UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006
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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer.
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]
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 July 31, 2006, there were 40,118,981 and 13,942,954 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
JUNE 30, 2006
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements 2
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 16
Item 3. Quantitative and Qualitative Disclosures about Market Risk 37
Item 4. Controls and Procedures 41
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 41
Item 1A. Risk Factors 42
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 42
Item 4. Submission of Matters to a Vote of Security Holders 42
Item 6. Exhibits 44
SIGNATURES 44
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
AS OF
AS OF DECEMBER 31,
JUNE 30, 2006 2005
------------- ------------
(UNAUDITED)
ASSETS:
Student loans receivable (net of allowance for loan losses of
$24,180 and $13,390, respectively) $22,404,492 20,260,807
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party 51,695 49,863
Cash and cash equivalents - held at a related party 49,784 53,787
------------- ------------
Total cash and cash equivalents 101,479 103,650
Restricted cash 1,677,800 1,228,570
Restricted investments 146,171 160,479
Restricted cash - due to customers 48,860 153,098
Accrued interest receivable 493,118 394,630
Accounts receivable, net 43,045 36,331
Goodwill 149,148 99,535
Intangible assets, net 177,483 153,117
Furniture, equipment, and leasehold improvements, net 44,459 36,750
Other assets 78,237 88,889
Fair value of derivative instruments, net 180,901 82,766
------------- ------------
Total assets $25,545,193 22,798,622
============= ============
LIABILITIES:
Bonds and notes payable $24,327,855 21,673,620
Accrued interest payable 113,471 94,281
Other liabilities 183,200 137,572
Deferred income taxes 119,618 89,933
Due to customers 48,860 153,098
------------- ------------
Total liabilities 24,793,004 22,148,504
------------- ------------
Minority interest -- 626
------------- ------------
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 40,118,981 shares as of
June 30, 2006 and 40,040,841 shares as of December 31, 2005 401 400
Class B, $0.01 par value. Authorized 60,000,000 shares;
issued and outstanding 13,942,954 shares as of
June 30, 2006 and 13,962,954 shares as of December 31, 2005 139 140
Additional paid-in capital 229,994 220,432
Retained earnings 526,005 428,186
Unearned compensation (5,155) (86)
Employee note receivable (501) --
Accumulated other comprehensive income, net of taxes 1,306 420
------------- ------------
Total shareholders' equity 752,189 649,492
------------- ------------
COMMITMENTS AND CONTINGENCIES
Total liabilities and shareholders' equity $25,545,193 22,798,622
============= ============
See accompanying notes to consolidated financial statements.
2
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
--------------------------- --------------------------
2006 2005 2006 2005
------------- ------------ ------------ ------------
INTEREST INCOME:
Loan interest $ 362,742 207,144 688,402 391,469
Investment interest 24,314 8,150 43,855 15,152
------------- ------------ ------------ ------------
Total interest income 387,056 215,294 732,257 406,621
INTEREST EXPENSE:
Interest on bonds and notes payable 300,844 133,277 559,793 237,802
------------- ------------ ------------ ------------
Net interest income 86,212 82,017 172,464 168,819
Less provision for loan losses 2,190 2,124 11,808 4,155
------------- ------------ ------------ ------------
Net interest income after provision for
loan losses 84,022 79,893 160,656 164,664
------------- ------------ ------------ ------------
OTHER INCOME (EXPENSE):
Loan and guarantee servicing income 44,042 34,678 91,116 71,854
Other fee-based income 16,074 9,027 34,229 12,383
Software services income 4,018 2,602 7,427 4,808
Other income 3,154 1,524 4,609 2,924
Derivative market value and foreign
currency adjustments 28,865 (51,372) 68,660 8,918
Derivative settlements, net 6,702 (6,001) 11,446 (16,087)
------------- ------------ ------------ ------------
Total other income (expense) 102,855 (9,542) 217,487 84,800
------------- ------------ ------------ ------------
OPERATING EXPENSES:
Salaries and benefits 62,207 39,977 119,891 79,304
Other operating expenses:
Depreciation and amortization 9,955 4,918 19,360 9,384
Trustee and other debt related fees 2,935 2,121 6,040 4,449
Occupancy and communications 6,081 4,344 11,907 8,576
Advertising and marketing 5,229 4,070 10,041 6,744
Professional services 6,651 4,576 14,467 10,352
Postage and distribution 6,449 5,079 12,299 9,385
Other 14,765 8,794 28,514 17,073
------------- ------------ ------------ ------------
Total other operating expenses 52,065 33,902 102,628 65,963
------------- ------------ ------------ ------------
Total operating expenses 114,272 73,879 222,519 145,267
------------- ------------ ------------ ------------
Income (loss) before income taxes 72,605 (3,528) 155,624 104,197
Income tax expense (benefit) 26,852 (1,755) 57,563 37,883
------------- ------------ ------------ ------------
Net income (loss) before
minority interest 45,753 (1,773) 98,061 66,314
Minority interest in subsidiary income -- -- (242) --
------------- ------------ ------------ ------------
Net income (loss) $ 45,753 (1,773) 97,819 66,314
============= ============ ============ ============
Earnings (loss) per share, basic and diluted $ 0.84 (0.03) 1.80 1.23
============= ============ ============ ============
Weighted average shares outstanding,
basic and diluted $ 54,297,230 53,712,048 54,269,440 53,697,390
============= ============ ============ ============
See accompanying notes to consolidated financial statements.
3
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands, except share data)
(unaudited)
PREFERRED COMMON STOCK SHARES COMMON STOCK ADDITIONAL
STOCK ----------------------- PREFERRED ------------------------ PAID-IN
SHARES CLASS A CLASS B STOCK CLASS A CLASS B CAPITAL
--------- ----------- ----------- ----------- ----------- ------------ ------------
Balance at March 31, 2005 -- 39,727,864 13,983,454 $ -- 397 140 209,259
Comprehensive income:
Net loss -- -- -- -- -- -- --
Other comprehensive loss:
Cash flow hedge, net of tax -- -- -- -- -- -- --
Foreign currency translation -- -- -- -- -- -- --
Total comprehensive loss
Issuance of common stock -- 14,829 -- -- 1 -- 690
Compensation expense for stock based awards -- -- -- -- -- -- --
Conversion of common stock -- 20,500 (20,500) -- -- -- --
--------- ----------- ----------- ----------- ----------- ------------ ------------
Balance at June 30, 2005 -- 39,763,193 13,962,954 $ -- 398 140 209,949
========= =========== =========== =========== =========== ============ ============
Balance at March 31, 2006 -- 40,428,988 13,942,954 $ -- 404 139 241,722
Comprehensive income:
Net income -- -- -- -- -- -- --
Other comprehensive income related to
foreign currency translation -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock -- 18,693 -- -- -- -- 922
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (328,700) -- -- (3) -- (12,650)
Loan to employee for purchase of
common stock -- -- -- -- -- -- --
--------- ----------- ----------- ----------- ----------- ------------ ------------
Balance at June 30, 2006 -- 40,118,981 13,942,954 $ -- 401 139 229,994
========= =========== =========== =========== =========== ============ ============
Balance at December 31, 2004 -- 39,687,037 13,983,454 $ -- 397 140 207,915
Comprehensive income:
Net income -- -- -- -- -- -- --
Other comprehensive income:
Cash flow hedge, net of tax -- -- -- -- -- -- --
Foreign currency translation -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock -- 55,656 -- -- 1 -- 2,034
Compensation expense for stock based awards -- -- -- -- -- -- --
Conversion of common stock -- 20,500 (20,500) -- -- -- --
--------- ----------- ----------- ------------- ----------- ------------ ----------
Balance at June 30, 2005 -- 39,763,193 13,962,954 $ -- 398 140 209,949
========= =========== =========== ============= =========== ============ ==========
Balance at December 31, 2005 -- 40,040,841 13,962,954 $ -- 400 140 220,432
Comprehensive income:
Net income -- -- -- -- -- -- --
Other comprehensive income related to
foreign currency translation -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock -- 386,840 -- -- 3 -- 22,212
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (328,700) -- -- (3) -- (12,650)
Conversion of common stock -- 20,000 (20,000) -- 1 (1) --
Loan to employee for purchase of
common stock -- -- -- -- -- -- --
--------- ----------- ----------- ------------- ----------- ------------ ----------
Balance at June 30, 2006 -- 40,118,981 13,942,954 $ -- 401 139 229,994
========= =========== =========== ============= =========== ============ ==========
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands, except share data)
(unaudited) (continued)
ACCUMULATED
UNEARNED EMPLOYEE OTHER TOTAL
RETAINED COMPEN- NOTE COMPREHENSIVE SHAREHOLDERS'
EARNINGS SATION RECEIVABLE INCOME (LOSS) EQUITY
------------ ----------- ----------- --------------- ------------
Balance at March 31, 2005 315,151 (64) -- 428 525,311
Comprehensive income:
Net loss (1,773) -- -- -- (1,773)
Other comprehensive loss:
Cash flow hedge, net of tax -- -- -- (335) (335)
Foreign currency translation -- -- -- (235) (235)
-----------
Total comprehensive loss (2,343)
Issuance of common stock -- -- -- -- 691
Compensation expense for stock based awards -- 11 -- -- 11
Conversion of common stock -- -- -- -- --
------------ ----------- ----------- ---------------- -----------
Balance at June 30, 2005 313,378 (53) -- (142) 523,670
============ =========== =========== ================ ===========
Balance at March 31, 2006 480,252 (5,700) -- 389 717,206
Comprehensive income:
Net income 45,753 -- -- -- 45,753
Other comprehensive income related to
foreign currency translation -- -- -- 917 917
-----------
Total comprehensive income 46,670
Issuance of common stock -- -- -- -- 922
Compensation expense for stock based awards -- 545 -- -- 545
Repurchase of common stock -- -- -- -- (12,653)
Loan to employee for purchase of
common stock -- -- (501) -- (501)
------------ ----------- ----------- ---------------- -----------
Balance at June 30, 2006 526,005 (5,155) (501) 1,306 752,189
============ =========== =========== ================ ===========
Balance at December 31, 2004 247,064 (77) -- 736 456,175
Comprehensive income:
Net income 66,314 -- -- -- 66,314
Other comprehensive income:
Cash flow hedge, net of tax -- -- -- (440) (440)
Foreign currency translation -- -- -- (438) (438)
-----------
Total comprehensive income 65,436
Issuance of common stock -- -- -- -- 2,035
Compensation expense for stock based awards -- 24 -- -- 24
Conversion of common stock -- -- -- -- --
---------- ------------ ----------- ----------------- -----------
Balance at June 30, 2005 313,378 (53) -- (142) 523,670
========== ============ =========== ================= ===========
Balance at December 31, 2005 428,186 (86) -- 420 649,492
Comprehensive income:
Net income 97,819 -- -- -- 97,819
Other comprehensive income related to
foreign currency translation -- -- -- 886 886
-----------
Total comprehensive income 98,705
Issuance of common stock -- (5,980) -- -- 16,235
Compensation expense for stock based awards -- 911 -- -- 911
Repurchase of common stock -- -- -- -- (12,653)
Conversion of common stock -- -- -- -- --
Loan to employee for purchase of
common stock -- -- (501) -- (501)
---------- ------------ ----------- ----------------- -----------
Balance at June 30, 2006 526,005 (5,155) (501) 1,306 752,189
========== ============ =========== ================= ===========
See accompanying notes to consolidated financial statements.
4
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED JUNE 30,
--------------------------
2006 2005
------------- -----------
Net income $ 97,819 66,314
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 67,116 45,380
Derivative market value adjustment (106,715) (8,918)
Foreign currency transaction adjustment 38,055 --
Proceeds from sale of floor contracts 8,580 --
Gain on sale of student loans (1,880) --
Non-cash compensation expense 1,075 1,567
Change in value of put options issued in business acquisitions 284 --
Deferred income tax expense 26,895 6,751
Provision for loan losses 11,808 4,155
Other non-cash items 531 (251)
Increase in accrued interest receivable (98,488) (45,418)
Increase in accounts receivable (606) (953)
Decrease in other assets 12,357 1,993
Increase in accrued interest payable 19,190 26,584
Increase (decrease) in other liabilities 34,310 (24,308)
----------- -----------
Net cash provided by operating activities 110,331 72,896
----------- -----------
Cash flows from investing activities, net of business acquisitions:
Originations, purchases, and consolidations of student loans,
including loan premiums and deferred origination costs (3,397,070) (2,024,666)
Purchases of student loans, including loan premiums,
from a related party (389,266) (939,175)
Net proceeds from student loan repayments, claims,
capitalized interest, andother 1,400,224 727,449
Proceeds from sale of student loans 189,513 407
Purchases of furniture, equipment, and leasehold improvements, net (14,533) (10,314)
Increase in restricted cash (449,230) (105,132)
Purchases of restricted investments (401,953) (434,826)
Proceeds from maturities of restricted investments 416,261 572,828
Purchase of loan origination rights -- (260)
Business acquisitions, net of cash acquired (60,271) (76,984)
----------- -----------
Net cash used in investing activities (2,706,325) (2,290,673)
----------- -----------
Cash flows from financing activities:
Payments on bonds and notes payable (1,552,432) (1,412,830)
Proceeds from issuance of bonds and notes payable 4,097,658 3,692,295
Proceeds from issuance of notes payable due to a related party 71,081 --
Payments of debt issuance costs (10,382) (10,880)
Proceeds from issuance of common stock 831 492
Repurchases of common stock (12,653) --
Loan to employee for purchase of common (501) --
----------- -----------
Net cash provided by financing activities 2,593,602 2,269,077
----------- -----------
Effect of exchange rate fluctuations on cash 221 38
Net (decrease) increase in cash and cash equivalents (2,171) 51,338
Cash and cash equivalents, beginning of period 103,650 39,989
----------- -----------
Cash and cash equivalents, end of period $ 101,479 91,327
=========== ===========
Supplemental disclosures of cash flow information:
Interest paid $ 529,226 205,078
=========== ===========
Income taxes paid, net of refunds $ 35,192 35,478
=========== ===========
Supplemental disclosures of noncash operating, investing, and financing
activities regarding the Company's acquisitions are contained in notes 3 and 9.
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF JUNE 30, 2006 AND FOR THE THREE AND SIX MONTHS ENDED
JUNE 30, 2006 AND 2005 IS UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS, UNLESS OTHERWISE NOTED)
1. BASIS OF FINANCIAL REPORTING
The accompanying unaudited consolidated financial statements of Nelnet, Inc. and
subsidiaries (the "Company") as of June 30, 2006 and for the three and six
months ended June 30, 2006 and 2005 have been prepared on the same basis as the
audited consolidated financial statements for the year ended December 31, 2005
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 U.S. generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the consolidated
financial statements and accompanying notes. Actual results could differ from
those estimates. Operating results for the three and six months ended June 30,
2006 are not necessarily indicative of the results for the year ending December
31, 2006. 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, 2005. Certain amounts from 2005 have been reclassified to conform
to the current period presentation.
2. STUDENT LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
Student loans receivable consist of the following:
AS OF AS OF
JUNE 30, DECEMBER 31,
2006 2005
------------- --------------
Federally insured loans $21,843,197 19,816,075
Non-federally insured loans 169,473 96,880
------------- --------------
22,012,670 19,912,955
Unamortized loan premiums and deferred
origination costs 416,002 361,242
Allowance for loan losses - federally insured loans (7,001) (98)
Allowance for loan losses - non-federally
insured loans (17,179) (13,292)
------------- --------------
$22,404,492 20,260,807
============= ==============
On February 8, 2006, the Higher Education Reconciliation Act ("HERA") of 2005
was enacted into law. HERA effectively reauthorized the Title IV provisions of
the Federal Family Education Loan Program (the "FFEL Program" or "FFELP") of the
U.S. Department of Education (the "Department") through 2012. One of the
provisions of HERA resulted in lower guarantee rates on FFELP loans, including a
decrease in insurance and reinsurance on portfolios receiving the benefit of
Exceptional Performance designation by 1%, from 100% to 99% of principal and
accrued interest (effective July 1, 2006) and a decrease in insurance and
reinsurance on portfolios not subject to the Exceptional Performance designation
by 1%, from 98% to 97% of principal and accrued interest (effective for all
loans first disbursed on or after July 1, 2006). In February 2006, as a result
of the change in these legislative provisions, the Company recorded an expense
of $6.9 million ($4.3 million after tax) to increase the Company's allowance for
loan losses.
On March 1, 2006, the Company entered into an agreement to acquire participation
interests in non-federally insured loans from First National Bank Northeast, a
related party, at a price equal to the outstanding principal balance and accrued
interest of such loans. The term of this agreement is for 364 days. As of June
30, 2006, the balance of loans participated under this agreement was $44.8
million, and is included in student loans receivable on the Company's balance
sheet. A director, executive officer, and significant shareholder of the
Company, Michael S. Dunlap, is a director and indirectly a significant
shareholder of First National Bank Northeast.
