UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2007
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 incorporation (I.R.S. Employer
or organization) Identification No.)
121 SOUTH 13TH STREET, SUITE 201 68508
LINCOLN, NEBRASKA (Zip Code)
(Address of principal executive offices)
(402) 458-2370 (Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer.
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of July 31, 2007, there were 37,958,775 and 11,495,377 shares of Class A
Common Stock and Class B Common Stock, par value $0.01 per share,
outstanding, respectively.
NELNET, INC.
FORM 10-Q
INDEX
JUNE 30, 2007
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements 2
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 26
Item 3. Quantitative and Qualitative Disclosures about Market Risk 57
Item 4. Controls and Procedures 61
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 61
Item 1A.Risk Factors 62
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 65
Item 4 Submission of Matters to a Vote of Security Holders 67
Item 6. Exhibits 68
Signatures 69
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
JUNE 30, 2007 DECEMBER 31, 2006
------------- -----------------
(UNAUDITED)
ASSETS:
Student loans receivable (net of allowance for loan
losses of $27,140 and $26,003, respectively) $26,174,958 23,789,552
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party 28,336 34,963
Cash and cash equivalents - held at a related party 77,670 67,380
------------- -----------------
Total cash and cash equivalents 106,006 102,343
Restricted cash 1,109,370 1,388,719
Restricted investments 107,226 129,132
Restricted cash - due to customers 44,655 153,557
Accrued interest receivable 584,819 503,365
Accounts receivable, net 56,053 49,227
Goodwill 191,256 191,420
Intangible assets, net 146,542 161,588
Property and equipment, net 68,441 62,285
Assets of discontinued operations -- 27,309
Other assets 91,722 92,277
Fair value of derivative instruments 192,326 146,099
------------- -----------------
Total assets $28,873,374 26,796,873
============= =================
LIABILITIES:
Bonds and notes payable $27,791,146 25,562,119
Accrued interest payable 118,666 120,211
Liabilities of discontinued operations -- 7,732
Other liabilities 264,169 253,431
Due to customers 44,655 153,557
Fair value of derivative instruments 43,560 27,973
------------- -----------------
Total liabilities 28,262,196 26,125,023
------------- -----------------
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 37,661,381 shares as of June 30,
2007 and 39,035,169 shares as of December 31, 2006 377 390
Class B, $0.01 par value. Authorized 60,000,000 shares;
issued and outstanding 11,495,377 shares as of June 30,
2007 and 13,505,812 shares as of December 31, 2006 115 135
Additional paid-in capital 98,702 182,846
Retained earnings 518,910 496,341
Unearned compensation (4,229) (5,168)
Employee notes receivable (2,697) (2,825)
Accumulated other comprehensive income, net of taxes -- 131
------------- -----------------
Total shareholders' equity 611,178 671,850
------------- -----------------
COMMITMENTS AND CONTINGENCIES
Total liabilities and shareholders' equity $28,873,374 26,796,873
============= =================
See accompanying notes to consolidated financial statements.
2
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
---------------------------- ----------------------------
2007 2006 2007 2006
------------- ------------- ------------- -------------
INTEREST INCOME:
Loan interest $ 417,086 362,742 814,140 688,402
Investment interest 18,783 24,249 40,208 43,726
------------- ------------- ------------- -------------
Total interest income 435,869 386,991 854,348 732,128
INTEREST EXPENSE:
Interest on bonds and notes payable 367,893 300,844 718,388 559,793
------------- ------------- ------------- -------------
Net interest income 67,976 86,147 135,960 172,335
Less provision for loan losses 2,535 2,190 5,288 11,808
------------- ------------- ------------- -------------
Net interest income after provision for loan losses 65,441 83,957 130,672 160,527
------------- ------------- ------------- -------------
OTHER INCOME:
Loan and guarantee servicing income 31,610 28,926 62,076 59,216
Other fee-based income 38,262 16,074 78,291 34,229
Software services income 5,848 4,018 11,596 7,427
Other income 2,937 2,906 9,816 4,893
Derivative market value, foreign currency,
and put option adjustments and derivative
settlements, net 10,743 35,782 2,853 79,789
------------- ------------- ------------- -------------
Total other income 89,400 87,706 164,632 185,554
------------- ------------- ------------- -------------
OPERATING EXPENSES:
Salaries and benefits 59,761 54,753 121,465 104,252
Other operating expenses:
Depreciation and amortization 10,647 9,218 21,657 17,917
Advertising and marketing 15,456 5,100 29,449 9,661
Professional and other services 10,514 5,552 18,883 11,252
Occupancy and communications 5,032 4,908 10,251 9,513
Postage and distribution 5,624 6,127 10,143 11,168
Trustee and other debt related fees 2,785 2,935 5,628 6,040
Other 10,827 12,697 24,399 24,707
------------- ------------- ------------- -------------
Total other operating expenses 60,885 46,537 120,410 90,258
------------- ------------- ------------- -------------
Total operating expenses 120,646 101,290 241,875 194,510
------------- ------------- ------------- -------------
Income before income taxes
and minority interest 34,195 70,373 53,429 151,571
Income tax expense 13,306 26,038 20,570 56,080
------------- ------------- ------------- -------------
Income before minority interest 20,889 44,335 32,859 95,491
Minority interest in subsidiary income -- -- -- (242)
------------- ------------- ------------- -------------
Income from continuing operations 20,889 44,335 32,859 95,249
Income (loss) from discontinued operations, net of tax (6,135) 1,418 (3,325) 2,570
------------- ------------- ------------- -------------
Net income $ 14,754 45,753 29,534 97,819
============= ============= ============= =============
Earnings per share, basic and diluted
Income from continuing operations $ 0.42 0.81 0.66 1.75
Income (loss) from discontinued
operations (0.12) 0.03 (0.07) 0.05
------------- ------------- ------------- -------------
Net income $ 0.30 0.84 0.59 1.80
============= ============= ============= =============
Weighted average shares outstanding, basic and diluted 49,452,960 54,297,230 50,213,349 54,269,440
============= ============= ============= =============
See accompanying notes to consolidated financial statements.
3
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
(Dollars in thousands, except share data)
(unaudited)
PREFERRED COMMON STOCK SHARES CLASS A CLASS B ADDITIONAL
STOCK --------------------------- PREFERRED COMMON COMMON PAID-IN
SHARES CLASS A CLASS B STOCK STOCK STOCK CAPITAL
--------- -------------- ------------ ---------- -------- ---------- -----------
Balance as of March 31, 2006 -- 40,428,988 13,942,954 $ -- 404 139 241,722
Comprehensive income:
Net income -- -- -- -- -- -- --
Other comprehensive income related
to foreign currency translation -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock, net of forfeitures -- 18,693 -- -- -- -- 922
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (328,700) -- -- (3) -- (12,650)
Loan to employee for purchase of
common stock -- -- -- -- -- -- --
--------- -------------- ------------ ---------- -------- ---------- -----------
Balance as of June 30, 2006 -- 40,118,981 13,942,954 $ -- 401 139 229,994
========= ============== ============ ========== ======== ========== ===========
Balance as of March 31, 2007 -- 38,097,623 11,495,377 $ -- 381 115 110,254
Comprehensive income:
Net income -- -- -- -- -- -- --
Other comprehensive income:
Foreign currency translation -- -- -- -- -- -- --
Non-pension postretirement benefit
plan -- -- -- -- -- -- --
Total comprehensive income
Cash dividend on Class A and Class B
common stock - $0.07 per share -- -- -- -- -- -- --
Issuance of common stock, net of forfeitures -- 39,182 -- -- 1 -- 972
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (998) -- -- -- -- (22)
Acquisition of enterprise under common control -- (474,426) -- -- (5) -- (12,502)
Payments received on employee
stock notes receivable -- -- -- -- -- -- --
--------- -------------- ------------ ---------- -------- ---------- -----------
Balance as of June 30, 2007 -- 37,661,381 11,495,377 $ -- 377 115 98,702
========= ============== ============ ========== ======== ========== ===========
Balance as of December 31, 2005 -- 40,040,841 13,962,954 $ -- 400 140 220,432
Comprehensive income:
Net income -- -- -- -- -- -- --
Other comprehensive income related
to foreign currency translation -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock, net of forfeitures -- 386,840 -- -- 3 -- 22,212
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (328,700) -- -- (3) -- (12,650)
Conversion of common stock -- 20,000 (20,000) -- 1 (1) --
Loan to employee for purchase of
common stock -- -- -- -- -- -- --
--------- -------------- ------------ ---------- -------- ---------- -----------
Balance as of June 30, 2006 -- 40,118,981 13,942,954 $ -- 401 139 229,994
========= ============== ============ ========== ======== ========== ===========
Balance as of December 31, 2006 -- 39,035,169 13,505,812 $ -- 390 135 182,846
Comprehensive income:
Net income -- -- -- -- -- -- --
Other comprehensive income:
Foreign currency translation -- -- -- -- -- -- --
Non-pension postretirement benefit
plan -- -- -- -- -- -- --
Total comprehensive income
Cash dividend on Class A and Class B
common stock - $0.14 per share -- -- -- -- -- -- --
Adjustment to adopt provisions of
FASB Interpretation No. 48 -- -- -- -- -- -- --
Issuance of common stock, net of forfeitures -- 152,273 -- -- 2 -- 3,810
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (3,062,070) -- -- (30) -- (75,452)
Conversion of common stock -- 2,010,435 (2,010,435) -- 20 (20) --
Acquisition of enterprise under common control -- (474,426) -- -- (5) -- (12,502)
Payments received on employee
stock notes receivable -- -- -- -- -- -- --
--------- -------------- ------------ ---------- -------- ---------- -----------
Balance as of June 30, 2007 -- 37,661,381 11,495,377 $ -- 377 115 98,702
========= ============== ============ ========== ======== ========== ===========
See accompanying notes to consolidated financial statements.
