UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 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 October 31, 2006, there were 38,959,471 and 13,525,812 shares of Class A
Common Stock and Class B Common Stock, par value $0.01 per share, outstanding,
respectively.
NELNET, INC.
FORM 10-Q
INDEX
SEPTEMBER 30, 2006
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements 2
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 18
Item 3. Quantitative and Qualitative Disclosures about Market Risk 41
Item 4. Controls and Procedures 47
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 47
Item 1A. Risk Factors 47
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 48
Item 6. Exhibits 51
SIGNATURES 52
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
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------- ------------
(UNAUDITED)
ASSETS:
Student loans receivable (net of allowance for loan losses of
$25,094 and $13,390, respectively) $ 22,933,718 20,260,807
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party 59,857 49,863
Cash and cash equivalents - held at a related party 228,088 53,787
------------- -------------
Total cash and cash equivalents 287,945 103,650
Restricted cash 1,309,172 1,228,570
Restricted investments 117,139 160,479
Restricted cash - due to customers 96,583 153,098
Accrued interest receivable 497,635 394,630
Accounts receivable, net 49,289 36,331
Goodwill 188,603 99,535
Intangible assets, net 169,824 153,117
Furniture, equipment, and leasehold improvements, net 57,842 36,750
Other assets 86,187 88,889
Fair value of derivative instruments, net 97,383 82,766
------------- -------------
Total assets $ 25,891,320 22,798,622
============= =============
LIABILITIES:
Bonds and notes payable $ 24,690,245 21,673,620
Accrued interest payable 147,901 94,281
Other liabilities 275,330 227,505
Due to customers 96,583 153,098
------------- -------------
Total liabilities 25,210,059 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 38,959,471 shares as of September 30,
2006 and 40,040,841 shares as of December 31, 2005 390 400
Class B, $0.01 par value. Authorized 60,000,000 shares;
issued and outstanding 13,525,812 shares as of September 30,
2006 and 13,962,954 shares as of December 31, 2005 135 140
Additional paid-in capital 181,338 220,432
Retained earnings 503,651 428,186
Unearned compensation (5,028) (86)
Employee note receivable (500) --
Accumulated other comprehensive income, net of taxes 1,275 420
------------- -------------
Total shareholders' equity 681,261 649,492
------------- -------------
COMMITMENTS AND CONTINGENCIES
Total liabilities and shareholders' equity $ 25,891,320 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 NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------------- --------------------------
2006 2005 2006 2005
------------- ------------ ------------ ------------
INTEREST INCOME:
Loan interest $ 380,136 227,750 1,068,538 619,219
Investment interest 25,986 11,491 69,841 26,643
------------- ------------ ------------ ------------
Total interest income 406,122 239,241 1,138,379 645,862
INTEREST EXPENSE:
Interest on bonds and notes payable 333,766 160,243 893,559 398,045
------------- ------------ ------------ ------------
Net interest income 72,356 78,998 244,820 247,817
Less provision for loan losses 1,700 1,402 13,508 5,557
------------- ------------ ------------ ------------
Net interest income after provision for loan losses 70,656 77,596 231,312 242,260
------------- ------------ ------------ ------------
OTHER INCOME (EXPENSE):
Loan and guarantee servicing income 48,462 37,459 139,578 109,313
Other fee-based income 31,221 10,503 65,450 22,886
Software services income 4,399 1,951 11,826 6,759
Other income 13,617 2,458 18,510 5,382
Derivative market value, foreign currency,
and put option adjustments (79,941) 65,382 (11,565) 74,300
Derivative settlements, net 4,973 (2,962) 16,419 (19,049)
------------- ------------ ------------ ------------
Total other income 22,731 114,791 240,218 199,591
------------- ------------ ------------ ------------
OPERATING EXPENSES:
Salaries and benefits 65,383 44,311 185,274 123,615
Other operating expenses:
Depreciation and amortization 10,904 5,515 30,264 14,899
Trustee and other debt related fees 3,048 1,945 9,088 6,394
Occupancy and communications 6,938 4,704 18,845 13,280
Advertising and marketing 14,872 4,112 24,913 11,860
Professional services 7,796 5,627 22,263 15,979
Postage and distribution 5,250 4,288 17,549 13,673
Other 14,651 8,433 43,165 24,502
------------- ------------ ------------ ------------
Total other operating expenses 63,459 34,624 166,087 100,587
------------- ------------ ------------ ------------
Total operating expenses 128,842 78,935 351,361 224,202
------------- ------------ ------------ ------------
Income (loss) before income taxes (35,455) 113,452 120,169 217,649
Income tax expense (benefit) (13,101) 41,091 44,462 78,974
------------- ------------ ------------ ------------
Net income (loss) before minority interest (22,354) 72,361 75,707 138,675
Minority interest in subsidiary income -- (229) (242) (229)
------------- ------------ ------------ ------------
Net income (loss) $ (22,354) 72,132 75,465 138,446
============= ============ ============ ============
Earnings (loss) per share, basic and diluted $ (0.42) 1.34 1.40 2.58
============= ============ ============ ============
Weighted average shares outstanding, basic and diluted 53,348,466 53,734,218 53,959,075 53,709,801
============= ============ ============ ============
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 RETAINED
SHARES CLASS A CLASS B STOCK CLASS A CLASS B CAPITAL EARNINGS
--------- ----------- ------------ --------- -------- ---------- ---------- ---------
Balance at June, 2005 -- 39,763,193 13,962,954 $ -- 398 140 209,949 313,378
Comprehensive income:
Net income -- -- -- -- -- -- -- 72,132
Other comprehensive income:
Cash flow hedge, net of tax -- -- -- -- -- -- -- --
Foreign currency translation -- -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock -- 10,571 -- -- -- -- 392 --
Compensation expense for
stock based awards -- -- -- -- -- -- -- --
--------- ----------- ------------ --------- -------- ---------- ---------- ---------
Balance at September 30, 2005 -- 39,773,764 13,962,954 $ -- 398 140 210,341 385,510
========= =========== ============ ========= ======== ========== ========== =========
Balance at June 30, 2006 -- 40,118,981 13,942,954 $ -- 401 139 229,994 526,005
Comprehensive loss:
Net loss -- -- -- -- -- -- -- (22,354)
Other comprehensive
income related to
foreign currency translation -- -- -- -- -- -- -- --
Total comprehensive loss
Issuance of common stock -- 34,848 -- -- 1 -- 1,063 --
Compensation expense for
stock based awards -- -- -- -- -- -- -- --
Repurchase of common stock -- (1,611,500) -- -- (16) -- (49,719) --
Conversion of common stock -- 417,142 (417,142) -- 4 (4) -- --
Loan to employee for purchase of
common stock -- -- -- -- -- -- -- --
--------- ----------- ------------ --------- -------- ---------- ---------- ---------
Balance at September 30, 2006 -- 38,959,471 13,525,812 $ -- 390 135 181,338 503,651
========= =========== ============ ========= ======== ========== ========== =========
Balance at December 31, 2004 -- 39,687,037 13,983,454 $ -- 397 140 207,915 247,064
Comprehensive income:
Net income -- -- -- -- -- -- -- 138,446
Other comprehensive income:
Cash flow hedge, net of tax -- -- -- -- -- -- -- --
Foreign currency translation -- -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock -- 66,227 -- -- 1 -- 2,426 --
Compensation expense for
stock based awards -- -- -- -- -- -- -- --
Conversion of common stock -- 20,500 (20,500) -- -- -- -- --
--------- ----------- ------------ --------- -------- ---------- ---------- ---------
Balance at September 30, 2005 -- 39,773,764 13,962,954 $ -- 398 140 210,341 385,510
========= =========== ============ ========= ======== ========== ========== =========
Balance at December 31, 2005 -- 40,040,841 13,962,954 $ -- 400 140 220,432 428,186
Comprehensive income:
Net income -- -- -- -- -- -- -- 75,465
Other comprehensive
income related to
foreign currency translation -- -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock -- 421,688 -- -- 4 -- 23,276 --
Compensation expense for
stock based awards -- -- -- -- -- -- -- --
Repurchase of common stock -- (1,940,200) -- -- (19) -- (62,370) --
Conversion of common stock -- 437,142 (437,142) -- 5 (5) -- --
Loan to employee for purchase of
common stock -- -- -- -- -- -- -- --
--------- ----------- ------------ --------- -------- ---------- ---------- ---------
Balance at September 30, 2006 -- 38,959,471 13,525,812 $ -- 390 135 181,338 503,651
========= =========== ============ ========= ======== ========== ========== =========
ACCUMULATED
COMPRE-
UNEARNED EMPLOYEE HENSIVE TOTAL
COMPEN- NOTE INCOME SHAREHOLDERS'
SATION RECEIVABLE (LOSS) EQUITY
--------- ---------- --------- -------------
Balance at June, 2005 (53) -- (142) 523,670
Comprehensive income:
Net income -- -- -- 72,132
Other comprehensive income:
Cash flow hedge, net of tax -- -- (296) (296)
Foreign currency translation -- -- 928 928
------------
Total comprehensive income 72,764
Issuance of common stock (21) -- -- 371
Compensation expense for
stock based awards 12 -- -- 12
--------- -------- ---------- ------------
Balance at September 30, 2005 (62) -- 490 596,817
========= ======== ========== ============
Balance at June 30, 2006 (5,155) (501) 1,306 752,189
Comprehensive loss:
Net loss -- -- -- (22,354)
Other comprehensive
income related to
foreign currency translation -- -- (31) (31)
------------
Total comprehensive loss (22,385)
Issuance of common stock (468) -- -- 596
Compensation expense for
stock based awards 595 -- -- 595
Repurchase of common stock -- -- -- (49,735)
Conversion of common stock -- -- -- --
Loan to employee for purchase of
common stock -- 1 -- 1
--------- -------- ---------- ------------
Balance at September 30, 2006 (5,028) (500) 1,275 681,261
========= ======== ========== ============
Balance at December 31, 2004 (77) -- 736 456,175
Comprehensive income:
Net income -- -- -- 138,446
Other comprehensive income:
Cash flow hedge, net of tax -- -- (736) (736)
Foreign currency translation -- -- 490 490
------------
Total comprehensive income 138,200
Issuance of common stock -- -- -- 2,427
Compensation expense for
stock based awards 15 -- -- 15
Conversion of common stock -- -- -- --
--------- -------- ---------- ------------
Balance at September 30, 2005 (62) -- 490 596,817
========= ======== ========== ============
Balance at December 31, 2005 (86) -- 420 649,492
Comprehensive income:
Net income -- -- -- 75,465
Other comprehensive
income related to
foreign currency translation -- -- 855 855
------------
Total comprehensive income 76,320
Issuance of common stock (6,448) -- -- 16,832
Compensation expense for
stock based awards 1,506 -- -- 1,506
Repurchase of common stock -- -- -- (62,389)
Conversion of common stock -- -- -- --
Loan to employee for purchase of
common stock -- (500) -- (500)
--------- -------- ---------- ------------
Balance at September 30, 2006 (5,028) (500) 1,275 681,261
========= ======== ========== ============
See accompanying notes to consolidated financial statements.
4
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
------------------------
2006 2005
----------- -----------
Net income $ 75,465 138,446
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 105,811 72,991
Derivative market value adjustment (23,198) (74,300)
Foreign currency transaction adjustment 30,942 --
Change in value of put options issued in business acquisitions 3,821 --
Proceeds from sale of floor contracts 8,580 --
Gain on sale of student loans (13,535) --
Non-cash compensation expense 1,850 1,728
Deferred income tax expense 25,667 36,305
Provision for loan losses 13,508 5,557
Other non-cash items 541 (811)
Increase in accrued interest receivable (103,005) (64,605)
Decrease in accounts receivable 147 300
Decrease (increase) in other assets 8,787 (2,420)
Increase in accrued interest payable 53,620 34,353
Increase (decrease) in other liabilities (10,354) (6,807)
----------- -----------
Net cash provided by operating activities 178,647 140,737
----------- -----------
Cash flows from investing activities, net of business acquisitions:
Originations, purchases, and consolidations of student loans,
including loan premiums and deferred origination costs (4,910,997) (3,050,807)
Purchases of student loans, including loan premiums,
from a related party (498,771) (1,022,700)
Net proceeds from student loan repayments, claims,
capitalized interest, and other 2,111,413 1,098,101
Proceeds from sale of student loans 560,916 --
Purchases of furniture, equipment, and leasehold improvements, net (26,199) (14,154)
Increase in restricted cash (80,602) (263,770)
Purchases of restricted investments (590,009) (640,384)
Proceeds from maturities of restricted investments 633,349 766,067
Purchase of loan origination rights -- (260)
Business acquisitions, net of cash acquired (99,388) (78,612)
Distributions from equity method investments -- 625
----------- -----------
Net cash used in investing activities (2,900,288) (3,205,894)
----------- -----------
Cash flows from financing activities:
Payments on bonds and notes payable (2,741,641) (1,767,330)
Proceeds from issuance of bonds and notes payable 5,649,381 4,885,400
Proceeds from issuance of notes payable due to a related party, net 74,292 --
Payments of debt issuance costs (14,770) (16,184)
Proceeds from issuance of common stock 1,247 714
Repurchases of common stock (62,389) --
Loan to employee for purchase of common stock (500) --
----------- -----------
Net cash provided by financing activities 2,905,620 3,102,600
----------- -----------
Effect of exchange rate fluctuations on cash 316 296
Net increase in cash and cash equivalents 184,295 37,739
Cash and cash equivalents, beginning of period 103,650 39,989
----------- -----------
Cash and cash equivalents, end of period $ 287,945 77,728
=========== ===========
Supplemental disclosures of cash flow information:
Interest paid $ 818,317 354,090
=========== ===========
Income taxes paid, net of refunds $ 52,627 47,589
=========== ===========
Supplemental disclosures of noncash operating, investing, and financing
activities regarding the Company's acquisitions are contained in note 4.