As part of the agreement for the acquisition of the capital stock of LoanSTAR
Funding Group, Inc. ("LoanSTAR") from the Greater Texas Foundation (the "Texas
Foundation") completed in October 2005, the Company agreed to sell student loans
in an aggregate amount sufficient to permit the Texas Foundation to maintain a
portfolio of loans equal to no less than $200.0 million through October 2010.
The sales price for such loans is the fair market value mutually agreed upon
between the Company and the Texas Foundation. To satisfy this obligation, the
Company will sell loans to the Texas Foundation on a quarterly basis. During the
three months ended June 30, 2006, the Company sold the Texas Foundation $120.8
million (par value) of student loans resulting in the recognition of a $1.1
million gain which is included in other income in the accompanying consolidated
statements of operations.
6
Subsequent to June 30, 2006, the Company sold approximately $312.6 million (par
value) of student loans to an unrelated party. Loans sold under this agreement
were originated by Nova Southeastern University ("Nova"), a school-as-lender
customer. Nova elected not to renew their existing contract with the Company,
which will expire in December 2006. Though the Company has not historically sold
loans in the ordinary course, the portfolio of loans sold were not serviced by
the Company and as such were at a greater risk of being consolidated away from
the Company by third parties.
3. ACQUISITIONS
Effective January 31, 2006, the Company purchased the remaining 50% of the stock
of infiNET Integrated Solutions, Inc. ("infiNET"). infiNET provides software for
customer focused electronic transactions, information sharing, and electronic
account and bill presentment for colleges, universities, and healthcare
organizations. Consideration for the purchase was $9.5 million in cash and
95,380 restricted shares of the Company's Class A common stock. Under the terms
of the purchase agreement, the 95,380 shares of Class A common stock issued in
the acquisition are subject to stock price guarantee provisions whereby if on or
about February 28, 2011 the average market trading price of the Class A common
stock is less than $104.8375 per share and has not exceeded that price for any
25 consecutive trading days during the 5-year period from the closing of the
acquisition to February 28, 2011, then the Company must pay additional cash to
the sellers of infiNET for each share of Class A common stock issued in an
amount representing the difference between $104.8375 less the greater of
$41.9335 or the gross sales price such seller obtained from a prior sale of the
shares. In connection with the acquisition, the Company entered into employment
agreements with two of the infiNET sellers, in which the guaranteed value
related to the shares of Class A common stock issued is dependent on their
continued employment with the Company. Accordingly, the guaranteed value
associated with the shares of Class A common stock issued to these employees of
$5.7 million was recorded as unearned compensation in the accompanying
consolidated balance sheet and will be recognized by the Company as compensation
expense over the three-year term of the employment agreements. The total
purchase price recorded by the Company to acquire the remaining interest in
infiNET was $13.8 million, which represents the $9.5 million in cash and $4.3
million attributable to the guaranteed value of the shares of Class A common
stock issued to the infiNET shareholders other than the two shareholders who
entered into employment agreements with the Company.
This acquisition 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. Prior to purchasing the remaining 50% of the
common stock of infiNET, the Company accounted for this investment under the
equity method. As of December 31, 2005, other assets in the accompanying
consolidated balance sheet included $5.0 million (including $3.3 million of
excess cost) related to the infiNET investment.
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 infiNET is
shown below:
Cash and cash equivalents $ 3,576
Restricted cash - due to customers 16,343
Accounts receivable 558
Furniture, equipment, and leasehold improvements 207
Other assets 583
Excess cost over fair value of net assets acquired 15,884
Due to customers (16,343)
Other liabilities (1,995)
Previously recorded investment in equity interest (5,032)
-----------
$ 13,781
===========
Effective June 1, 2005, the Company purchased 80% of the capital stock of FACTS
Management Co. ("FACTS") for $56.1 million, including $0.1 million of direct
acquisition costs. Effective January 31, 2006, the Company purchased the
remaining 20% of the stock of FACTS. FACTS provides actively managed tuition
payment solutions, online payment processing, detailed information reporting,
and data integration services to K-12 and post-secondary educational
institutions, families, and students. In addition, FACTS provides financial
needs analysis for students applying for aid in private and parochial K-12
schools. Consideration for the purchase of the remaining 20% of FACTS was $5.6
million in cash and 238,237 restricted shares of the Company's Class A common
stock valued at $9.9 million. Under the terms of the purchase agreement, the
238,237 shares of Class A common stock issued in the acquisition are subject to
put option arrangements whereby during the 30-day period beginning February 28,
2010 the holders of such shares can require the Company to repurchase all or
part of the shares at a price of $83.95 per share. The put option in the
alternative similarly applies to replacement shares of Class A common stock
purchased by the holders from the proceeds of, and within 60 days of, a sale by
the holders of the shares of Class A common stock issued in the acquisition back
to the Company pursuant to provisions whereby during the 6-month period ending
June 30, 2009 the Company may be required to repurchase the shares at the market
trading price at that time. The exercisability of the put option is subject to
acceleration and then termination in the event that during the 4-year period
ending February 28, 2010 the market trading price of the Class A common stock is
equal to or exceeds $83.95 per share. The value of the put option as of January
31, 2006 (the closing date of the acquisition on the remaining 20% of the stock
of FACTS) was approximately $7.5 million and was recorded by the Company as
additional purchase price. Accordingly, the total consideration recorded by the
Company for the remaining 20% of the stock of FACTS was $23.0 million, which
represents the $5.6 million in cash, the value of the Class A common stock of
$9.9 million, and the value of the put option arrangements of $7.5 million.
7
The allocation of the purchase price for FACTS is shown below:
INITIAL 80% REMAINING 20% TOTAL
----------- ------------- ---------
Cash and cash equivalents $ 2,466 -- 2,466
Restricted cash - due to customers 11,034 -- 11,034
Accounts receivable 55 -- 55
Intangible assets 36,438 8,374 44,812
Furniture, equipment, and leasehold improvements 321 -- 321
Other assets 24 -- 24
Excess cost over fair value of net assets acquired 28,689 16,487 45,176
Due to customers (11,034) -- (11,034)
Other liabilities (11,901) (2,699) (14,600)
Minority interests' ownership in net assets acquired (23) -- (23)
Previously recorded minority interest -- 868 868
----------- ------------ ---------
Total purchase price $ 56,069 23,030 79,099
=========== ============ =========
On October 24, 2005, the Company purchased 100% of the capital stock of LoanSTAR
and servicing assets from LoanSTAR Systems, Inc. for $168.5 million, including
$0.2 million of direct acquisition costs. The final purchase price was subject
to change based on certain purchase price adjustments as defined in the purchase
agreement. During the three months ended June 30, 2006, the Company paid $1.2
million (net) to settle all obligations associated with the purchase of these
entities.
The Company is in the process of obtaining third-party valuations of certain
intangible assets related to the 2005 acquisitions of 5280 Solutions, Inc.
("5280"), FirstMark Services, LLC ("Firstmark"), and LoanSTAR. As a result, the
allocation of purchase price is subject to refinement for these acquisitions.
The following pro forma information presents the combined results of the Company
as though the 2005 acquisitions of Student Marketing Group, Inc., National Honor
Roll, LLC, FACTS (80%), Foresite Solutions, Inc., LoanSTAR, 5280, and FirstMark
and the 2006 acquisitions of infiNET and FACTS (20%) occurred as of the
beginning of each reporting period. Information about the Company's 2005
acquisitions is included in the Company's Annual Report on Form 10-K for the
year ended December 31, 2005. 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 (where applicable).
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
------------------------- ------------------------
2006 2005 2006 2005
------------ ----------- ---------- -----------
Net interest income $ 86,212 87,724 172,489 179,847
Other income (expense) (a) 102,855 1,716 217,791 111,115
Net income (loss) 45,753 (2,028) 97,835 66,288
Weighted average shares outstanding, basic and diluted 54,297,230 54,304,425 54,326,579 54,289,767
Earnings (loss) per share, basic and diluted $ 0.84 (0.04) 1.80 1.22
(a) Other income (expense) includes derivative market value and foreign currency
adjustments and net derivative settlements
8
4. INTANGIBLE ASSETS AND GOODWILL
Intangible assets consist of the following:
WEIGHTED
AVERAGE
REMAINING
USEFUL LIFE AS OF AS OF
AS OF JUNE 30, JUNE 30, DECEMBER 31,
2006 2006 2005
-------------- ---------- ------------
Amortizable intangible assets:
Covenants not to compete (net of accumulated
amortization of $3,187 and $499, respectively) 57 months $ 22,911 3,874
Student lists (net of accumulated amortization of
$2,732 and $1,708, respectively) 32 months 5,465 6,489
Loan origination rights (net of accumulated amortization
of $6,348 and $2,505, respectively) 74 months 45,851 49,694
Customer relationships (net of accumulated amortization
of $7,526 and $3,771, respectively) 133 months 77,442 70,369
Computer software (net of accumulated amortization of $1,163
and $677, respectively) 37 months 1,692 1,644
Trade names (net of accumulated amortization of $132 and
$54, respectively) 55 months 1,499 767
-------------- ---------- ------------
Total - amortizable intangible assets 98 months 154,860 132,837
==============
Unamortizable intangible assets - trade names 22,623 20,280
---------- ------------
$177,483 153,117
========== =============
The Company recorded amortization expense on its intangible assets of $6.2
million and $1.6 million for the three months ended June 30, 2006 and 2005,
respectively, and $11.8 million and $2.7 million for the six months ended June
30, 2006 and 2005, respectively. The Company will continue to amortize
intangible assets over their remaining useful lives. As disclosed in note 3, the
Company is in the process of obtaining third party valuations of certain
intangible assets, however, as of June 30, 2006 the Company estimates it will
record amortization expense as follows:
2006 $ 14,208
2007 26,404
2008 25,758
2009 22,620
2010 18,958
2011 and thereafter 46,912
----------
$ 154,860
==========
The change in the carrying amount of goodwill by operating segment was as
follows:
STUDENT
LOAN AND PAYMENT
ASSET GUARANTEE SOFTWARE DIRECT MANAGEMENT
MANAGEMENT SERVICING SERVICES MARKETING SERVICES TOTAL
---------- ---------- ---------- ---------- ---------- ---------
Balance as of December 31, 2005 $ 35,356 3,060 11,059 17,150 32,910 99,535
Goodwill acquired during the period -- -- -- -- 32,858 32,858
Effect of foreign currency fluctuations -- (4) -- -- -- (4)
---------- ---------- ---------- ---------- ---------- ---------
Balance as of March 31, 2006 $ 35,356 3,056 11,059 17,150 65,768 132,389
Goodwill acqired during the period -- -- -- 20,912 -- 20,912
Goodwill from prior period acquisition
allocated during the current period 413 -- -- -- (4,708) (4,295)
Effect of foreign currency fluctuations -- 142 -- -- -- 142
---------- ---------- ---------- ---------- ---------- ---------
Balance as of June 30, 2006 $ 35,769 3,198 11,059 38,062 61,060 149,148
========== ========== ========== ========== ========== =========
9
5. BONDS AND NOTES PAYABLE
On February 21, 2006 and May 18, 2006, the Company consummated debt offerings of
student loan asset-backed notes of $2.0 billion and $2.1 billion, respectively,
with final maturity dates ranging from 2011 through 2039. Notes issued in these
transactions included $3.1 billion with variable interest rates based on a
spread to LIBOR and (euro)773.2 million (500.0 million and 450.0 million in U.S.
dollars on February 21, 2006 and May 18, 2006, respectively) with variable
interest rates based on a spread to EURIBOR (the "Euro Notes").
As of March 31, 2006 and June 30, 2006, the Euro Notes were recorded on the
Company's balance sheet at $510.5 million and $988.1 million, respectively,
based on the foreign currency exchange rate as of the respective balance sheet
dates. The increases in the principal amount of the Euro Notes of $27.6 million
and $38.1 million as a result of the foreign currency exchange rate fluctuations
are included in the derivative market value and foreign currency adjustments in
the accompanying consolidated statements of operations for the three and six
months ended June 30, 2006, respectively.
Concurrently with the issuances of the Euro Notes, the Company entered into
foreign currency derivative instruments which are further discussed in note 6.
As of June 30, 2006, bonds and notes payable includes $71.8 million of notes due
to Union Bank and Trust, an entity under common control with the Company. The
Company has used the proceeds from these notes to invest in student loan assets
via a participation agreement.
6. DERIVATIVE FINANCIAL INSTRUMENTS
The Company maintains an overall interest rate risk management strategy that
incorporates the use of derivative instruments to reduce the economic effect of
interest rate volatility. Derivative instruments used as part of the Company's
interest rate risk management strategy include interest rate swaps, basis swaps,
interest rate floor contracts, and cross-currency interest rate swaps.
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 Company's derivative instruments do not qualify for hedge
accounting under SFAS No. 133. As a result, the change in fair value of
derivative instruments is recorded in the consolidated statements of operations
at each reporting date.
INTEREST RATE SWAPS
The following table summarizes the Company's outstanding interest rate swaps as
of June 30, 2006:
WEIGHTED
AVERAGE FIXED
RATE PAID
MATURITY NOTIONAL AMOUNT BY THE COMPANY
-------------------- ------------------ ----------------
2006 (a) $ 612,500 2.99 %
2007 512,500 3.42
2008 462,500 3.76
2009 312,500 4.01
2010 1,137,500 4.25
2011 -- --
2012 275,000 4.31
2013 525,000 4.36
------------- ----------
Total $ 3,837,500 3.88 %
============= ===========
(a) Includes $362,500 of interest rate swaps that expired
July 1, 2006 with a weighted average fixed rate of
2.88%.
BASIS SWAPS
On May 1, 2006, the Company entered into three ten-year basis swaps with
notional amounts of $500.0 million each in which the Company receives
three-month LIBOR and pays one-month LIBOR less a spread as defined in the
agreements. The effective dates of these agreements are November 25, 2006,
December 25, 2006, and January 25, 2007.
10
In addition to the three basis swaps summarized above, the Company also has a
basis swap with a notional amount of $500.0 million that matures in August 2006
in which the Company pays a floating interest rate based on the U.S. Treasury
bill rate and receives a floating interest rate based on the three-month LIBOR
rate.
INTEREST RATE FLOOR CONTRACTS
In June 2006, the Company entered into interest rate floor contracts in which
the Company received an upfront fee of $8.6 million. These contracts were
structured to monetize on an upfront basis the potential floor income associated
with certain consolidation loans (see (a) below). Under the terms of these
contracts, the Company is obligated to pay the counterparty floor income earned
on a notional amount of underlying consolidation student loans over the life of
the floor income contracts. Specifically, the Company agreed to pay the
counterparty the difference, if positive, between the fixed borrower rate less
the special allowance payment spread for consolidation loans and the three-month
LIBOR rate plus a spread to better match the LIBOR floor strike rate to the
underlying student loan asset on that notional amount, regardless of the actual
balance of underlying student loans, over the life of the contracts. The
contracts do not extend over the life of the underlying consolidation student
loans.
The following provide the terms of these contracts:
AMORTIZING FLOOR
NOTIONAL STRIKE
AMOUNT RATE
----------- --------
$ 51,296 2.760%
44,873 2.885%
38,174 3.010%
34,953 3.135%
47,420 3.260%
78,390 3.385%
51,300 3.510%
53,745 3.635%
46,842 3.760%
45,971 3.885%
41,076 4.010%
64,167 4.135%
24,044 4.460%
31,648 5.060%
37,103 5.510%
7,097 4.300%
21,968 4.550%
17,220 4.800%
62,466 5.550%
---------
$799,753
=========
Those contracts with floor strike rates of 2.76%-4.135% and 4.460%-5.55% have an
effective start date of June 30, 2006 and June 30, 2010, respectively. All
contracts expire on June 30, 2016.
(a) FFELP student loans originated prior to July 1, 2006 generally earn
interest at the greater of the borrower rate or a floating rate
determined by reference to the average of the applicable floating rates
(91-day Treasury bill rate or commercial paper rate) in a calendar
quarter, plus a fixed spread that is dependent upon when the loan was
originated, the loan's repayment status, and funding sources for the
loan. If the resulting floating rate exceeds the borrower rate, the
Department pays the difference directly to the Company. This payment is
referred to as special allowance payments (SAP). The Company generally
finances its student loan portfolio with floating rate debt. In low
and/or declining interest rate environments, when the fixed borrower
rate is higher than the rate produced by the SAP formula, student loans
earn at a fixed rate while the interest on the floating rate debt
continues to decline. In these interest rate environments, the Company
earns additional spread income referred to as floor income.
CROSS-CURRENCY INTEREST RATE SWAPS
The Company entered into derivative instruments in February 2006 and May 2006 as
a result of the issuance of the Euro Notes discussed in note 5. Under the terms
of these derivative instrument agreements, the Company receives from a
counterparty a spread to the EURIBOR index based on a notional amount of
(euro)420.5 million and (euro)352.7 million, respectively, and pays a spread to
the LIBOR index based on a notional amount of $500.0 million and $450.0 million,
respectively. In addition, under the terms of these agreements, all principal
payments on the Euro Notes will effectively be paid at the exchange rate in
effect as of the issuance of these notes.