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
(Dollars in thousands, except share data)
(unaudited) (continued)
ACCUMULATED
UNEARNED EMPLOYEE OTHER TOTAL
RETAINED COMPEN- NOTES COMPREHENSIVE SHAREHOLDERS'
EARNINGS SATION RECEIVABLE INCOME EQUITY
----------- ---------- ----------- -------------- --------------
Balance as of March 31, 2006 480,252 (5,700) -- 389 717,206
Comprehensive income:
Net income 45,753 -- -- -- 45,753
Other comprehensive income related
to foreign currency translation -- -- -- 917 917
--------------
Total comprehensive income 46,670
Issuance of common stock, net of forfeitures -- -- -- -- 922
Compensation expense for stock based awards -- 545 -- -- 545
Repurchase of common stock -- -- -- -- (12,653)
Loan to employee for purchase of
common stock -- -- (501) -- (501)
----------- ---------- ----------- -------------- --------------
Balance as of June 30, 2006 526,005 (5,155) (501) 1,306 752,189
=========== ========== =========== ============== ==============
Balance as of March 31, 2007 507,596 (4,909) (2,701) 382 611,118
Comprehensive income:
Net income 14,754 -- -- -- 14,754
Other comprehensive income:
Foreign currency translation -- -- -- (574) (574)
Non-pension postretirement benefit
plan -- -- -- 192 192
--------------
Total comprehensive income 14,372
Cash dividend on Class A and Class B
common stock - $0.07 per share (3,440) -- -- -- (3,440)
Issuance of common stock, net of forfeitures -- (92) -- -- 881
Compensation expense for stock based awards -- 772 -- -- 772
Repurchase of common stock -- -- -- -- (22)
Acquisition of enterprise under common control -- -- -- -- (12,507)
Payments received on employee
stock notes receivable -- -- 4 -- 4
----------- ---------- ----------- -------------- --------------
Balance as of June 30, 2007 518,910 (4,229) (2,697) -- 611,178
=========== ========== =========== ============== ==============
Balance as of December 31, 2005 428,186 (86) -- 420 649,492
Comprehensive income:
Net income 97,819 -- -- -- 97,819
Other comprehensive income related
to foreign currency translation -- -- -- 886 886
--------------
Total comprehensive income 98,705
Issuance of common stock, net of forfeitures -- (5,980) -- -- 16,235
Compensation expense for stock based awards -- 911 -- -- 911
Repurchase of common stock -- -- -- -- (12,653)
Conversion of common stock -- -- -- -- --
Loan to employee for purchase of
common stock -- -- (501) -- (501)
----------- ---------- ----------- -------------- --------------
Balance as of June 30, 2006 526,005 (5,155) (501) 1,306 752,189
=========== ========== =========== ============== ==============
Balance as of December 31, 2006 496,341 (5,168) (2,825) 131 671,850
Comprehensive income:
Net income 29,534 -- -- -- 29,534
Other comprehensive income:
Foreign currency translation -- -- -- (322) (322)
Non-pension postretirement benefit
plan -- -- -- 191 191
--------------
Total comprehensive income 29,403
Cash dividend on Class A and Class B
common stock - $0.14 per share (6,904) -- -- -- (6,904)
Adjustment to adopt provisions of
FASB Interpretation No. 48 (61) -- -- -- (61)
Issuance of common stock, net of forfeitures -- (591) -- -- 3,221
Compensation expense for stock based awards -- 1,530 -- -- 1,530
Repurchase of common stock -- -- -- -- (75,482)
Conversion of common stock -- -- -- -- --
Acquisition of enterprise under common control -- -- -- -- (12,507)
Payments received on employee
stock notes receivable -- -- 128 -- 128
----------- ---------- ----------- -------------- --------------
Balance as of June 30, 2007 518,910 (4,229) (2,697) -- 611,178
=========== ========== =========== ============== ==============
See accompanying notes to consolidated financial statements.
4
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED JUNE 30,
------------------------
2007 2006
----------- -----------
Net income $ 29,534 97,819
Income (loss) from discontinued operations (3,325) 2,570
----------- -----------
Income from continuing operations 32,859 95,249
Adjustments to reconcile income from continuing
operations to net cash provided
by operating activities, net of business acquisistions
Depreciation and amortization, including loan premiums and
deferred origination costs 150,465 65,673
Derivative market value adjustment (20,374) (106,682)
Foreign currency transaction adjustment 24,974 38,055
Change in value of put options issued in business acquisitions 1,983 284
Proceeds from the sale of floor contracts -- 8,580
Payments to terminate floor contracts (8,100) --
Gain on termination of floor contracts (2,058) --
Loss on sale of business 9,041 --
Gain on sale of student loans (2,286) (1,880)
Non-cash compensation expense 2,591 1,075
Deferred income tax expense (921) 27,255
Provision for loan losses 5,288 11,808
Other non-cash items (848) 531
Increase in accrued interest receivable (81,421) (98,488)
Increase in accounts receivable (6,698) (345)
Decrease in other assets 6,491 13,317
(Decrease) increase in accrued interest payable (1,545) 19,190
Increase in other liabilities 5,667 36,186
----------- -----------
Net cash flows from operating activities - continuing operations 115,108 109,808
Net cash flows from operating activities - discontinued operations (4,467) 523
----------- -----------
Net cash provided by operating activities 110,641 110,331
----------- -----------
Cash flows from investing activities, net of business acquisitions:
Originations, purchases, and consolidations of
student loans, including loan premiums
and deferred origination costs (3,389,420) (3,397,070)
Purchases of student loans, including
loan premiums, from a related party (191,003) (389,266)
Net proceeds from student loan repayments,
claims, capitalized interest, and other 1,060,117 1,400,224
Proceeds from sale of student loans 88,205 189,513
Purchases of property and equipment, net (13,830) (9,385)
Decrease (increase) in restricted cash 279,349 (449,230)
Purchases of restricted investments (239,691) (401,953)
Proceeds from maturities of restricted investments 261,597 416,261
Distribution from equity method investment 434 --
Business acquisitions, net of cash acquired 2,211 (60,271)
Proceeds from sale of business, net of cash sold 7,551 --
----------- -----------
Net cash flows from investing activities - continuing operations (2,134,480) (2,701,177)
Net cash flows from investing activities - discontinued operations (294) (5,148)
----------- -----------
Net cash used in investing activities (2,134,774) (2,706,325)
----------- -----------
Cash flows from financing activities:
Payments on bonds and notes payable (1,435,054) (1,552,432)
Proceeds from issuance of bonds and notes payable 3,601,480 4,097,658
(Payments) proceeds from issuance of notes payable
due to a related party, net (55,715) 71,081
Payments of debt issuance costs (5,899) (10,382)
Dividends paid (6,904) --
Proceeds from issuance of common stock 951 831
Repurchases of common stock (75,482) (12,653)
Payments received on employee stock notes receivable 128 --
Loan to employee for purchase of common stock -- (501)
----------- -----------
Net cash flows from financing activities - continuing operations 2,023,505 2,593,602
Net cash flows from financing activities - discontinued operations -- --
----------- -----------
Net cash provided by financing activities 2,023,505 2,593,602
----------- -----------
Effect of exchange rate fluctuations on cash 548 221
Net decrease in cash and cash equivalents (80) (2,171)
Cash and cash equivalents, beginning of period 106,086 103,650
----------- -----------
Cash and cash equivalents, end of period $ 106,006 101,479
=========== ===========
Supplemental disclosures of cash flow information:
Interest paid $ 630,175 529,266
=========== ===========
Income taxes paid, net of refunds $ 12,130 35,192
=========== ===========
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF JUNE 30, 2007 AND FOR THE THREE MONTHS AND SIX MONTHS ENDED
JUNE 30, 2007 AND 2006 IS UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS, UNLESS OTHERWISE NOTED)
1. BASIS OF FINANCIAL REPORTING
The accompanying unaudited consolidated financial statements of Nelnet, Inc. and
subsidiaries (the "Company") as of June 30, 2007 and for the three and six
months ended June 30, 2007 and 2006 have been prepared on the same basis as the
audited consolidated financial statements for the year ended December 31, 2006
and, in the opinion of the Company's management, the unaudited consolidated
financial statements reflect all adjustments, consisting of normal recurring
adjustments, necessary for a fair presentation of results of operations for the
interim periods presented. The preparation of financial statements in conformity
with U.S. generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the consolidated
financial statements and accompanying notes. Actual results could differ from
those estimates. Operating results for the three and six months ended June 30,
2007 are not necessarily indicative of the results for the year ending December
31, 2007. 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, 2006. Certain amounts from 2006 have been reclassified to conform
to the current period presentation.
2. DISCONTINUED OPERATIONS
On May 25, 2007, the Company sold EDULINX Canada Corporation ("EDULINX"), a
Canadian student loan service provider and subsidiary of the Company, for
initial proceeds of $19.0 million, including the impact of a preliminary working
capital adjustment. The Company recognized a net loss of $9.0 million related to
the transaction. The initial proceeds and the related loss on disposal exclude
up to $2.5 million of contingent consideration that, if earned based on EDULINX
meeting certain performance measures as defined in an existing servicing
agreement between EDULINX and the Government of Canada, will be payable to the
Company in the second quarter 2008. If the Company receives this incentive
payment of up to $2.5 million, these additional proceeds will be recognized by
the Company as a gain in the period when such cash is received.
As a result of this transaction, the results of operations for EDULINX are
reported as discontinued operations in the accompanying consolidated statements
of income for all periods presented. The segment results in note 11 also reflect
the reclassification of EDULINX to discontinued operations. The operating
results of EDULINX were included in the Student Loan and Guaranty Servicing
operating segment.
The components of the income (loss) from discontinued operations are presented
below.
Three months Six months
ended June 30, ended June 30,
----------------- ------------------
2007 2006 2007 2006
--------- ------- -------- ---------
Operating income of discontinued operations $ 4,864 2,232 9,278 4,053
Income tax on operations (1,958) (814) (3,562) (1,483)
Loss on disposal (8,151) -- (8,151) --
Income tax on disposal (890) -- (890) --
--------- ------- -------- ---------
Income (loss) from discontinued
operations, net of tax $ (6,135) 1,418 (3,325) 2,570
========= ======= ======== =========
6
The following operations related to EDULINX have been segregated from continuing
operations and reported as discontinued operations through the date of
disposition. Interest expense was not allocated to EDULINX and, therefore, all
of the Company's interest expense is included within continuing operations.
Three months Six months
ended June 30, ended June 30,
------------------ -------------------
2007 2006 2007 2006
--------- -------- --------- ---------
Net interest income $ 53 65 124 129
Other income 12,480 15,149 31,511 31,933
Operating expenses (7,669) (12,982) (22,357) (28,009)
-------- --------- --------- ----------
Income before income taxes 4,864 2,232 9,278 4,053
Income tax expense 1,958 814 3,562 1,483
-------- --------- --------- ----------
Operating income of
discontinued operations,
net of tax $ 2,906 1,418 5,716 2,570
======== ========= ========= ==========
The assets and liabilities of EDULINX are classified as assets and liabilities
of discontinued operations within the Company's consolidated balance sheet for
all periods prior to the sale of EDULINX. Assets and liabilities of discontinued
operations as of December 31, 2006 are summarized below.
Cash $ 3,743
Accounts receivable, net 15,632
Property and equipment, net 5,639
Intangible assets, net 1,406
Other assets 889
---------
Assets of discontinued operations $ 27,309
=========
Other liabilities $ 7,732
---------
Liabilities of discontinued operations $ 7,732
=========
3. RECENT DEVELOPMENTS
DEPARTMENT OF EDUCATION SETTLEMENT
In June 2005, the Office of Inspector General of the U.S. Department of
Education (the "OIG") commenced an audit of the portion of the Company's student
loan portfolio receiving special allowance payments at a minimum 9.5% interest
rate based on provisions of the Higher Education Act and regulations and
guidance of the U.S. Department of Education (the "Department") and related
interpretations. On September 29, 2006, the Company received a final audit
report from the OIG where the OIG found that an increase in the amount of 9.5%
special allowance payments received by the Company was based on what the OIG
deemed to be ineligible loans.
On January 19, 2007, the Company entered into a Settlement Agreement with the
Department to resolve the OIG audit of the Company's portfolio of student loans
receiving 9.5% special allowance payments. Under the terms of the Settlement
Agreement, the Company is permitted to retain the 9.5% special allowance
payments that it received from the Department prior to July 1, 2006. In
addition, the Settlement Agreement eliminates all 9.5% special allowance
payments with respect to the Company's portfolios of student loans for periods
on and after July 1, 2006.
The Company disagrees with the OIG audit report, and continues to believe that
it billed for the 9.5% special allowance payments in accordance with applicable
laws, regulations, and the Department's previous guidance. As a part of the
Settlement Agreement, the Company and the Department acknowledge a dispute
exists related to guidance previously issued by the Department and the
application of the existing laws and regulations related to the Company
receiving certain 9.5% special allowance payments, and that the Settlement
Agreement is based in part on the parties' desire to avoid costly litigation
regarding that dispute. The new guidance provided to the Company in the
Settlement Agreement eliminates all 9.5% special allowance payments for the
Company. These loans will continue to receive special allowance payments using
other applicable special allowance formulas.