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF SEPTEMBER 30, 2006 AND FOR THE THREE AND NINE MONTHS ENDED
SEPTEMBER 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 September 30, 2006 and for the three and nine
months ended September 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 nine months ended September
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. RECENT DEVELOPMENTS
Based on provisions of the Higher Education Act and regulations and guidance of
the U.S. Department of Education (the "Department") and related interpretations,
education lenders may receive special allowance payments from the Department
which provide a minimum 9.5% interest rate (the "9.5% Floor") on loans currently
financed or financed prior to September 30, 2004 with proceeds of tax-exempt
obligations originally issued prior to October 1, 1993. A portion of the
Company's Federal Family Education Loan Program (the "FFEL Program" or "FFELP")
loan portfolio is comprised of loans financed prior to September 30, 2004 with
tax-exempt obligations originally issued prior to October 1, 1993. Accordingly,
the Company believes that it is entitled to receive special allowance payments
on these loans equal to the 9.5% Floor. As of September 30, 2006, the Company
had $3.1 billion of FFELP loans it has determined are eligible to receive
special allowance payments at the 9.5% Floor rate. Of this portfolio, $2.5
billion in loans were financed prior to September 30, 2004 with proceeds of
tax-exempt obligations originally issued prior to October 1, 1993 and then
subsequently sold to taxable obligations, without retiring the tax-exempt
obligations.
In May 2003, the Company sought confirmation from the Department regarding
whether the Company was allowed to receive the special allowance payments based
on the 9.5% Floor on loans being acquired with funds obtained from the proceeds
of tax-exempt obligations originally issued prior to October 1, 1993 and then
subsequently sold using proceeds of taxable obligations without retiring the
tax-exempt obligations. In June 2004, after consideration of certain clarifying
information received in connection with the guidance the Company had sought, and
based on written and verbal communications with the Department, including
written confirmation from the Department that the public could continue to rely
on a Department guidance letter issued in March 1996, the Company concluded that
the earnings process had been completed and recognized the previously deferred
income of $124.3 million on this portfolio. Pending satisfactory resolution of
this issue, the Company deferred recognition of that portion of the 9.5% Floor
income generated by these loans which exceeded statutorily defined special
allowance rates under a taxable financing.
In October 2004, Congress passed and President Bush signed into law the
Taxpayer-Teacher Protection Act of 2004 (the "October 2004 Act"), which
prospectively suspended eligibility for the 9.5% Floor on any loans sold
to taxable obligations between September 30, 2004 and January 1, 2006. This
suspension of eligibility for the 9.5% Floor was made permanent under the
Deficit Reduction Act of 2005. The loans in the Company's student loan portfolio
that have been sold to taxable obligations and are receiving special
allowance payments under the 9.5% Floor were all sold to taxable obligations
before September 30, 2004. In April 2004, the Company ceased adding to its
portfolio of loans receiving special allowance payments subject to the 9.5%
Floor financed with taxable debt, and thus the provisions of the October 2004
Act or the Deficit Reduction Act of 2005 do not have an effect upon the
eligibility of such loans to receive the 9.5% Floor.
In June 2005, the Office of Inspector General of the Department of Education
(the "OIG") commenced an audit of the portion of the Company's student loan
portfolio receiving 9.5% Floor special allowance payments. In August 2006, the
Company received a draft of the audit report, which the Company responded to on
September 7, 2006, and on September 29, 2006, the Company received a copy of the
final audit report from the OIG related to this audit.
6
The final audit report contains a finding by the OIG that an increase in the
amount of 9.5% special allowance payments that have been received by the Company
was based on what the OIG deemed to be ineligible loans. Such loans are deemed
by the OIG to be ineligible for 9.5% special allowance payments due to
interpretive issues related to the legal characterization of refinancing
transfers of qualifying loans from a trust for tax-exempt financing obligations
originally issued prior to October 1, 1993 to trusts for taxable obligations,
and the extent to which sales of qualifying loans can result in qualification of
additional loans. The audit report also contains a recommendation by the OIG
that the Department require the Company to calculate and return what the OIG
deems to be overpayments attributable to the deemed ineligible loans, and
instruct the Company to exclude such loans from future claims for 9.5% special
allowance payments. The Department may accept or reject the finding or
recommendation of the OIG contained in the final audit report.
Through June 30, 2006, the Company recorded approximately $322.6 million of
pre-tax income related to that portion of the 9.5% special allowance payments
received which exceeds regular special allowance payments on the underlying
loans at the otherwise applicable statutory rate. Management believes that, if
the recommendation contained in the OIG's final audit report is implemented by
the Department and upheld after any administrative or other legal proceedings, a
significant portion of those payments would be disallowed and would need to be
returned by the Company.
On October 6, 2006, the Company received a letter from the Department related to
the OIG audit report. The Department's letter indicated that, effective July 1,
2006 until the issues raised in the OIG audit report are resolved, the
Department will pay future regular special allowance payments on the underlying
loans at the generally applicable statutory rate, and not the 9.5% special
allowance rate. The letter also stated that if resolution of the audit upholds
the propriety of the Company's billings for special allowance payments at the
9.5% minimum rate, the Department will pay the withheld amounts. As a result of
receipt of this letter, the Company has determined to defer recognition of the
9.5% special allowance payments for which the Department has withheld payment
pending satisfactory resolution of this issue. Income from the 9.5% special
allowance payments withheld would have been $8.9 million for the three months
ended September 30, 2006.
The Company disagrees with the OIG's final audit report, and continues to
believe that the Company has billed for the 9.5% special allowance payments in
accordance with applicable laws, regulations, and the Department's previous
guidance. The Company intends to seek a satisfactory resolution of this matter
with the Department, and examine other remedies if a satisfactory resolution
cannot be reached with the Department; however, the Company cannot predict the
final outcome of any subsequent review by the Department or of any
administrative or other legal proceedings following any further action by the
Department. If the Company is ultimately required to return deemed overpayments
in connection with the 9.5% special allowance payment program, is no longer
eligible to receive 9.5% special allowance payments, and/or incurs significant
other costs, expenses or loss of revenues associated with an adverse final
outcome of this matter, it may have a material adverse effect on the Company's
financial condition and results of operations. However, it is the opinion of the
Company's management, based on information currently known, that it would not
have a material adverse effect on the Company's ongoing business operations.
3. STUDENT LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
Student loans receivable consist of the following:
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------- --------------
Federally insured loans $22,354,199 19,816,075
Non-federally insured loans 180,462 96,880
------------- --------------
22,534,661 19,912,955
Unamortized loan premiums and deferred
origination costs 424,151 361,242
Allowance for loan losses - federally insured loans (7,517) (98)
Allowance for loan losses - non-federally
insured loans (17,577) (13,292)
------------- --------------
$22,933,718 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 FFEL Program through 2012. One of the provisions of HERA reduced 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 these changes, 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
September 30, 2006, the balance of loans participated under this agreement was
$35.9 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.
7
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
nine months ended September 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. Subsequent to September 30, 2006, the
Company sold an additional $9.5 million (par value) of student loans to the
Texas Foundation under this agreement.
During the three months ended September 30, 2006, the Company sold $353.2
million (par value) of student loans to an unrelated party resulting in the
recognition of an $11.7 million gain which is included in other income in the
accompanying consolidated statements of operations. Loans sold under this
agreement were originated by Nova Southeastern University ("Nova"), a
school-as-lender customer, and were not serviced by the Company and, as such,
management believed these loans were at a greater risk of being consolidated
away from the Company by third parties.
4. ACQUISITIONS
INFINET INTEGRATED SOLUTIONS, INC. ("INFINET")
Effective January 31, 2006, the Company purchased the remaining 50% of the stock
of 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
===========
8
FACTS MANAGEMENT CO. ("FACTS")
Effective June 1, 2005, the Company purchased 80% of the capital stock of 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. 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.
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
=========== ============ =========
CUNET, LLC ("CUNET")
On June 30, 2006, the Company purchased 100% of the membership interests of
CUnet. The initial consideration paid by the Company was $40.0 million in cash.
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 have been included in the consolidated financial statements from the
effective date of the acquisition.
9
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 CUnet is shown
below:
Accounts receivable $ 5,033
Furniture, equipment, and leasehold improvements 223
Other assets 397
Intangible assets 16,402
Excess cost over fair value of net assets acquired 22,075
Other liabilities (4,130)
----------
$ 40,000
==========
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 of
Peterson's 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 was accounted
for as a business combination under purchase accounting and the results of
operations have been included in the consolidated financial statements from the
effective date of the acquisition.
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 Peterson's is
shown below:
Accounts receivable $ 7,055
Furniture, equipment, and leasehold improvements 6,055
Other assets 2,493
Excess cost over fair value of net assets acquired 37,081
Other liabilities (14,047)
----------
$ 38,637
==========
2005 ACQUISITIONS
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 2006, the Company paid $1.2 million (net) to settle all
obligations associated with this acquisition.
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.
PRO FORMA INFORMATION
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, FACTS (20%), CUnet, and Peterson's
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).
10
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- ------------------------
2006 2005 2006 2005
------------ ----------- ----------- -----------
Net interest income $ 72,356 86,090 244,860 265,967
Other income (expense) (a) 25,570 136,043 275,651 271,072
Net income (loss) (22,334) 73,639 75,507 139,174
Weighted average shares outstanding,
basic and diluted 53,348,466 54,326,595 53,996,958 54,302,178
Earnings (loss) per share, basic and diluted $ (0.42) 1.36 1.40 2.56
(a) Other income (expense) includes derivative market value, foreign currency,
and put option adjustments and net derivative settlements.
5. INTANGIBLE ASSETS AND GOODWILL
Intangible assets consist of the following:
WEIGHTED
AVERAGE
REMAINING
USEFUL LIFE AS OF AS OF AS OF
SEPTEMBER 30, SEPTEMBER 30, DECEMBER 31,
2006 2006 2005
---------------- ------------- ------------
Amortizable intangible assets:
Customer relationships (net of accumulated
amortization of $10,017 and $3,771, respectively) 126 months $ 73,306 70,369
Loan origination rights (net of accumulated
amortization of $8,268 and $2,505, respectively) 72 months 43,930 49,694
Covenants not to compete (net of accumulated
amortization of $4,393 and $499, respectively) 55 months 20,975 3,874
Student lists (net of accumulated amortization
of $3,245 and $1,708, respectively) 29 months 4,952 6,489
Trade names (net of accumulated amortization
of $277 and $54, respectively) 47 months 2,254 767
Computer software (net of accumulated
amortization of $1,423 and $677, respectively) 37 months 1,439 1,644
---------------- ----------- -------------
Total - amortizable intangible assets 94 months 146,856 132,837
================
Unamortizable intangible assets - trade names 22,968 20,280
----------- -------------
$ 169,824 153,117
=========== =============
The Company recorded amortization expense on its intangible assets of $6.5
million and $1.9 million for the three months ended September 30, 2006 and 2005,
respectively, and $18.3 million and $4.7 million for the nine months ended
September 30, 2006 and 2005, respectively. The Company will continue to amortize
intangible assets over their remaining useful lives. As disclosed in note 4, the
Company is in the process of obtaining third party valuations of certain
intangible assets; however, as of September 30, 2006 the Company estimates it
will record amortization expense as follows:
2006 $ 6,580
2007 26,023
2008 25,160
2009 22,650
2010 19,573
2011 and thereafter 46,870
---------
$146,856
=========
11
The change in the carrying amount of goodwill by operating segment was as
follows:
STUDENT LOAN PAYMENT
ASSET AND 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 acquired 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
=========== ========== ========= ========= ========== ==========
Goodwill acquired during the period -- -- -- 37,081 435 37,516
Goodwill from prior period acquisition
allocated during the current period 777 -- -- 1,163 -- 1,940
Effect of foreign currency fluctuations -- (1) -- -- -- (1)
----------- ---------- --------- --------- ---------- ----------
Balance as of September 30, 2006 $ 36,546 3,197 11,059 76,306 61,495 188,603
=========== ========== ========= ========= ========== ==========
6. BONDS AND NOTES PAYABLE
ASSET-BACKED SECURITIZATIONS
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 initially based on a spread to EURIBOR (the "Euro Notes").
As of June 30, 2006 and September 30, 2006, the Euro Notes were recorded on the
Company's balance sheet at $988.1 million and $980.9 million, respectively,
based on the foreign currency exchange rate as of the respective balance sheet
dates. The decrease in the principal amount of the Euro Notes of $7.2 million
for the three months ended September 30, 2006, and increase in the principal
amount of Euro Notes of $30.9 million for the nine months ended September 30,
2006 as a result of the foreign currency exchange rate fluctuations are included
in the derivative market value, foreign currency, and put option adjustments in
the accompanying consolidated statements of operations. Concurrently with the
issuances of the Euro Notes, the Company entered into cross-currency interest
rate swaps which are further discussed in note 7.