11
As of June 30, 2006, the net fair value of the Company's derivative portfolio
was $180.9 million and the net change in the fair value of the Company's
derivative portfolio for the three and six months ended June 30, 2006 was $56.4
million and $106.7 million, respectively.
The following table summarizes the components included in derivative settlements
on the consolidated statements of operations:
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
-------------------- ----------------------
2006 2005 2006 2005
---------- --------- ---------- ----------
Interest rate swaps $ 10,715 (5,208) 16,925 (14,005)
Basis swaps (197) (793) (511) (2,082)
Cross-currency interest rate swaps (3,816) -- (4,968) --
---------- --------- ---------- ----------
Derivative settlements, net $ 6,702 (6,001) 11,446 (16,087)
========== ========= ========== ==========
7. STOCKHOLDERS' EQUITY
CONVERSION OF COMMON STOCK
In February 2006, a principal shareholder gifted 20,000 Class B shares of common
stock to certain charitable organizations. Per the articles of incorporation,
these shares automatically converted to Class A shares upon transfer.
INCREASE IN AUTHORIZED CLASS B COMMON STOCK
In May 2006, the Company's shareholders approved an amendment of the Company's
Articles of Incorporation to increase the number of authorized shares of Class B
common stock from 15 million shares to 60 million shares to allow for future
stock splits.
DIRECTORS STOCK COMPENSATION PLAN
The Company has a compensation plan for non-employee directors pursuant to which
non-employee directors can elect to receive their annual retainer fees in the
form of cash or Class A common stock. Non-employee 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 30, 2006, the Company issued 8,133 shares of its Class A common stock to
non-employee directors under this plan. The shares were issued to directors that
elected to receive shares and did not defer receipt of the shares. In addition,
4,066 shares were issued to directors that elected to defer receipt of their
shares. The Company's weighted average shares outstanding include 10,793 shares
that were issued since inception of this plan, including the 4,066 shares issued
in 2006, that will be issued to directors upon their termination from the board
of directors.
STOCK REPURCHASE PROGRAM
In May 2006, the Company's board of directors authorized a stock repurchase
program. The program allows the Company to buy back up to a total of 5 million
shares of the Company's Class A common stock and has an expiration date of May
24, 2008. During the three months ended June 30, 2006, the Company repurchased
and retired 328,700 Class A common shares for $12.6 million (average price of
$38.46 per share) under this authority. Subsequent to June 30, 2006 (through
August 8, 2006), the Company has repurchased an additional 674,300 shares for
$21.1 million (average price of $31.24 per share) under this plan for a combined
total of 1,003,000 shares repurchased by the Company through August 8, 2006.
EMPLOYEE STOCK PURCHASE LOAN PLAN
In June 2006, the Company entered into a loan agreement with an employee
pursuant to the Company's Employee Stock Purchase Loan Plan (the "Loan Plan").
The Loan Plan was approved by the Company's board of directors and shareholders
at the annual shareholders meeting in May 2006. The loan was granted to enable
the employee to purchase 12,641 shares of the Company's stock in the open
market. The loan matures in June 2010 and bears interest equal to the
three-month LIBOR rate plus 50 basis points (5.95% as of June 30, 2006). The
balance of this loan totaled $0.5 million at June 30, 2006, and is reflected as
a reduction to stockholders' equity on the consolidated balance sheet.
8. SEGMENT REPORTING
The Company 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 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, 2005.
12
The Asset Management segment includes the acquisition, management, and ownership
of the student loan assets. Revenues are primarily generated from net interest
income on the student loan assets. The Company generates student loan assets
through direct origination or through acquisitions. The student loan assets are
held in a series of education lending subsidiaries designed specifically for
this purpose. The Company's derivative market value and foreign currency
adjustments are included in the Asset Management segment. Because the Company's
derivatives do not qualify for hedge accounting under SFAS No. 133, the
derivative market value adjustment can cause the percentage of revenue and net
income before taxes to fluctuate from period to period between segments. Due to
fluctuations in currency rates, foreign currency adjustments can also cause the
percentage of revenue and net income before taxes to fluctuate from period to
period between segments.
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 and
servicing support 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. In addition, under an agreement with College Access Network
("CAN"), a state-designated guaranty agency, the Company provides certain other
guarantee operations.
The Software Services segment develops loan servicing software and also provides
this software to third-party student loan holders and servicers. In addition,
this segment provides information technology products and services, with core
areas of business in student loan software solutions for schools, lenders, and
guarantors; technical consulting services; and enterprise content management.
The Direct Marketing segment 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. This segment also
provides marketing services and college bound student lists to college and
university admissions offices nationwide. In addition, this segment recognizes
middle and high school students for exceptional academic success through its
publications and scholarships.
The Payment Management Services segment provides actively managed tuition
payment solutions, online payment processing, detailed information reporting,
financial needs analysis, and data integration services to K-12 and
post-secondary educational institutions, families, and students. In addition,
this segment provides customer-focused electronic transactions, information
sharing, and account and bill presentment to colleges, universities, and
healthcare organizations.
Substantially all of the Company's revenues are earned from customers in the
United States except for revenue generated from servicing Canadian student loans
at EDULINX. For the three and six months ended June 30, 2006, the Company
recognized $15.1 million and $31.9 million, respectively, from Canadian student
loan servicing customers.
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 July 2007. For the three and six
months ended June 30, 2006, the Company recognized $11.6 million, or 26.5%, and
$24.2 million, or 26.6%, respectively, of its loan and guarantee servicing
income, from this customer. EDULINX cannot guarantee that it will obtain a
renewal of this largest servicing agreement or that it will maintain its other
servicing agreements and the termination of any such servicing agreements could
result in an adverse effect on the Company.
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 JUNE 30,
------------------------------------------------------------------------------------
2006 2005
---------------------------------------- -------------------------------------------
STUDENT STUDENT
LOAN AND LOAN AND
ASSET GUARANTEE TOTAL ASSET GUARANTEE TOTAL
MANAGEMENT SERVICING OTHER SEGMENTS MANAGEMENT SERVICING OTHER SEGMENTS
---------- --------- -------- ---------- ---------- --------- --------- ---------
Net interest income $ 89,226 1,691 660 91,577 82,546 753 108 83,407
Other income (expense) 40,687 43,831 17,024 101,542 (55,015) 34,677 9,605 (10,733)
Intersegment revenues -- 34,298 4,705 39,003 -- 26,830 883 27,713
--------- ---------- -------- ---------- --------- --------- --------- ---------
Total revenue 129,913 79,820 22,389 232,122 27,531 62,260 10,596 100,387
Provision for loan losses 2,190 -- -- 2,190 2,124 -- -- 2,124
Depreciation and amortization 1,583 2,396 2,658 6,637 32 951 1,057 2,040
Net income (loss) before taxes $ 86,220 13,659 4,086 103,965 (4,450) 19,406 4,585 19,541
SIX MONTHS ENDED JUNE 30,
------------------------------------------------------------------------------------
2006 2005
---------------------------------------- -------------------------------------------
STUDENT STUDENT
LOAN AND LOAN AND
ASSET GUARANTEE TOTAL ASSET GUARANTEE TOTAL
MANAGEMENT SERVICING OTHER SEGMENTS MANAGEMENT SERVICING OTHER SEGMENTS
---------- --------- -------- ---------- ---------- --------- --------- ---------
Net interest income $177,551 3,564 1,523 182,638 168,616 1,431 123 170,170
Other income (expense) 89,506 90,252 35,681 215,439 (2,586) 71,843 13,035 82,292
Intersegment revenues -- 67,703 9,377 77,080 -- 52,932 2,185 55,117
--------- ---------- -------- ---------- --------- --------- --------- ---------
Total revenue 267,057 161,519 46,581 475,157 166,030 126,206 15,343 307,579
Provision for loan losses 11,808 -- -- 11,808 4,155 -- -- 4,155
Depreciation and amortization 2,607 1,788 4,766 9,161 58 1,870 1,855 3,783
Net income before taxes $173,738 32,591 12,517 218,846 103,223 38,068 6,611 147,902
AS OF AS OF
JUNE 30, DECEMBER 31,
2006 2005
------------- -------------
Segment total assets
Asset management $ 25,093,132 22,316,657
Student loan and guarantee servicing 476,442 505,958
Other 239,656 156,548
------------- -------------
Total segments $ 25,809,230 22,979,163
============= =============
Reconciliation of segment data to the consolidated financial statements is as
follows:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
-------------------------- -------------------------
2006 2005 2006 2005
------------ ----------- ----------- -----------
Total segment revenues $ 232,122 100,387 475,157 307,579
Elimination of intersegment revenues (39,003) (27,713) (77,080) (55,117)
Unsecured debt interest expense (5,625) -- (10,785) --
Corporate activities' revenues, net 1,573 (199) 2,659 1,157
------------ ----------- ----------- -----------
Total consolidated revenues $ 189,067 72,475 389,951 253,619
============ =========== =========== ===========
Total net income before taxes of segments $ 103,965 19,541 218,846 147,902
Corporate activities' expenses, net (31,360) (23,069) (63,222) (43,705)
------------ ----------- ----------- -----------
Total consolidated net income (loss) before taxes $ 72,605 (3,528) 155,624 104,197
============ =========== =========== ===========
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.
14
AS OF AS OF
JUNE 30, DECEMBER 31,
2006 2005
------------- -------------
Total segment assets $ 25,809,230 22,979,163
Elimination of intercompany assets (332,604) (247,982)
Corporate assets 68,567 67,441
------------- -------------
Total consolidated assets $ 25,545,193 22,798,622
============= =============
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.
9. RECENT ACQUISITIONS
ACQUISITION OF CUNET
On June 30, 2006, the Company purchased 100% of the membership interests of
CUnet, LLC ("CUnet"). The initial consideration paid by the Company on June 30,
2006 was $40.0 million in cash, which is included in other assets on the
accompanying consolidated balance sheet. CUnet 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. In addition to the initial
purchase price, additional payments are to be paid by the Company based on the
operating results of CUnet. The contingent consideration is based on the
aggregate cumulative net income before taxes (excluding any amortization of
intangibles from the purchase price allocation) of CUnet earned for the period
from July 1, 2006 through June 30, 2009 ("Cumulative Net Income"), provided,
however, that the contingent consideration may not exceed $80.0 million. The
Company will calculate the Cumulative Net Income as of each June 30, 2007, June
30, 2008, and June 30, 2009 (individually, the "Calculation Period"). In partial
satisfaction of the contingent consideration, the Company will issue shares of
Class A common stock subsequent to each Calculation Period, provided, however,
that the market value of the shares issued shall not exceed $5.0 million in any
one year, unless the Company elects at its option to make a distribution in a
higher amount. No later than June 30, 2010, 10% of the remaining contingent
consideration will be paid in cash, and the balance of 90% of the contingent
consideration will be paid in cash no later than December 31, 2010. The cash
portion of the contingent consideration to be paid in December 2010 will be
reduced by the market value of the shares issued as of December 15, 2010.
In connection with the acquisition, the Company entered into employment
agreements with certain sellers, in which the contingency payments are related
to their continued employment with the Company. Accordingly, when these
contingency payments are paid, they will be recognized by the Company as
compensation expense over the remaining term of the employment agreements.
This acquisition was accounted for under purchase accounting and the results
of operations will be included in the consolidated financial statements from the
effective date of the acquisition (July 1, 2006).
The Company is in the process of obtaining third-party valuations of certain
intangible assets; the allocation of the purchase price is subject to
refinement. The preliminary allocation of the purchase price for CUnet is shown
below:
Cash and cash equivalents $ --
Accounts receivable 5,033
Furniture, equipment, and leasehold improvements 223
Other assets 397
Intangible assets 17,565
Excess cost over fair value of net assets acquired 20,912
Other liabilities (4,130)
---------
$ 40,000
=========
ACQUISITION OF PETERSON'S
On July 27, 2006, the Company purchased certain assets and assumed certain
liabilities (hereafter referred to as "Peterson's") from Thomson Learning Inc.
for total consideration of $38.6 million in cash. The final purchase price is
subject to change based on certain purchase price adjustments as defined in the
purchase agreement. 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. Peterson's 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. This acquisition will be accounted for as a business
combination under purchase accounting and the results of operations will be
included in the consolidated financial statements from the effective date of the
acquisition.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
(MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS IS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2006 AND 2005. ALL
DOLLARS ARE IN THOUSANDS, EXCEPT PER SHARE AMOUNTS, UNLESS OTHERWISE NOTED).
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, 2005.
FORWARD-LOOKING AND CAUTIONARY STATEMENTS
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
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, and the uncertain nature of the expected benefits from acquisitions and
the ability to successfully integrate operations. Additionally, financial
projections may not prove to be accurate and may vary materially. 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 services and finance companies in
the United States and is focused on providing quality products and services to
students, families, and schools nationwide. The Company ranks among the nation's
leaders in terms of total student loan assets originated, consolidated, held,
and serviced, principally consisting of loans originated under the FFEL Program.
The Company is a vertically-integrated organization that offers a broad range of
pre-college, in-college, and post-college products and services to its
customers.
The Company has five operating segments as defined in SFAS No. 131 as follows:
Asset Management, Student Loan and Guarantee Servicing, Software Services,
Direct Marketing, and Payment Management Services.
o ASSET MANAGEMENT. The Company owns a large portfolio of student loan assets
through a series of education lending subsidiaries. The Company obtains loans
through direct origination or through acquisition of loans.
o STUDENT LOAN AND GUARANTEE SERVICING. The Company services its student loan
portfolio and the portfolios of third parties. Servicing activities include
loan origination activities, application processing, borrower updates,
payment processing, due diligence procedures, and claim processing. The
Student Loan and Guarantee Servicing segment includes EDULINX, a Canadian
subsidiary of the Company that services student loans in Canada. The
following table summarizes the Company's loan servicing volumes as of June
30, 2006:
COMPANY THIRD-PARTY TOTAL
--------- ----------- --------
FFELP and private loans $ 19,820 8,856 28,676
Canadian loans (in U.S. $) -- 8,592 8,592
--------- ----------- --------
Total $ 19,820 17,448 37,268
========= =========== ========
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. In addition, under an
agreement with College Access Network ("CAN"), a state-designated guaranty
agency, the Company provides certain other guarantee operations.
16
o SOFTWARE SERVICES. The Company uses internally developed loan servicing
software and also provides this software to third-party student loan holders
and servicers. In addition, the Company provides information technology
products and services, with core areas of business in student loan software
solutions for schools, lenders, and guarantors; technical consulting
services; and enterprise content management.
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 marketplaces. The
Company also provides marketing services and college bound student lists to
college and university admissions offices nationwide. In addition, the
Company recognizes middle and high school students for exceptional academic
success through its publications and scholarships.
o PAYMENT MANAGEMENT SERVICES. The Company provides actively managed tuition
payment solutions, online payment processing, detailed information reporting,
financial needs analysis, and data integration services to K-12 and
post-secondary educational institutions, families, and students. In addition,
the Company provides customer-focused electronic transactions, information
sharing, and account and bill presentment to colleges, universities, and
healthcare organizations.
The Company's Asset Management and Student Loan and Guarantee Servicing
operations constitute reportable operating segments according to the provisions
of SFAS No. 131. The Software Services, Direct Marketing, and Payment Management
Services operations are operating segments that do not meet the quantitative
thresholds, and, therefore, are combined and included as "Other segments." The
following table shows the percentage of total segment revenue (excluding
intersegment revenue) and net income before taxes for each of the Company's
reportable segments:
THREE MONTHS ENDED JUNE 30,
----------------------------------------------------------------
2006 2005
------------------------------- -------------------------------
STUDENT STUDENT
LOAN LOAN
AND AND
ASSET GUARANTEE OTHER ASSET GUARANTEE OTHER
MANAGEMENT SERVICING SEGMENTS ANAGEMENT SERVICING SEGMENTS
---------- --------- -------- --------- --------- --------
Segment revenues 67.3% 23.6% 9.1% 37.9% 48.8% 13.3%
Segment net income (loss)
before taxes 82.9% 13.1% 4.0% (22.8)% 99.3% 23.5%
SIX MONTHS ENDED JUNE 30,
----------------------------------------------------------------
2006 2005
------------------------------- -------------------------------
STUDENT STUDENT
LOAN LOAN
AND AND
ASSET GUARANTEE OTHER ASSET GUARANTEE OTHER
MANAGEMENT SERVICING SEGMENTS ANAGEMENT SERVICING SEGMENTS
---------- --------- -------- --------- --------- --------
Segment revenues 67.1% 23.6% 9.3% 65.8% 29.0% 5.2%
Segment net income before
taxes 79.4% 14.9% 5.7% 69.8% 25.7% 4.5%
The Company's derivative market value and foreign currency adjustments are
included in the Asset Management segment. Because the Company's derivatives do
not qualify for hedge accounting under SFAS No. 133, the derivative market value
adjustment can cause the percentage of revenue and net income before taxes to
fluctuate from period to period between segments. Due to fluctuations in
currency rates, foreign currency adjustments can also cause the percentage of
revenue and net income before taxes to fluctuate from period to period between
segments.
