's student loan portfolio receiving a 9.5% special allowance payment (SAP). Under the terms of the agreement, NNI will retain all 9.5% SAPs it received from the DOE prior to July 1, 2006, while eliminating all 9.5% SAPs for periods on and after July 1, including the SAPs which had been billed and were pending for the third and fourth quarters of 2006. As a part of the agreement, NNI and the DOE acknowledged that a dispute existed related to guidance previously issued by the DOE and the application of existing laws and regulations related to the receipt of certain 9.5% SAPs. The new guidance provided in the agreement will effectively eliminate all future 9.5% SAPs for NNI (related loans will continue to receive SAPs using other applicable special allowance formulas). The agreement brings to conclusion a major overhang related to owning the shares however, it also materially lowers NNI's revenue stream and earnings potential. Our estimates and price target have fallen materially.
Other legal and regulatory matters
While the matter of the 9.5% SAP has been resolved, several other items cloud the horizon. Regulatory risk remains elevated as budget talks threaten to reduce funding for the FFELP program and a Democrat-heavy Congress is believed to favor direct lending. In addition, in January NNI received a letter from the NY State Attorney General requesting information regarding the AG's investigation into preferred lender list activities. NNI understands that the AG is conducting an investigation to determine if there are conflict of interest issues relating to lenders being placed on preferred lender lists at colleges and universities. While NNI is cooperating with the AG's investigation and believes that its practices comply with all applicable laws and regulations, there is clearly the potential for negative fallout.
On April 20, NNI announced that it had agreed with the Nebraska Attorney General to voluntarily adopt a Nelnet Student Loan Code of Conduct, and commit $1.0 million to help educate students and families on how to plan and pay for their education.
On July 31, NNI announced that it had agreed with the New York Attorney General to adopt the New York Attorney General's Code of Conduct, which is substantially similar to the Nelnet Student Loan Code of Conduct, but which also includes an agreement to eliminate two services the Company had previously announced plans to discontinue. As part of the agreement, the Company agreed to contribute $2.0 million to a national fund for educating high school seniors and their parents regarding the financial aid process.
On July 27, 2006, NNI announced that it had completed its acquisition of Peterson's from Thomson Corp. According to NNI, Peterson's provides a comprehensive suite of education and career-related solutions in the areas of education search, test preparation, admissions, financial aid information, and career assistance and reaches an estimated 105 million consumers annually with its publications and online information about colleges and universities, career schools, graduate programs, distance learning, executive training, private secondary schools, summer opportunities, study abroad, financial aid, test preparation, and career exploration resources. The release also noted that a significant portion of revenue for the first several months will be deferred and recognized during the period of service. Therefore, the acquisition will have a dilutive effect on NNI's base net income in 2006. It is anticipated the transaction will be accretive, although immaterial, in 2007. The consideration for the deal was $38.6 million in cash.
On June 30, 2006, NNI completed the purchase of CUnet, LLC (announced June 26). CUnet was founded in 2004, and reportedly provides campus locations and online schools with performance-based educational marketing, web-based marketing, lead generation, and vendor management services to enhance their brands and improve student recruitment and retention. The initial consideration was $40 million in cash. Additional consideration of up to $80 million (part stock, part cash) will be based on the aggregate cumulative net income before taxes (excluding any amortization of intangibles from the purchase price allocation) that CUnet earns during the three-year period beginning July 1. Due to the transaction structure, management does not expect the acquisition to be accretive to GAAP net income for at least 3 years. It is expected to be accretive to base net income in 2006 if certain compensation-related charges are excluded.
In March 2006, NNI announced that it completed its acquisitions of the 20% of FACTS Management Co. and the 50% of infiNET Integrated Solutions, Inc. that it did not yet own. The acquisition of the remaining 20% of FACTS provided for a total purchase price of $14.6 million, including 238,237 shares of NNI Class A common stock valued at approximately $10 million ($41.98 per share). We were a bit shocked to note that the shares issued are subject to put option arrangements with the selling shareholders such that during the 30-day period after the fourth anniversary of the closing NNI may be required to repurchase the shares at a price of $83.95 per share (guaranteeing a minimum 100% return on the NNI shares). The acquisition of the remaining 50% of infiNET provided for a total purchase price of $13.5 million, including 95,380 shares of NNI Class A common stock valued at $4 million ($41.9335 per share). The shares issued are subject to stock price guarantee provisions such that, if on the fifth anniversary after the closing the market trading price of the Class A shares is less than $104.8375 per share (and has not exceeded that price for any twenty-five consecutive trading days during the five years after the closing), then NNI may be required to pay additional cash to the shareholder for each share issued to bring the value received per share to $104.8375 (guaranteeing a minimum 150% return). NNI purchased the initial 80% of FACTS Management Co. and American Card Services, Inc. for $56.0 million (along with an option for the remaining 20%) in June 2005. NNI initially made its initial 50% investment in infiNET in April 2004.
In November 2005, NNI entered into an agreement with the shareholders of 5280 Solutions, Inc. and FirstMark Services LLC that provides for NNI to purchase the remaining 50% interest in each of these entities that it did not already own, for total consideration of approximately $12 million. The closing of the 5280 Solutions transaction occurred on November 30, and NNI issued a total of 258,760 shares of Class A common stock valued under the agreement at approximately $9.7 million (~$37.49 per share). The shares issued are subject to certain put option arrangements with the selling shareholders pursuant to which during the thirty-day period ending on the third anniversary date of the closing NNI may be required to repurchase the shares at a price of $37.10 per share (roughly equal to the market price).
In October 2005, NNI acquired approximately $2.2 billion of FFELP loans from Chela Education Financing, Inc. 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.
Also in October 2005, NNI purchased 100% of the capital stock of LoanSTAR Funding Group, Inc. and servicing assets from LoanSTAR Systems, Inc. for approximately $169 million. The two 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.
In July 2005, NNI purchased 100% of the capital stock of Foresite Solutions, Inc. for $750,000. 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 expands the marketing agreement between the companies that allowed Nelnet to co-brand and sell Foresite products to schools.
In February 2005, NNI 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 was $27.0 million. SMG and NHR were entities owned under common control. SMG provides products and services to help businesses reach the middle school, high school, college-bound, college, and young adult marketplace, and provides marketing services and college-bound student lists to college and university admissions offices. NHR recognizes middle and high school students for exceptional academic success. Additional payments are to be paid based on the operating results of SMG and NHR as defined in the purchase agreement, payable in annual installments through April 2008 (the total additional payment will range from $4.0 million to $24.0 million).
In December 2004, NNI purchased 100% of the capital stock of EDULINX Canada Corporation and its wholly owned subsidiary, Tricura Canada Inc., for $7.4 million. An additional payment of approximately $6.3 million was to be paid if EDULINX obtained an extension or renewal of a significant customer servicing contract that was set to expire in March 2006.