SECURED LIQUIDITY NOTES
In August 2006, the Company established a $5.0 billion loan warehouse program
under which it will issue one or more short-term extendable secured liquidity
notes (the "Secured Liquidity Notes"). Each Secured Liquidity Note will be
issued at a discount or an interest-bearing basis having an expected maturity of
between 1 and 307 days (each, an "Expected Maturity") and a final maturity of 90
days following the Expected Maturity. The Secured Liquidity Notes issued as
interest-bearing notes may be issued with fixed interest rates or with interest
rates that fluctuate based upon a one-month LIBOR rate, a three-month LIBOR
rate, a commercial paper rate, or a federal funds rate. The Secured Liquidity
Notes are not redeemable by the Company nor subject to voluntary prepayment
prior to the Expected Maturity date. The Secured Liquidity Notes are secured by
FFELP loans purchased in connection with the program. As of September 30, 2006,
the Company has $1.3 billion of Secured Liquidity Notes outstanding and $3.7
billion of capacity remaining under this warehouse program.
CAPITAL EFFICIENT NOTES
On September 27, 2006 the Company consummated a debt offering of $200.0 million
aggregate principal amount of Capital Efficient Notes ("CENts"). The CENts were
offered under the Company's $750.0 million universal shelf registration
statement filed with the Securities and Exchange Commission on April 13, 2005.
The CENts are unsecured obligations of the Company.
12
The interest rate on the CENts from the date they were issued through September
28, 2011 is 7.40%, payable semi-annually. Beginning September 29, 2011 through
September 29, 2036, the "scheduled maturity date", the interest rate on the
CENts will be equal to three-month LIBOR plus 3.375%, payable quarterly. The
principal amount of the CENts will become due on the scheduled maturity date
only to the extent that the Company has received proceeds from the sale of
certain qualifying capital securities prior to such date (as defined in the
CENts' prospectus). If any amount is not paid on the scheduled maturity date, it
will remain outstanding and bear interest at a floating rate as defined in the
prospectus, payable monthly. On September 15, 2061, the Company must pay any
remaining principal and interest on the CENts in full whether or not the Company
has sold qualifying capital securities.
At the Company's option, the CENts are redeemable (i) in whole or in part, at
any time on or after September 29, 2011, at their principal amount plus accrued
and unpaid interest, provided in the case of a redemption in part that the
principal amount outstanding after such redemption is at least $50.0 million, or
(ii) in whole, but not in part, prior to September 29, 2011, after certain
events involving taxation (as described in the CENts prospectus).
OTHER
As of September 30, 2006, bonds and notes payable includes $74.3 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.
7. DERIVATIVE FINANCIAL INSTRUMENTS
The Company maintains an overall risk management strategy that incorporates the
use of derivative instruments to reduce the economic effect of interest rate
volatility and fluctuations in foreign currency exchange rates. Derivative
instruments used as part of the Company's risk management strategy include
interest rate swaps, basis swaps, interest rate floor contracts, and
cross-currency interest rate swaps.
INTEREST RATE SWAPS
The following table summarizes the Company's outstanding interest rate swaps as
of September 30, 2006:
WEIGHTED
AVERAGE FIXED
RATE PAID
MATURITY NOTIONAL AMOUNT BY THE COMPANY
---------- ---------------- --------------
2006 $ 250,000 3.16 %
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 $ 3,475,000 3.98 %
================ ==============
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.
In addition to the three basis swaps summarized above, the Company also had a
basis swap with a notional amount of $500.0 million which matured in August 2006
in which the Company paid a floating interest rate based on the U.S. Treasury
bill rate and received 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.
13
The following provide the terms of these contracts:
AMORTIZING FLOOR STRIKE
NOTIONAL AMOUNT RATE
--------------- ----
$ 50,354 2.760%
44,068 2.885%
37,499 3.010%
34,338 3.135%
46,550 3.260%
76,911 3.385%
50,379 3.510%
52,793 3.635%
46,012 3.760%
45,159 3.885%
40,352 4.010%
63,002 4.135%
24,044 4.460%
31,648 5.060%
37,103 5.510%
7,097 4.300%
21,969 4.550%
17,220 4.800%
62,466 5.550%
--------------
$ 788,964
==============
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 April 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 6. 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.
ACCOUNTING FOR DERIVATIVE FINANCIAL INSTRUMENTS
The Company accounts for derivative instruments under Statement of Financial
Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND
HEDGING ACTIVITIES ("SFAS No. 133"), which requires that every derivative
instrument be recorded on the balance sheet as either an asset or liability
measured at its fair value. Management has structured all of the Company's
derivative transactions with the intent that each is economically effective;
however, the 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.
As of September 30, 2006, the net fair value of the Company's derivative
portfolio was $97.4 million and the net change in the fair value of the
Company's derivative portfolio was an $83.5 million decrease and a $65.4 million
increase for the three months ended September 30, 2006 and 2005, respectively,
and increases of $23.2 million and $74.3 million for the nine months ended
September 30, 2006 and 2005, respectively.
14
The following table summarizes the components included in derivative settlements
on the consolidated statements of operations:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- --------------------
2006 2005 2006 2005
----------- --------- --------- ---------
Interest rate swaps $ 12,226 (972) 29,151 (3,053)
Basis swaps (145) (1,990) (656) (15,996)
Cross-currency interest rate swaps (5,115) -- (10,083) --
Other (1) (1,993) -- (1,993) --
----------- --------- --------- ---------
Derivative settlements, net $ 4,973 (2,962) 16,419 (19,049)
=========== ========= ========= =========
(1) In connection with the issuance of the CENts described in note 6, the
Company entered into a derivative instrument to economically lock into a
fixed interest rate of 7.65% prior to the actual pricing of the
transaction. Upon pricing of the CENts, the Company terminated this
derivative instrument. The consideration paid by the Company to
terminate this derivative was $2.0 million, which is reflected as a
derivative settlement in the accompanying consolidated statements of
operations.
8. STOCKHOLDERS' EQUITY
CONVERSION OF CLASS B COMMON STOCK
In February and August 2006, principal shareholders gifted 20,000 and 17,142,
respectively, Class B shares of common stock to certain charitable
organizations. In September 2006, a principal shareholder sold 400,000 Class B
shares of common stock to another principal shareholder in a private
transaction. 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. In
June 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 and nine months ended September 30, 2006, the Company
repurchased and retired 1,611,500 and 1,940,200 Class A common shares for $49.7
million and $62.4 million (average price of $30.82 and $32.12 per share),
respectively, under this authority.
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 2016 and bears interest equal to the
three-month LIBOR rate plus 50 basis points. The balance of this loan totaled
$0.5 million at September 30, 2006, and is reflected as a reduction to
stockholders' equity on the consolidated balance sheet.
15
9. 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.
The Asset Management segment includes the acquisition, management, and ownership
of the Company's 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 schools and businesses reach the middle school, high
school, college bound high school, college, and/or young adult market places.
This segment also provides a suite of education and career-related solutions for
families in the areas of education search, test preparation, admissions,
financial aid information, and career assistance. 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 nine months ended September 30, 2006, the Company
recognized $16.3 million and $48.2 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 nine
months ended September 30, 2006, the Company recognized $13.1 million, or 27.1%,
and $37.3 million, or 26.8%, 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.
16
Segment data is as follows:
THREE MONTHS ENDED SEPTEMBER 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 $ 75,044 2,519 1,088 78,651 80,363 1,275 555 82,193
Other income (expense) (54,824) 43,079 33,030 26,285 64,800 37,455 10,257 112,512
Intersegment revenues -- 38,358 4,757 43,115 -- 29,681 716 30,397
--------- ---------- -------- ---------- --------- --------- --------- ---------
Total revenue 20,220 88,956 38,875 148,051 145,163 68,411 11,528 225,102
Provision for loan losses 1,700 -- -- 1,700 1,402 -- -- 1,402
Depreciation and amortization 1,583 2,400 3,540 7,523 32 1,153 1,306 2,491
Net income (loss) before taxes (24,685) 18,721 4,469 (1,495) 112,823 22,432 2,946 138,201
SIX MONTHS ENDED SEPTEMBER 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 $252,595 6,082 2,610 261,287 248,979 2,706 680 252,365
Other income (expense) 34,682 138,331 68,711 241,724 62,214 109,298 23,293 194,805
Intersegment revenues -- 106,061 14,135 120,196 -- 82,613 2,901 85,514
--------- ---------- -------- ---------- --------- --------- --------- ---------
Total revenue 287,277 250,474 85,456 623,207 311,193 194,617 26,874 532,684
Provision for loan losses 13,508 -- -- 13,508 5,557 -- -- 5,557
Depreciation and amortization 4,749 7,161 8,306 20,216 90 3,023 3,160 6,273
Net income before taxes 148,494 48,339 16,986 213,819 216,046 60,501 9,557 286,104
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
2006 2005
-------------- --------------
Segment total assets:
Asset management $ 25,162,078 22,316,657
Student loan and guarantee
servicing 736,804 505,958
Other 309,120 156,548
-------------- --------------
Total segments $ 26,208,002 22,979,163
============== ==============
Reconciliation of segment data to the consolidated financial statements is as
follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- -------------------
2006 2005 2006 2005
---------- --------- --------- ---------
Total segment revenues $ 148,051 225,102 623,207 532,684
Elimination of intersegment revenues (43,115) (30,397) (120,196) (85,514)
Unsecured debt interest expense (6,597) (3,696) (17,382) (5,595)
Put option adjustment (3,536) -- (3,821) --
Corporate activities' revenues, net
income before taxes 284 2,780 3,230 5,833
---------- --------- --------- ---------
Total consolidated revenues $ 95,087 193,789 485,038 447,408
========== ========= ========= =========
Total net income before taxes
of segments $ (1,495) 138,201 213,819 286,104
Corporate activities' net income
before taxes (33,960) (24,749) (93,650) (68,455)
---------- --------- --------- ---------
Total consolidated net income
(loss) before taxes $ (35,455) 113,452 120,169 217,649
========== ========= ========= =========
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 (included in corporate activities' net income before taxes) 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.
17
AS OF AS OF
SEPTEMBER 30, DECEMBER 31,
2006 2005
------------- -------------
Total segment assets $ 26,208,002 22,979,163
Elimination of intercompany assets (390,436) (247,982)
Corporate assets 73,754 67,441
------------- -------------
Total consolidated assets $ 25,891,320 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.
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 NINE MONTHS ENDED SEPTEMBER 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. In addition, a larger than
expected increase in third party consolidations of our FFELP loans could
materially adversely affect our results of operations. 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, guaranty
rates, loan floor 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
September 30, 2006:
18
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.
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 schools and businesses reach the middle school,
high school, college bound high school, college, and/or young adult market
places. This segment also provides a suite of education and career-related
solutions for families in the areas of education search, test preparation,
admissions, financial aid information, and career assistance. In addition,
this segment 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:
NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------------------------------------
2006 2005
------------------------------- -------------------------------
STUDENT STUDENT
LOAN AND LOAN AND
ASSET GUARANTEE OTHER ASSET GUARANTEE OTHER
MANAGEMENT SERVICING SEGMENTS MANAGEMENT SERVICING SEGMENTS
Segment revenues 57.1% 28.7% 14.2% 69.6% 25.0% 5.4%
Segment net income before
taxes 69.4% 22.6% 8.0% 75.5% 21.1% 3.4%
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;
19
o the interest rate environment, funding spreads on the Company's
financing programs, and access to capital markets; and
o prepayment rates on student loans, including prepayments relating to loan
consolidations.
The Company's net interest income, or net interest earned on its student loan
portfolio, is 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 originated prior to April 1,
2006 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. 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. As a result of one of the provisions of HERA, the
Company's portfolio of FFELP loans originated on or after April 1, 2006 earns
interest at a variable rate based on the SAP formula. For this portfolio of
loans, when the borrower rate exceeds the variable rate based on the SAP
formula, the Company must return the excess to the Department.
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. As of September 30, 2006, the Company's non-consolidation
portfolio was 30.5% of its total portfolio. For the three and nine months ended
September 30, 2006 the Company's net consolidation originations were $767.3
million and $1.8 billion, respectively, and the consolidation loans lost to
external parties were $342.4 million and $923.6 million, respectively.
The Company's core spread on its portfolio of student loans has decreased from
1.54% to 1.45% for the nine months ended September 30, 2005 and 2006,
respectively, and from 1.46% to 1.34% for the three months ended September 30,
2005 and 2006, respectively. This decrease is primarily due to (i) an increase
in lower yielding consolidation loans and increase in the consolidation rebate
fees; and (ii) the mismatch in the reset frequency between the Company's
floating rate assets and floating rate liabilities. During the third quarter
2006, interest rates remained relatively flat as compared to the prior two years
in which there was a rising interest rate environment. The Company's core
student loan spread benefited in the rising interest rate environment because
the Company's cost of funds reset quarterly on the discreet basis while the
Company's student loans kept increasing in yield on an average daily basis. 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
20
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.
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:
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.
Student Loan and Guarantee Servicing
On October 31, 2005, the Company entered into an agreement to amend an existing
contract with 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.
Direct Marketing
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.
21
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.
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.
Payment Management Services
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.
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.
The Company's portfolio of FFELP loans originated prior to April 1, 2006 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. 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. As a result of one of the provisions of HERA, the Company's portfolio of
FFELP loans originated on or after April 1, 2006 earns interest at a variable
rate based on the SAP formula. For the portfolio of loans originated on or after
April 1, 2006, when the borrower rate exceeds the variable rate based on the SAP
formula, the Company must return the excess to the Department.
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.
RECENT DEVELOPMENTS- SPECIAL ALLOWANCE YIELD ADJUSTMENT
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 $3.1 billion in loans held by the Company as of September 30,
2006 that the Company has determined are eligible to receive the 9.5% Floor,
22
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. In June
2005, the OIG commenced an audit of the portion of the Company's student loan
portfolio receiving 9.5% Floor special allowance payments. On September 29,
2006, the Company received a copy of the final audit report from the OIG related
to this audit.