SIGNIFICANT DRIVERS AND TRENDS
The Company's earnings and earnings growth are directly affected by the size of
its portfolio of student loans, the interest rate characteristics of its
portfolio, the costs associated with financing and managing its portfolio, and
the costs associated with the origination and acquisition of the student loans
in the portfolio. In addition to the impact of growth of the Company's student
loan portfolio, the Company's results of operations and financial condition may
be materially affected by, among other things, changes in:
o applicable laws and regulations that may affect the volume, terms,
effective yields, or refinancing options of education loans;
o demand for education financing and competition within the student loan
industry;
o the interest rate environment, funding spreads on the Company's
financing programs, and access to capital markets; and
o prepayment rates on student loans, including prepayments relating to loan
consolidations.
17
The Company's net interest income, or net interest earned on its student loan
portfolio, is a significant 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 (SAP)
formula set by the Department and the borrower rate, which is fixed over a
period of time. The SAP formula is based on an applicable index plus a fixed
spread that is dependent upon when the loan was originated, the loan's repayment
status, and funding sources for the loan.
Based upon provisions of the Higher Education Act, and related interpretations
by the Department, loans financed prior to September 30, 2004 with tax-exempt
obligations originally issued prior to October 1, 1993 are entitled to receive
special allowance payments equal to a 9.5% minimum rate of return (the "9.5%
Floor"). Of the $3.3 billion in loans held by the Company as of June 30, 2006
that are receiving the 9.5% Floor, approximately $2.5 billion in loans were
purchased prior to September 30, 2004 with proceeds of tax-exempt obligations
originally issued prior to October 1, 1993 and then subsequently funded with the
proceeds of taxable obligations, without retiring the tax-exempt obligations.
(This $2.5 billion portfolio excludes $0.2 billion of 9.5% Floor loans purchased
from LoanSTAR that were also purchased prior to September 30, 2004 with proceeds
of tax-exempt obligations originally issued prior to October 1, 1993 and then
subsequently funded with taxable obligations.) Interest income that is generated
from this $2.5 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 $2.5 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, floor income on this portfolio of loans will decrease, 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. Derivative instruments used as part of the Company's interest rate
risk management strategy include interest rate swaps, basis swaps, interest rate
floor contracts, and cross-currency interest rate swaps. The Company's
management has structured all of its derivative instruments with the intent that
each is economically effective. However, 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 consolidated
statement of operations each reporting period. This mark-to-market adjustment
may fluctuate from period to period and adversely impact earnings.
In addition, during 2006, the Company consummated certain debt offerings of
student loan asset-backed notes denominated in Euros. Changes in currency rates
between the U.S. and Euro dollars may fluctuate from period to period and
adversely impact earnings when re-measuring the Company's Euro-denominated bonds
to U.S. dollars.
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 percentage of student loan yield should decrease.
However, due to increased competition in the student loan industry, this
decrease may be offset by increased costs to acquire student loans through the
Company's various student loan channels and through certain portfolio and
business combinations.
The Company's student loan origination and lending activities could be
significantly impacted by the repeal of the single holder rule. The single
holder rule, which generally restricted a competitor from consolidating loans
away from a holder that owns all of a student's loans, was abolished effective
June 15, 2006. As a result, a substantial portion of the Company's
non-consolidated portfolio could be at risk of being consolidated away by a
competitor. On the other hand, the abolition of the rule has also opened up a
portion of the rest of the market and provided the Company with the potential to
gain market share.
The Company's core spread on its portfolio of student loans has decreased from
1.58% to 1.51% for the six months ended June 30, 2005 and 2006, respectively. As
discussed previously, this decrease is primarily due to an increase in lower
yielding consolidation loans, an increase in the consolidation rebate fees, and
rising interest rates which compress the margins on the Company's fixed-rate
loans that are not hedged (see "--Student Loan Portfolio--Student Loan Spread
Analysis" for additional information on the Company's core student loan spread).
As a result of margin compression on its student loan portfolio and management's
continued focus on growing and diversifying fee based revenue, business and
asset acquisitions have remained a significant aspect of the Company's strategy.
18
BUSINESS AND ASSET ACQUISITIONS
Management believes the Company's business and asset acquisitions in recent
years have enhanced its position as a vertically-integrated industry leader and
established a strong foundation for growth. 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. Management
believes these acquisitions allow the Company to expand the scope, number, and
type of products and services delivered to customers and further diversify
revenue and asset generation streams.
As a result of these recent 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 2005 and 2006 business and asset acquisitions by type of
service offering follows:
Portfolio and Asset Management
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. LoanSTAR is a Texas-based secondary market and loan originator. 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.
On October 25, 2005, the Company purchased from Chela Education Financing, Inc.
("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.
Loan and Guarantee Servicing and Processing
On October 31, 2005, the Company entered into an agreement to amend an existing
contract with College Access Network ("CAN"). CAN is the Colorado
state-designated guarantor of FFELP student loans. Under the agreement, the
Company provides student loan servicing and guarantee operations and assumed the
operational expenses and employment of certain CAN employees. CAN pays the
Company a portion of the gross servicing and guarantee fees as consideration for
the Company providing these services on behalf of CAN. The agreement terminates
November 1, 2015 and can be extended for an additional 10-year period upon
mutual agreement.
Effective November 1, 2005, the Company purchased the remaining 50% interest in
FirstMark Services, LLC ("FirstMark"). The Company owned 50% of this entity and
accounted for it under the equity method of accounting prior to the transaction.
FirstMark specializes in originating and servicing education loans funded
outside the federal student loan programs. 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.
Software Services
Effective November 1, 2005, the Company purchased the remaining 50% interest in
5280 Solutions, LLC ("5280"). The Company owned 50% of this entity and accounted
for it under the equity method of accounting prior to the transaction. 5280
provides information technology products and services, with core areas of
business in student loan software solutions for schools, lenders, and
guarantors; technical consulting services; and enterprise content management.
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 Solutions, Inc. ("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.
Tuition Management and Transaction Processing
Effective June 1, 2005, the Company purchased 80% of the capital stock of FACTS
Management Co. ("FACTS"). FACTS provides actively managed 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
January 31, 2006, the Company purchased the remaining 20% interest in FACTS.
Effective January 31, 2006, the Company purchased the remaining 50% interest in
infiNET Integrated Solutions, Inc. ("infiNET"). The Company owned 50% of this
entity and accounted for it under the equity method of accounting prior to the
transaction. infiNET provides customer-focused electronic transactions,
information sharing, and account and bill presentment to colleges, universities,
and healthcare organizations. 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.
19
List Management and Lead Generation
Effective February 28, 2005, the Company acquired 100% of the capital stock of
Student Marketing Group, Inc. ("SMG"), a full service direct marketing agency,
and 100% of the membership interests of National Honor Roll, LLC ("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.
RECENT ACQUISITIONS - EFFECT ON FUTURE OPERATING RESULTS
CUNET. On June 30, 2006, the Company purchased 100% of the membership interests
of CUnet. CUnet 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.
CUnet is intended to be a strategic acquisition for the Company based on (i)
increasing the Company's fee-based revenue, (ii) further developing an
enrollment services business line, and (iii) increasing the Company's exposure
to the on-line education and for-profit sectors. In addition to expanding the
fee-based product offerings available to the Company's existing school client
base, the Company believes it can leverage CUnet's existing and future customer
base through the Company's counseling services within its college planning
centers as well as financial loan products. Management also believes CUnet will
expand the product offerings available to the Company's campus marketing
representatives.
The Company expects to recognize annual revenue of approximately $47-50 million
and incur annual operating expenses of approximately $40-42 million (excluding
any compensation charges related to contingency payments and amortization of
intangible assets from purchase price accounting) from CUnet; however, these
amounts are estimates and actual results could differ materially. Included in
the terms of the CUnet purchase agreement, the Company is obligated to pay
contingent consideration based on the operating results of CUnet for the period
from July 1, 2006 through June 30, 2009. In connection with the acquisition, the
Company entered into employment agreements with certain sellers, in which the
contingency payments are related to their continued employment with the Company.
Accordingly, when these contingency payments are paid they will be recognized by
the Company as compensation expense over the remaining term of the employment
agreements. If the contingent payments were not tied to employment of key
management, the actual future payments would have been recorded as purchase
price. Dependent upon the performance of CUnet and the timing of when the
contingent payments are accrued, the amount required to be recognized as
compensation expense in a given period may be greater than CUnet's net income
for that period. As discussed in note 9 to the consolidated financial
statements, the maximum amount of contingent consideration is $80 million. In
order to achieve the maximum payout, CUnet's cumulative net income before tax
from July 1, 2006 through June 30, 2009 would need to reach $70 million.
PETERSON'S. On July 27, 2006, the Company purchased certain assets and assumed
certain liabilities (hereafter referred to as "Peterson's") from Thomson
Learning Inc. Peterson's provides a comprehensive suite of education and
career-related solutions in the areas of education search, test preparation,
admissions, financial aid information (including scholarship search), and career
assistance. Peterson's delivers these services through a variety of media
including print (i.e. books) and online. Peterson's 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.
Peterson's is intended to be a strategic acquisition for the Company based on
(i) increasing the Company's fee-based revenue, (ii) further developing an
enrollment services business line, (iii) expanding career preparation services
for students, (iv) increasing the Company's exposure to the 4-year school
market, and (v) leveraging Peterson's customer base to other services offered by
the Company (specifically its financial loan products).
The Company expects to recognize annual revenue of approximately $35-38 million
and incur annual operating expenses (including cost of goods sold and excluding
amortization of intangible assets from purchase price accounting) of $35-37
million from Peterson's; however, these amounts are estimates and actual results
could differ materially. Upon acquiring Peterson's, the Company assumed certain
obligations related to fulfilling services sold by Peterson's prior to the
closing of the acquisition. The Company expects to incur costs during the
remainder of 2006 to fulfill these obligations. Certain of these costs will be
recognized as a liability during the purchase price allocation and not effect
the operating results of the Company. However, the incremental costs to fulfill
these obligations are expected to be greater than the amount recorded as a
liability upon acquisition. In addition, the majority of Peterson's revenue is
recognized over the period in which services are provided to customers and does
not always correspond with when the Company will recognize the related expenses.
Due to the incremental costs to fulfill assumed obligations as a result of this
business combination and Peterson's revenue recognition model, the Company
expects Peterson's operating expenses to be greater than revenue during 2006.
Depending on the amount of costs incurred by the Company to fulfill purchased
obligations that can not be recorded as purchase price and the amount of costs
incurred associated with revenue that will be deferred for accounting purposes,
the Company could recognize a loss during 2006 of approximately $4-6 million;
however, this amount is an estimate and actual results could differ materially.
Cash provided by Peterson's operations is expected to be accretive to the
Company's cash flow from the date of acquisition.
20
NET INTEREST INCOME
The Company generates a significant portion 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 consolidated 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.
FFELP student loans originated prior to July 1, 2006 generally earn interest at
the higher of a variable rate based on the special allowance payment (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.
On those FFELP loans originated prior to July 1, 2006 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 a significant portion 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.
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.
One of the changes to the Higher Education Act as a result of HERA's enactment
in February 2006 was to lower the guarantee rates on FFELP loans, including a
decrease in insurance and reinsurance on portfolios receiving the benefit of the
Exceptional Performance designation by 1%, from 100% to 99% of principal and
accrued interest (effective July 1, 2006), and a decrease in insurance and
reinsurance on portfolios not subject to the Exceptional Performance designation
by 1%, from 98% to 97% of principal and accrued interest (effective for all
loans first disbursed on and after July 1, 2006). In February 2006, as a result
of the change in these legislative provisions, the Company recorded an expense
of $6.9 million ($4.3 million after tax) to increase the Company's allowance for
loan losses.
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 (99% reimbursement effective July 1, 2006) on all eligible
FFELP default claims submitted for reimbursement during a 12-month period (June
1, 2005 through May 31, 2006). 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 (99% reimbursement effective July 1, 2006). As of
June 30, 2006, more than 99% of the Company's federally insured loans were
serviced by providers designated as Exceptional Performers. If the Company or a
third party servicer were to lose its Exceptional Performer designation, either
by a legislative discontinuance of 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 (3% risk sharing effective for
all loans first disbursed on and after July 1, 2006).
21
In June 2006, the Company submitted its application for Exceptional Performer
redesignation to the Department. The Department has 60 days to redesignate the
Company as an Exceptional Performer or deny the Company's application. Until
that time, the Company continues to receive the benefit of the Exceptional
Performer designation. It is the opinion of the Company's management, based on
information currently known, that there is no reason to believe the Company's
application will be rejected. If the Department rejected the Company's
application for Exceptional Performer status, the Company would have to
establish a provision for loan losses related to the risk sharing on those loans
that the Company services internally. Based on the balance of federally insured
loans outstanding as of June 30, 2006, this provision would be approximately
$12.5 million.
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 income on borrower
late fees, payment management activities, and direct marketing; and fees from
providing software services.
LOAN AND GUARANTEE SERVICING INCOME - 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. Revenue is recognized when earned pursuant to applicable agreements,
and when ultimate collection is assured.
OTHER FEE-BASED INCOME - Other fee-based income primarily consists of borrower
late fee income, providing payment management services and academic
publications, and the sale of lists. Borrower late fee income earned by the
Company's education lending subsidiaries is recognized when payments are
collected from the borrower. Fees for payment management services are recognized
over the period in which services are provided to customers. Revenue from the
sale of publications and lists is recognized when the products are shipped.
SOFTWARE SERVICES - Software services income is determined from individual
agreements with customers and includes license and maintenance fees associated
with student loan software products. Computer and software consulting services
are recognized over the period in which services are provided to customers.
Other income also includes the derivative market value and foreign currency
adjustments and derivative net settlements from the Company's derivative
instruments and Euro Notes as further discussed in Item 3, "Quantitative and
Qualitative Disclosures about Market Risk."
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.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2006 COMPARED TO THREE MONTHS ENDED JUNE 30, 2005
INTEREST INCOME. Interest income for the three months ended June 30, 2006
increased $171.8 million compared to the same period in 2005 as reflected in the
following table and explained below.
22
Three months ended June 30, Change
-------------------------- ------------------
2006 2005 Dollars Percent
------------ ------------- --------- --------
Loan interest, excluding special
allowance yield adjustment $ 410,652 221,210 189,442 85.6 %
Special allowance yield adjustment 10,550 25,919 (15,369) (59.3)
Consolidation rebate fees (37,335) (23,438) (13,897) (59.3)
Amortization of loan premiums and
deferred origination costs (21,125) (16,547) (4,578) (27.7)
------------ ------------- ---------
Total loan interest 362,742 207,144 155,598 75.1
Investment interest 24,314 8,150 16,164 198.3
------------ ------------- ---------
Total interest income $ 387,056 215,294 171,762 79.8
============ ============= =========
o The average student loan portfolio increased $6.4 billion, or 42.6%, for
the three months ended June 30, 2006 compared to 2005. When excluding
the special allowance yield adjustment, the student loan yield increased
to 7.75% in 2006 from 5.93% in 2005. This increase in the student loan
yield is a result of a rising interest rate environment and is offset by
an increase in the percentage of lower yielding consolidation loans to
the total portfolio. Loan interest income, excluding the special
allowance yield adjustment, increased $189.4 million as a result of
these factors.
o 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 $15.4 million. 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.
o Consolidation rebate fees increased due to the $5.3 billion increase in
the consolidation loan portfolio to $14.5 billion at June 30, 2006 from
$9.2 billion at June 30, 2005.
o Amortization of loan premiums and deferred origination costs increased
as a result of the growth in the student loan portfolio.
o Investment interest income has increased as a result of an increase in
cash, cash equivalents, and investments from student loan growth and
acquisitions, and as a result of the rising interest rate environment.
INTEREST EXPENSE. Interest on bonds and notes payable for the three months ended
June 30, 2006 increased $167.6 million compared to the same period in 2005 as
reflected in the following table and explained below.
Three months
ended June 30, Change
---------------------- -----------------
2006 2005 Dollars Percent
---------- ----------- --------- -------
Interest expense on debt funding loan assets $ 295,219 131,999 163,220 123.7 %
Interest expense on debt funding operations 5,625 1,739 3,886 223.5
Other -- (461) 461 100.0
---------- ----------- ---------
Total interest expense $ 300,844 133,277 167,567 125.7
========== =========== =========
o Average debt increased approximately $7.4 billion, or 46.9%, for the
three months ended June 30, 2006 compared to 2005 and the Company's cost
of funds increased to 5.12% for the three months ended June 30, 2006 up
from 3.36% for the same period a year ago. Together these two factors
resulted in a $163.2 million increase in interest expense related to
debt used to fund the Company's loan assets.
o The Company issued $275 million of unsecured fixed-rate debt in May 2005
which resulted in an increase in the Company's operating interest
expense of $2.2 million. Interest expense also increased approximately
$1.7 million as a result of increased borrowings on the Company's
operating line of credit.