7
INDUSTRY INQUIRIES AND INVESTIGATIONS
Since January 2007, a number of state attorneys general and the U.S. Senate
Committee on Health, Education, Labor, and Pensions have announced or are
reportedly conducting broad inquiries or investigations of the activities of
various participants in the student loan industry, including activities which
may involve perceived conflicts of interest. The general focus of the inquiries
or investigations to date has primarily been on any financial arrangements among
student loan lenders and other industry participants which may facilitate
increased volumes of student loans for particular lenders. Like many other
student loan lenders, the Company has received informal requests for information
from certain state attorneys general and the Chairman of the U.S. Senate
Committee on Health, Education, Labor, and Pensions in connection with their
inquiries or investigations. In addition, the Company has received subpoenas for
information from the New York Attorney General, the New Jersey Attorney General,
and the Ohio Attorney General. In each case the Company is cooperating with the
requests and subpoenas for information that it has received.
On April 20, 2007, the Company announced that it had agreed with the Nebraska
Attorney General to voluntarily adopt a Nelnet Student Loan Code of Conduct,
post a review of the Company's business practices on its website, and commit
$1.0 million to help educate students and families on how to plan and pay for
their education.
On July 31, 2007, the Company announced that it had agreed with the New York
Attorney General to adopt the New York Attorney General's Code of Conduct, which
is substantially similar to the Nelnet Student Loan Code of Conduct, but which
also includes an agreement to eliminate two services the Company had previously
announced plans to discontinue - the Company's outsourcing of calls for
financial aid offices and its agreements with college alumni associations
providing for marketing of consolidation loans to the associations' members. As
part of the agreement, the Company agreed to contribute $2.0 million to a
national fund for educating high school seniors and their parents regarding the
financial aid process. One million dollars of the national fund contribution
will come from the money the Company committed to helping educate students and
families in connection with the Company's agreement with the Nebraska Attorney
General.
While the Company cannot predict the ultimate outcome of any other inquiry or
investigation, the Company believes its activities have materially complied with
the Higher Education Act, the rules and regulations adopted by the Department of
Education thereunder, and the Department's guidance regarding those rules and
regulations.
DEPARTMENT OF EDUCATION REVIEW
The Department of Education periodically reviews participants in the FFEL
Program for compliance with program provisions. On June 28, 2007, the Department
of Education notified the Company that it would be conducting a review of the
Company's administration of the FFEL Program under the Higher Education Act. The
Company understands that as of July 23, 2007, the Department of Education has
selected 47 schools and 27 lenders for review. Specifically, the Department is
reviewing the Company's practices in connection with the inducement provisions
of the Higher Education Act and the provisions of the Higher Education Act and
the associated regulations which allow borrowers to have a choice of lenders.
The Company is cooperating with the Department of Education's review. While the
Company cannot predict the ultimate outcome of the review, the Company believes
its activities have materially complied with the Higher Education Act, the rules
and regulations adopted by the Department of Education thereunder, and the
Department's guidance regarding those rules and regulations.
LEGISLATION RELATED TO THE HIGHER EDUCATION ACT
Recently the U.S. House of Representatives passed the College Cost Reduction Act
of 2007 and the U.S. Senate passed the Higher Education Access Act of 2007. Both
of these bills contain provisions with significant implications for participants
in the FFEL Program. Among other things, these bills include the following
provisions:
o reducing special allowance payments to lenders;
o reducing default insurance rates and elimination of the
Exceptional Performer program;
o increasing lender origination fees;
o increasing annual and aggregate loan limits for certain Stafford
loans; and
o reducing interest rates for subsidized Stafford loans.
Neither the College Cost Reduction Act of 2007 nor the Higher Education Access
Act of 2007 has been enacted into law. The impact of these bills is difficult to
predict; however, if the proposed federal government spending cuts and increased
fees for FFEL Program participants are enacted, the Company's revenues would be
negatively impacted. See Part I, Item II, "Management's Discussion and Analysis
of Financial Condition and Results of Operations - Results of Operations -
Recent Developments - Legislation Related to the Higher Education Act."
8
In addition to the College Cost Reduction Act of 2007 and the Higher Education
Access Act of 2007, other bills have been introduced in Congress which contain
provisions which could significantly impact participants in the FFEL Program.
Among other things, the proposals include:
o requiring disclosures relating to placement on "preferred lender
lists";
o banning various arrangements between lenders and schools;
o banning lenders from offering certain gifts to school employees;
o eliminating the school-as-lender program;
o encouraging borrowers to maximize their borrowing through
government loan programs prior to private loan programs with
higher interest rates;
o encouraging schools to participate in the Federal Direct Loan
Program through increased federal grant funds; and
o increasing the lender origination fee for consolidation loans.
As of the date of this Report, none of these bills has been enacted into law.
The impact of the proposed legislation is difficult to predict; however,
increased fees for FFEL Program lenders and decreased loan volume as a result of
increased participation in the Federal Direct Loan Program could have a negative
impact on the Company's revenues.
4. STUDENT LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
Student loans receivable consist of the following:
As of As of
June 30, 2007 December 31, 2006
------------- ----------------
Federally insured loans $25,510,977 23,217,321
Non-federally insured loans 235,023 197,147
------------- -------------
25,746,000 23,414,468
Unamortized loan premiums and deferred origination costs 456,098 401,087
Allowance for loan losses - federally insured loans (8,194) (7,601)
Allowance for loan losses - non-federally insured loans (18,946) (18,402)
------------- -------------
$26,174,958 23,789,552
============= =============
Non-federally insured allowance as a percentage of
ending balance of non-federally insured loans 8.06% 9.33%
Total allowance as a percentage of ending
balance of total loans 0.11% 0.11%
Management has begun to estimate the impact to the Company's operating results
based on the legislative changes discussed in note 3. At the time the
legislation becomes final, the Company will recognize a provision for loan
losses related to the increase in risk share due to the anticipated elimination
of the Exceptional Performer program. Assuming the elimination of the
Exceptional Performer program and a default insurance rate of 97 percent, based
on the balance of federally insured loans outstanding as of June 30, 2007, this
provision is expected to be approximately $17 to $18 million.
LOAN SALES
As part of the Company's asset management strategy, the Company periodically
sells student loan portfolios to third parties. During the three and six months
ended June 30, 2007 the Company sold $34.4 million and $86.0 million (par
value), respectively, of student loans resulting in the recognition of a gain of
$1.0 million and $2.8 million, respectively. The gain on the sale of the student
loans is included in "other income" on the consolidated statements of income.
5. BUSINESS ACQUISITIONS
The Company has positioned itself for growth by building a strong foundation
through business and certain asset acquisitions. Although the Company's assets,
loan portfolios, net interest income, 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. The acquisitions described below expand the Company's
products and services offered to education and financial institutions and
students and families throughout the education and education finance process. In
addition, these acquisitions diversify the Company's asset generation streams
and/or diversify revenue by offering other products and services that are not
dependent on government programs, which management believes will reduce the
Company's exposure to legislation and political risk. The Company also expects
to reduce costs from theses acquisitions through economies of scale and by
integrating certain support services. In addition, the Company expects to
increase revenue from these acquisitions by offering multiple products and
services to its customers.
9
During 2006, the Company (i) purchased the remaining 20% of the stock of FACTS
Management Co. ("FACTS"), (ii) purchased the remaining 50% of the stock of
infiNET Integrated Solutions, Inc. ("infiNET"), (iii) purchased 100% of the
membership interests of CUnet, LLC ("CUnet"), and (iv) purchased certain assets
and assumed certain liabilities (hereafter referred to as "Peterson's") from
Thompson Learning Inc. These acquisitions were accounted for by the Company
under purchase accounting and are described in footnote 4 in the Company's
consolidated financial statements included in the Company's Annual Report on
Form 10-K for the year ended December 31, 2006. The Company finalized the
purchase price allocation of infiNET and CUnet during 2007 which is presented
below. The Company is in the process valuing certain intangible assets of
Peterson's; thus, the allocation of the purchase price for Peterson's is subject
to refinement.
INFINET INTEGRATED SOLUTIONS, INC.
On April 20, 2004, the Company purchased 50% of the stock of infiNET for $4.9
million. On February 17, 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 and universities. Consideration for the purchase of the remaining
50% of the stock of infiNET 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 guaranty 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 of $5.7 million issued to these employees 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. Any cash paid by the Company in consideration of satisfying the
guaranteed value of stock issued for this acquisition would be recorded by the
Company as a reduction to additional paid-in capital.
Prior to purchasing the remaining 50% of the common stock of infiNET, the
Company accounted for this investment under the equity method. The purchase of
the remaining 50% of the stock of infiNET was accounted for under purchase
accounting and the results of operations have been included in the consolidated
financial statements from January 31, 2006, the effective date of the
acquisition.
The following table summarizes the estimated fair values of the assets acquired
and liabilities assumed at the date of acquisition for the remaining 50% of the
stock of infiNET.
Cash and cash equivalents $ 3,266
Restricted cash - due to customers 16,343
Accounts receivable 558
Intangible assets 4,172
Property and equipment 134
Other assets 576
Excess cost over fair value of net assets acquired (goodwill) 12,474
Due to customers (16,343)
Other liabilities (2,334)
Previously recorded investment in equity interest (5,047)
----------
$ 13,799
==========
As of the date of acquisition, the $4.2 million of acquired intangible assets
had a weighted average useful life of approximately seven years. The intangible
assets that made up this amount included non-competition agreements of $2.0
million (5-year useful life), customer relationships of $1.6 million (10-year
useful life), computer software of $0.4 million (5-year useful life), and trade
names of $0.2 million (3-year useful life). All intangible assets are amortized
using a straight-line amortization method with the exception of customer
relationships. The customer relationships intangible asset is amortized over the
period of projected revenues and expenses (cash flows) attributable to this
asset as of the date of acquisition. Because of customer attrition, the
estimated annual cash flows related to customer relationships diminish as time
extends from the date of acquisition. As such, the Company uses an accelerated
amortization method that reflects the pattern in which the estimated economic
benefits of this acquired asset is used by the Company.
The $12.5 million of goodwill was assigned to the Tuition Payment Processing and
Campus Commerce operating segment and is not expected to be deductible for tax
purposes.
10
CUNET, LLC
On June 30, 2006, the Company purchased 100% of the membership interests of
CUnet. The initial consideration paid by the Company was $40.1 million in cash,
including $0.1 million of direct acquisition costs. 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 as
of December 15, 2010 of any shares previously issued as contingent
consideration. The Company will record the contingency payments when the
applicable contingency is resolved and the additional consideration is issued or
issuable or the outcome of the contingency is determinable beyond a reasonable
doubt. 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
date of the acquisition.
The following table summarizes the estimated fair values of the assets acquired
and liabilities assumed at the date of acquisition.
Accounts receivable $ 5,154
Intangible assets 14,962
Property and equipment 360
Other assets 520
Excess cost over fair value of net assets acquired (goodwill) 23,910
Other liabilities (4,818)
--------
$40,088
========
As of the date of acquisition, the $15.0 million of acquired intangible assets
had a weighted-average useful life of approximately seven years. The intangible
assets that made up this amount included customer relationships of $10.4 million
(8-year useful life), non-competition agreements of $2.6 million (5-year useful
life), trade names of $1.7 million (4-year useful life), and computer software
of $0.3 million (3-year useful life). All intangible assets are amortized using
a straight-line amortization method with the exception of customer
relationships. The customer relationships intangible asset is amortized over the
period of projected revenues and expenses (cash flows) attributable to this
asset as of the date of acquisition. Because of customer attrition, the
estimated annual cash flows related to customer relationships diminish as time
extends from the date of acquisition. As such, the Company uses an accelerated
amortization method that reflects the pattern in which the estimated economic
benefits of this acquired asset is used by the Company.