The final audit report contained a finding by the OIG that an increase in the
amount of 9.5% special allowance payments that have been received by the Company
was based on what the OIG deemed to be ineligible loans. Such loans are deemed
by the OIG to be ineligible for 9.5% special allowance payments due to
interpretive issues related to the legal characterization of refinancing
transfers of qualifying loans from a trust for tax-exempt financing obligations
originally issued prior to October 1, 1993 to trusts for taxable obligations,
and the extent to which sales of qualifying loans can result in qualification of
additional loans. The audit report also contains a recommendation by the OIG
that the Department require the Company to calculate and return what the OIG
deems to be overpayments attributable to the deemed ineligible loans, and
instruct the Company to exclude such loans from future claims for 9.5% special
allowance payments.
On October 6, 2006, the Company received a letter from the Department related to
the audit report. The Department's letter indicated that, until the issues
raised by the OIG audit report are resolved, the Department will pay future
regular special allowance payments on the underlying loans at the generally
applicable statutory rate, and not the 9.5% special allowance rate. The letter
also stated that if resolution of the audit upholds the propriety of the
Company's billings for special allowance payments at the 9.5% minimum rate, the
Department will pay the withheld amounts. As a result of this letter, the
Company deferred the special allowance yield adjustment earned for the three
months ended September 30, 2006 of $8.9 million.
See note 2, "Recent Developments," in the accompanying financial statements for
additional information related to the Company's 9.5% portfolio and the OIG
audit.
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
September 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).
23
In June 2006, the Company submitted its application for Exceptional Performer
redesignation to the Department. Until the Department confirms or denies the
Company's application for renewal, 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 September 30, 2006, this provision
would be approximately $13.8 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 the sale of academic
publications, lists, leads, and online academic services. 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 academic publications, lists, leads, and online
services is recognized when the products are shipped/delivered or over the term
of the subscription period.
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." In addition, the change in the fair
value of put options (issued as part of the consideration for certain business
combinations) is included in other income.
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 SEPTEMBER 30, 2006 COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 2005
INTEREST INCOME. Interest income for the three months ended September 30, 2006
increased $166.9 million compared to the same period in 2005 as reflected in the
following table and explained below.
THREE MONTHS ENDED
SEPTEMBER 30, CHANGE
---------------------- -----------------
2006 2005 DOLLARS PERCENT
----------- ---------- --------- -------
Loan interest, excluding special
allowance yield adjustment $ 441,678 251,609 190,069 75.5 %
Special allowance yield adjustment -- 21,766 (21,766) (100.0)
Consolidation rebate fees (39,974) (25,584) (14,390) (56.2)
Amortization of loan premiums and
deferred origination costs (21,568) (20,041) (1,527) (7.6)
----------- ---------- ---------
Total loan interest 380,136 227,750 152,386 66.9
Investment interest 25,986 11,491 14,495 126.1
----------- ---------- ---------
Total interest income $ 406,122 239,241 166,881 69.8
=========== ========== =========
24
o The average student loan portfolio increased $6.5 billion, or 42%, for
the three months ended September 30, 2006 compared to 2005. When
excluding the special allowance yield adjustment, the student loan yield
increased to 7.91% in 2006 from 6.39% 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 $190.1
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 $21.8 million. As
discussed in note 2 to the financial statements in this Quarterly
Report, the Company deferred recognition of the portion of the 9.5%
special allowance payments currently being withheld by the Department
during the three months ended September 30, 2006.
o Consolidation rebate fees increased due to the $5.5 billion increase in
the consolidation loan portfolio to $15.7 billion at September 30, 2006
from $10.2 billion at September 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
business combinations, and as a result of the rising interest rate
environment.
INTEREST EXPENSE. Interest on bonds and notes payable for the three months ended
September 30, 2006 increased $173.5 million compared to the same period in 2005
as reflected in the following table and explained below.
THREE MONTHS ENDED
SEPTEMBER 30, CHANGE
--------------------- ------------------
2006 2005 DOLLARS PERCENT
---------- ---------- --------- -------
Interest expense on debt funding loan assets $ 327,169 157,015 170,154 108.4 %
Interest expense on debt funding operations 6,597 3,653 2,944 80.6
Other -- (425) 425 100.0
---------- ---------- ---------
Total interest expense $ 333,766 160,243 173,523 108.3
========== ========== =========
o Average debt increased approximately $7.3 billion, or 44%, for the three
months ended September 30, 2006 compared to 2005 and the Company's cost
of funds increased to 5.44% for the three months ended September 30,
2006 up from 3.76% for the same period a year ago. Together these two
factors resulted in a $170.2 million increase in interest expense
related to debt used to fund the Company's loan assets.
o Interest expense increased approximately $2.7 million as a result of
increased borrowings on the Company's unsecured operating line of
credit. The average outstanding balance on this credit facility was
$161.3 million during the three months ended September 30, 2006. The
Company had no borrowings on its unsecured operating line during the
same period in 2005.
LOAN AND GUARANTEE SERVICING INCOME. Loan and guarantee servicing income has
increased $11.0 million for the three months ended September 30, 2006 compared
to the same period in 2005. Several factors have contributed to this change as
follows:
Three months ended September 30, 2005 $ 37,459
Acquisition-related activities:
Acquisition of private loan servicing operations (FirstMark) 2,748
Expansion of guarantee servicing operations related
to amended agreement with CAN 6,992
Existing operations:
Increase in loan servicing revenue from Canadian operations (a) 1,387
Decrease in loan servicing revenue from U.S. operations (b) (350)
Other 226
---------
Three months ended September 30, 2006 $ 48,462
=========
(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 volume added as a result of the
acquisitions of LoanSTAR, CAN, and Chela.
25
OTHER FEE-BASED INCOME. Other fee-based income has increased $20.7 million for
the three months ended September 30, 2006 compared to the three months ended
September 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 September 30, 2005 $ 10,503
Acquisition-related activities:
Acquisition of payment management company (infiNET) 1,513
Acquisition of direct marketing companies
CUnet 11,556
Peterson's 5,230
Existing operations:
Increased list sales due to customer demand 1,236
Increased payment management fees due to increased volume 869
Increased borrower late fee income due to student
loan portfolio growth 524
Other (210)
---------
Three months ended September 30, 2006 $ 31,221
=========
SOFTWARE SERVICES INCOME. Software services income has increased $2.4 million
from $2.0 million for the three months ended September 30, 2005 to $4.4 million
for the three months ended September 30, 2006. Software services income
increased $2.7 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 specialty software consulting.
OTHER INCOME. Other income increased $11.1 million from $2.5 million for the
three months ended September 30, 2005 to $13.6 million for the three months
ended September 30, 2006. Other income for the three months ended September 30,
2006 includes income of $11.7 million from the sale of loan assets as described
in note 3 to the financial statements in this Quarterly Report. In addition,
income from equity method investments has decreased $0.6 million as the result
of the Company's acquisition of the remaining 50% interests in infiNET, 5280,
and Firstmark as discussed in this Quarterly Report under "Business and Asset
Acquisitions." The revenues from these companies are now classified as discussed
in the results of operations above.
DERIVATIVE MARKET VALUE, FOREIGN CURRENCY, AND PUT OPTION ADJUSTMENTS. The
components of the derivative market value, foreign currency, and put option
adjustments for the three months ended September 30, 2006 and 2005 are as
follows:
2006 2005
--------- ---------
Interest rate swaps, basis swaps, and
interest rate floor contracts (a) $ (71,136) 65,382
Re-measurement of Euro Notes (b) 7,113 --
Cross-currency interest rate swaps (b) (12,382) --
Put option agreements ( c) (3,536) --
--------- ---------
Derivative market value, foreign currency, and
put option adjustments $ (79,941) 65,382
========= =========
(a) The Company's derivative instruments do not qualify for hedge
accounting under the provisions of SFAS No. 133. As such, the
change in fair value each reporting period is recognized in the
statement of operations.
(b) In February and May 2006, the Company consummated debt offerings
of student loan asset-backed notes that included notes
denominated in Euros with variable interest rates based on a
spread to EURIBOR (the "Euro Notes"). The Company re-measures the
Euro Notes to U.S. dollars at each balance sheet date and the
change in value is recognized in the statement of operations.
Concurrently with the issuances of the Euro Notes, the Company
entered into cross-currency interest rate swaps. These derivative
instruments do not qualify for hedge accounting and, accordingly,
the change in fair value of these instruments is recognized in
the statement of operations.
(c) In connection with the acquisitions of 5280 in December 2005 and
FACTS in January 2006, the Company issued stock subject to put
option arrangements whereby the holders of such shares can
require the Company to repurchase the shares at a defined price.
The Company records the put options at fair value at each balance
sheet date and the change in value is recognized in the statement
of operations.
26
DERIVATIVE SETTLEMENTS, NET. The components of derivative settlements for the
three months ended September 30, 2006 and 2005 are as follows:
2006 2005
---------- ---------
Interest rate swaps and basis swaps $ 12,081 (2,962)
Cross-currency interest rate swaps (5,115) --
Other (a) (1,993) --
---------- ---------
Derivative settlements, net $ 4,973 (2,962)
========== =========
(a) In September 2006, the Company issued CENts as discussed in note
6 to the financial statements in this Quarterly Report. The
Company entered into a derivative instrument to economically lock
into a fixed interest rate of 7.65% prior to actual pricing of
the transaction. Between entering into this derivative and
pricing of the CENts, interest rates dropped, and as a result,
the Company paid $2.0 million to terminate this derivative
instrument. The fixed interest rate on the CENts is 7.40% through
September 30, 2011.
OPERATING EXPENSES. Operating expenses increased $49.9 million from $78.9
million for the three months ended September 30, 2005 to $128.8 million in 2006.
Operating expenses of the Company's acquisitions, in which there were no
comparable operations during the three months ended September 30, 2005, resulted
in $44.5 million of this increase which is summarized in the following table:
THREE NET CHANGE THREE
MONTHS ENDED IMPACT OF AFTER MONTHS ENDED
SEPTEMBER 30, 2005 ACQUISITIONS ACQUISITIONS SEPTEMBER 30, 2006
------------------ ------------ ------------ ------------------
Salaries and benefits $ 44,311 16,819 4,253 65,383
Other expenses 32,705 22,689 1,531 56,925
Amortization of intangible assets 1,919 4,970 (355) 6,534
------------------ ------------ ------------ ------------------
Total operating expenses $ 78,935 44,478 5,429 128,842
================== ============ ============ ==================
The increase in operating expenses after adjusting for the impact of
acquisitions was $5.4 million. This increase was a 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 recruitment, development, and retention of intellectual
capital and technology enhancements to support a larger, more diversified
customer and employee base.
NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 2005
INTEREST INCOME. Interest income for the nine months ended September 30, 2006
increased $492.5 million compared to the same period in 2005 as reflected in the
following table and explained below.
NINE MONTHS ENDED
SEPTEMBER 30, CHANGE
------------------------ -------------------
2006 2005 DOLLARS PERCENT
------------ ---------- ---------- --------
Loan interest, excluding special
allowance yield adjustment $ 1,221,488 664,965 556,523 83.7 %
Special allowance yield adjustment 24,460 77,427 (52,967) (68.4)
Consolidation rebate fees (112,855) (70,803) (42,052) (59.4)
Amortization of loan premiums and
deferred origination costs (64,555) (52,370) (12,185) (23.3)
------------ ---------- ----------
Total loan interest 1,068,538 619,219 449,319 72.6
Investment interest 69,841 26,643 43,198 162.1
------------ ---------- ----------
Total interest income $ 1,138,379 645,862 492,517 76.3
============ ========== ==========
o The average student loan portfolio increased $6.5 billion, or 44%, for
the nine months ended September 30, 2006 compared to 2005. When
excluding the special allowance yield adjustment, the student loan yield
increased to 7.68% in 2006 from 6.02% 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 $556.5
million as a result of these factors.
27
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 $53.0 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. In addition, as
discussed in note 2 to the financial statements in this Quarterly
Report, the Company deferred recognition of the portion of the 9.5%
special allowance payments currently being withheld by the Department
during the three months ended September 30, 2006.
o Consolidation rebate fees increased due to the $5.5 billion increase in
the consolidation loan portfolio to $15.7 billion at September 30, 2006
from $10.2 billion at September 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
business combinations, and as a result of the rising interest rate
environment.
INTEREST EXPENSE. Interest on bonds and notes payable for the nine months ended
September 30, 2006 increased $495.5 million compared to the same period in 2005
as reflected in the following table and explained below.
NINE MONTHS ENDED
SEPTEMBER 30, CHANGE
-------------------- ------------------
2006 2005 DOLLARS PERCENT
---------- --------- --------- -------
Interest expense on debt funding loan assets $876,177 393,539 482,638 122.6 %
Interest expense on debt funding operations 17,382 5,464 11,918 218.1
Other -- (958) 958 100.0
---------- --------- ---------
Total interest expense $893,559 398,045 495,514 124.5
========== ========= =========
o Average debt increased approximately $7.3 billion, or 47%, for the nine
months ended September 30, 2006 compared to 2005 and the Company's cost
of funds increased to 5.10% for the nine months ended September 30, 2006
up from 3.36% for the same period a year ago. Together these two factors
resulted in a $482.6 million increase in interest expense related to
debt used to fund the Company's loan assets.
o The Company issued $275.0 million of unsecured fixed-rate debt in May
2005 which resulted in an increase in the Company's interest expense of
$5.8 million for the nine months ended September 30, 2006 compared to
2005. Interest expense also increased approximately $5.8 million as a
result of increased borrowings on the Company's operating line of
credit. The average outstanding balance on this credit facility was
$137.7 million during the nine months ended September 30, 2006 as
compared to $9.3 million in 2005.