LOAN AND GUARANTEE SERVICING INCOME. Loan and guarantee servicing income has
increased $9.4 million for the three months ended June 30, 2006 compared to the
same period in 2005. Several factors have contributed to this change as follows:
23
Three months ended June 30, 2005 $ 34,678
ACQUISITION-RELATED ACTIVITIES:
Acquisition of private loan servicing operations (FirstMark) 2,296
Expansion of guarantee servicing operations related to
amended agreement with CAN 6,341
EXISTING OPERATIONS:
Increase in loan servicing revenue from Canadian operations (a) 2,073
Decrease in loan servicing revenue from U.S. operations (b) (884)
Other (462)
---------
Three months ended June 30, 2006 $ 44,042
=========
(a) The increase in loan servicing revenue from Canadian operations
is the result of an increase in the volume of loans serviced and
an increase in certain servicing rates effective in April 2006.
(b) The decrease in loan servicing revenue from U.S. operations is
the result of the Company acquiring loans from third party
lenders that were serviced by the Company prior to the
acquisition of such loans. This decrease is offset by servicing
loan volume added as a result of the acquisitions of LoanSTAR,
CAN, and Chela. The increase in this servicing volume is not
included as an acquisition-related activity as these servicing
portfolios have or will be integrated onto the Company's
servicing platform.
OTHER FEE-BASED INCOME. Other fee-based income has increased $7.0 million for
the three months ended June 30, 2006 compared to the three months ended June 30,
2005. Other fee-based income consists primarily of income from the Company's
payment management and direct marketing segments. Detail of the change in other
fee-based income is as follows:
Three months ended June 30, 2005 $ 9,027
ACQUISITION-RELATED ACTIVITIES:
Acquisition of payment management companies (FACTS, infiNET) 6,220
EXISTING OPERATIONS:
Increased list sales volume due to customer demand 1,026
Increased borrower late fee income due to student
loan portfolio growth 547
Decreased shipments related to merchandise revenue (a) (1,210)
Other 464
---------
Three months ended June 30, 2006 $ 16,074
=========
(a) The decrease in merchandise revenue is the result of decreased
sales efforts targeted at certain customers with a low profit
margin.
SOFTWARE SERVICES INCOME. Software services income has increased $1.4 million
from $2.6 million for the three months ended June 30, 2005 to $4.0 million for
the three months ended June 30, 2006. Software services income increased $2.3
million as a result of the acquisition of 5280. Maintenance and enhancement fee
revenues on the Company's existing operations decreased as a result of decreased
customer demand.
OTHER INCOME. Other income increased $1.6 million from $1.5 million for the
three months ended June 30, 2005 to $3.2 million for the three months ended June
30, 2006. Other income for the three months ended June 30, 2006 includes income
of $1.1 million from the sale of loan assets to the Greater Texas Foundation as
described in note 2 to the consolidated financial statements. In addition, the
change in the fair value of put options issued in connection with the purchases
of 5280 and FACTS resulted in income of $0.2 million for the three months ended
June 30, 2006.
DERIVATIVE MARKET VALUE AND FOREIGN CURRENCY ADJUSTMENTS. The derivative market
value and foreign currency adjustments includes the re-measurement of the
Company's Euro Notes at June 30, 2006 and the change in the fair value of the
Company's derivatives resulting from changes in interest rates and fluctuations
in the forward yield curve and currency exchange rates. See Item 3,
"Quantitative and Qualitative Disclosures about Market Risk" for more
information on the derivative market value and foreign currency adjustments. The
components of the derivative market value and foreign currency adjustments for
the three months ended June 30, 2006 and 2005, respectively, are as follows:
24
2006 2005
----------- ---------
Interest rate swaps, basis swaps, and
interest rate floor contracts $ 27,921 (51,372)
Cross-currency interest rate swaps 28,516 --
Re-measurement of Euro Notes (27,572) --
----------- ---------
Derivative market value and foreign currency adjustments $ 28,865 (51,372)
=========== =========
DERIVATIVE SETTLEMENTS, NET. The components of derivative settlements for the
three months ended June 30, 2006 and 2005, respectively, are as follows:
2006 2005
---------- ----------
Interest rate swaps and basis swaps $ 10,518 (6,001)
Cross-currency interest rate swaps (3,816) --
---------- ----------
Derivative settlements, net $ 6,702 (6,001)
========== ==========
OPERATING EXPENSES. Acquisitions that occurred during 2005 and 2006 were the
primary cause of the increase in operating expenses. Operating expenses of the
Company's recent acquisitions resulted in a $35.1 million increase in operating
expenses for the three months ended June 30, 2006 compared to 2005. The table
below summarizes the impact acquisitions had on operating expenses for the three
months ended June 30, 2006 compared to 2005.
THREE NET CHANGE THREE
MONTHS ENDED IMPACT OF AFTER MONTHS ENDED
JUNE 30, 2005 ACQUISITIONS ACQUISITIONS JUNE 30, 2006
-------------- ------------ ------------- --------------
Salaries and benefits $ 39,977 16,979 5,251 62,207
Other expenses 32,343 13,131 430 45,904
Amortization of intangible assets 1,559 4,982 (380) 6,161
-------------- ------------ ------------- --------------
Total operating expenses $ 73,879 35,092 5,301 114,272
============== ============ ============= ==============
The increase in operating expenses after adjusting for the impact of
acquisitions was $5.3 million. This increase was a result of the following:
o Increased costs related to the Company's asset generation activities,
specifically its consolidation loan portfolio, resulted in increased
operating expenses of $2.8 million.
o The remaining increase of approximately $2.5 million is the result of i)
increased costs to develop systems to support a larger organizational
structure and ii) organic growth of the organization, specifically that
of the Company's school based marketing efforts. The Company's costs to
develop its corporate structure include projects such as development and
retention of intellectual capital and technology enhancements to support
a larger, more diversified customer and employee base.
SIX MONTHS ENDED JUNE 30, 2006 COMPARED TO SIX MONTHS ENDED JUNE 30, 2005
INTEREST INCOME. Interest income for the six months ended June 30, 2006
increased $325.6 million compared to the same period in 2005 as reflected in the
following table and explained below.
Six months ended June 30, Change
------------------------ -----------------
2006 2005 Dollars Percent
----------- ----------- --------- -------
Loan interest, excluding special
allowance yield adjustment $ 779,810 413,355 366,455 88.7 %
Special allowance yield adjustment 24,460 55,661 (31,201) (56.1)
Consolidation rebate fees (72,881) (45,218) (27,663) (61.2)
Amortization of loan premiums and
deferred origination costs (42,987) (32,329) (10,658) (33.0)
----------- ----------- ---------
Total loan interest 688,402 391,469 296,933 75.9
Investment interest 43,855 15,152 28,703 189.4
----------- ----------- ---------
Total interest income $ 732,257 406,621 325,636 80.1
=========== =========== =========
o The average student loan portfolio increased $6.4 billion, or 44.9%, for
the six months ended June 30, 2006 compared to 2005. When excluding the
special allowance yield adjustment, the student loan yield increased to
7.59% in 2006 from 5.81% in 2005. This increase in the student loan
yield is a result of a rising interest rate environment and is offset by
an increase in the percentage of lower yielding consolidation loans to
the total portfolio. Loan interest income, excluding the special
allowance yield adjustment, increased $366.5 million as a result of
these factors.
25
o 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 $31.2 million. 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.
o Consolidation rebate fees increased due to the $5.3 billion increase in
the consolidation loan portfolio to $14.5 billion at June 30, 2006 from
$9.2 billion at June 30, 2005.
o Amortization of loan premiums and deferred origination costs increased
as a result of the growth in the student loan portfolio.
o Investment interest income has increased as a result of an increase in
cash, cash equivalents, and investments from student loan growth and
acquisitions, and as a result of the rising interest rate environment.
INTEREST EXPENSE. Interest on bonds and notes payable for the six months ended
June 30, 2006 increased $322.0 million compared to the same period in 2005 as
reflected in the following table and explained below.
Six months ended June 30, Change
------------------------- ------------------
2006 2005 Dollars Percent
----------- ------------ ---------- -------
Interest expense on debt funding loan assets $ 549,008 236,524 312,484 132.1 %
Interest expense on debt funding operations 10,785 1,811 8,974 495.5
Other -- (533) 533 100.0
----------- ------------ ----------
Total interest expense $ 559,793 237,802 321,991 135.4
=========== ============ ==========
o Average debt increased approximately $7.3 billion, or 47.7%, for the six
months ended June 30, 2006 compared to 2005 and the Company's cost of
funds increased to 4.93% for the six months ended June 30, 2006 up from
3.13% for the same period a year ago. Together these two factors
resulted in a $312.5 million increase in interest expense related to
debt used to fund the Company's loan assets.
o The Company issued $275 million of unsecured fixed-rate debt in May 2005
which resulted in an increase in the Company's operating interest
expense of $5.8 million. Interest expense also increased approximately
$3.1 million as a result of increased borrowings on the Company's
operating line of credit.
LOAN AND GUARANTEE SERVICING INCOME. Loan and guarantee servicing income has
increased $19.3 million for the six months ended June 30, 2006 compared to the
same period in 2005. Several factors have contributed to this change as follows:
Six months ended June 30, 2005 $ 71,854
ACQUISITION-RELATED ACTIVITIES:
Acquisition of private loan servicing operations (FirstMark) 4,479
Expansion of guarantee servicing operations related
to amended agreement with CAN 13,383
EXISTING OPERATIONS:
Increase in loan servicing revenue from Canadian operations (a) 3,423
Decrease in loan servicing revenue from U.S. operations (b) (1,325)
Other (698)
---------
Six months ended June 30, 2006 $ 91,116
=========
(a) The increase in loan servicing revenue from Canadian operations
is the result of an increase in the volume of loans serviced and
an increase in certain servicing rates effective in April 2006.
(b) The decrease in loan servicing revenue from U.S. operations is
the result of the Company acquiring loans from third party
lenders that were serviced by the Company prior to the
acquisition of such loans. This decrease is offset by servicing
loan volume added as a result of the acquisitions of LoanSTAR,
CAN, and Chela. The increase in this servicing volume is not
included as an acquisition-related activity as these servicing
portfolios have or will be integrated onto the Company's
servicing platform.
OTHER FEE-BASED INCOME. Other fee-based income has increased $21.8 million for
the six months ended June 30, 2006 compared to the six months ended June 30,
2005. Other fee-based income consists primarily of income from the Company's
payment management and direct marketing segments. Details of the change in other
fee-based income are as follows:
26
Six months ended June 30, 2005 $ 12,383
ACQUISITION-RELATED ACTIVITIES:
Acquisition of payment management companies (FACTS, infiNET) 15,875
Acquisition of direct marketing operations (a) 4,422
EXISTING OPERATIONS:
Increased borrower late fee income due to student
loan portfolio growth 1,135
Other 414
----------
Six months ended June 30, 2006 $ 34,229
==========
(a) The Company's direct marketing operations were acquired in
February 2005. As a result, the operating results for the six
months ended June 30, 2006 include six months of operations
versus four months in the same period in 2005. In addition, the
Company experienced an increase in customer demand which
resulted in increased income from the sale of lists. These two
factors, when combined, resulted in a $4.4 million increase in
other-fee based income.
SOFTWARE SERVICES INCOME. Software services income has increased $2.6 million
from $4.8 million for the six months ended June 30, 2005 to $7.4 million for the
six months ended June 30, 2006. Software services income increased $4.3 million
as a result of the acquisition of 5280. Maintenance and enhancement fee revenues
on the Company's existing operations decreased as a result of decreased customer
demand.
OTHER INCOME. Other income has increased $1.7 million from $2.9 million for the
six months ended June 30, 2005 to $4.6 million for the six months ended June 30,
2006. Other income for the six months ended June 30, 2006 includes income of
$1.9 million from the sale of certain loan assets. This income is offset by an
expense of $0.3 million for the change in the fair value of put options issued
in connection with the purchases of 5280 and FACTS for the six months ended June
30, 2006.
DERIVATIVE MARKET VALUE AND FOREIGN CURRENCY ADJUSTMENTS. The derivative market
value and foreign currency adjustments include the re-measurement of the
Company's Euro Notes at June 30, 2006 and the change in the fair value of the
Company's derivatives resulting from changes in interest rates and fluctuations
in the forward yield curve and currency exchange rates. See Item 3,
"Quantitative and Qualitative Disclosures about Market Risk" for more
information on the derivative market value and foreign currency adjustments. The
components of the derivative market value and foreign currency adjustments for
the six months ended June 30, 2006 and 2005, respectively, are as follows:
2006 2005
----------- ----------
Interest rate swaps, basis swaps, and
interest rate floor contracts $ 70,560 8,918
Cross-currency interest rate swaps 36,155 --
Re-measurement of Euro Notes (38,055) --
----------- ----------
Derivative market value and foreign currency adjustments $ 68,660 8,918
=========== ==========
DERIVATIVE SETTLEMENTS, NET. The components of derivative settlements for the
six months ended June 30, 2006 and 2005, respectively, are as follows:
2006 2005
------------ ---------
Interest rate swaps and basis swaps $ 16,414 (16,087)
Cross-currency interest rate swaps (4,968) --
------------ ---------
Derivative settlements, net $ 11,446 (16,087)
============ =========
OPERATING EXPENSES. Acquisitions that occurred during 2005 and 2006 were the
primary cause of the increase in operating expenses. Operating expenses of the
Company's recent acquisitions resulted in a $69.3 million increase in operating
expenses for the six months ended June 30, 2006 compared to 2005. The table
below summarizes the impact acquisitions had on operating expenses for the six
months ended June 30, 2006 compared to 2005.
SIX NET CHANGE SIX
MONTHS ENDED IMPACT OF AFTER MONTHS ENDED
JUNE 30, 2005 ACQUISITIONS ACQUISTIONS JUNE 30, 2006
-------------- ------------ ----------- -------------
Salaries and benefits $ 79,304 32,424 8,163 119,891
Other expenses 63,231 27,057 546 90,834
Amortization of intangible assets 2,732 9,849 (787) 11,794
-------------- ------------ ----------- -------------
Total operating expenses $ 145,267 69,330 7,922 222,519
============== ============ =========== =============
27
The increase in operating expenses after adjusting for the impact of
acquisitions was $7.9 million. This increase was a result of the following:
o Increased costs related to the Company's asset generation activities,
specifically its consolidation loan portfolio, resulted in increased
operating expenses of approximately $3.7 million.
o The remaining increase of approximately $4.2 million is the result of i)
increased costs to develop systems to support a larger organizational
structure and ii) organic growth of the organization, specifically that
of the Company's school based marketing efforts. The Company's costs to
develop its corporate structure include projects such as development and
retention of intellectual capital and technology enhancements to support
a larger, more diversified customer and employee base.
NON-GAAP PERFORMANCE MEASURES
The Company prepares financial statements in accordance with generally accepted
accounting principles ("GAAP"). In addition to evaluating the Company's
GAAP-based financial information, management also evaluates the Company on
certain non-GAAP performance measures that the Company refers to as base net
income. While base net income is not a substitute for reported results under
GAAP, the Company provides base net income as additional information regarding
its financial results.
Adjusted base net income, which excludes the special allowance yield adjustment
and related hedging activity on the Company's portfolio of student loans earning
a minimum special allowance payment of 9.5%, is used by management to develop
the Company's financial plans, track results, and establish corporate
performance targets.
The following table provides a reconciliation of GAAP net income to base and
adjusted base net income.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- --------------------------
2006 2005 2006 2005
------------ ------------- ------------- -----------
GAAP net income (loss) (a) $ 45,753 (1,773) 97,819 66,314
Base adjustments:
Derivative market value and foreign
currency adjustments (28,865) 51,372 (68,660) (8,918)
Amortization of intangible assets 6,161 1,559 11,794 2,732
Variable-rate floor income -- -- -- --
------------ ------------- ------------- -----------
Total base adjustments before income taxes (22,704) 52,931 (56,866) (6,186)
Net tax effect (b) 8,628 (20,114) 21,609 2,351
------------ ------------- ------------- -----------
Total base adjustments (14,076) 32,817 (35,257) (3,835)
------------ ------------- ------------- -----------
Base net income (a) 31,677 31,044 62,562 62,479
Adjustments to base net income:
Special allowance yield adjustment (10,550) (25,919) (24,460) (55,661)
Derivative settlements, net (7,721) 5,454 (11,885) 14,317
------------ ------------- ------------- -----------
Total adjustments to base net income
before income taxes (18,271) (20,465) (36,345) (41,344)
Net tax effect (b) 6,943 7,777 13,811 15,711
------------ ------------- ------------- -----------
Total adjustments to base net income (11,328) (12,688) (22,534) (25,633)
------------ ------------- ------------- -----------
Adjusted base net income (a) $ 20,349 18,356 40,028 36,846
============ ============= ============= ===========
Earnings (loss) per share, basic and
diluted:
GAAP net income (loss) (a) $ 0.84 (0.03) 1.80 1.23
Total base adjustments (0.26) 0.61 (0.65) (0.07)
------------ ------------- ------------- -----------
Base net income (a) 0.58 0.58 1.15 1.16
Total adjustments to base net income (0.21) (0.24) (0.41) (0.48)
------------ ------------- ------------- -----------
Adjusted base net income (a) $ 0.37 0.34 0.74 0.68
============ ============= ============= ===========
(a) Includes expense of $6.9 million ($4.3 million after tax) for
the six months ended June 30, 2006 to increase the Company's
allowance for loan losses due to a provision in the Deficit
Reduction Act that increased risk sharing for student loan
holders by 1% on FFELP loans. Excluding this expense, GAAP net
income, base net income, and adjusted base net income would have
been $1.88 per share, $1.23 per share, and $0.82 per share,
respectively, for the six months ended June 30, 2006.