The $23.9 million of goodwill was assigned to the Enrollment Services and List
Management operating segment and is expected to be deductible for tax purposes.
PETERSON'S
On July 27, 2006, the Company purchased certain assets and assumed certain
liabilities from Thomson Learning Inc. The initial consideration paid by the
Company was $38.6 million in cash. The final purchase price of Peterson's was
subject to certain purchase price adjustments as defined in the purchase price
agreement. During the first quarter of 2007, the purchase price for Peterson's
was finalized per the terms of the purchase agreement and the Company received a
$2.2 million working capital settlement. As such, the total consideration paid
by the Company for Peterson's was $36.4 million. 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 provides its customers with 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 date of the
acquisition.
11
The following table summarizes the estimated fair values of the assets acquired
and liabilities assumed at the date of acquisition. The Company is in the
process of valuing certain intangible assets; thus, the allocation of the
purchase price is subject to refinement.
Accounts receivable $ 7,055
Intangible assets 3,714
Property and equipment 2,341
Other assets 2,375
Excess cost over fair value of net assets acquired (goodwill) 35,114
Other liabilities (14,173)
---------
$ 36,426
=========
As of the date of acquisition, the intangible assets consist of database content
and computer software of $1.9 million and $1.8 million, respectively, and are
being amortized using a straight-line amortization method over their estimated
useful life of three years.
The $35.1 million of goodwill was assigned to the Enrollment Services and List
Management operating segment and is expected to be deductible for tax purposes.
PRO FORMA INFORMATION
The following pro forma information presents the combined results of the Company
as though the 2006 acquisitions of FACTS (20%), infiNET, CUnet, and Peterson's
occurred as of the beginning of each reporting period. The pro forma information
does not necessarily reflect the results of operations if the acquisitions had
been in effect at the beginning of the period or that may be attained in the
future. In addition, the pro forma information reflects the results of
operations based on the Company's preliminary allocation of purchase price
(where applicable).
Three months ended June 30, Six months ended June 30,
---------------------------- --------------------------
2007 2006 2007 2006
----------- --------------- ----------- -------------
Net interest income $ 67,976 86,156 135,960 172,375
Other income (expense) (a) 89,400 103,819 164,632 218,148
Net income from continuing operations 20,889 43,084 32,859 93,108
Net income 14,754 44,502 29,534 95,678
Weighted average shares outstanding, basic and diluted 49,452,960 54,297,230 50,213,349 54,326,579
Earnings per share, basic and diluted:
Income from continuing operations $ 0.42 0.79 0.66 1.71
Net Income 0.30 0.82 0.59 1.76
(a) Other income (expense) includes derivative market value, foreign currency,
and put option adjustments and net derivative settlements.
12
6. INTANGIBLE ASSETS AND GOODWILL
Intangible assets consist of the following:
Weighted
average
remaining
useful life as of As of As of
June 30, June 30, December 31,
2007 2007 2006
----------------- ------------ ------------
Amortizable intangible assets:
Customer relationships (net of accumulated amortization of $15,335
and $10,483, respectively) 123 $ 63,285 67,377
Covenants not to compete (net of accumulated amortization of
$13,255 and $9,559, respectively) 52 31,727 37,573
Loan origination rights (net of accumulated amortization of $9,409
and $7,238, respectively) 63 25,400 27,571
Student lists (net of accumulated amortization of $4,782 and
$3,757, respectively) 20 3,415 4,440
Computer software (net of accumulated amortization of $2,112
and $1,354, respectively) 13 2,662 3,578
Trade names (net of accumulated amortization of $594 and
$327, respectively) 34 1,433 1,700
Other (net of accumulated amortization of $632 and $348, respectively) 36 1,521 2,250
----------------- ------------ ------------
Total - amortizable intangible assets 87 months 129,443 144,489
=================
Unamortizable intangible assets - trade names 17,099 17,099
------------ ------------
$ 146,542 161,588
============ ============
The Company recorded amortization expense on its intangible assets of $6.5
million and $5.8 million for the three months ended June 30, 2007 and 2006,
respectively, and $13.1 million and $11.1 million for the six months ended June
30, 2007 and 2006, respectively. The Company will continue to amortize
intangible assets over their remaining useful lives. As disclosed in note 5, the
Company is in the process of valuing certain intangible assets; however, as of
June 30, 2007, the Company estimates it will record amortization expense as
follows:
2007 $ 13,319
2008 25,836
2009 22,240
2010 18,257
2011 12,910
2012 and thereafter 36,881
---------
$129,443
=========
The change in the carrying amount of goodwill by operating segment was as
follows:
Tuition
Asset Payment Enrollment Software
Generation Student Loan Processing Services and
and and Guaranty and Campus and List Technical
Management Servicing Commerce Management Services Total
---------- ----------- ---------- ----------- ----------- -----------
Balance as of December 31, 2006 $ 42,550 -- 57,858 82,416 8,596 191,420
Goodwill from prior period acquisition
allocated during the period -- -- 228 (434) -- (206)
---------- ----------- ---------- ----------- ----------- -----------
Balance as of March 31, 2007 $ 42,550 -- 58,086 81,982 8,596 191,214
---------- ----------- ---------- ----------- ----------- -----------
Goodwill from prior period acquisition
allocated during the period -- -- -- 42 -- 42
---------- ----------- ---------- ----------- ----------- -----------
Balance as of June 30, 2007 $ 42,550 -- 58,086 82,024 8,596 191,256
========== =========== ========== =========== =========== ===========
13
7. BONDS AND NOTES PAYABLE
The following tables summarize outstanding bonds and notes payable by type of
instrument:
As of June 30, 2007
---------------------------------------------
Carrying Interest rate
amount range Final maturity
----------- ------------- -----------------
Variable-rate bonds and notes (a):
Bonds and notes based on indices $ 18,025,310 3.75% - 6.06% 05/01/11 - 05/01/42
Bonds and notes based on auction 2,261,395 3.07% - 5.40% 11/01/09 - 07/01/43
-----------
Total variable-rate bonds and notes 20,286,705
Commercial paper and other 6,444,656 5.32% - 5.60% 10/17/07 - 05/09/08
Fixed-rate bonds and notes (a) 219,617 5.20% - 6.68% 11/01/09 - 05/01/29
Unsecured fixed rate debt 475,000 5.13% - 7.40% 06/01/10 - 09/29/36
Unsecured line of credit 307,710 5.39% - 5.50% 05/08/12
Other borrowings 57,458 5.10% - 5.80% 06/28/08 - 11/01/15
-----------
$ 27,791,146
===========
(a) Issued in securitization transactions
As of December 31, 2006
------------------------------------------------
Carrying Interest rate
amount range Final maturity
------------- ------------- ----------------
Variable-rate bonds and notes (a):
Bonds and notes based on indices $ 16,622,385 3.63% - 6.08% 02/26/07 - 05/01/42
Bonds and notes based on auction 2,671,370 3.63% - 5.45% 11/01/09 - 07/01/43
-------------
Total variable-rate bonds and notes 19,293,755
Commercial paper and other 5,173,723 5.26% - 5.62% 05/11/07 - 10/17/08
Fixed-rate bonds and notes (a) 403,431 5.20% - 6.68% 11/01/09 - 05/01/29
Unsecured fixed rate debt 475,000 5.13% - 7.40% 06/01/10 - 09/29/36
Unsecured line of credit 103,000 5.69% - 8.25% 08/19/10
Other borrowings 113,210 5.10% - 5.78% 06/29/07 - 11/01/15
-------------
$ 25,562,119
=============
(a) Issued in securitization transactions
On May 16, 2007 the Company consummated a debt offering of student loan
asset-backed notes of $2.4 billion with a final maturity date of 2037. Notes
issued in this transaction carry interest rates based on a spread to LIBOR or
auction rates.
As of June 30, 2007, the Company had a loan warehousing capacity of $3.8
billion, of which $3.1 billion was outstanding, through bank supported
commercial paper conduit programs. The Company had $0.7 billion in warehouse
capacity available under its warehouse facilities as of June 30, 2007.
In August 2006, the Company established a $5.0 billion loan warehouse program
under which it can issue one or more short-term extendable secured liquidity
notes (the "Secured Liquidity Notes"). The Secured Liquidity Notes are secured
by Federal Family Education Loan Program ("FFELP" or "FFEL Program") loans
purchased in connection with the program. As of June 30, 2007, the Company had
$3.4 billion of Secured Liquidity Notes outstanding and an additional $1.6
billion authorized for future issuance under this warehouse program.
On August 19, 2005, the Company entered into a credit agreement for a $500.0
million unsecured line of credit. On May 8, 2007, the Company amended this
agreement to increase the line of credit to $750.0 million. As of June 30, 2007,
there were no borrowings outstanding on this line. The amended agreement
terminates in May 2012.
14
On January 24, 2007, the Company established a $475.0 million unsecured
commercial paper program and in May 2007 increased the amount authorized for
issuance under the program to $725.0 million. Under the program, the Company may
issue commercial paper for general corporate purposes. The maturities of the
notes issued under this program will vary, but may not exceed 397 days from the
date of issue. Notes issued under this program will bear interest at rates that
will vary based on market conditions at the time of issuance. As of June 30,
2007, there was $307.7 million of notes outstanding under this program and
$417.3 million authorized for future issuance.
As of June 30, 2007 and December 31, 2006, bonds and notes payable includes
$52.4 million and $108.1 million of notes due, respectively, 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.
Notes issued in February 2006 and May 2006 included (euro)420.5 million and
(euro)352.7 million (500.0 million and 450.0 million in U.S. dollars,
respectively) with variable interest rates initially based on a spread to
EURIBOR (the "Euro Notes"). The increase in the principal amount of Euro Notes
as a result of the fluctuation of the foreign currency exchange rate of $11.3
million and $25.0 million for the three and six months ended June 30, 2007,
respectively, and $27.6 million and $38.1 million for the three and six months
ended June 30, 2006, respectively, is included in the "derivative market value,
foreign currency, and put option adjustments and derivative settlements, net" in
the consolidated statements of income. Concurrently with the issuance of the
Euro Notes, the Company entered into cross-currency interest rate swaps which
are further discussed in note 8.
8. 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 Company has historically used interest rate swaps to hedge fixed-rate
student loan assets. As previously disclosed, the Company reached a Settlement
Agreement with the Department to resolve the audit by the OIG of the Company's
portfolio of student loans receiving 9.5% special allowance payments. Under the
terms of the Agreement, the Company will no longer receive 9.5% special
allowance payments. In December 2006, in consideration of not receiving the 9.5%
special allowance payments on a prospective basis, the Company entered into a
series of off-setting interest rate swaps that mirror the $2.45 billion in
pre-existing interest rate swaps that the Company had utilized to hedge its loan
portfolio receiving 9.5% special allowance payments against increases in
interest rates. During the 2nd quarter 2007, the Company entered into a series
of off-setting interest rate swaps that mirrored the remaining interest rate
swaps utilized to hedge the Company's student loan portfolio against increases
in interest rates. The net effect of the offsetting derivatives was to lock in a
series of future income streams on underlying trades through their respective
maturity dates. The following table summarizes these derivatives as of June 30,
2007:
Weighted Weighted
average fixed average fixed
Notional rate paid by Notional rate received by
Maturity Amount the Company Amount the Company
------------ ------------ --------------- ------------ -----------------
2007 $ 512,500 3.42 % $ 512,500 5.25 %
2008 462,500 3.76 462,500 5.34
2009 312,500 4.01 312,500 5.37
2010 1,137,500 4.25 1,137,500 4.75
2011 -- -- -- --
2012 275,000 4.31 275,000 4.76
2013 525,000 4.36 525,000 4.80
------------ --------------- ------------ -----------------
$3,225,000 4.05 % $ 3,225,000 4.98 %
============ =============== ============ =================
In August 2007, the Company terminated all interest rate swaps summarized above
for net proceeds of $50.8 million.