LOAN AND GUARANTEE SERVICING INCOME. Loan and guarantee servicing income has
increased $30.3 million for the nine months ended September 30, 2006 compared to
the same period in 2005. Several factors have contributed to this change as
follows:
Nine months ended September 30, 2005 $109,313
Acquisition-related activities:
Acquisition of private loan servicing operations (FirstMark) 7,227
Expansion of guarantee servicing operations related to
amended agreement with CAN 20,375
Existing operations:
Increase in loan servicing revenue from Canadian operations (a) 4,810
Decrease in loan servicing revenue from U.S. operations (b) (1,675)
Other (472)
---------
Nine months ended September 30, 2006 $139,578
=========
(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.
OTHER FEE-BASED INCOME. Other fee-based income has increased $42.6 million for
the nine months ended September 30, 2006 compared to the nine months ended
September 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:
28
Nine months ended September 30, 2005 $22,886
Acquisition-related activities:
Acquisition of payment management companies:
FACTS 14,143
infiNET 3,245
Acquisition of direct marketing companies:
SMG 4,624
NHR 1,092
CUnet 11,556
Peterson's 5,230
Existing operations:
Increased list sales due to customer demand 1,035
Increased payment management fees due to increased volume 869
Increased borrower late fee income due to student
loan portfolio growth 1,659
Decreased merchandise revenue (a) (1,349)
Other 460
--------
Nine months ended September 30, 2006 $65,450
========
(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 $5.0 million
from $6.8 million for the nine months ended September 30, 2005 to $11.8 million
for the nine months ended September 30, 2006. Software services income increased
$7.0 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 specialty software consulting.
OTHER INCOME. Other income has increased $13.1 million from $5.4 million for the
nine months ended September 30, 2005 to $18.5 million for the nine months ended
September 30, 2006. Other income for the nine months ended September 30, 2006
includes income of $13.5 million from the sale of certain loan assets as
described in note 3 to the financial statements in this Quarterly Report. In
addition, income from equity method investments has decreased $0.9 million as
the result of the Company's acquisition of the remaining 50% interests in
infiNET, 5280, and Firstmark as discussed in this Quarterly Report under
"Business and Asset Acquisitions." The revenues from these companies are now
classified as discussed in the results of operations above.
DERIVATIVE MARKET VALUE, FOREIGN CURRENCY, AND PUT OPTION ADJUSTMENTS. The
components of the derivative market value, foreign currency, and put option
adjustments for the nine months ended September 30, 2006 and 2005 are as
follows:
2006 2005
---------- ----------
Interest rate swaps, basis swaps, and
interest rate floor contracts (a) (576) 74,300
Re-measurement of Euro Notes (b) (30,942) --
Cross-currency interest rate swaps (b) 23,774 --
Put option agreements ( c) (3,821) --
---------- ----------
Derivative market value, foreign currency, and
put option adjustments (11,565) 74,300
========== ==========
(a) The Company's derivative instruments do not qualify for hedge
accounting under the provisions of SFAS No. 133. As such, the
change in fair value each reporting period is recognized in the
statement of operations.
(b) In February and May 2006, the Company consummated debt offerings of
student loan asset-backed notes that included notes denominated in
Euros with variable interest rates based on a spread to EURIBOR
(the "Euro Notes"). The Company re-measures the Euro Notes to U.S.
dollars at each balance sheet date and the change in value is
recognized in the statement of operations. Concurrently with the
issuances of the Euro Notes, the Company entered into
cross-currency interest rate swaps. These derivative instruments do
not qualify for hedge accounting and, accordingly, the change in
fair value of these instruments is recognized in the statement of
operations.
29
(c) In connection with the acquisitions of 5280 in December 2005 and
FACTS in January 2006, the Company issued stock subject to put
option arrangements whereby the holders of such shares can require
the company to repurchase the shares at a defined price. The
Company records the put options at fair value at each balance sheet
date and the change in value is recognized in the statement of
operations.
DERIVATIVE SETTLEMENTS, NET. The components of derivative settlements for the
nine months ended September 30, 2006 and 2005 are as follows:
2006 2005
---------- ---------
Interest rate swaps and basis swaps $ 28,495 (19,049)
Cross-currency interest rate swaps (10,083) --
Other (a) (1,993) --
---------- ---------
Derivative settlements, net $ 16,419 (19,049)
========== =========
(a) In September 2006, the Company issued CENts as discussed in note 6
to the financial statements in this Quarterly Report. The Company
entered into a derivative instrument to economically lock into a
fixed interest rate of 7.65% prior to actual pricing of the
transaction. Between entering into this derivative and pricing of
the CENts, interest rates dropped, and as a result, the Company
paid $2.0 million to terminate this derivative instrument. The
fixed interest rate on the CENts is 7.40% through September 30,
2011.
OPERATING EXPENSES. Operating expenses increased $127.2 million from $224.2
million for the nine months ended September 30, 2005 to $351.4 million in 2006.
Operating expenses of the Company's acquisitions, in which there were no
comparable operations during the nine months ended September 30, 2005, resulted
in $113.8 million of this increase which is summarized in the following table:
NINE NET CHANGE NINE
MONTHS ENDED IMPACT OF AFTER MONTHS ENDED
SEPTEMBER 30, 2005 ACQUISITIONS ACQUISTIONS SEPTEMBER 30, 2006
------------------ ------------ ------------- -----------------
Salaries and benefits $ 123,615 49,243 12,416 185,274
Other expenses 95,936 49,746 2,077 147,759
Amortization of intangible
assets 4,651 14,819 (1,142) 18,328
-------------- -------------- ------------ --------------
Total operating expenses $ 224,202 113,808 13,351 351,361
============== ============== ============ ==============
The increase in operating expenses after adjusting for the impact of
acquisitions was $13.4 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, during the first six
months of 2006, resulted in increased operating expenses of
approximately $3.7 million.
o The remaining increase of approximately $9.7 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 recruitment,
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.
30
The following table provides a reconciliation of GAAP net income to base and
adjusted base net income.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
2006 2005 2006 2005
----------- --------- --------- ----------
GAAP net income (loss) (a) $ (22,354) 72,132 75,465 138,446
Base adjustments:
Derivative market value, foreign currency,
and put option adjustments 79,941 (65,382) 11,565 (74,300)
Amortization of intangible assets 6,534 1,919 18,328 4,651
Non-cash stock based compensation
related to business combinations 476 -- 1,271 --
Variable-rate floor income -- -- -- --
----------- --------- --------- ----------
Total base adjustments before income taxes 86,951 (63,463) 31,164 (69,649)
Net tax effect (c) (31,698) 24,116 (10,391) 26,467
----------- --------- --------- ----------
Total base adjustments 55,253 (39,347) 20,773 (43,182)
----------- --------- --------- ----------
Base net income (a) 32,899 32,785 96,238 95,264
Adjustments to base net income:
Special allowance yield adjustment (b) -- (21,766) (24,460) (77,427)
Derivative settlements, net (7,909) 2,644 (19,794) 16,961
----------- --------- --------- ----------
Total adjustments to base net income
before income taxes (7,909) (19,122) (44,254) (60,466)
Net tax effect (c) 3,006 7,266 16,817 22,977
----------- --------- --------- ----------
Total adjustments to base net income (4,903) (11,856) (27,437) (37,489)
----------- --------- --------- ----------
Adjusted base net income (a) $ 27,996 20,929 68,801 57,775
=========== ========= ========= ==========
Earnings (loss) per share, basic and diluted:
GAAP net income (loss) (a) $ (0.42) 1.34 1.40 2.58
Total base adjustments 1.04 (0.73) 0.38 (0.81)
----------- --------- --------- ----------
Base net income (a) 0.62 0.61 1.78 1.77
Total adjustments to base net income (0.10) (0.22) (0.50) (0.70)
----------- --------- --------- ----------
Adjusted base net income (a) $ 0.52 0.39 1.28 1.07
=========== ========= ========= ==========
-----------------------------------------------
(a) Includes expense of $6.9 million ($4.3 million or $0.08 per share
after tax) for the nine months ended September 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 one percent on FFELP loans. This expense was recognized by
the Company in the first quarter 2006.
(b) As discussed in note 2 to the financial statements in this Quarterly
Report, pending satisfactory resolution of the October 6, 2006 letter
from the Department related to the audit report by the OIG regarding
certain loans receiving the 9.5% special allowance payments, the
Company has determined to defer recognition of the 9.5% special
allowance payments which the Department is currently withholding
payment. Income from these 9.5% special allowance payments would have
been $8.9 million ($5.5 million or $0.10 per share after tax) for the
three months ended September 30, 2006.
(c) Tax effect computed at 38%. The change in the value of the put option
is not tax effected as this is not deductible for income tax
purposes.
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, FOREIGN CURRENCY, AND PUT OPTION 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. 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.
31
Base net income also excludes the foreign currency transaction gain or loss
caused by the re-measurement of the Company's Euro-denominated bonds to U.S.
dollars and the change in the market value of put options issued by the Company
for certain business acquisitions.
AMORTIZATION OF INTANGIBLE ASSETS: Base net income excludes the amortization of
acquired intangibles.
NON-CASH STOCK BASED COMPENSATION RELATED TO BUSINESS COMBINATIONS: The Company
has structured certain business combinations in which the stock consideration
paid has been dependent on the sellers' continued employment with the Company.
As such, the value of the consideration paid is recognized as compensation
expense by the Company over the term of the applicable employment agreement.
Base net income excludes this expense.
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 nine months ended September 30, 2006 and 2005.
FINANCIAL CONDITION
AS OF SEPTEMBER 30, 2006 COMPARED TO DECEMBER 31, 2005
AS OF AS OF CHANGE
SEPTEMBER 30, DECEMBER 31, --------------------
2006 2005 DOLLARS PERCENT
------------ ------------ ------------ -------
ASSETS:
Student loans receivable, net $ 22,933,718 20,260,807 2,672,911 13.2 %
Cash, cash equivalents, and investments 1,810,839 1,645,797 165,042 10.0
Goodwill 188,603 99,535 89,068 89.5
Intangible assets 169,824 153,117 16,707 10.9
Fair value of derivative instruments, net 97,383 82,766 14,617 17.7
Other assets 690,953 556,600 134,353 24.1
------------ ------------ ------------
Total assets $ 25,891,320 22,798,622 3,092,698 13.6
============ ============ ============
LIABILITIES:
Bonds and notes payable $ 24,690,245 21,673,620 3,016,625 13.9
Other liabilities 519,814 474,884 44,930 9.5
------------ ------------ ------------
Total liabilities 25,210,059 22,148,504 3,061,555 13.8
Minority interest -- 626 (626) (100.0)
SHAREHOLDERS' EQUITY 681,261 649,492 31,769 4.9
------------ ------------ ------------
Total liabilities and
shareholders' equity $ 25,891,320 22,798,622 3,092,698 13.6
============ ============ ============
Total assets increased primarily due to an increase in student loans receivable.
The Company originated D] and acquired $5.4 billion of student loans during the
nine months ended September 30, 2006, offset by repayments and loan sales of
approximately $2.7 billion. Fair value of derivative instruments experienced a
net increase of $23.2 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 $8.6 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.
Also, in September 2006, the Company issued $200.0 million of unsecured debt
under its universal shelf registration statement. In addition, during 2006, the
amount of borrowings under its unsecured line of credit increased $124.0
million, primarily to fund general operations, business acquisitions, and to
repurchase stock. Shareholders' equity increased as a result of net income of
$75.5 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 1.9 million shares of its Class A common
stock for $62.4 million.
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.
32
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.
OPERATING LINES OF CREDIT
The Company uses its line of credit agreements primarily for general operating
purposes, to fund certain asset and business acquisitions, and to repurchase
stock under the Company's stock repurchase program. As of September 30, 2006 the
Company had outstanding a $500.0 million unsecured line of credit which
terminates on August 19, 2010. The Company had $214.0 million of outstanding
borrowings and $286.0 million of available capacity under this facility as of
September 30, 2006. In addition, EDULINX has a credit facility agreement with a
Canadian financial institution for approximately $11.3 million ($12.6 million in
Canadian dollars) that is cancelable by either party upon demand. The Company
had no borrowings under the EDULINX facility as of September 30, 2006.
SECURED FINANCING TRANSACTIONS
The Company relies upon secured financing vehicles as its most significant
source of funding for student loans on a long-term basis. The net cash flow the
Company receives from the securitized student loans generally represents the
excess amounts, if any, generated by the underlying student loans over the
amounts required to be paid to the bondholders, after deducting servicing fees
and any other expenses relating to the securitizations. The Company's rights to
cash flow from securitized student loans are subordinate to bondholder interests
and may fail to generate any cash flow beyond what is due to bondholders. The
Company's secured financing vehicles are loan warehouse facilities and
asset-backed securitizations.