(b) Tax effect computed at 38%.
28
The Company's base net income is a non-GAAP financial measure and may not be
comparable to similarly titled measures reported by other companies. The
Company's base net income presentation does not represent another comprehensive
basis of accounting. A more detailed discussion of the differences between GAAP
and base net income follows.
DERIVATIVE MARKET VALUE AND FOREIGN CURRENCY ADJUSTMENTS: Base net income
excludes the periodic unrealized gains and losses caused by the change in market
value on those derivatives in which the Company does not qualify for hedge
accounting. The Company maintains an overall interest rate risk management
strategy that incorporates the use of derivative instruments to reduce the
economic effect of interest rate volatility. Derivative instruments that are
primarily used as part of the Company's interest rate risk management strategy
include interest rate swaps, basis swaps, interest rate floor contracts, and
cross-currency interest rate swaps. Management has structured all of the
Company's derivative transactions with the intent that each is economically
effective. However, the Company's derivative instruments do not qualify for
hedge accounting under SFAS No. 133 and thus may adversely impact earnings.
In addition, base net income excludes the foreign currency transaction gain or
loss caused by the re-measurement of the Company's Euro-denominated bonds to
U.S. dollars.
AMORTIZATION OF INTANGIBLE ASSETS: The Company excludes amortization of acquired
intangibles in its base net income.
VARIABLE-RATE FLOOR INCOME: Loans that reset annually on July 1 can generate
excess spread income as compared to the rate based on the special allowance
payment formula in declining interest rate environments. The Company refers to
this additional income as variable-rate floor income. There was no variable-rate
floor income during the three and six months ended June 30, 2006 and 2005.
FINANCIAL CONDITION
AS OF JUNE 30, 2006 COMPARED TO DECEMBER 31, 2005
AS OF AS OF CHANGE
JUNE 30, DECEMBER 31, ------------------
2006 2005 DOLLARS PERCENT
----------- ------------ --------- -------
ASSETS:
Student loans receivable, net $ 22,404,492 20,260,807 2,143,685 10.6 %
Cash, cash equivalents, and investments 1,974,310 1,645,797 328,513 20.0
Goodwill 149,148 99,535 49,613 49.8
Intangible assets 177,483 153,117 24,366 15.9
Fair value of derivative instruments, net 180,901 82,766 98,135 118.6
Other assets 658,859 556,600 102,259 18.4
----------- ------------ ----------
Total assets $ 25,545,193 22,798,622 2,746,571 12.0
=========== ============ ==========
LIABILITIES:
Bonds and notes payable $ 24,327,855 21,673,620 2,654,235 12.2 %
Other liabilities 465,149 474,884 (9,735) (2.0)
----------- ------------ ----------
Total liabilities 24,793,004 22,148,504 2,644,500 11.9
Minority interest -- 626 (626) (100.0)
SHAREHOLDERS' EQUITY 752,189 649,492 102,697 15.8
----------- ------------ ----------
Total liabilities and shareholders' equity $ 25,545,193 22,798,622 2,746,571 12.0
=========== ============ ==========
Total assets increased primarily due to an increase in student loans receivable.
The Company originated and acquired $3.7 billion of student loans during the six
months ended June 30, 2006, offset by repayments and loan sales of approximately
$1.6 billion. Fair value of derivative instruments experienced a net increase of
$105.7 million 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 and currency
fluctuations. In addition, the Company entered into certain interest rate floor
contracts during 2006 which resulted in a $7.6 million decrease in the fair
value of the Company's derivative instruments. Goodwill and intangible assets
increased as a result of the 2006 acquisitions. Total liabilities increased
primarily because of an increase in bonds and notes payable, resulting from
additional borrowings to fund growth in student loans. Shareholders' equity
increased as a result of net income of $97.8 million and the issuance of common
stock as consideration for the acquisitions of FACTS and infiNET in 2006. These
increases were offset as a result of the Company repurchasing 328,700 shares of
its Class A common stock for $12.7 million.
29
LIQUIDITY AND CAPITAL RESOURCES
The Company utilizes operating cash flow, operating lines of credit, and secured
financing transactions to fund operations and student loan and business
acquisitions. The Company has also used its common stock to partially fund
certain business acquisitions. In addition, the Company has a universal shelf
registration statement with the Securities and Exchange Commission ("SEC") which
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.
In May 2005, the Company consummated a debt offering under its 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.
The interest rate 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.
The Company uses its line of credit agreements primarily for general operating
purposes and to fund certain asset and business acquisitions. As of June 30,
2006 the Company had outstanding a $500.0 million unsecured line of credit which
terminates on August 19, 2010. The Company had $120.0 million of outstanding
borrowings and $380.0 million of available capacity under this facility as of
June 30, 2006. In addition, EDULINX has a credit facility agreement with a
Canadian financial institution for approximately $11.4 million ($12.7 million in
Canadian dollars) that is cancelable by either party upon demand. The Company
had no borrowings under the EDULINX facility as of June 30, 2006.
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 $24.3 billion of
debt outstanding as of June 30, 2006, $19.0 billion was issued under
securitization transactions. On February 21, 2006, and May 18, 2006, the Company
completed asset-backed securities transactions totaling $2.0 billion and $2.1
billion, respectively. These transactions included (euro)773.2 million of notes
issued with spreads to the 3-month EURIBOR. This represents the Company's first
asset-backed securities offerings with Euro denominated notes. Depending on
market conditions, the Company anticipates continuing to access the asset-backed
securities market during 2006 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.
Management believes 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 June 30, 2006, the Company had a loan warehousing capacity of $7.6
billion, of which $4.9 billion was outstanding and $2.7 billion was available
for future use, through 364-day commercial paper conduit programs. These conduit
programs mature in 2007 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 presents a significant risk to its liquidity.
The Company is limited in the amounts of funds that can be transferred from its
subsidiaries through intercompany loans, advances, or cash dividends. These
limitations result from the restrictions contained in trust indentures under
debt financing arrangements to which the Company's education lending
subsidiaries are parties. The Company does not believe these limitations will
significantly affect its operating cash needs. The amounts of cash and
investments restricted in the respective reserve accounts of the education
lending subsidiaries are shown on the balance sheets as restricted cash and
investments.
The following table summarizes the Company's bonds and notes outstanding as of
June 30, 2006:
INTEREST RATE
CARRYING PERCENT OF RANGE OF
AMOUNT TOTAL CARRYING AMOUNT FINAL MATURITY
------------- ----------- ---------------- -----------------
Variable-rate bonds and notes (a):
Bond and notes based on indices (b) $ 15,643,746 64.3 % 2.85% -6.16% 08/17/06 -05/01/42
Bond and notes based on auction 2,874,870 11.8 3.40% -5.47% 11/01/09 -07/01/43
------------- --------
Total variable-rate bonds and notes 18,518,616 76.1
Commerical paper and other 4,874,958 20.1 5.08% -5.31% 01/19/07 -09/02/09
Fixed-rate bonds and notes (a) 468,200 1.9 5.20% -6.68% 11/01/06 -05/01/29
Unsecured fixed-rate debt 275,000 1.1 5.13% 06/01/10
Other borrowings 191,081 0.8 5.62% -5.92% 06/29/07 - 08/19/10
------------- --------
Total $ 24,327,855 100.0 %
============= ========
(a) Issued in securitization transactions.
(b) Includes (euro)773.2 million Euro Notes re-measured to $988.1
million U.S. dollars as of June 30, 2006.
30
The Company is committed under noncancelable operating leases for certain office
and warehouse space and equipment. The Company's contractual obligations as of
June 30, 2006 were as follows:
LESS THAN MORE THAN
TOTAL 1 YEAR 1 TO 3 YEARS 3 TO 5 YEARS 5 YEARS
-------------- ----------- -------------- ------------- ------------
Bonds and notes payable $ 24,327,855 3,877,751 157,122 1,776,204 18,516,778
Operating lease obligations 23,344 8,438 10,509 4,129 268
Other 16,874 1,950 6,957 7,967 --
-------------- ----------- -------------- ------------- ------------
Total $ 24,368,073 3,888,139 174,588 1,788,300 18,517,046
============== =========== ============== ============= ============
On May 25, 2006, the Company entered into an agreement with Mad Dog Guest Ranch
LLC, a Nebraska limited liability company, for the purchase by the Company of
the building in Lincoln, Nebraska in which the Company's corporate headquarters
are located. The purchase price for the property will be $8.3 million, including
the assumption of debt on the property. The Company paid $0.2 million and $0.4
million in rent for space in the building for the three and six month periods
ended June 30, 2006, respectively. Rent for these two periods in 2005 was the
same as 2006. The agreement is expected to close by November 15, 2006, after the
receipt of any necessary regulatory approvals. Total operating lease obligations
of $3.3 million related to this property is included in the table above.
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 typically 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. Commitments to purchase loans under these
arrangements are not included in the table above.
As a result of the Company's recent acquisitions, the Company has certain
contractual obligations or commitments as follows:
o LoanSTAR - Commitment to sell student loans to the Texas Foundation on a
quarterly basis.
o EDULINX - Contingent payment of $6.3 million if EDULINX obtains an
extension or renewal of a significant customer servicing contract. This
contingency payment is due following the date on which such extension or
renewal period of the servicing contract commences and is not included
in the table above.
o SMG/NHR - Contingent payments of $4.0 million - $24.0 million payable in
annual installments through April 2008 based on the operating results of
SMG and NHR. The Company made an additional payment of $3.0 million
under this agreement in 2006. Four million of the remaining contingent
consideration is included in the table above.
o infiNET - Stock price guarantee of $104.8375 per share on 95,380 Class A
common shares issued as part of the original purchase price. The
obligation to pay this guaranteed stock price is due February 28, 2011
and is not included in the table above.
o FACTS - 238,237 shares of Class A common stock issued as part of the
original purchase price is subject to a put option arrangement whereby
during the 30-day period beginning February 28, 2010, the holders of
such shares can require the Company to repurchase all or part of the
shares at a price of $83.95 per share. The value of this put option as
of June 30, 2006 was $7.6 million and is included in "other" in the
above table (see (a) below).
o CUnet - Contingent payments not to exceed $80.0 million due in annual
installments through December 2010 based on the aggregate cumulative net
income before taxes of CUnet. In partial satisfaction of the contingent
consideration, the Company will issue shares of Class A common stock.
These contingency payments are not included in the table above.
o 5280 - 258,760 shares of Class A common stock issued as part of the
original purchase price is subject to a put option arrangement whereby
during the 30-day period ending November 30, 2008, the holders may
require the Company to repurchase all or part of the shares at a price
of $37.10 per share. The value of this put option as of June 30, 2006
was $1.0 million and is included in "other" in the above table (see (a)
below).
(a) As of July 31, 2006, the value of the FACTS and 5280 put
options increased by $2.0 million and $0.9 million,
respectively. The combined increase in value of $2.9 million is
recognized as an expense in the Company's statement of
operation.
Additional information concerning the Company's obligations related to the above
acquisitions can be found in the consolidated financial statements in the
Company's Annual Report on Form 10-K for the year ended December 31, 2005 and in
note 3 to the financial statements included in this report.
31
STUDENT LOAN PORTFOLIO
The table below describes the components of the Company's loan portfolio:
AS OF JUNE 30, 2006 AS OF DECEMBER 31, 2005
------------------------ ------------------------
DOLLARS PERCENT DOLLARS PERCENT
------------- --------- ------------ ----------
Federally insured:
Stafford $ 6,891,180 30.8 % $ 6,434,655 31.8 %
PLUS/SLS 430,409 1.9 376,042 1.8
Consolidation 14,521,608 64.7 13,005,378 64.2
Non-federally insured 169,473 0.8 96,880 0.5
------------- --------- ------------ ----------
Total 22,012,670 98.2 19,912,955 98.3
Unamortized premiums and deferred origination costs 416,002 1.9 361,242 1.8
Allowance for loan losses:
Allowance - federally insured (7,001) -- (98) --
Allowance - non-federally insured (17,179) (0.1) (13,292) (0.1)
------------- --------- ------------ ----------
Net $ 22,404,492 100.0 % $ 20,260,807 100.0 %
============= ========= ============ ==========
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 JUNE 30, SIX MONTHS ENDED JUNE 30,
---------------------------- -------------------------
2006 2005 2006 2005
-------------- ------------ ------------ -----------
Balance at beginning of period $ 22,225 8,852 13,390 7,272
Provision for loan losses:
Federally insured loans 200 124 7,468 205
Non-federally insured loans 1,990 2,000 4,340 3,950
-------------- ------------ ------------ -----------
Total provision for loan losses 2,190 2,124 11,808 4,155
Charge-offs, net of recoveries:
Federally insured loans (274) (124) (565) (223)
Non-federally insured loans 39 (163) (453) (515)
-------------- ------------ ------------ -----------
Net charge-offs (235) (287) (1,018) (738)
-------------- ------------ ------------ -----------
Balance at end of period $ 24,180 10,689 24,180 10,689
============== ============ ============ ===========
Allocation of the allowance for loan losses:
Federally insured loans $ 7,001 99 7,001 99
Non-federally insured loans 17,179 10,590 17,179 10,590
-------------- ------------ ------------ -----------
Total allowance for loan losses $ 24,180 10,689 24,180 10,689
============== ============ ============ ===========
Net loan charge-offs as a percentage of average
student loans 0.004 % 0.008 0.010 0.010
Total allowance as a percentage of average student loanS 0.114 0.072 0.116 0.075
Total allowance as a percentage of ending balance
of student loans 0.110 0.069 0.110 0.069
Non-federally insured allowance as a percentage of
the ending balance of non-federally insured loans 10.137 10.839 10.137 10.839
Average student loans $ 21,289,877 14,927,290 20,763,472 14,334,826
Ending balance of student loans 22,012,670 15,469,689 22,012,670 15,469,689
Ending balance of non-federally insured loans 169,473 97,705 169,473 97,705
The Company recognized a $6.9 million provision on its federally insured
portfolio during the three months ended March 31, 2006 as a result of HERA which
was enacted into law on February 8, 2006.
32
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 Company's student loan delinquency amounts:
AS OF JUNE 30, 2006 AS OF DECEMBER 31, 2005
----------------------- ------------------------
DOLLARS PERCENT DOLLARS PERCENT
-------------- ------- -------------- -------
Federally Insured Loans:
Loans in-school/grace/deferment(1) $ 6,556,148 $ 5,512,448
Loans in forebearance(2) 2,252,183 2,160,577
Loans in repayment status:
Loans current 11,534,975 88.5 % 10,790,625 88.9 %
Loans delinquent 31-60 days(3) 500,663 3.8 526,044 4.3
Loans delinquent 61-90 days(3) 351,350 2.7 236,117 1.9
Loans delinquent 91 days or greater(4) 647,878 5.0 590,264 4.9
-------------- ------- -------------- -------
Total loans in repayment 13,034,866 100.0 % 12,143,050 100.0 %
-------------- ======= -------------- =======
Total federally insured loans $ 21,843,197 $ 19,816,075
============== ==============
NON-FEDERALLY INSURED LOANS:
Loans in-school/grace/deferment(1) $ 80,935 $ 27,709
Loans in forebearance(2) 3,934 2,938
Loans in repayment status:
Loans current 79,782 94.3 % 61,079 92.2 %
Loans delinquent 31-60 days(3) 2,400 2.8 2,059 3.1
Loans delinquent 61-90 days(3) 1,193 1.4 1,301 2.0
Loans delinquent 91 days or greater(4) 1,229 1.5 1,794 2.7
-------------- ------- -------------- -------
Total loans in repayment 84,604 100.0 % 66,233 100.0 %
-------------- ======= -------------- =======
Total non-federally insured loans $ 169,473 $ 96,880
============== ==============
(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.
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
table below sets forth the activity of loans originated or acquired through each
of the Company's channels:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
---------------------------- ---------------------------
2006 2005 2006 2005
------------- ------------- ------------ -------------
Beginning balance $ 20,963,219 14,357,207 19,912,955 13,299,094
Direct channel:
Consolidation loan originations 1,045,094 781,580 2,069,929 1,526,670
Less consolidation of existing portfolio (567,300) (377,300) (1,001,200) (714,400)
------------- ------------- ------------ -------------
Net consolidation loan originations 477,794 404,280 1,068,729 812,270
Stafford/PLUS loan originations 151,017 172,599 457,165 327,622
Branding partner channel 326,764 409,013 747,029 1,082,854
Forward flow channel 579,701 453,950 931,513 641,113
Other channels 424,620 2,497 478,458 34,185
------------- ------------- ------------ -------------
Total channel acquisitions 1,959,896 1,442,339 3,682,894 2,898,044
Repayments, claims, capitalized interest, and other (453,866) (195,457) (819,024) (469,349)
Consolidation loans lost to external parties (310,800) (134,400) (581,200) (258,100)
Loans sold (145,779) -- (182,955) --
------------- ------------- ------------ -------------
Ending balance $ 22,012,670 15,469,689 22,012,670 15,469,689
============= ============= ============ =============
33
Included in the branding partner channel for the three and six months ended June
30, 2005 is $161.8 million and $630.8 million, respectively, of student loans
purchased from Union Bank and Trust ("Union Bank"), an entity under common
control with the Company. The acquisition of these loans was made by the Company
as part of an agreement with Union Bank entered into in February 2005. As part
of this agreement, Union Bank also committed to transfer to the Company
substantially all of the remaining balance of Union Bank's origination rights in
guaranteed student loans. As such, beginning in the second quarter of 2005, all
loans originated by Union Bank on behalf of the Company are presented in the
table above as direct channel originations.