BASIS SWAPS
On May 1, 2006, the Company entered into three, 10-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 were November 25, 2006,
December 25, 2006, and January 25, 2007.
During 2007, the Company entered into basis swaps in which the Company receives
three-month LIBOR set discretely in advance and pays a daily weighted average
three-month LIBOR less a spread as defined in the individual agreements. The
Company entered into these derivative instruments to better match the interest
rate characteristics on its student loan assets and the debt funding such
assets. The following table summarizes these derivatives as of June 30, 2007:
15
Notional Amount
----------------------------------------------------------------------------------------------
Effective date in Effective date in Effective date in Effective date in
Maturity second quarter 2007 third quarter 2007 second quarter 2008 third quarter 2008 Total
--------- -------------------- ----------------- --------------------- ------------------- ------------
2008 $ 2,000,000 2,000,000 -- -- 4,000,000
2009 2,000,000 4,000,000 -- -- 6,000,000
2010 500,000 3,000,000 2,000,000 1,000,000 6,500,000
2011 1,350,000 2,700,000 -- -- 4,050,000
2012 500,000 1,000,000 800,000 1,600,000 3,900,000
-------------------- ----------------- --------------------- ------------------- ------------
$ 6,350,000 12,700,000 2,800,000 2,600,000 24,450,000
==================== ================= ===================== =================== ============
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. On January 30, 2007, the Company paid $8.1
million to terminate these interest rate floor contracts which resulted in the
recognition of a $2.1 million gain that is included in other income on the
consolidated statement of income.
CROSS-CURRENCY INTEREST RATE SWAPS
The Company entered into derivative instruments in 2006 as a result of the
issuance of the Euro Notes as discussed in note 7. 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 income at
each reporting date.
The following table summarizes the net fair value of the Company's derivative
portfolio:
As of As of
June 30, 2007 December 31,2006
------------- ----------------
Interest rate swaps $ 52,248 61,468
Basis swaps 3,181 591
Interest rate floor contracts -- (10,158)
Cross-currency interest
rate swaps 93,337 66,225
--------- ---------
Net fair value $148,766 118,126
========= =========
The change in the fair value of the Company's derivative portfolio included in
"derivative market value, foreign currency, and put option adjustments and
derivative settlements, net" on the Company's consolidated statements of income
resulted in a gain of $16.7 million and $20.4 million for the three and six
months ended June 30, 2007, respectively, and a gain of $56.4 million and $106.7
million for the three and six months ended June 30, 2006, respectively.
The following table summarizes the net derivative settlements that are included
in the "derivative market value, foreign currency, and put option adjustments
and derivative settlements, net" on the consolidated statements of income:
Three months Six months
ended June 30, ended June 30,
--------------------- --------------------
2007 2006 2007 2006
---------- ---------- --------- ---------
Interest rate swaps $ 7,576 10,715 15,074 16,925
Basis swaps 58 (197) 119 (511)
Cross-currency interest rate swaps (2,438) (3,816) (5,757) (4,968)
---------- ---------- --------- ---------
Derivative settlements, net $ 5,196 6,702 9,436 11,446
========== ========== ========= =========
16
9. SHAREHOLDERS' EQUITY
RELATED PARTY TRANSACTIONS
On May 31, 2007, the Company entered into an agreement with Packers Service
Group, Inc. ("Packers"), under which the Company agreed to acquire Packers in
exchange for the issuance of 10,594,178 shares of the Company's Class A common
stock to the shareholders of Packers.
Packers was owned by 30 individual shareholders, the most significant of whom
included Michael S. Dunlap, an executive officer, member of the Board of
Directors, and a substantial shareholder of the Company, and Angela L.
Muhleisen, a substantial shareholder of the Company and a sister of Mr. Dunlap.
Packers was primarily a holding company, whose principal asset was an investment
in 11,068,604 shares of the Company's Class A Common Stock. Upon acquisition,
these shares are not included in total shares outstanding for accounting
purposes. Packers also owned all of the outstanding capital stock of First
National Life Insurance Company ("First National Life"), which writes credit
life and credit accident and health insurance policies. First National Life's
net assets as of May 31, 2007 were $1.6 million. In addition, Packers had
outstanding debt of $14.1 million, which the Company assumed.
The Company accounted for this transaction as exchanges of assets or equity
instruments between enterprises under common control and, accordingly, recorded
the assets acquired and liabilities assumed from this transaction at Packer's
historical carrying values. This transaction resulted in a $12.5 million
decrease to the Company's consolidated shareholders' equity and a decrease of
474,426 shares of the Company's Class A common stock outstanding.
RESTRICTED STOCK PLAN
In order to facilitate increased equity ownership by Company employees, on July
23, 2007, the Company issued approximately 522,000 shares of Class A common
stock or common stock units under the Company's Restricted Stock Plan. Under the
terms for such awards, the shares will vest on a pro rata basis over a period of
10 years based on the award recipient's continued employment with the Company.
Upon issuance, the value of these shares will be included as unearned
compensation within shareholders' equity. The Company will recognize
compensation expense related to these awards over the 10-year vesting period.
PUT OPTION SETTLEMENT
On July 19, 2007, the Company paid $15.9 million to redeem 238,237 shares of the
Company's Class A common stock that were subject to put option agreements
exercisable in February 2010 at $83.95 per share. These shares were issued by
the Company in February 2006 in consideration for the purchase of the remaining
20% interest of FACTS. The 238,237 shares of Class A common stock purchased by
the Company were retired resulting in a $5.4 million decrease to the Company's
consolidated shareholders' equity.
CONVERSION OF CLASS B COMMON STOCK
In February 2007, a principal shareholder gifted 10,435 shares of Class B common
stock to a charitable organization. Per the articles of incorporation, these
shares were voluntarily converted to Class A shares upon transfer. Also in
February 2007, in anticipation of selling shares to the Company under the
Company's stock repurchase program in a private transaction, a principal
shareholder voluntarily converted 2,000,000 shares of Class B common stock to
shares of Class A common stock.
STOCK REPURCHASE PROGRAM
In February 2007, the Company's Board of Directors increased the number of
shares the Company is authorized to repurchase under a stock repurchase program
from five million to 10 million shares of the Company's Class A common stock.
The program has an expiration date of May 24, 2008. During the six months ended
June 30, 2007, the Company repurchased 3,062,070 shares of Class A common stock,
including 2,725,000 shares repurchased from certain members of management of the
Company, for $75.5 million (average price of $24.66 per share) under this
authority.
10. INCOME TAXES
On January 1, 2007, the Company adopted the provisions of Financial Accounting
Standards Board Interpretation No. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME
TAXES--AN INTERPRETATION OF FASB STATEMENT NO. 109 ("FIN 48"), which clarifies
the accounting for uncertainty in income tax positions. This interpretation
requires the Company to recognize in the consolidated financial statements only
those tax positions determined to be more likely than not of being sustained
upon examination, based on the technical merits of the positions. Upon adoption,
the Company recognized approximately $61,000 of tax liabilities for positions
that were previously recognized, of which the Company accounted for as a
reduction to retained earnings. Additionally, the adoption of FIN 48 resulted in
the recognition of additional tax reserves for positions where there is
uncertainty about the timing or character of such deductibility. These
additional reserves were largely offset by increased deferred tax assets.
17
After considering the impact of adopting FIN 48, the Company had a $10.8 million
reserve for uncertain income tax positions as of January 1, 2007. Approximately
$8.3 million of this, if recognized, would favorably affect the effective tax
rate. Movement in the reserve balance during the six months ended June 30, 2007
was not material. The Company currently anticipates such uncertain income tax
positions will decrease by $3.6 million prior to June 30, 2008 as a result of a
lapse of applicable statute of limitations; however, actual developments in this
area could differ from those currently expected. Approximately $1.0 million of
this, if recognized, would favorably affect the Company's effective tax rate.
The Company's policy is to recognize interest and penalties accrued on uncertain
tax positions as part of interest expense and other expense, respectively. As of
January 1, 2007, approximately $1.5 million in accrued interest and penalties
was included in other liabilities. The impact of timing differences and tax
attributes are considered when calculating interest and penalty accruals
associated with the unrecognized tax benefits. The change in the accrual for
interest and penalties for the six months ended June 30, 2007 was an increase of
approximately $543,000.
The Company and its subsidiaries file a consolidated federal income tax return
in the U.S. and the Company or one of its subsidiaries files income tax returns
in various state, local, and foreign jurisdictions. With few exceptions, the
Company is not subject to federal or foreign income tax examinations for taxable
years prior to 2003, or state and local examinations prior to 2002.
As a U.S. corporation, Nelnet, Inc. and its subsidiaries are subject to U.S.
taxation, currently, on all foreign pretax earnings earned by a foreign branch.
Pretax earnings of a foreign subsidiary or affiliate are subject to U.S.
taxation when effectively repatriated. The Company repatriated $5.1 million in
2007 in connection with the sale of EDULINX. The Company recognized $0.9 million
of additional income tax expense during the second quarter 2007 related to this
repatriation. This expense is included in the loss on disposal of EDULINX within
discontinued operations. As of June 30, 2007, the Company had $0.7 million of
foreign tax credits available to offset future U.S. federal income taxes. Under
current tax law, the 10-year carryforward period for the foreign tax credits
will expire in 2017. An adjustment was made to these foreign tax credits via a
valuation allowance. The valuation allowance was required due to the Company's
assessment that these deferred tax assets did not meet the more-likely-than-not
recognition criteria of SFAS No. 109, ACCOUNTING FOR INCOME TAXES.
11. SEGMENT REPORTING
The Company has five operating segments as defined in SFAS No. 131, DISCLOSURES
ABOUT SEGMENTS OF ENTERPRISE AND RELATED INFORMATION ("SFAS No. 131") as
follows: Asset Generation and Management, Student Loan and Guaranty Servicing,
Tuition Payment Processing and Campus Commerce, Enrollment Services and List
Management, and Software and Technical Services. The Company's operating
segments are defined by the products and services they offer or the types of
customers they serve, and they reflect the manner in which financial information
is currently evaluated by management. During 2006, the Company changed the
structure of its internal organization in a manner that caused the composition
of its operating segments to change. As a result, the presentation of segment
financial information for the three and six months ended June 30, 2006, has been
restated to conform to the current operating segment presentation. The
accounting policies of the Company's operating segments are the same as those
described in the summary of significant accounting policies included in the
Company's consolidated financial statements included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2006. Intersegment revenues
are charged by a segment to another segment that provides the product or
service. Intersegment revenues and expenses are included within each segment
consistent with the income statement presentation provided to management.
Changes in management structure or allocation methodologies and procedures may
result in changes in reported segment financial information.