LOAN WAREHOUSE FACILITIES
In August 2006, the Company established a $5.0 billion loan warehouse program
under which it will issue one or more short-term extendable secured liquidity
notes (the "Secured Liquidity Notes"). Each Secured Liquidity Note will be
issued at a discount or an interest-bearing basis having an expected maturity of
between 1 and 307 days (each, an "Expected Maturity") and a final maturity of 90
days following the Expected Maturity. The Secured Liquidity Notes issued as
interest-bearing notes may be issued with fixed interest rates or with interest
rates that fluctuate based upon a one-month LIBOR rate, a three-month LIBOR
rate, a commercial paper rate, or a federal funds rate. The Secured Liquidity
Notes are not redeemable by the Company nor subject to voluntary prepayment
prior to the Expected Maturity date. The Secured Liquidity Notes are secured by
FFELP loans purchased in connection with the program. As of September 30, 2006,
the Company has $1.3 billion of Secured Liquidity Notes outstanding and $3.7
billion of capacity remaining under this warehouse program.
In addition to the Secured Liquidity Notes, the Company had a loan warehousing
capacity of $6.5 billion as of September 30, 2006, of which $4.4 billion was
outstanding and $2.1 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.
As a result of establishing the Secured Liquidity Notes loan warehouse program,
the Company had a total loan warehousing capacity of $11.5 billion as of
September 30, 2006, an increase of $3.9 billion from $7.6 billion as of June 30,
2006. As of September 30, 2006, the Company had $5.7 billion outstanding under
its loan warehouse programs and $5.8 billion was available for future use.
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.
Student loan warehousing allows the Company to buy and manage student loans
prior to transferring them into more permanent financing arrangements. The
Company uses its large warehousing capacity to pool student loans in order to
maximize loan portfolio characteristics for efficient financing and to properly
time market conditions for movement of the loans. Generally, loans that best fit
long-term financing vehicles are selected to be transferred into long-term
securitizations. Because transferring those loans to a long-term securitization
includes certain fixed administrative costs, the Company maximizes its economies
of scale by executing large transactions.
ASSET-BACKED SECURITIZATIONS
Of the $24.7 billion of debt outstanding as of September 30, 2006, $18.3 billion
was issued under asset-backed securitizations. 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 initial 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. 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.
33
UNIVERSAL SHELF OFFERINGS
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.
On September 27, 2006 the Company consummated a debt offering under its
universal shelf consisting of $200.0 million aggregate principal amount of
Capital Efficient Notes ("CENts"). The CENts are unsecured obligations of the
Company. The interest rate on the CENts from the date they were issued through
September 28, 2011 is 7.40%, payable semi-annually. Beginning September 29, 2011
through September 29, 2036, the "scheduled maturity date", the interest rate on
the CENts will be equal to three-month LIBOR plus 3.375%, payable quarterly. The
principal amount of the CENts will become due on the scheduled maturity date
only to the extent that the Company has received proceeds from the sale of
certain qualifying capital securities prior to such date (as defined in the
CENts' prospectus). If any amount is not paid on the scheduled maturity date, it
will remain outstanding and bear interest at a floating rate as defined in the
prospectus, payable monthly. On September 15, 2061, the Company must pay any
remaining principal and interest on the CENts in full whether or not the Company
has sold qualifying capital securities. At the Company's option, the CENts are
redeemable in whole at any time or in part from time to time at the redemption
price described in the prospectus supplement.
The proceeds from these unsecured debt offerings were or will be used by the
Company to fund general business operations, certain asset and business
acquisitions, and the repurchase of stock under the Company's stock repurchase
plan. As of September 30, 2006, the Company has $275.0 million remaining under
its universal shelf.
The following table summarizes the Company's bonds and notes outstanding as of
September 30, 2006:
INTEREST RATE
CARRYING PERCENT OF RANGE ON CARRYING FINAL
AMOUNT TOTAL AMOUNT MATURITY
------------- ---------- ----------------- -------------------
Variable-rate bonds and notes (a):
Bond and notes based on indices (b) $ 15,076,211 61.1 % 3.12% -6.19% 10/17/06 - 05/01/42
Bond and notes based on auction 2,770,020 11.2 3.58% -5.45% 11/01/09 - 07/01/43
------------- -------
Total variable-rate bonds and notes 17,846,231 72.3
Commercial paper and other 5,636,576 22.8 4.77% -5.36% 01/05/07 - 09/02/09
Fixed-rate bonds and notes (a) 444,147 1.8 5.20% -6.68% 11/01/06 - 05/01/29
Unsecured fixed-rate debt 475,000 1.9 5.13% -7.40% 06/01/10 - 09/29/36
Other borrowings 288,291 1.2 5.69% -5.77% 06/29/07 - 08/19/10
------------- -------
Total $ 24,690,245 100.0 %
============= =======
--------------------------------
(a) Issued in securitization transactions.
(b) Includes (euro)773.2 million Euro Notes re-measured to $980.9 million
U.S. dollars as of September 30, 2006.
The Company is committed under noncancelable operating leases for certain office
and warehouse space and equipment. The Company's contractual obligations as of
September 30, 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 $ 24,690,245 5,524,094 733,745 601,269 17,831,137
Operating lease obligations 27,272 9,153 12,352 4,741 1,026
Other 20,411 1,950 8,021 10,440 --
------------- ------------ ----------- ------------ -----------
Total $ 24,737,928 5,535,197 754,118 616,450 17,832,163
============= ============ =========== ============ ===========
On October 13, 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 was $8.3 million,
including the assumption of debt on the property. The above table excludes rent
payments made in October of approximately $70,000 for space in the purchased
building.
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
34
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 September 30, 2006 was
$10.1 million and is included in "other" in the above table.
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 September 30, 2006 was $2.0 million and is
included in "other" in the above table.
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 4 to the financial statements included in this report.
STUDENT LOAN PORTFOLIO
The table below describes the components of the Company's loan portfolio:
AS OF SEPTEMBER 30, 2006 AS OF DECEMBER 31, 2005
------------------------- -------------------------
DOLLARS PERCENT DOLLARS PERCENT
------------- ---------- ------------- ----------
Federally insured:
Stafford $ 6,290,116 27.4 % $ 6,434,655 31.8 %
PLUS/SLS 391,981 1.7 376,042 1.8
Consolidation 15,672,102 68.3 13,005,378 64.2
Non-federally insured 180,462 0.8 96,880 0.5
------------- ---------- ------------- ----------
Total 22,534,661 98.2 19,912,955 98.3
Unamortized premiums and deferred
origination costs 424,151 1.9 361,242 1.8
Allowance for loan losses:
Allowance - federally insured (7,517) -- (98) --
Allowance - non-federally insured (17,577) (0.1) (13,292) (0.1)
------------- ---------- ------------- ----------
Net $ 22,933,718 100.0 % $ 20,260,807 100.0 %
============= ========== ============= ==========
35
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- -------------------------
2006 2005 2006 2005
------------- ----------- ------------ -----------
Balance at beginning of period $ 24,180 10,689 $ 13,390 7,272
Provision for loan losses:
Federally insured loans 800 2 8,268 207
Non-federally insured loans 900 1,400 5,240 5,350
------------- ----------- ------------ -----------
Total provision for loan losses 1,700 1,402 13,508 5,557
Charge-offs, net of recoveries:
Federally insured loans (284) (3) (849) (226)
Non-federally insured loans (502) (4) (955) (519)
------------- ----------- ------------ -----------
Net charge-offs (786) (7) (1,804) (745)
------------- ----------- ------------ -----------
Balance at end of period $ 25,094 12,084 $ 25,094 12,084
============= =========== ============ ===========
Allocation of the allowance for loan losses:
Federally insured loans $ 7,517 98 $ 7,517 98
Non-federally insured loans 17,577 11,986 17,577 11,986
------------- ----------- ------------ -----------
Total allowance for loan losses $ 25,094 12,084 $ 25,094 12,084
============= =========== ============ ===========
Net loan charge-offs as a percentage of average student loans 0.014 % -- % 0.011 % 0.007 %
Total allowance as a percentage of average student loans 0.113 % 0.077 % 0.118 % 0.082 %
Total allowance as a percentage of ending balance
of student loans 0.111 % 0.075 % 0.111 % 0.075 %
Non-federally insured allowance as a percentage of the ending
balance of non-federally insured loans 9.740 % 12.367 % 9.740 % 12.367 %
Average student loans $ 22,170,118 15,628,420 21,268,972 14,766,024
Ending balance of student loans 22,534,661 16,185,721 22,534,661 16,185,721
Ending balance of non-federally insured loans 180,462 96,920 180,462 96,920
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. See note 3 to the financial statements
in this Quarterly Report for additional information related to HERA.
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 SEPTEMBER 30, 2006 AS OF DECEMBER 31, 2005
------------------------ ------------------------
DOLLARS PERCENT DOLLARS PERCENT
-------------- ------- -------------- -------
Federally Insured Loans:
Loans in-school/grace/deferment(1) $ 6,701,102 $ 5,512,448
Loans in forebearance(2) 2,361,637 2,160,577
Loans in repayment status:
Loans current 11,757,297 88.5 % 10,790,625 88.9 %
Loans delinquent 31-60 days(3) 551,983 4.2 526,044 4.3
Loans delinquent 61-90 days(3) 275,896 2.1 236,117 1.9
Loans delinquent 91 days or greater(4) 706,284 5.2 590,264 4.9
-------------- ------- -------------- -------
Total loans in repayment 13,291,460 100.0 % 12,143,050 100.0 %
-------------- ======= -------------- =======
Total federally insured loans $ 22,354,199 $ 19,816,075
============== ==============
NON-FEDERALLY INSURED LOANS:
Loans in-school/grace/deferment(1) $ 88,000 $ 27,709
Loans in forebearance(2) 4,112 2,938
Loans in repayment status:
Loans current 82,870 93.8 % 61,079 92.2 %
Loans delinquent 31-60 days(3) 2,474 2.8 2,059 3.1
Loans delinquent 61-90 days(3) 1,309 1.5 1,301 2.0
Loans delinquent 91 days or greater(4) 1,697 1.9 1,794 2.7
-------------- ------- -------------- -------
Total loans in repayment 88,350 100.0 % 66,233 100.0 %
-------------- ======= -------------- =======
Total non-federally insured loans $ 180,462 $ 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.
36
(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, if applicable, 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2006 2005 2006 2005
------------ ------------ ------------ ------------
Beginning balance $22,012,670 15,469,689 19,912,955 13,299,094
Direct channel:
Consolidation loan originations 1,493,981 1,097,436 3,563,910 2,624,106
Less consolidation of existing portfolio (726,700) (559,700) (1,727,900) (1,274,100)
------------ ------------ ------------ ------------
Net consolidation loan originations 767,281 537,736 1,836,010 1,350,006
Stafford/PLUS loan originations 385,997 239,927 843,162 567,549
Branding partner channel 94,229 43,934 841,258 1,126,788
Forward flow channel 336,775 260,072 1,268,288 901,185
Other channels 2,070 5,015 480,528 39,200
------------ ------------ ------------ ------------
Total channel acquisitions 1,586,352 1,086,684 5,269,246 3,984,728
Repayments, claims, capitalized interest,
and other (368,789) (130,252) (1,187,813) (599,601)
Consolidation loans lost to external parties (342,400) (240,400) (923,600) (498,500)
Loans sold (353,172) -- (536,127) --
------------ ------------ ------------ ------------
Ending balance $22,534,661 16,185,721 22,534,661 16,185,721
============ ============ ============ ============
Included in the branding partner channel for the nine months ended September 30,
2005 is $630.8 million 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 $423.7 million of loans in a
spot purchase from an unrelated third party.
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 $74.9 million and $72.5
million for the three months ended September 30, 2006 and 2005, respectively;
$236.7 million and $236.2 million for the nine months ended September 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.
During the three months ended September 30, 2006, the Company sold approximately
$353.2 million (par value) of student loans to an unrelated party. Loans sold
under this agreement were originated by Nova. The portfolio of loans sold was
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 nine months ended September 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.
37
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2006 2005 2006 2005
------------ ----------- ------------ -----------
Student loan yield 7.91 % 6.94 % 7.84 % 6.72 %
Consolidation rebate fees (0.72) (0.65) (0.71) (0.64)
Premium and deferred origination costs
amortization (0.39) (0.51) (0.41) (0.47)
------------ ----------- ------------ -----------
Student loan net yield 6.80 5.78 6.72 5.61
Student loan cost of funds (a) (5.32) (3.83) (4.99) (3.52)
------------ ----------- ------------ -----------
Student loan spread 1.48 1.95 1.73 2.09
Special allowance yield adjustment, net of
settlements on derivatives (b) (0.14) (0.49) (0.28) (0.55)
------------ ----------- ------------ -----------
Core student loan spread 1.34 % 1.46 % 1.45 % 1.54 %
============ =========== ============ ===========
Average balance of student loans (in thousands) $22,170,118 15,628,420 21,268,972 14,766,024
Average balance of debt outstanding (in thousands) 23,881,928 16,564,494 22,984,011 15,669,656
(a) The student loan cost of funds includes the effects of the net
settlement costs on the Company's derivative instruments (excluding the
$2.0 million settlement related to the derivative instrument entered
into in connection with the issuance of the CENts).
(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 nine
months ended September 30, 2006 compared to the three and nine months ended
September 30, 2005 has been primarily due to (i) an increase in lower yielding
consolidation loans and increase in the consolidation rebate fees; and (ii) the
mismatch in the reset frequency between the Company's floating rate assets and
floating rate liabilities. During the third quarter 2006, interest rates
remained relatively flat as compared to the prior two years in which there was a
rising interest rate environment. The Company's core student loan spread
benefited in the rising interest rate environment because the Company's cost of
funds reset quarterly on the discreet basis while the Company's student loans
kept increasing in yield on an average daily basis.