In June 2006, the Company acquired approximately $424 million of loans in a spot
purchase from an unrelated third party.
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.
Nova Southeastern University ("Nova"), a school-as-lender customer, has elected
not to renew their existing contract with the Company, which will expire in
December 2006. Total loans acquired from Nova were $121.7 million and $127.4
million for the three months ended June 30, 2006 and 2005, respectively; $161.8
million and $163.8 million for the six months ended June 30, 2006 and 2005,
respectively; and $299.3 million for the year ended December 31, 2005. Loans
acquired from Nova are included in the forward flow channel in the above table.
Subsequent to June 30, 2006, the Company sold approximately $312.6 million (par
value) of student loans to an unrelated party. Loans sold under this agreement
were originated by Nova. The portfolio of loans sold were not serviced by the
Company and as such were at a greater risk of being consolidated away from the
Company by third parties.
As part of the agreement for the acquisition of the capital stock of LoanSTAR
from the Texas Foundation completed in October 2005, the Company agreed to sell
student loans in an aggregate amount sufficient to permit the Texas Foundation
to maintain a portfolio of loans equal to no less then $200.0 million through
October 2010. The sales price for such loans is the fair market value mutually
agreed upon between the Company and the Texas Foundation. To satisfy this
obligation, the Company will sell loans to the Texas Foundation on a quarterly
basis. During the three months ended June 30, 2006, the Company sold the Texas
Foundation $120.8 million (par value) of student loans which is reflected in
loan sales in the above table.
STUDENT LOAN SPREAD ANALYSIS
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 and derivative instruments used to fund the assets:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
2006 2005 2006 2005
------------- ------------ ------------ ------------
Student loan yield 7.93 % 6.64 7.82 6.60
Consolidation rebate fees (0.70) (0.63) (0.71) (0.64)
Premium and deferred origination costs amortization (0.40) (0.44) (0.42) (0.45)
------------- ------------ ------------ ------------
Student loan net yield 6.83 5.57 6.69 5.51
Student loan cost of funds (a) (5.00) (3.52) (4.83) (3.35)
------------- ------------ ------------ ------------
Student loan spread 1.83 2.05 1.86 2.16
Variable-rate floor income -- -- -- --
Special allowance yield adjustment, net of
settlements on derivatives (b) (0.34) (0.55) (0.35) (0.58)
------------- ------------ ------------ ------------
Core student loan spread 1.49 % 1.50 1.51 1.58
============= ============ ============ ============
Average balance of student loans (in thousands) $21,289,877 14,927,290 20,763,472 14,334,826
Average balance of debt outstanding (in thousands) 23,126,198 15,746,521 22,465,046 15,214,821
(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 adjustments represent the impact on net
spread had loans earned at statutorily defined rates under a taxable
financing. The special allowance yield adjustments have been reduced by
net settlements on derivative instruments that were used to hedge this
loan portfolio earning the excess yield.
The compression of the Company's core student loan spread for the three and six
months ended June 30, 2006 compared to the three and six months ended June 30,
2005 has been primarily 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; and
o rising interest rates which compressed the margins on the Company's
fixed-rate loans that were not hedged.
34
As noted on page 37, the Company has a portfolio of $4.3 billion of student
loans that are earning interest at a fixed borrower rate which exceeds the
statutorily defined variable lender rate. This portfolio of loans includes the
portfolio of approximately $2.5 billion of consolidation loans that have been
previously financed with tax-exempt obligations, the impact of which has been
adjusted for in the spread table as the special allowance yield adjustment. Thus
the company has a portfolio of approximately $1.8 billion of loans earning at
fixed rates above the statutorily defined variable lender rates creating floor
income which is included in its core student loan spread. The majority of these
loans are consolidation loans that earn the greater of the borrower rate or
2.64% above the average commercial paper rate during the calendar quarter. The
Company estimates that its core student loan spread for the three and six months
ended June 30, 2006 included approximately 15 and 17 basis points, respectively,
related to this floor income. When excluding floor income, the company's core
student loan spread was 1.34% for both periods.
The following table presents the student loan spread for certain loan types
originated by the Company in 2006. The student loan spreads shown below do not
necessarily reflect the spread for all loans originated in 2006 or spreads that
may be attained in the future. The purpose of this information is to illustrate
what the Company expects to experience on spreads on the majority of new student
loans most recently added to its portfolio. The following amounts could vary
based on the cost of acquisition or origination, changes to borrower benefit
programs and borrower qualification rates on such programs, constant repayment
rates, and cost of funds.
NEW STAFFORD LOANS - NEW STAFFORD LOANS - NEW
IN-SCHOOL STATUS REPAYMENT STATUS CONSOLIDATION LOANS
-------------------- -------------------- -------------------
LOW HIGH LOW HIGH LOW HIGH
-------- --------- -------- ---------- ------- ---------
Student loan
spread 1.00 % 1.10 % 1.50 % 1.60 % 1.20 % 1.30 %
======== ========= ======== ========== ======= =========
CRITICAL ACCOUNTING POLICIES
This Management's Discussion and Analysis of Financial Condition and Results of
Operations discusses the Company's 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, 2005, includes a summary of the significant accounting
policies and methods used in the preparation of the consolidated financial
statements.
On an on-going basis, management evaluates its estimates and judgments,
particularly as they relate to accounting policies that management believes are
most "critical" -- that is, they are most important to the portrayal of the
Company's financial condition and results of operations and they require
management's most difficult, subjective, or complex judgments, often as a result
of the need to make estimates about the effect of matters that are inherently
uncertain. Management has identified the following critical accounting policies
that are discussed in more detail below: allowance for loan losses, student loan
income, and purchase price accounting related to business and certain asset
acquisitions.
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.
Should any of these factors change, the estimates made by management would also
change, which in turn would impact the level of the Company's future provision
for loan losses.
On February 8, 2006, HERA was enacted into law. HERA effectively reauthorized
the Title IV provisions of the FFEL Program through 2012. One of the provisions
of HERA resulted in lower guarantee rates on FFELP loans, including a decrease
in insurance and reinsurance on portfolios receiving the benefit of Exceptional
Performance designation by 1%, from 100% to 99% of principal and accrued
interest (effective July 1, 2006) and a decrease in insurance and reinsurance on
portfolios not subject to the Exceptional Performance designation by 1%, from
98% to 97% of principal and accrued interest (effective for all loans first
disbursed on and after July 1, 2006). As a result, during the three and six
months ended June 30, 2006, the Company applied the new provisions to its
evaluation of the adequacy of the allowance for loan losses on its federally
insured loan portfolio.
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. Should any of these factors change, the
estimates made by management would also change, which in turn would impact the
level of the Company's future provision for loan losses. 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.
35
STUDENT LOAN INCOME
The Company recognizes student loan income as earned, net of amortization of
loan premiums and deferred origination costs. Loan income is recognized based
upon the expected yield of the loan after giving effect to borrower utilization
of incentives such as timely payments ("borrower benefits") and other yield
adjustments. The estimate of the borrower benefits discount is dependent on the
estimate of the number of borrowers who will eventually qualify for these
benefits. For competitive purposes, the Company frequently changes the borrower
benefit programs in both amount and qualification factors. These programmatic
changes must be reflected in the estimate of the borrower benefit discount. Loan
premiums, deferred origination costs, and borrower benefits are included in the
carrying value of the student loan on the consolidated balance sheet and are
amortized over the estimated life of the loan in accordance with SFAS No. 91,
ACCOUNTING FOR NON-REFUNDABLE FEES AND COSTS ASSOCIATED WITH ORIGINATING OR
ACQUIRING LOANS AND INITIAL DIRECT COSTS OF LEASES. The most sensitive estimate
for loan premiums, deferred origination costs, and borrower benefits is the
estimate of the constant repayment rate ("CPR"). CPR is a variable in the life
of loan estimate that measures the rate at which loans in a portfolio pay before
their stated maturity. The CPR is directly correlated to the average life of the
portfolio. CPR equals the percentage of loans that prepay annually as a
percentage of the beginning of period balance. A number of factors can affect
the CPR estimate such as the rate of consolidation activity and default rates.
Should any of these factors change, the estimates made by management would also
change, which in turn would impact the amount of loan premium and deferred
origination cost amortization recognized by the Company in a particular period.
PURCHASE PRICE ACCOUNTING RELATED TO BUSINESS AND CERTAIN ASSET ACQUISITIONS
The Company has completed several business and asset acquisitions which have
generated significant amounts of goodwill and intangible assets and related
amortization. The values assigned to goodwill and intangibles, as well as their
related useful lives, are subject to judgment and estimation by the Company.
Goodwill and intangibles related to acquisitions are determined and based on
purchase price allocations. Valuation of intangible assets is generally based on
the estimated cash flows related to those assets, while the initial value
assigned to goodwill is the residual of the purchase price over the fair value
of all identifiable assets acquired and liabilities assumed. Thereafter, the
value of goodwill cannot be greater than the excess of fair value of the
Company's reportable unit over the fair value of the identifiable assets and
liabilities, based on an annual impairment test. Useful lives are determined
based on the expected future period of the benefit of the asset, the assessment
of which considers various characteristics of the asset, including historical
cash flows. Due to the number of estimates involved related to the allocation of
purchase price and determining the appropriate useful lives of intangible
assets, management has identified purchase price accounting as a critical
accounting policy.
RECENT ACCOUNTING PRONOUNCEMENTS
In March 2006, the Financial Accounting Standards Board ("FASB") issued SFAS No.
156, ACCOUNTING FOR SERVICING OF FINANCIAL ASSETS, which amends SFAS No. 140,
ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS
OF LIABILITIES. This statement will be effective for the first fiscal year
beginning after September 15, 2006. This statement:
o Requires an entity to recognize a servicing asset or liability each time
it undertakes an obligation to service a financial asset as the result
of i) a transfer of the servicer's financial assets that meet the
requirement for sale accounting; ii) a transfer of the servicer's
financial assets to a qualifying special-purpose entity in a guaranteed
mortgage securitization in which the transferor retains all of the
resulting securities and classifies them as either available-for-sale or
trading securities in accordance with SFAS No. 115, ACCOUNTING FOR
CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES; or iii) an
acquisition or assumption of an obligation to service a financial asset
that does not relate to financial assets of the servicer or its
consolidated affiliates.
o Requires all separately recognized servicing assets or liabilities to be
initially measured at fair value, if practicable.
o Permits an entity to either i) amortize servicing assets or liabilities
in proportion to and over the period of estimated net servicing income
or loss and assess servicing assets or liabilities for impairment or
increased obligation based on fair value at each reporting date
(amortization method); or ii) measure servicing assets or liabilities at
fair value at each reporting date and report changes in fair value in
earnings in the period in which the changes occur (fair value
measurement method). The method must be chosen for each separately
recognized class of servicing asset or liability.
o At its initial adoption, permits a one-time reclassification of
available-for-sale securities to trading securities by entities with
recognized servicing rights, without calling into question the treatment
of other available-for-sale securities under SFAS No. 115, provided that
the available-for-sale securities are identified in some manner as
offsetting the entity's exposure to changes in fair value of servicing
assets or liabilities that a servicer elects to subsequently measure at
fair value.
o Requires separate presentation of servicing assets and liabilities
subsequently measured at fair value in the statement of financial
position and additional disclosures for all separately recognized
servicing asset and liabilities.
The Company is currently evaluating this statement to assess its impact on the
Company's financial statements.
36
On July 13, 2006, the FASB released FASB Interpretation No. 48, ACCOUNTING FOR
UNCERTAINTY IN INCOME TAXES, AN INTERPRETATION OF FASB STATEMENT NO. 109 ("FIN
48"). FIN 48 clarifies the accounting and reporting for income taxes where
interpretation of the tax law may be uncertain. FIN 48 prescribes a
comprehensive model for the financial statement recognition, measurement,
presentation and disclosure of income tax uncertainties with respect to
positions taken or expected to be taken in income tax returns. The Company will
adopt FIN 48 on January 1, 2007. Management is currently evaluating this
statement to assess its impact on the Company's financial statements.
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 a
significant portion 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 held by the Company have variable-rate characteristics in certain
interest rate environments. Some of the student loans include fixed-rate
components depending upon the rate reset provisions, or, in the case of
consolidation loans, are fixed at the weighted average interest rate of the
underlying loans at the time of consolidation. The following table sets forth
the Company's loan assets and debt instruments by rate characteristics:
AS OF JUNE 30, 2006 AS OF DECEMBER 31, 2005
---------------------- --------------------------
DOLLARS PERCENT DOLLARS PERCENT
------------ --------- ---------------- --------
Fixed-rate loan assets $ 4,252,973 19.3 % $ 4,908,865 24.7 %
Variable-rate loan assets 17,759,697 80.7 15,004,090 75.3
------------ --------- ---------------- --------
Total $ 22,012,670 100.0 % $ 19,912,955 100.0 %
============ ========= ================ ========
Fixed-rate debt instruments $ 743,200 3.1 % $ 794,086 3.7 %
Variable-rate debt instruments 23,584,655 96.9 20,879,534 96.3
------------ --------- ---------------- --------
Total $ 24,327,855 100.0 % $ 21,673,620 100.0 %
============ ========= ================ ========
The following table shows the Company's student loan assets currently earning at
a fixed rate as of June 30, 2006:
BORROWER/ ESTIMATED
LENDER VARIABLE CURRENT
FIXED INTEREST WEIGHTED CONVERSION BALANCE OF
RATE RANGE AVERAGE YIELD RATE (a) FIXED RATE ASSETS
----------------- -------------- ---------------- ----------------
8.0 - 9.0% 8.15% 5.51% $ 571,959
> 9.0% 9.04 6.40 411,563
9.5 floor yield 9.50 6.86 3,269,451
--------------
$ 4,252,973
==============
---------------------
(a) The estimated variable conversion rate is the estimated short-term
interest rate at which loans would convert to variable rate.
Historically, the Company has followed a policy of funding the majority of its
student loan portfolio with variable-rate debt. In a low interest rate
environment, the FFELP loan portfolio yields excess income primarily due to the
reduction in interest rates on the variable-rate liabilities that fund student
loans at a fixed borrower rate and also due to consolidation loans earning
interest at a fixed rate to the borrower. Therefore, absent utilizing derivative
instruments, in a low interest rate environment, a rise in interest rates will
have an adverse effect on earnings. In higher interest rate environments, where
the interest rate rises above the borrower rate and the fixed-rate loans become
variable rate and are effectively matched with variable-rate debt, the impact of
rate fluctuations is substantially reduced.
The majority of the Company's student loan assets earning a fixed rate as of
June 30, 2006 are consolidation loans that earn the higher of the borrower rate
or 2.64% over the average commercial paper rate in a calendar quarter. This
portfolio of loans includes the portfolio of approximately $2.5 billion of
consolidation loans that have been previously financed with tax-exempt
obligations further discussed below. Thus, excluding the loans earning the
special allowance yield adjustment, the Company has a portfolio of approximately
$1.8 billion of loans earning at fixed rates above the statutorily defined
variable lender rates creating floor income. Using the weighted average lender
yield from the above table and the average applicable commercial paper rates,
the Company's loan interest income for the three and six months ended June 30,
2006 includes approximately $5 million and $13 million of floor income.
37
The Company attempts to match the interest rate characteristics of pools of loan
assets with debt instruments of substantially similar characteristics,
particularly in rising interest rate environments. Due to the variability in
duration of the Company's assets and varying market conditions, the Company does
not attempt to perfectly match the interest rate characteristics of the entire
loan portfolio with the underlying debt instruments. The Company has adopted a
policy of periodically reviewing the mismatch related to the interest rate
characteristics of its assets and liabilities and the Company's outlook as to
current and future market conditions. Based on those factors, the Company will
periodically use derivative instruments as part of its overall risk management
strategy to manage risk arising from its fixed-rate and variable-rate financial
instruments. Derivative instruments used as part of the Company's interest rate
risk management strategy include interest rate swaps, basis swaps, interest rate
floor contracts, and cross-currency interest rate swaps.