The management reporting process measures the performance of the Company's
operating segments based on the management structure of the Company as well as
the methodology used by management to evaluate performance and allocate
resources. Management, including the Company's chief operating decision maker,
evaluates the performance of the Company's operating segments based on their
profitability. As discussed further below, management measures the profitability
of the Company's operating segments based on "base net income." Accordingly,
information regarding the Company's operating segments is provided based on
"base net income." The Company's "base net income" is not a defined term within
GAAP and may not be comparable to similarly titled measures reported by other
companies. Unlike financial accounting, there is no comprehensive, authoritative
guidance for management reporting.
In May 2007, the Company sold EDULINX, a Canadian student loan service provider
and subsidiary of the Company. As a result of this transaction, the results of
operations for EDULINX are reported as discontinued operations for all periods
presented. The operating results of EDULINX were included in the Student Loan
and Guaranty Servicing operating segment. The Company presents "base net income"
excluding discontinued operations since the operations and cash flows of EDULINX
have been eliminated from the ongoing operations of the Company. Therefore, the
results of operations for the Student Loan and Guaranty Servicing segment
exclude the operating results of EDULINX for all periods presented. See note 2
for additional information concerning EDULINX' detailed operating results that
have been segregated from continuing operations and reported as discontinued
operations.
18
ASSET GENERATION AND MANAGEMENT
In the Company's Asset Generation and Management segment, the Company generates
primarily federally guaranteed student loans through direct origination or
through acquisitions. The student loan assets are held in a series of education
lending subsidiaries designed specifically for this purpose. Revenues are
primarily generated from net interest income on the student loan assets.
Earnings and earnings growth are directly affected by the size of the Company's
portfolio of student loans, the interest rate characteristics of its portfolio,
the costs associated with financing, servicing, and managing its portfolio, and
the costs associated with origination and acquisition of the student loans in
the portfolio, which includes, among other things, borrower benefits and rebate
fees paid to the federal government. The Company generates the majority of its
earnings from the spread, referred to as its student loan spread, between the
yield it receives on its student loan portfolio and the costs previously
described. While the spread may vary due to fluctuations in interest rates, the
special allowance payments the Company receives from the federal government
ensure the Company receives a minimum yield on its student loans, so long as
certain requirements are met.
STUDENT LOAN AND GUARANTY SERVICING
The Student Loan and Guaranty 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
application processing, underwriting, disbursement of funds, customer service,
account maintenance, federal reporting and billing collections, payment
processing, default aversion, claim filing, and recovery/collection services.
These activities are performed internally for the Company's portfolio in
addition to generating fee revenue when performed for third-party clients. The
following are the primary product and service offerings the Company offers as
part of its Student Loan and Guaranty Servicing segment:
o Origination and servicing of FFELP loans;
o Origination and servicing of non-federally insured student
loans; and
o Servicing and support outsourcing for guaranty agencies.
TUITION PAYMENT PROCESSING AND CAMPUS COMMERCE
The Tuition Payment Processing and Campus Commerce segment 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, this segment
provides financial needs analysis for students applying for aid in private and
parochial K-12 schools. This segment also provides customer-focused electronic
transactions, information sharing, and account and bill presentment to
educational institutions.
ENROLLMENT SERVICES AND LIST MANAGEMENT
The Enrollment Services and List Management 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 young adult
market places. In addition, this segment offers products and services that are
focused on helping i) students plan and prepare for life after high school and
ii) colleges recruit and retain students.
SOFTWARE AND TECHNICAL SERVICES
The Software and Technical Services segment provides information technology
products and full-service technical consulting, with core areas of business in
educational loan software solutions, business intelligence, technical consulting
services, and Enterprise Content Management (ECM) solutions.
SEGMENT OPERATING RESULTS - "BASE NET INCOME"
The tables below include the operating results of each of the Company's
operating segments. Management, including the chief operating decision maker,
evaluates the Company on certain non-GAAP performance measures that the Company
refers to as "base net income" for each operating segment. While "base net
income" is not a substitute for reported results under GAAP, the Company relies
on "base net income" to manage each operating segment because it believes this
measure provides additional information regarding the operational and
performance indicators that are most closely assessed by management.
"Base net income" is the primary financial performance measure used by
management to develop the Company's financial plans, track results, and
establish corporate performance targets and incentive compensation. Management
believes this information provides additional insight into the financial
performance of the core business activities of the Company's operating segments.
Accordingly, the tables presented below reflect "base net income," which is the
operating measure reviewed and utilized by management to manage the business.
Reconciliation of the segment totals to the Company's operating results in
accordance with GAAP are also included in the tables below.
19
SEGMENT RESULTS AND RECONCILIATIONS TO GAAP
Three months ended June 30, 2007
---------------------------------------------------------------------------------------------------------
Student Tuition Enrollment Elimina- "Base net
Asset Loan Payment Services Software Corporate tions income" GAAP
Generation and Processing and and Activity and Adjustments Results
and Guaranty and Campus List Technical Total and Reclass- to GAAP of Oper-
Management Servicing Commerce Management Services Segments Overhead ifications Results ations
---------------------------------------------------------------------------------------------------------
Total interest income $ 433,404 1,181 670 93 -- 435,348 554 (33) -- 435,869
Interest expense 358,341 -- 2 2 -- 358,345 9,581 (33) - 367,893
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Net interest income 75,063 1,181 668 91 -- 77,003 (9,027) -- -- 67,976
Less provision for
loan losses 2,535 -- -- -- -- 2,535 -- -- -- 2,535
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Net interest income
after provision
for loan losses 72,528 1,181 668 91 -- 74,468 (9,027) -- -- 65,441
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Other income (expense):
Loan and guarantee
servicing income 118 31,492 -- -- -- 31,610 -- -- -- 31,610
Other fee-based income 3,674 -- 9,405 24,923 -- 38,002 260 -- -- 38,262
Software services income -- -- -- 157 5,691 5,848 -- -- -- 5,848
Other income 1,115 5 25 -- -- 1,145 1,792 -- -- 2,937
Intersegment revenue -- 20,120 188 178 4,389 24,875 4,100 (28,975) -- --
Derivative
market value,
foreign currency,
and put option
adjustment -- -- -- -- -- -- -- -- 5,547 5,547
Derivative
settlements, net (461) -- -- -- -- (461) 5,657 -- -- 5,196
---------- -------- -------- -------- -------- --------- ------------------ ---------- ----------
Total other income
(expense) 4,446 51,617 9,618 25,258 10,080 101,019 11,809 (28,975) 5,547 89,400
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Operating expenses:
Salaries and benefits 7,167 22,023 5,082 9,022 5,857 49,151 12,272 (2,138) 476 59,761
Other expenses 7,246 8,404 2,333 14,589 751 33,323 21,071 -- 6,491 60,885
Intersegment expenses 22,034 3,750 25 29 403 26,241 596 (26,837) -- --
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Total operating
expenses 36,447 34,177 7,440 23,640 7,011 108,715 33,939 (28,975) 6,967 120,646
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Income (loss) before
income taxes 40,527 18,621 2,846 1,709 3,069 66,772 (31,157) -- (1,420) 34,195
Income tax expense
(benefit) (a) 15,400 7,076 1,082 649 1,167 25,374 (11,500) -- (568) 13,306
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Net income (loss)
from continuing
operations 25,127 11,545 1,764 1,060 1,902 41,398 (19,657) -- (852) 20,889
Income (loss) from
discontinued
operations,
net of tax -- -- -- -- -- -- -- -- (6,135) (6,135)
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Net income $ 25,127 11,545 1,764 1,060 1,902 41,398 (19,657) -- (6,987) 14,754
========== ======== ======== ======== ======== ========= ======== ======== ========== ==========
(a) Income taxes are based on a percentage of net income before tax for the
individual operating segment.
20
Three months ended June 30, 2006
---------------------------------------------------------------------------------------------------------
Student Tuition Enrollment Elimina- "Base net
Asset Loan Payment Services Software Corporate tions income" GAAP
Generation and Processing and and Activity and Adjustments Results
and Guaranty and Campus List Technical Total and Reclass- to GAAP of Oper-
Management Servicing Commerce Management Services Segments Overhead ifications Results ations
---------------------------------------------------------------------------------------------------------
Total interest income $ 384,295 1,625 705 129 25 386,779 450 (238) -- 386,991
Interest expense 295,260 -- 1 -- -- 295,261 5,821 (238) -- 300,844
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Net interest income 89,035 1,625 704 129 25 91,518 (5,371) -- -- 86,147
Less provision for
loan losses 2,190 -- -- -- -- 2,190 -- -- -- 2,190
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Net interest income
after provision
for loan losses 86,845 1,625 704 129 25 89,328 (5,371) -- -- 83,957
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Other income (expense):
Loan and guarantee
servicing income -- 28,926 -- -- -- 28,926 -- -- -- 28,926
Other fee-based income 3,035 -- 7,019 6,020 -- 16,074 -- -- -- 16,074
Software services income 65 1 -- 34 3,918 4,018 -- -- -- 4,018
Other income 2,161 40 -- -- -- 2,201 705 -- -- 2,906
Intersegment revenue -- 15,671 228 13 4,465 20,377 155 (20,532) -- --
Derivative market value,
foreign currency, and
put option adjustments -- -- -- -- -- -- -- -- 29,080 29,080
Derivative settlements, net 6,702 -- -- -- -- 6,702 -- -- -- 6,702
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Total other income
(expense) 11,963 44,638 7,247 6,067 8,383 78,298 860 (20,532) 29,080 87,706
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Operating expenses:
Salaries and benefits 13,638 22,237 4,847 1,934 5,257 47,913 8,629 (2,266) 477 54,753
Other expenses 14,956 7,065 2,208 1,310 713 26,252 14,468 -- 5,817 46,537
Intersegment expenses 13,270 2,500 -- -- -- 15,770 2,496 (18,266) -- --
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Total operating
expenses 41,864 31,802 7,055 3,244 5,970 89,935 25,593 (20,532) 6,294 101,290
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Income (loss) before
income taxes 56,944 14,461 896 2,952 2,438 77,691 (30,104) -- 22,786 70,373
Income tax expense
(benefit) (a) 21,639 5,495 340 1,122 926 29,522 (12,048) -- 8,564 26,038
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Net income (loss) from
continuing operations 35,305 8,966 556 1,830 1,512 48,169 (18,056) -- 14,222 44,335
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- 1,418 1,418
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Net income $35,305 8,966 556 1,830 1,512 48,169 (18,056) -- 15,640 45,753
========== ======== ======== ======== ======== ========== ======== ========= ========== ===========
(a) Income taxes are based on a percentage of net income before tax for the
individual operating segment.