As noted on page 41, the Company has a portfolio of $4.1 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 $1.6 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 nine
months ended September 30, 2006 included approximately 14 and 16 basis points,
respectively, related to this floor income. When excluding floor income, the
Company's core student loan spread was 1.20% and 1.29% for the three and nine
months ended September 30, 2006, respectively.
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 %
========= ======== ======== ======== ======== =========
38
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 nine
months ended September 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.
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.
39
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 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.
In July 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.
In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS. This
Statement defines fair value, establishes a framework for measuring fair value
in generally accepted accounting principles, and expands disclosures about fair
value measurements. The provisions of SFAS No. 157 are effective as of the
beginning of the first fiscal year that begins after November 15, 2007.
In September 2006, the FASB issued SFAS No. 158, EMPLOYERS' ACCOUNTING FOR
DEFINED BENEFIT PENSION AND OTHER POSTRETIREMENT PLANS-AN AMENDMENT OF FASB
STATEMENTS NO. 87, 88, 106, AND 132(R). This Statement requires an employer to
recognize the overfunded or underfunded status of a defined benefit
postretirement plan (other than a multiemployer plan) as an asset or liability
in its statement of financial position and to recognize changes in that funded
status in the year in which the changes occur through comprehensive income of a
business entity. This Statement also requires an employer to measure the funded
status of a plan as of the date of its year-end statement of financial position,
with limited exceptions. The provisions of SFAS No. 158 are effective as of the
end of the fiscal year ending after December 15, 2006.
40
In September 2006, the Securities and Exchange Commission published Staff
Accounting Bulletin ("SAB") No. 108, CONSIDERING THE EFFECTS OF PRIOR YEAR
MISSTATEMENTS WHEN QUANTIFYING MISSTATEMENTS IN CURRENT YEAR FINANCIAL
STATEMENTS ("SAB No 108"). SAB No. 108 requires registrants to quantify
misstatements using both the balance-sheet and income-statement approaches, with
adjustment required if either method results in a material error. The provisions
of SAB No. 108 are effective for annual financial statements for the first
fiscal year ending after November 15, 2006.
Management is currently evaluating the above accounting pronouncements to assess
their 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 Company's portfolio of FFELP loans originated prior to April 1, 2006 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. 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. As a result of one of the provisions of HERA, the Company's portfolio of
FFELP loans originated on or after April 1, 2006 earns interest at a variable
rate based on the SAP formula. For the portfolio of loans originated on or after
April 1, 2006, when the borrower rate exceeds the variable rate based on the SAP
formula, the Company must return the excess to the Department.
The following table sets forth the Company's loan assets and debt instruments by
rate characteristics:
AS OF SEPTEMBER 30, 2006 AS OF DECEMBER 31, 2005
------------------------ ------------------------
DOLLARS PERCENT DOLLARS PERCENT
------------- -------- ------------- ---------
Fixed-rate loan assets $ 4,107,514 18.2 % $ 4,908,865 24.7 %
Variable-rate loan assets 18,427,147 81.8 15,004,090 75.3
------------- -------- ------------- ---------
Total $ 22,534,661 100.0 % $ 19,912,955 100.0 %
============= ======== ============= =========
Fixed-rate debt instruments $ 919,147 3.7 % $ 794,086 3.7 %
Variable-rate debt
instruments 23,771,098 96.3 20,879,534 96.3
------------- -------- ------------- ---------
Total $ 24,690,245 100.0 % $ 21,673,620 100.0 %
============= ======== ============= =========
The following table shows the Company's student loan assets currently earning at
a fixed rate as of September 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% $ 564,227
> 9.0% 9.04 6.40 402,641
9.5 floor yield 9.50 6.86 3,140,646
----------------
$ 4,107,514
================
---------------------
(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.
41
The majority of the Company's student loan assets earning a fixed rate as of
September 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
$1.6 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 nine months ended September
30, 2006 includes approximately $4 million and approximately $16 million of
floor income.
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 $4.1 billion held by the Company as
of September 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
September 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
September 30, 2006, the fair market value of this derivative portfolio was $61.3
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
NOTIONAL PAID BY
MATURITY VALUES THE COMPANY
------------ ----------- ------------------
2006 $ 250,000 3.16 %
2007 118,750 3.35
2008 293,750 3.78
2009 193,750 4.01
2010 687,500 4.25
2011 -- 0.00
2012 275,000 4.31
2013 525,000 4.36
-----------
Total $2,343,750 4.04
===========
As discussed in note 2 of the financial statements included in this Quarterly
Report, pending satisfactory resolution of the October 6, 2006 letter from the
Department related to the OIG's audit report regarding certain loans receiving
9.5% special allowance payments, the Company has determined to defer recognition
of the 9.5% special allowance payments which the Department is currently
withholding payment. The Company has maintained its portfolio of interest rate
swaps (summarized in the previous table) used to hedge the portfolio of loans in
which the Department is currently withholding the 9.5% special allowance
payments pending satisfactory resolution of this issue.
42
The following table summarizes the outstanding derivative instruments as of
September 30, 2006 used by the Company to hedge the remaining fixed-rate loan
portfolio.
WEIGHTED AVERAGE
FIXED RATE
NOTIONAL PAID BY
MATURITY VALUES THE COMPANY
------------ ----------- -----------------
2007 $ 393,750 3.45 %
2008 168,750 3.72
2009 118,750 4.01
2010 450,000 4.25
-----------
Total $1,131,250 3.87
===========
In addition to the interest rate swaps with notional values of $1.1 billion
summarized above, as of September 30, 2006, the Company had $444.1 million of
fixed-rate debt (excluding the Company's fixed-rate unsecured debt of $475
million) that was used by the Company to hedge fixed-rate student loan assets.
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.
In addition to the three basis swaps summarized above, the Company also had a
basis swap with a notional amount of $500.0 million that matured 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
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.
43
The following provide the terms of these contracts:
AMORTIZING FLOOR STRIKE
NOTIONAL AMOUNT RATE
---------------- ------------
(IN THOUSANDS)
$ 50,354 2.760%
44,068 2.885%
37,499 3.010%
34,338 3.135%
46,550 3.260%
76,911 3.385%
50,379 3.510%
52,793 3.635%
46,012 3.760%
45,159 3.885%
40,352 4.010%
63,002 4.135%
24,044 4.460%
31,648 5.060%
37,103 5.510%
7,097 4.300%
21,969 4.550%
17,220 4.800%
62,466 5.550%
--------------
$ 788,964
==============
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".
FINANCIAL STATEMENT IMPACT OF DERIVATIVE INSTRUMENTS
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 interest rate swaps,
basis swaps and floor contracts which is included in derivative market value,
foreign currency, and put option adjustments in the Company's statements of
operations was a loss of $71.1 million and $0.6 million for the three and nine
months ended September 30, 2006, respectively.
44
The following summarizes the components included in derivative settlements on
the consolidated statement of operations:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- --------------------
2006 2005 2006 2005
---------- --------- --------- ---------
Special allowance yield adjustment
derivatives $ 7,909 (2,644) 19,794 (16,961)
Other interest rate swaps 4,317 1,672 9,357 13,908
Basis swaps (145) (1,990) (656) (15,996)
Cross-currency interest rate swaps (5,115) -- (10,083) --
Other (1) (1,993) -- (1,993) --
---------- --------- --------- ---------
Derivative settlements, net $ 4,973 (2,962) 16,419 (19,049)
========== ========= ========= =========
(1) In connection with the issuance of the CENts described in note 6 to the
financial statements in this Quarterly Report, the Company entered into a
derivative instrument to economically lock into a fixed interest rate of 7.65%
prior to the actual pricing of the transaction. Upon pricing of the CENts, the
Company terminated this derivative instrument. The consideration paid by the
Company to terminate this derivative was $2.0 million, which is reflected as a
derivative settlement in the accompanying consolidated statements of operations.
SENSITIVITY ANALYSIS
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.
45
THREE MONTHS ENDED SEPTEMBER 30, 2006
---------------------------------------------------------------------------
CHANGE FROM DECREASE CHANGE FROM INCREASE CHANGE FROM INCREASE
OF 100 BASIS POINTS OF 100 BASIS POINTS OF 200 BASIS POINTS
------------------------- ------------------------ ----------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ---------- ------------ ---------- ----------- ----------
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements $ 7,836 22.1 % (490) (1.4) % 1,029 2.9 %
Impact of derivative settlements (8,759) (24.7) 8,759 24.7 17,518 49.4
------------- ---------- ------------ ---------- ----------- ----------
Increase (decrease) in net income before taxes $ (923) (2.6) % 8,269 23.3 % 18,547 52.3 %
============= ========== ============ ========== =========== ==========
Increase (decrease) in basic and diluted
earning per share $ (0.01) 0.10 0.22
============= ============ ===========
THREE MONTHS ENDED SEPTEMBER 30, 2005
---------------------------------------------------------------------------
CHANGE FROM DECREASE CHANGE FROM INCREASE CHANGE FROM INCREASE
OF 100 BASIS POINTS OF 100 BASIS POINTS OF 200 BASIS POINTS
------------------------- ------------------------ ---------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ---------- ------------ ---------- ----------- --------
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements $ 14,264 12.6 % (9,730) (8.6) % (17,781) (15.7)%
Impact of derivative settlements (9,134) (8.1) 9,134 8.1 18,269 16.1
------------- ---------- ----------- ---------- ------------ ----------
Increase (decrease) in net income before taxes $ 5,130 4.5 % (596) 0.5) % 488 0.4 %
============= ========== =========== ========== ============ ==========
Increase (decrease) in basic and diluted
earning per share $ 0.06 (0.01) 0.01
============= =========== ===========
NINE MONTHS ENDED SEPTEMBER 30, 2006
---------------------------------------------------------------------------
CHANGE FROM DECREASE CHANGE FROM INCREASE CHANGE FROM INCREASE
OF 100 BASIS POINTS OF 100 BASIS POINTS OF 200 BASIS POINTS
------------------------ ------------------------ -----------------------
Dollar Percent Dollar Percent Dollar Percent
------------ ---------- ------------ ---------- ----------- ---------
Effect on earnings:
Increase in pre-tax net income before
impact of derivative settlements $ 31,837 26.5 % 5,228 4.4 % 15,741 13.1%
Impact of derivative settlements (25,991) (21.6) 25,991 21.6 51,982 43.3
------------- --------- ----------- ---------- --------- ---------
Increase in net income before taxes $ 5,846 4.9 % 31,219 26.0 % 67,723 56.4 %
============= ========= =========== ========== ========= =========
Increase in basic and diluted
earning per share $ 0.07 0.36 0.79
============= =========== =========
NINE MONTHS ENDED SEPTEMBER 30, 2005
----------------------------------------------------------------------------
CHANGE FROM DECREASE CHANGE FROM INCREASE CHANGE FROM INCREASE
OF 100 BASIS POINTS OF 100 BASIS POINTS OF 200 BASIS POINTS
------------------------- ------------------------ -----------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ---------- ------------ ---------- ----------- ----------
Effect on earnings:
Increase (decrease) in pre-tax net income before
impact of derivative settlements $ 58,620 26.9 % (26,852) (12.3) % (46,971) (21.6)%
Impact of derivative settlements (29,044) (13.3) 29,044 13.3 58,089 26.7
------------- ---------- --------- --------- ---------- --------
Increase in net income before taxes $ 29,576 13.6 % 2,192 1.0 % 11,118 5.1 %
============= ========== ========= ========= ========== ========
Increase in basic and diluted
earning per share $ 0.35 0.03 0.13
============= ========= =========
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,
foreign currency, and put option adjustments in the Company's consolidated
statements of operations.
46
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 nine months ended September 30, 2006, the Company recorded
income of $7.2 million and an expense of $30.9 million, respectively, as a
result of re-measurement of the Euro Notes and expense of $12.4 million and
income of $23.8 million, respectively, for the increase in the fair value of the
related derivative instrument. Both of these amounts are included in derivative
market value, foreign currency, and put option adjustments on the Company's
consolidated statement of operations.
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
GENERAL
The Company is subject to various claims, lawsuits, and proceedings that arise
in the normal course of business. These matters principally consist of claims by
borrowers disputing the manner in which their loans have been processed and
disputes with other business entities. On the basis of present information,
anticipated insurance coverage, and advice received from counsel, it is the
opinion of the Company's management that the disposition or ultimate
determination of these claims, lawsuits, and proceedings will not have a
material adverse effect on the Company's business, financial position, or
results of operations.
REPORT BY THE OFFICE OF INSPECTOR GENERAL OF THE DEPARTMENT OF EDUCATION
On September 29, 2006, the Company received a copy of the final audit report
from the OIG related to the OIG's audit of the Company's student loan portfolio
receiving 9.5% Floor special allowance payments. The final audit report is
discussed in note 2 to the financial statements and Item 1A of Part II of this
report. Nelnet disagrees with the OIG's final audit report, and continues to
believe that Nelnet has billed for the 9.5% special allowance payments in
accordance with applicable laws, regulations, and the Department's previous
guidance. Nelnet intends to seek a satisfactory resolution of this matter with
the Department, and examine other remedies if a satisfactory resolution cannot
be reached with the Department. However, Nelnet cannot predict the final outcome
of any subsequent review by the Department or of any administrative or other
legal proceedings following any further action by the Department.
ITEM 1A. RISK FACTORS
There have been no material changes from the risk factors described in Nelnet'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.