INTEREST RATE SWAPS
The total fixed-rate student loan assets of $4.3 billion held by the Company as
of June 30, 2006, includes $2.5 billion of loans purchased prior to September
30, 2004 with proceeds of tax-exempt obligations originally issued prior to
October 1, 1993 and then subsequently funded with the proceeds of taxable
obligations, without retiring the tax-exempt obligations. As discussed
previously, interest income that is generated from this $2.5 billion portfolio
in excess of income based upon standard special allowance rates is referred to
by the Company as the special allowance yield adjustment. The following table
summarizes the outstanding interest rate swaps used by the Company as of June
30, 2006 to hedge this $2.5 billion loan portfolio. These derivatives are
referred to by the Company as the special allowance yield derivatives. As of
June 30, 2006, the fair market value of this derivative portfolio was
approximately $132.1 million. Since the $2.5 billion portfolio of student loans
will decrease as principal payments are made on these loans, the Company has
structured the related derivatives to expire or "amortize" in a similar pattern.
WEIGHTED AVERAGE
FIXED RATE PAID
MATURITY NOTIONAL VALUES BY THE COMPANY
--------------- --------------- -----------------
2006 (a) $ 250,000 3.16 %
2007 118,750 3.35
2008 293,750 3.78
2009 193,750 4.01
2010 1,137,500 4.25
2011 -- --
2012 275,000 4.31
2013 525,000 4.36
--------------- ----------------
Total $ 2,793,750 4.07 %
=============== ================
(a) Excludes $243.75 million of interest rate swaps that expired on July 1,
2006.
The Company recognized $7.7 million and $11.9 million of net derivative
settlements on the special allowance yield derivatives for the three and six
months ended June 30, 2006, respectively.
The following table summarizes the outstanding derivative instruments as of June
30, 2006 used by the Company to hedge the remaining fixed-rate loan portfolio.
WEIGHTED AVERAGE
FIXED RATE PAID
MATURITY NOTIONAL VALUES BY THE COMPANY
--------------- --------------- -----------------
2007 $ 393,750 3.45 %
2008 168,750 3.72
2009 118,750 4.01
--------------- -----------------
Total (a) $ 681,250 3.61 %
=============== =================
(a) Excludes $118.75 million of interest rate swaps that expired on July 1,
2006.
In addition to the interest rate swaps with notional values of $681.25 million
summarized above, as of June 30, 2006, the Company had $468 million of
fixed-rate debt (excluding the Company's fixed-rate unsecured debt of $275
million) that was used by the Company to hedge fixed-rate student loan assets.
The Company recognized $3.0 million and $5.0 million of net derivative
settlements on the non-special allowance yield derivative interest rate swaps
for the three and six months ended June 30, 2006, respectively.
BASIS SWAPS
On May 1, 2006, the Company entered into three ten-year basis swaps with
notional values of $500.0 million each in which the Company receives three-month
LIBOR and pays one-month LIBOR less a spread as defined in the agreements. The
effective dates of these agreements are November 25, 2006, December 25, 2006,
and January 25, 2007.
38
In addition to the three basis swaps summarized above, the Company also has a
basis swap with a notional amount of $500.0 million that matures in August 2006
in which the Company pays a floating interest rate based on the U.S. Treasury
bill rate and receives a floating interest rate based on the three-month LIBOR
rate.
During the three and six months ended June 30, 2006, the Company recognized a
net loss of $0.2 million and $0.5 million, respectively, of net derivative
settlements related to its basis swaps.
INTEREST RATE FLOOR CONTRACTS
FFELP student loans originated prior to July 1, 2006 generally earn interest at
the greater of the borrower rate or a floating rate determined by reference to
the average of the applicable floating rates (91-day Treasury bill rate or
commercial paper rate) in a calendar quarter, plus a fixed spread that is
dependent upon when the loan was originated, the loan's repayment status, and
funding sources for the loan. If the resulting floating rate exceeds the
borrower rate, the Department pays the difference directly to the Company. This
payment is referred to as special allowance payments (SAP). The Company
generally finances its student loan portfolio with floating rate debt. In low
and/or declining interest rate environments, when the fixed borrower rate is
higher than the rate produced by the SAP formula, student loans earn at a fixed
rate while the interest on the floating rate debt continues to decline. In these
interest rate environments, the Company earns additional spread income referred
to as floor income.
In June 2006, the Company entered into interest rate floor contracts in which
the Company received an upfront fee of $8.6 million. These contracts were
structured to monetize on an upfront basis the potential floor income associated
with certain consolidation loans. Under the terms of these contracts, the
Company is obligated to pay the counterparty floor income earned on a notional
amount of underlying consolidation student loans over the life of the floor
income contracts. Specifically, the Company agreed to pay the counterparty the
difference, if positive, between the fixed borrower rate less the special
allowance payment spread for consolidation loans and the three-month LIBOR rate
plus a spread to better match the LIBOR floor strike rate to the underlying
student loan asset on that notional amount, regardless of the actual balance of
underlying student loans, over the life of the contracts. The contracts do not
extend over the life of the underlying consolidation student loans.
The following provide the terms of these contracts:
AMORTIZING FLOOR STRIKE
NOTIONAL AMOUNT RATE
--------------- ----
$ 51,296 2.760%
44,873 2.885%
38,174 3.010%
34,953 3.135%
47,420 3.260%
78,390 3.385%
51,300 3.510%
53,745 3.635%
46,842 3.760%
45,971 3.885%
41,076 4.010%
64,167 4.135%
24,044 4.460%
31,648 5.060%
37,103 5.510%
7,097 4.300%
21,968 4.550%
17,220 4.800%
62,466 5.550%
----------
$ 799,753
==========
Note: Those contracts with floor strike rates of 2.76%-4.135% and
4.460%-5.55% have an effective start date of June 30, 2006 and June 30,
2010, respectively. All contracts expire on June 30, 2016.
CROSS-CURRENCY INTEREST RATE SWAPS
See "-- Foreign Currency Exchange Risk".
39
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 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 and fluctuations in currency rates
can significantly impact the valuation of the Company's derivatives.
Accordingly, changes or shifts to the forward yield curve and fluctuations in
currency rates will impact the financial position and results of operations of
the Company. The change in fair value of the Company's derivatives which is
included in derivative market value and foreign currency adjustments in the
Company's statements of operations was $56.4 million and $106.7 million for the
three and six months ended June 30, 2006, respectively.
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 Company's interest rate swaps, basis
swaps, and interest rate floor contracts in existence during these periods. As a
result of the Company's interest rate management activities, the Company expects
such a change in pre-tax net income resulting from a 100 basis point increase or
decrease or a 200 basis point increase in interest rates would not result in a
proportional decrease in net income.
THREE MONTHS ENDED JUNE 30, 2006
-----------------------------------------------------------------------------
CHANGE FROM DECREASE OF 100 CHANGE FROM INCREASE OF CHANGE FROM INCREASE
BASIS POINTS 100 BASIS POINTS OF 200 BASIS POINTS
--------------------------- ------------------------- ---------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ------------ ----------- ------------ ---------- ---------
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements $ 8,743 12.0 % $ (7,103) (9.8)% $ (9,597) (13.2)%
Impact of derivative settlements (9,567) (13.2) 9,567 13.2 19,135 26.4
------------- ------------ ----------- ------------ ---------- ---------
Increase (decrease) in net income before taxes $ (824) (1.2) % $ 2,464 3.4 % $ 9,538 13.2 %
============= ============ =========== ============ ========== =========
Increase (decrease) in basic and diluted
earning per share $ (0.01) $ 0.03 $ 0.11
============= =========== ==========
THREE MONTHS ENDED JUNE 30, 2005
-----------------------------------------------------------------------------
CHANGE FROM DECREASE OF 100 CHANGE FROM INCREASE OF CHANGE FROM INCREASE
BASIS POINTS 100 BASIS POINTS OF 200 BASIS POINTS
--------------------------- -------------------------- ---------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ------------ ------------ ------------ ---------- ---------
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements $ 10,789 305.8 % $ (9,745) (276.2)% $(17,495) (495.9)%
Impact of derivative settlements (10,394) (294.6) 10,394 294.6 20,787 589.2
------------- ------------ ------------ ------------ ---------- ---------
Increase in net income before taxes $ 395 11.2 % 649 18.4 % $ 3,292 93.3 %
============= ============ ============ ============ ========== =========
Increase in basic and diluted
earning per share $ -- $ 0.01 $ 0.04
=============== ============ ==========
SIX MONTHS ENDED JUNE 30, 2006
-----------------------------------------------------------------------------
CHANGE FROM DECREASE OF 100 CHANGE FROM INCREASE OF CHANGE FROM INCREASE
BASIS POINTS 100 BASIS POINTS OF 200 BASIS POINTS
--------------------------- ------------------------- ---------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ------------ ----------- ------------ ---------- ---------
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements $ 16,408 10.5 % $ (13,389) (8.6)% $ (22,324) (14.3)%
Impact of derivative settlements (19,030) (12.2) 19,030 12.2 38,060 24.5
------------- ------------ ----------- ------------ ---------- ---------
Increase (decrease) in net income before taxes $ (2,622) (1.7) % $ 5,641 3.6 % $ 15,736 10.2 %
============= ============ =========== ============ ========== =========
Increase (decrease) in basic and diluted
earning per share $ (0.03) $ 0.07 $ 0.18
============= =========== ==========
SIX MONTHS ENDED JUNE 30, 2005
-----------------------------------------------------------------------------
CHANGE FROM DECREASE OF 100 CHANGE FROM INCREASE OF CHANGE FROM INCREASE
BASIS POINTS 100 BASIS POINTS OF 200 BASIS POINTS
--------------------------- -------------------------- ---------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ------------ ------------ ------------ ---------- ---------
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements $ 20,616 19.8 % $ (18,765) (18.0)% $ (33,135) (31.8)%
Impact of derivative settlements (20,294) (19.5) 20,294 19.5 40,587 39.0
------------- ------------ ------------ ------------ ---------- ---------
Increase in net income before taxes $ 322 0.3 % 1,529 1.5 % $ 7,452 7.2 %
============= ============ ============ ============ ========== =========
Increase in basic and diluted
earning per share $ -- $ 0.02 $ 0.09
============= ============ ==========
40
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.
On February 21, 2006, and May 18, 2006, the Company completed separate debt
offerings of student loan asset-backed securities that included 420.5 million
and 352.7 million Euro-denominated notes with interest rates based on a spread
to the EURIBOR index. As a result of this transaction, the Company is exposed to
market risk related to fluctuations in foreign currency exchange rates between
the U.S. and Euro dollars. The principal and accrued interest on these notes is
re-measured at each reporting period and recorded on the Company's balance sheet
in U.S. dollars based on the foreign currency exchange rate on that date.
Changes in the principal and accrued interest amounts as a result of foreign
currency exchange rate fluctuations are included in the derivative market value
and foreign currency adjustments in the Company's consolidated statements of
operations.
The Company entered into cross-currency interest rate swaps in connection with
the issuance of the Euro Notes. Under the terms of these derivative instrument
agreements, the Company receives from a counterparty a spread to the EURIBOR
index based on notional amounts of (euro)420.5 million and (euro)352.7 million
and pays a spread to the LIBOR index based on notional amounts of $500.0 million
and $450.0 million, respectively. In addition, under the terms of these
agreements, all principal payments on the Euro Notes will effectively be paid at
the exchange rate in effect as of the issuance of the notes. The Company did not
qualify these derivative instruments as hedges under SFAS No. 133; consequently,
the change in fair value is included in the Company's operating results.
For the three and six months ended June 30, 2006, the Company recorded an
expense of $27.6 million and $38.1 million, respectively, as a result of
re-measurement of the Euro Notes and income of $28.5 million and $36.2 million,
respectively, for the increase in the fair value of the related derivative
instrument. Both of these amounts are included in derivative market value and
foreign currency adjustments on the Company's consolidated statement of income.
In addition, net settlements on the foreign currency derivative instrument were
an expense of $3.8 million and $5.0 million for the three and six months ended
June 30, 2006, respectively.
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
41
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.
ITEM 1A. RISK FACTORS
There have been no material changes from the risk factors described in the
Company's Annual Report on Form 10-K for the year ended December 31, 2005 in
response to Item 1A of Part I of such Form 10-K except as set forth below.
As has been previously disclosed, the Office of Inspector General of the
Department of Education (the "OIG") has been conducting an audit of the
Company's portfolio of student loans receiving 9.5% special allowance payments
(the "9.5% Floor"). On August 9, 2006, the Company received from the OIG a copy
of its draft audit report. The draft audit report recommends that, with respect
to the loans in question, Nelnet be required to return overpayments the OIG
contends were paid to Nelnet in connection with the 9.5% Floor and that Nelnet
be instructed to exclude such loans from its claims in the future for payment
under the 9.5% Floor. The Company has recorded approximately $322.6 million of
pre-tax income related to the 9.5% special allowance as of June 30, 2006. The
Company has 30 days to respond to the draft audit report, and any such response
may be part of any final audit report submitted by the OIG to the Department of
Education. The Department of Education may accept or reject any findings or
recommendations contained in any final audit report issued by the OIG. While the
Company cannot predict the final outcome of the audit or of any subsequent
review by the Department of Education or of any court proceedings following any
action by the Department of Education, the Company continues to believe it has
billed for the special allowance payments in accordance with applicable laws,
regulations and Department of Education guidance.
In addition, as a result of the Company's offerings of Euro-denominated notes
completed in February and May 2006, the Company is subject to increased foreign
currency exchange risk as discussed under the caption "Foreign Currency Exchange
Risk" in Item 3 of Part I of this report.
The Company's student loan origination and lending activities could be
significantly impacted by the repeal of the single holder rule. The single
holder rule, which generally restricted a competitor from consolidating loans
away from a holder that owns all of a student's loans, was abolished effective
June 15, 2006. As a result, 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, the abolition of the rule has also opened up a
portion of the rest of the market and provided the Company with the potential to
gain market share.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table summarizes the Company's repurchases of Class A common stock
during the second quarter of 2006 pursuant to a stock repurchase program
authorized on May 25, 2006 by the Company's Board of Directors. The program
allows the Company to buy back up to a total of 5 million shares of its Class A
common stock and has an expiration date of May 24, 2008 (not January 31, 2008 as
indicated in the press release dated May 25, 2006 which announced the program).
TOTAL NUMBER OF MAXIMUM NUMBER
SHARES PURCHASED OF SHARES THAT MAY
TOTAL NUMBER AVERAGE AS PART OF PUBLICLY YET BE PURCHASED
OF SHARES PRICE PAID ANNOUNCED PLANS UNDER THE PLANS
PERIOD PURCHASED PER SHARE OR PROGRAMS OR PROGRAMS
------------------- ------------ ----------- ------------------- ------------------
May 25 - 31, 2006 56,400 $ 37.20 56,400 4,943,600
June 1 - 30, 2006 (1) 284,941 38.75 284,941 4,658,659
------------ ----------- -----------------
Total 341,341 $ 38.50 341,341
============ =========== =================
(1) Includes 12,641 shares purchased under the Company's Employee
Stock Purchase Loan Plan.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's annual meeting of shareholders held on May 25, 2006, the
following proposals were approved by the margins indicated:
42
1. To elect nine directors to serve on the Company's Board of Directors for
one-year terms or until their successors are elected and qualified.
NUMBER OF SHARES
-----------------------------
VOTES FOR VOTES WITHHELD
------------- --------------
James P. Abel 172,939,826 146,939
Don R. Bouc 172,827,791 258,974
Stephen F. Butterfield 172,796,087 290,678
Michael S. Dunlap 172,795,326 291,439
Thomas E. Henning 172,995,544 91,221
Arturo R. Moreno 167,354,219 5,732,546
Brian J. O'Connor 172,991,294 95,471
Michael D. Reardon 172,940,021 146,744
James H. Van Horn 172,845,810 240,955
2. To ratify the appointment of KPMG LLP as independent auditors for 2006.
NUMBER OF SHARES
---------------------------------------------------------
VOTES FOR VOTES AGAINST ABSTAIN
----------------- ------------------ ------------------
172,763,728 178,096 139,540
3. To approve the Employee Stock Purchase Loan Plan.
NUMBER OF SHARES
---------------------------------------------------------
VOTES FOR VOTES AGAINST ABSTAIN
----------------- ------------------ ------------------
169,206,971 479,014 71,044
4. To approve an amendment to the Company's Articles of Incorporation to
increase the number of authorized shares of Class B common stock to
allow for future stock splits.
NUMBER OF SHARES
--------------------------------------------------------
VOTES FOR VOTES AGAINST ABSTAIN
(CLASS A) (CLASS A) (CLASS A)
----------------- ------------------- ----------------
26,093,531 4,165,996 67,272
NUMBER OF SHARES
--------------------------------------------------------
VOTES FOR VOTES AGAINST ABSTAIN
(CLASS B) (CLASS B) (CLASS B)
----------------- ------------------- ----------------
13,942,954 -- --
43
ITEM 6. EXHIBITS
10.1* Amended Nelnet, Inc. Restricted Stock Plan.
10.2 Agreement of Purchase and Sale dated as of May 25, 2006 between
Mad Dog Guest Ranch LLC and Nelnet, Inc., filed as Exhibit 10.1
to Nelnet, Inc.'s Current Report on Form 8-K filed on June 1,
2006 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
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NELNET, INC.
Date: August 9, 2006 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
44