21
Six months ended June 30, 2007
---------------------------------------------------------------------------------------------------------
Student Tuition Enrollment Elimina- "Base net
Asset Loan Payment Services Software Corporate tions income" GAAP
Generation and Processing and and Activity and Adjustments Results
and Guaranty and Campus List Technical Total and Reclass- to GAAP of Oper-
Management Servicing Commerce Management Services Segments Overhead ifications Results ations
---------------------------------------------------------------------------------------------------------
Total interest income $ 847,894 3,425 1,680 180 18 853,197 4,355 (3,204) -- 854,348
Interest expense 699,999 -- 7 4 -- 700,010 21,582 (3,204) -- 718,388
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Net interest income 147,895 3,425 1,673 176 18 153,187 (17,227) -- -- 135,960
Less provision for
loan losses 5,288 -- -- -- -- 5,288 -- -- -- 5,288
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Net interest income
after provision
for loan losses 142,607 3,425 1,673 176 18 147,899 (17,227) -- -- 130,672
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Other income (expense):
Loan and guarantee
servicing income 118 61,958 -- -- -- 62,076 -- -- -- 62,076
Other fee-based income 6,985 -- 21,176 49,870 -- 78,031 260 -- -- 78,291
Software services income -- -- -- 287 11,309 11,596 -- -- -- 11,596
Other income 5,944 11 28 -- -- 5,983 3,833 -- -- 9,816
Intersegment revenue -- 36,584 340 928 8,221 46,073 6,116 (52,189) -- --
Derivative market value,
foreign currency, and
put option adjustments -- -- -- -- -- -- -- -- (6,583) (6,583)
Derivative settlements, net (885) -- -- -- -- (885) 10,321 -- -- 9,436
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Total other income
(expense) 12,162 98,553 21,544 51,085 19,530 202,874 20,530 (52,189) (6,583) 164,632
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Operating expenses:
Salaries and benefits 14,446 45,027 10,000 18,391 12,332 100,196 24,978 (4,662) 953 121,465
Other expenses 15,511 17,654 4,493 29,148 1,535 68,341 38,940 -- 13,129 120,410
Intersegment expenses 38,670 7,068 399 185 403 46,725 802 (47,527) -- --
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Total operating expenses 68,627 69,749 14,892 47,724 14,270 215,262 64,720 (52,189) 14,082 241,875
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Income (loss) before
income taxes 86,142 32,229 8,325 3,537 5,278 135,511 (61,417) -- (20,665) 53,429
Income tax expense
(benefit) (a) 32,734 12,247 3,164 1,344 2,006 51,495 (23,826) -- (7,099) 20,570
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Net income (loss) from
continuing operations 53,408 19,982 5,161 2,193 3,272 84,016 (37,591) -- (13,566) 32,859
Income (loss) from
discontinued operations, net
of tax -- -- -- -- -- -- -- -- (3,325) (3,325)
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Net income $ 53,408 19,982 5,161 2,193 3,272 84,016 (37,591) -- (16,891) 29,534
========= ======== ======== ======== ======== ========== ======== ======== ========== ==========
(a) Income taxes are based on a percentage of net income before tax for the
individual operating segment.
22
Six months ended June 30, 2006
---------------------------------------------------------------------------------------------------------
Student Tuition Enrollment Elimina- "Base net
Asset Loan Payment Services Software Corporate tions income" GAAP
Generation and Processing and and Activity and Adjustments Results
and Guaranty and Campus List Technical Total and Reclass- to GAAP of Oper-
Management Servicing Commerce Management Services Segments Overhead ifications Results ations
---------------------------------------------------------------------------------------------------------
Total interest income $ 726,271 3,434 1,587 212 43 731,547 985 (404) -- 732,128
Interest expense 549,093 -- 2 -- -- 549,095 11,102 (404) -- 559,793
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net interest income 177,178 3,434 1,585 212 43 182,452 (10,117) -- -- 172,335
Less provision for
loan losses 11,808 -- -- -- -- 11,808 -- -- -- 11,808
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net interest income
after provision
for loan losses 165,370 3,434 1,585 212 43 170,644 (10,117) -- -- 160,527
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Other income (expense):
Loan and guarantee
servicing income -- 59,216 -- -- -- 59,216 -- -- -- 59,216
Other fee-based income 5,934 -- 16,673 11,622 -- 34,229 -- -- -- 34,229
Software services income 115 1 -- 40 7,271 7,427 -- -- -- 7,427
Other income 3,803 61 -- -- -- 3,864 1,029 -- -- 4,893
Intersegment revenue -- 30,184 228 765 8,385 39,562 196 (39,758) -- --
Derivative market value,
foreign currency, and
put option adjustments -- -- -- -- -- -- -- -- 68,343 68,343
Derivative settlements, net 11,446 -- -- -- -- 11,446 -- -- -- 11,446
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Total other income
(expense) 21,298 89,462 16,901 12,427 15,656 155,744 1,225 (39,758) 68,343 185,554
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Operating expenses:
Salaries and benefits 25,409 42,106 8,802 3,112 9,973 89,402 18,812 (4,757) 795 104,252
Other expenses 27,001 15,611 4,256 2,703 1,448 51,019 28,124 -- 11,115 90,258
Intersegment expenses 26,146 5,657 -- -- -- 31,803 3,198 (35,001) -- --
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Total operating
expenses 78,556 63,374 13,058 5,815 11,421 172,224 50,134 (39,758) 11,910 194,510
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Income (loss) before
income taxes 108,112 29,522 5,428 6,824 4,278 154,164 (59,026) -- 56,433 151,571
Income tax expense
(benefit) (a) 41,083 11,218 2,062 2,593 1,625 58,581 (24,053) -- 21,552 56,080
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net income (loss)
before minority
interest 67,029 18,304 3,366 4,231 2,653 95,583 (34,973) -- 34,881 95,491
Minority interest in
subsidiary income -- -- (242) -- -- (242) -- -- -- (242)
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net income (loss)
from continuing
operations 67,029 18,304 3,124 4,231 2,653 95,341 (34,973) -- 34,881 95,249
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- 2,570 2,570
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net income (loss) $ 67,029 18,304 3,124 4,231 2,653 95,341 (34,973) -- 37,451 97,819
========== ======== ======== ========= ======== ========== ========= ======== =========== ==========
(a) Income taxes are based on a percentage of net income before tax for the
individual operating segment.
Corporate Activity and Overhead in the previous tables primarily includes the
following items:
o Income earned on certain investment activities;
o Interest expense incurred on unsecured debt transactions;
o Other products and service offerings that are not considered
operating segments; and
o Corporate activities and overhead functions such as executive
management, human resources, accounting and finance, legal,
marketing, and corporate technology support.
The adjustments required to reconcile from the Company's "base net income"
measure to its GAAP results of operations relate to differing treatments for
derivatives, foreign currency transaction adjustments, discontinued operations,
and certain other items that management does not consider in evaluating the
Company's operating results. The following tables reflect adjustments associated
with these areas by operating segment and Corporate Activity and Overhead for
the three and six months ended June 30, 2007 and 2006:
23
Three months ended June 30, 2007
------------------------------------------------------------------------------------
Student Tuition Enrollment
Asset Loan Payment Services Software Corporate
Generation and Processing and and Activity
and Guaranty and Campus List Technical and
Management Servicing Commerce Management Services Overhead Total
----------- ----------- ---------- ---------- ----------- ---------- -----------
Derivative market value, foreign currency,
and put option adjustments (1) $ 6,002 -- -- -- -- (11,549) (5,547)
Amortization of intangible assets (2) 1,840 1,350 1,469 1,545 287 -- 6,491
Non-cash stock based compensation related
to business combinations (3) -- -- -- -- -- 476 476
Income (loss) from
discontinued operations,
net of tax (4) -- 6,135 -- -- -- -- 6,135
Net tax effect (5) (2,980) (513) (558) (587) (109) 4,179 (568)
----------- ----------- ---------- ---------- ----------- ---------- -----------
Total adjustments to GAAP $ 4,862 6,972 911 958 178 (6,894) 6,987
=========== =========== ========== ========== =========== ========== ===========
Three months ended June 30, 2006
------------------------------------------------------------------------------------
Student Tuition Enrollment
Asset Loan Payment Services Software Corporate
Generation and Processing and and Activity
and Guaranty and Campus List Technical and
Management Servicing Commerce Management Services Overhead Total
----------- ----------- ---------- ---------- ----------- ---------- -----------
Derivative market value, foreign currency,
and put option adjustments (1) $ (28,865) -- -- -- -- (215) (29,080)
Amortization of intangible assets (2) 2,229 1,165 1,693 610 120 -- 5,817
Non-cash stock based compensation related
to business combinations (3) -- -- -- -- -- 477 477
Income (loss) from
discontinued operations,
net of tax (4) -- (1,418) -- -- -- -- (1,418)
Net tax effect (5) 10,122 (455) (643) (232) (46) (182) 8,564
----------- ----------- ---------- ---------- ----------- ---------- -----------
Total adjustments to GAAP $ (16,514) (708) 1,050 378 74 80 (15,640)
=========== =========== ========== ========== =========== ========== ===========
24
Six months ended June 30, 2007
--------------------------------------------------------------------------------
Student Tuition Enrollment
Asset Loan Payment Services Software Corporate
Generation and Processing and and Activity
and Guaranty and Campus List Technical and
Management Servicing Commerce Management Services Overhead Total
---------- ---------- ---------- ----------- ---------- ---------- --------
Derivative market value, foreign currency,
and put option adjustments (1) $ 12,216 -- -- -- -- (5,633) 6,583
Amortization of intangible assets (2) 3,825 2,394 2,938 3,355 617 -- 13,129
Non-cash stock based compensation related
to business combinations (3) -- -- -- -- -- 953 953
Income (loss) from discontinued
operations, net of tax (4) -- 3,325 -- -- -- -- 3,325
Net tax effect (5) (6,096) (910) (1,116) (1,275) (234) 2,532 (7,099)
---------- ---------- ---------- ----------- ---------- ---------- --------
Total adjustments to GAAP $ 9,945 4,809 1,822 2,080 383 (2,148) 16,891
========== ========== ========== =========== ========== ========== ========
Six months ended June 30, 2006
--------------------------------------------------------------------------------
Student Tuition Enrollment
Asset Loan Payment Services Software Corporate
Generation and Processing and and Activity
and Guaranty and Campus List Technical and
Management Servicing Commerce Management Services Overhead Total
---------- ---------- ---------- ----------- ---------- ---------- --------
Derivative market value, foreign currency,
and put option adjustments (1) $ (68,660) -- -- -- -- 317 (68,343)
Amortization of intangible assets (2) 4,456 2,331 2,868 1,220 240 -- 11,115
Non-cash stock based compensation related
to business combinations (3) -- -- -- -- -- 795 795
Income (loss) from discontinued
operations, net of tax (4) -- (2,570) -- -- -- -- (2,570)
Net tax effect (5) 24,398 (899) (1,089) (464) (92) (302) 21,552
---------- ---------- ---------- ----------- ---------- ---------- --------
Total adjustments to GAAP $ (39,806) (1,138) 1,779 756 148 810 (37,451)
========== ========== ========== =========== ========== ========== ========
(1) Derivative market value, foreign currency, and put option
adjustments: "Base net income" excludes the periodic unrealized
gains and losses that are caused by the change in fair value on
derivatives in which the Company does not qualify for "hedge
treatment" under GAAP. Included in "base net income" are the
economic effects of the Company's derivative instruments, which
includes any cash paid or received being recognized as an expense
or revenue upon actual derivative settlements. "Base net income"
also excludes the foreign currency transaction gains or losses
caused by the re-measurement of the Company's Euro-denominated
bonds to U.S. dollars and the change in fair value of put options
issued by the Company for certain business acquisitions.
(2) Amortization of intangible assets: "Base net income" excludes the
amortization of acquired intangibles.
(3) Non-cash stock based compensation related to business
combinations: As discussed in note 5, 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.
(4) Discontinued operations: In May 2007, the Company sold EDULINX.
As a result of this transaction, the results of operations for
EDULINX are reported as discontinued operations for all periods
presented. The Company presents "base net income" excluding
discontinued operations since the operations and cash flows of
EDULINX have been eliminated from the ongoing operations of the
Company.
(5) Tax effect computed at 38%. The change in the value of the put
option (included in Corporate Activity and Overhead) is not tax
effected as this is not deductible for income tax purposes.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
(MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS IS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2007 AND 2006. 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, 2006.