47
THE FINAL AUDIT REPORT FROM THE OFFICE OF INSPECTOR GENERAL OF THE DEPARTMENT OF
EDUCATION CONTAINS RECOMMENDATIONS THAT THE DEPARTMENT OF EDUCATION REQUIRE
NELNET TO CALCULATE AND RETURN WHAT THE OIG DEEMS TO BE OVERPAYMENTS
ATTRIBUTABLE TO DEEMED INELIGIBLE LOANS AND THAT THE DEPARTMENT INSTRUCT NELNET
TO EXCLUDE SUCH LOANS FROM FUTURE CLAIMS FOR 9.5% SPECIAL ALLOWANCE PAYMENTS. IF
NELNET IS REQUIRED TO RETURN THE ALLEGED OVERPAYMENTS OR IS PROHIBITED FROM
BILLING FOR 9.5% SPECIAL ALLOWANCE PAYMENTS IN THE FUTURE, NELNET'S RESULTS OF
OPERATIONS WOULD BE ADVERSELY AFFECTED.
In June 2005, the OIG commenced an audit of the portion of Nelnet's student loan
portfolio receiving 9.5% Floor special allowance payments. Nelnet received a
draft of the audit report in August 2006, which Nelnet responded to on September
7, 2006. On September 29, 2006, Nelnet received a copy of the final audit report
from the OIG related to this audit. Nelnet intends to respond to the OIG's
finding in the final audit report prior to November 19, 2006.
The final audit report contains a finding by the OIG that an increase in the
amount of 9.5% special allowance payments that have been received by Nelnet was
based on what the OIG deemed to be ineligible loans. Such loans are deemed by
the OIG to be ineligible for 9.5% special allowance payments due to interpretive
issues related to the legal characterization of refinancing transfers of
qualifying loans from a trust for tax-exempt financing obligations originally
issued prior to October 1, 1993 to trusts for taxable obligations, and the
extent to which sales of qualifying loans can result in qualification of
additional loans. The audit report also contains a recommendation by the OIG
that the Department require Nelnet to calculate and return what the OIG deems to
be overpayments attributable to the deemed ineligible loans, and instruct Nelnet
to exclude such loans from future claims for 9.5% special allowance payments.
The final audit report is publicly available through the Department's web site
at www.ed.gov (information on the Department's web site is not incorporated by
reference into this report and should not be considered part of this report).
The Department may accept or reject the finding or recommendation of the OIG
contained in the final audit report.
Through June 30, 2006, Nelnet recorded approximately $322.6 million of pre-tax
income related to that portion of the 9.5% special allowance payments received
which exceeds regular special allowance payments on the underlying loans at the
otherwise applicable statutory rate. If the recommendation contained in the
OIG's final audit report is implemented by the Department and upheld after any
administrative or other legal proceedings, a significant portion of those
payments would be disallowed and need to be returned by Nelnet.
On October 6, 2006, Nelnet received a letter from the Department related to the
OIG audit report. The Department's letter indicated that, effective July 1, 2006
and until the issues raised in the OIG audit report are resolved, the Department
will pay future regular special allowance payments on the underlying loans at
the generally applicable statutory rate, and not the 9.5% special allowance
rate. The letter also stated that if resolution of the audit upholds the
propriety of Nelnet's billings for special allowance payments at the 9.5%
minimum rate, the Department will pay the withheld amounts. Nelnet has
determined to defer recognition of these 9.5% special allowance payments for
which the Department is currently withholding payment. Income from these 9.5%
special allowance payments would have been $8.9 million ($5.5 million or $0.10
per share after tax) for the three months ended September 30, 2006.
Nelnet cannot predict the final outcome of any subsequent review by the
Department or of any administrative or other legal proceedings following any
further action by the Department. If Nelnet is ultimately required to return
deemed overpayments in connection with the 9.5% special allowance payment
program, is no longer eligible to receive 9.5% special allowance payments,
and/or incurs significant other costs, expenses, or loss of revenues associated
with an adverse final outcome of this matter, it may have a material adverse
effect on Nelnet's financial condition and results of operations.
NELNET IS SUBJECT TO FOREIGN CURRENCY EXCHANGE RISK IN CONNECTION WITH
EURO-DENOMINATED NOTES ISSUED BY NELNET AND SUCH RISK COULD LEAD TO INCREASED
COSTS.
As a result of Nelnet's offerings of Euro-denominated notes completed in
February and May 2006, Nelnet 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 REPEAL OF THE SINGLE HOLDER RULE COULD LEAD TO INCREASED CONSOLIDATIONS BY
COMPETITORS OF LOANS HELD BY NELNET, WHICH COULD REDUCE NELNET'S LOAN PORTFOLIO
AND COULD RESULT IN NELNET NOT BEING ABLE TO RECOVER UP-FRONT COSTS ASSOCIATED
WITH MAKING STUDENT LOANS UNDER THE FFEL PROGRAM.
Nelnet'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 Nelnet's non-consolidated loan portfolio is
subject to the risk of being consolidated away by a competitor.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table summarizes the repurchases of Class A common stock during
the third quarter of 2006 by the Company or any "affiliated purchaser" of the
Company, as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of
1934.
48
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 (1) PER SHARE OR PROGRAMS (2) (3) OR PROGRAMS (4)
-------------------------------- -------------- ------------- --------------------- -------------------
July 1 - July 31, 2006 -- $ -- -- 5,959,203
August 1 - August 31, 2006 1,093,400 30.73 1,093,400 4,905,631
September 1 - September 30, 2006 518,100 31.03 518,100 4,344,771
-------------- ------------- ---------------------
Total 1,611,500 $ 30.82 1,611,500
============== ============= =====================
(1) The total number of shares includes: (i) shares purchased
pursuant to the 2006 Plan discussed in footnote (2) below; and
(ii) shares repurchased pursuant to the 2006 ESLP discussed in
footnote (3) below, of which there were none for the months of
July, August, and September 2006.
(2) On May 25, 2006, the Company publicly announced that its Board of
Directors had authorized a stock repurchase program to buy back
up to a total of five million shares of the Company's Class A
common stock (the "2006 Plan"). The 2006 Plan 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).
All of the shares repurchased by the Company during July, August,
and September 2006 were repurchased under the 2006 Plan.
(3) On May 25, 2006, the Company publicly announced that the
shareholders of the Company approved an Employee Stock Purchase
Loan Plan (the "2006 ESLP") to allow the Company to make loans
to employees for the purchase of shares of the Company's Class A
common stock either in the open market or directly from the
Company. A total of $40 million in loans may be made under the
2006 ESLP, and a total of one million shares of Class A common
stock are reserved for issuance under the 2006 ESLP. Shares may
be purchased directly from the Company or in the open market
through a broker at prevailing market prices at the time of
purchase, subject to any conditions or restrictions on the
timing, volume or prices of purchases as determined by the
Compensation Committee of the Board of Directors and set forth
in the Stock Purchase Loan Agreement with the participant. The
2006 ESLP shall terminate May 25, 2016. No shares were purchased
under the 2006 ESLP during July, August, or September 30, 2006.
(4) The maximum number of shares that may yet be purchased under the
plans is calculated below. There are no assurances that any
additional shares will be repurchased under either the 2006 Plan
or the 2006 ESLP. Shares under the 2006 ESLP may be issued by the
Company rather than purchased in open market transactions.
(B/C) (A+D)
APPROXIMATE CLOSING PRICE APPROXIMATE APPROXIMATE
MAXIMUM DOLLAR VALUE OF ON THE LAST NUMBER OF NUMBER OF
NUMBER OF SHARES SHARES THAT MAY TRADING DAY OF SHARES THAT MAY SHARES THAT MAY
THAT MAY YET BE YET BE PURCHASED THE COMPANY'S YET BE PURCHASED YET BE PURCHASED
PURCHASED UNDER UNDER THE 2006 CLASS A UNDER THE 2006 UNDER THE 2006
THE 2006 PLAN ESLP COMMON STOCK ESLP PLAN AND 2006
AS OF (A) (B) ( C) (D) ESLP
------------------- ---------------------------------------------------------------------------------
July 31, 2006 4,671,300 $39,500,000 $30.67 1,287,903 5,959,203
August 31, 2006 3,577,900 39,500,000 29.75 1,327,731 4,905,631
September 30, 2006 3,059,800 39,500,000 30.74 1,284,971 4,344,771
WORKING CAPITAL AND DIVIDEND RESTRICTIONS/LIMITATIONS
The Company's credit facilities, including its revolving line of credit which is
available through August of 2010, impose restrictions on the Company's minimum
consolidated net worth, the ratio of the Company's Adjusted EBITDA to corporate
debt interest, the indebtedness of the Company's subsidiaries, and the ratio of
Non-FFELP loans to all loans in the Company's portfolio. In addition, trust
indentures and other financing agreements governing debt issued by the Company's
education lending subsidiaries may have general limitations on the amounts of
funds that can be transferred to the Company by its subsidiaries through cash
dividends.
49
On September 27, 2006 the Company consummated a debt offering of $200.0 million
aggregate principal amount of Capital Efficient Notes ("CENts"). So long as any
CENts remain outstanding, if the Company gives notice of its election to defer
interest payments but the related deferral period has not yet commenced or a
deferral period is continuing, then the Company will not, and will not permit
any of its subsidiaries to:
o declare or pay any dividends or distributions on, or redeem,
purchase, acquire or make a liquidation payment regarding, any
of the Company's capital stock;
o except as required in connection with the repayment of
principal, and except for any partial payments of deferred
interest that may be made through the alternative payment
mechanism described in the CENts indenture, make any payment of
principal of, or interest or premium, if any, on, or repay,
repurchase, or redeem any of the Company's debt securities that
rank PARI PASSU with or junior to the CENts; or
o make any guarantee payments regarding any guarantee by the
Company of the subordinated debt securities of any of the
Company's subsidiaries if the guarantee ranks PARI PASSU with or
junior in interest to the CENts.
In addition, if any deferral period lasts longer than one year, the limitation
on the Company's ability to redeem or repurchase any of its securities that rank
PARI PASSU with or junior in interest to the CENts will continue until the first
anniversary of the date on which all deferred interest has been paid or
cancelled.
If the Company is involved in a business combination where immediately after its
consummation more than 50% of the surviving entity's voting stock is owned by
the shareholders of the other party to the business combination, then the
immediately preceding sentence will not apply to any deferral period that is
terminated on the next interest payment date following the date of consummation
of the business combination.
However, at any time, including during a deferral period, the Company will be
permitted to:
o pay dividends or distributions in additional shares of the
Company's capital stock;
o declare or pay a dividend in connection with the implementation
of a shareholders' rights plan, or issue stock under such a
plan, or redeem or repurchase any rights distributed pursuant to
such a plan; and
o purchase common stock for issuance pursuant to any employee
benefit plans.
50
ITEM 6. EXHIBITS
3.1* Second Amended and Restated Articles of Incorporation of
Nelnet, Inc., as amended
4.1 Indenture dated as of September 27, 2006 between Nelnet, Inc.
and Deutsche Bank Trust Company Americas (filed as
Exhibit 4.1 to the registrant's Current Report on Form
8-K filed on September 28, 2006 and incorporated by
reference herein)
4.2 Supplemental Indenture dated as of September 27, 2006 between
Nelnet, Inc. and Deutsche Bank Trust Company Americas (filed
as Exhibit 4.2 to the registrant's Current Report on Form 8-K
filed on September 28, 2006 and incorporated by reference
herein)
4.3 Form of CENt (filed as Exhibit 4.3 to the registrant's Current
Report on Form 8-K filed on September 28, 2006 and
incorporated by reference herein)
10.1 Replacement Capital Covenant of Nelnet, Inc. dated
September 27, 2006 (filed as Exhibit 10.1 to the registrant's
Current Report on Form 8-K filed on September 28, 2006 and
incorporated by reference herein)
10.2 Amendment to Agreement of Purchase and Sale dated as of
September 25, 2006 between Mad Dog Guest Ranch LLC and Nelnet,
Inc. (filed as Exhibit 10.2 to the registrant's Current Report
on Form 8-K filed on October 16, 2006 and incorporated by
reference herein)
10.3 Office Building Lease dated June 21, 1996 between Miller &
Paine and Union Bank and Trust Company (filed as Exhibit 10.3
to the registrant's Current Report on Form 8-K filed on
October 16, 2006 and incorporated by reference herein)
10.4 Amendment to Office Building Lease dated June 11, 1997 between
Miller & Paine and Union Bank and Trust Company (filed as
Exhibit 10.4 to the registrant's Current Report on Form 8-K
filed on October 16, 2006 and incorporated by reference
herein)
10.5 Lease Amendment Number Two dated February 8, 2001 between
Miller & Paine and Union Bank and Trust Company (filed as
Exhibit 10.5 to the registrant's Current Report on Form 8-K
filed on October 16, 2006 and incorporated by reference
herein)
10.6 Lease Amendment Number Three dated May 23, 2005 between Miller
& Paine, LLC and Union Bank and Trust Company (filed as
Exhibit 10.6 to the registrant's Current Report on Form 8-K
filed on October 16, 2006 and incorporated by reference
herein)
10.7 Lease Agreement dated May 20, 2005 between Miller & Paine, LLC
and Union Bank and Trust Company (filed as Exhibit 10.7 to the
registrant's Current Report on Form 8-K filed on October 16,
2006 and incorporated by reference herein)
10.8 Office Sublease dated April 30, 2001 between Union Bank and
Trust Company and Nelnet, Inc. (filed as Exhibit 10.8 to the
registrant's Current Report on Form 8-K filed on October 16,
2006 and incorporated by reference herein)
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
51
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NELNET, INC.
Date: November 9, 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
52