25
FORWARD-LOOKING AND CAUTIONARY STATEMENTS
This report contains forward-looking statements and information 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
the Company's Annual Report on Form 10-K for the year ended December 31, 2006
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, special allowance
payments, and costs of yields on student loans under the Federal Family
Education Loan Program ("FFELP" or "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 the Company's
FFELP loans could materially adversely affect the Company's 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; changes
in prepayment rates, guaranty rates, loan floor rates, and credit spreads; and
the uncertain nature of the expected benefits from acquisitions and the ability
to successfully integrate operations. 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. 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 an education planning and financing company focused on providing
quality products and services to students, families, and schools nationwide. 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.
Built through a focus on long-term organic growth and further enhanced by
strategic acquisitions, the Company earns its revenues from net interest income
on its portfolio of student loans and from fee-based revenues related to its
education finance and service operations.
During the three and six months ended June 30, 2007, the Company had solid asset
growth, continued to diversify its revenue streams, increased fee-based revenue,
and deployed capital by repurchasing shares of the Company's stock and paying
its first quarterly dividends.
o Student loan assets increased by $2.4 billion, or 10.0%, as of
June 30, 2007 compared to December 31, 2006.
o Fee-based revenue for the three and six months ended June 30,
2007 was 53% of total revenues, compared to 36% and 37% of total
revenues for the three and six months ended June 30, 2006,
respectively.
o The Company repurchased 3.1 million shares of its Class A common
stock, including 2.7 million from certain members of management,
for $75.5 million during the six months ended June 30, 2007.
o The Company paid a cash dividend of $0.07 per share on the
Company's Class A and Class B common stock on March 15, 2007 and
June 15, 2007.
On May 25, 2007, the Company sold EDULINX, a Canadian student loan service
provider and subsidiary of the Company. The Company recognized a net loss of
$9.0 million related to the transaction. As a result of this transaction, the
results of operations for EDULINX are reported as discontinued operations for
all periods presented.
Net income reported based on generally accepted accounting principles for the
three and six months ended June 30, 2007 was $14.8 million and $29.5 million
compared to $45.8 million and $97.8 million for the same periods in 2006. The
change in net income was driven primarily by the change in the derivative market
value, foreign currency, and put option adjustments, not receiving 9.5% special
allowance payments in accordance with the Company's Settlement Agreement with
the Department in January 2007, and the loss recognized by the Company related
to the sale of EDULINX.
26
RESULTS OF OPERATIONS
The Company's operating results are primarily driven by the performance of its
existing portfolio, the cost necessary to generate new assets, the revenues
generated by its fee based businesses, and the cost to provide those services.
The performance of the Company's portfolio is driven by net interest income and
losses related to credit quality of the assets along with the cost to administer
and service the assets and related debt.
ACQUISITIONS
Management believes the Company's business and asset acquisitions in recent
years have enhanced the Company's 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 increased 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
products and services offered to educational and financial institutions and
students and families throughout the education and education finance process. In
addition, these acquisitions diversify the Company's asset generation streams
and/or diversify revenue by offering other products and services that are not
dependent on government programs, which management believes will reduce the
Company's exposure to legislation and political risk. The Company also expects
to reduce costs from these acquisitions through economies of scale and by
integrating certain support services. In addition, the Company expects to
increase revenue from these acquisitions by offering multiple products and
services to its customers. 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.
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 statements of income 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 statements of income. The amortization of debt issuance costs is
included in interest expense on the Company's statements of income.
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 U.S. Department of Education (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 the Higher Education Reconciliation Act of 2005 ("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.
Current legislation will have a significant impact on the Company's net interest
income in future periods and should be considered when reviewing the Company's
results of operations. The impact of the legislation is discussed in this Item 2
under "Recent Developments - Legislation Related to the Higher Education Act".
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.
Net interest income also includes interest expense on unsecured debt offerings.
The proceeds from these unsecured debt offerings were 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.
27
PROVISION FOR LOAN LOSSES
Management estimates and establishes an allowance for loan losses 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. Management maintains the allowance for federally insured and
non-federally insured loans at a level believed to be 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.
Management bases the allowance for the federally insured loan portfolio 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 99%
reimbursement (100% reimbursement prior to July 1, 2006) on all eligible FFELP
default claims submitted for reimbursement. 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 99% reimbursement. As of June 30, 2007, 99.9% 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 3% risk sharing for all claims submitted after loss of the
designation (2% risk sharing effective for all loans disbursed prior to July 1,
2006).
In June 2006, the Company submitted its application for Exceptional Performer
redesignation to the Department to continue receiving reimbursements at the 99%
level for the 12-month period from June 1, 2006 through May 31, 2007. As of the
date of this Report, the Department has not notified the Company of its
redesignation. 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.
Current legislation will have a significant impact on the Company's provision
for loan losses and should be considered when reviewing the Company's results of
operations. The impact of the legislation is discussed in this Item 2 under
"Recent Developments - Legislation Related to the Higher Education Act".
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 guaranty servicing income; fee-based income on borrower
late fees, payment management activities, and certain marketing and enrollment
services; and fees from providing software services.
LOAN AND GUARANTY 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. Guaranty
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 includes borrower late fee
income, payment management fees, the sale of lists and print products, and
subscription-based products and 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 lists and printed products is generally earned and recognized, net of
estimated returns, upon shipment or delivery. Revenues from the sales of
subscription-based products and services are recognized ratably over the term of
the subscription. Subscription revenue received or receivable in advance of the
delivery of services is included in deferred revenue.
28
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." The change in the fair value of put
options (issued as part of the consideration for certain business combinations)
is also 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 tuition payment processing, campus commerce, enrollment,
list management, software, and technical services to third parties, and other
general and administrative expenses. Operating expenses also includes the
depreciation and amortization of capital assets and intangible assets.
RECENT DEVELOPMENTS
DISCONTINUED OPERATIONS
On May 25, 2007, the Company sold EDULINX, a Canadian student loan service
provider and subsidiary of the Company. The Company recognized a net loss of
$9.0 million related to the transaction. As a result of this transaction, the
results of operations for EDULINX are reported as discontinued operations for
all periods presented.
SETTLEMENT AGREEMENT - DEPARTMENT OF EDUCATION
In June 2005, the Office of Inspector General of the U.S. Department of
Education (the "OIG") commenced an audit of the portion of the Company's student
loan portfolio receiving special allowance payments at a minimum 9.5% interest
rate based on provisions of the Higher Education Act and regulations and
guidance of the Department and related interpretations. On September 29, 2006,
the Company received a final audit report from the OIG where the OIG found that
an increase in the amount of 9.5% special allowance payments received by the
Company was based on what the OIG deemed to be ineligible loans.
On January 19, 2007, the Company entered into a Settlement Agreement with the
Department to resolve the OIG audit of the Company's portfolio of student loans
receiving 9.5% special allowance payments. Under the terms of the Settlement
Agreement, the Company is permitted to retain the 9.5% special allowance
payments that it received from the Department prior to July 1, 2006. In
addition, the Settlement Agreement eliminates all 9.5% special allowance
payments with respect to the Company's portfolios of student loans for periods
on and after July 1, 2006.
The Company disagrees with the OIG audit report, and continues to believe that
it billed for the 9.5% special allowance payments in accordance with applicable
laws, regulations, and the Department's previous guidance. As a part of the
Settlement Agreement, the Company and the Department acknowledge a dispute
exists related to guidance previously issued by the Department and the
application of the existing laws and regulations related to the Company
receiving certain 9.5% special allowance payments, and that the Settlement
Agreement is based in part on the parties' desire to avoid costly litigation
regarding that dispute. The new guidance provided to the Company in the
Settlement Agreement eliminates all future 9.5% special allowance payments for
the Company. These loans will continue to receive special allowance payments
using other applicable special allowance formulas.
The Company believes the prospective loss of the 9.5% special allowance payments
will not have a material adverse affect on the Company's operations. In
addition, the Company does not expect the Settlement Agreement to have any
material adverse effect on the outstanding debt obligations issued by the
Company's education lending subsidiaries in the securitization of student loan
assets. The Settlement Agreement resolves all issues between the Company and the
Department that arise out of or relate to the contents of the OIG audit report
and the Department's review of the issues raised therein. The Settlement
Agreement does not preclude any other government agency from reviewing the
issues raised in the OIG audit report.
INDUSTRY INQUIRIES AND INVESTIGATIONS
Since January 2007, a number of state attorneys general and the U.S. Senate
Committee on Health, Education, Labor, and Pensions have announced or are
reportedly conducting broad inquiries or investigations of the activities of
various participants in the student loan industry, including activities which
may involve perceived conflicts of interest. The general focus of the inquiries
or investigations to date has primarily been on any financial arrangements among
student loan lenders and other industry participants which may facilitate
increased volumes of student loans for particular lenders. Like many other
student loan lenders, the Company has received informal requests for information
from certain state attorneys general and the Chairman of the U.S. Senate
Committee on Health, Education, Labor, and Pensions in connection with their
inquiries or investigations. In addition, the Company has received subpoenas for
information from the New York Attorney General, the New Jersey Attorney General,
and the Ohio Attorney General. In each case the Company is cooperating with the
requests and subpoenas for information that it has received.
29
On April 20, 2007, the Company announced that it had agreed with the Nebraska
Attorney General to voluntarily adopt a Nelnet Student Loan Code of Conduct,
post a review of the Company's business practices on its website, and commit
$1.0 million to help educate students and families on how to plan and pay for
their education.
On July 31, 2007, the Company announced that it had agreed with the New York
Attorney General to adopt the New York Attorney General's Code of Conduct, which
is substantially similar to the Nelnet Student Loan Code of Conduct, but which
also includes an agreement to eliminate two services the Company had previously
announced plans to discontinue - the Company's outsourcing of calls for
financial aid offices and its agreements with college alumni associations
providing for marketing of consolidation loans to the associations' members. As
part of the agreement, the Company agreed to contribute $2.0 million to a
national fund for educating high school seniors and their parents regarding the
financial aid process. One million dollars of the national fund contribution
will come from the money the Company committed to helping educate students and
families in connection with the Company's agreement with the Nebraska Attorney
General.
While the Company cannot predict the ultimate outcome of any other inquiry or
investigation, the Company believes its activites have materially complied with
the Higher Education Act, the rules and regulations adopted by the Department of
Education thereunder, and the Department's guidance regarding those rules and
regulations.
Department of Education Review
------------------------------
The Department of Education periodically reviews participants in the FFEL
Program for compliance with program provisions. On June 28, 2007, the Department
of Education notified the Company that it would be conducting a review of the
Company's administration of the FFEL Program under the Higher Education Act. The
Company understands that as of July 23, 2007, the Department of Education has
selected 47 schools and 27 lenders for review. Specifically, the Department is
reviewing the Company's practices in connection with the inducement provisions
of the Higher Education Act and the provisions of the Higher Education Act and
the associated regulations which allow borrowers to have a choice of lenders.
The Company is cooperating with the Department of Education's review. While the
Company cannot predict the ultimate outcome of the review, the Company believes
its activities have materially complied with the Higher Education Act, the rules
and regulations adopted by the Department of Education thereunder, and the
Department's guidance regarding those rules and regulations.
LEGISLATION RELATED TO THE HIGHER EDUCATION ACT
Recently the U.S. House of Representatives passed the College Cost Reduction Act
of 2007 and the U.S. Senate passed the Higher Education Access Act of 2007. Both
of these bills contain provisions with significant implications for participants
in the FFEL Program. Among other things, these bills include the following
provisions:
o reducing special allowance payments to lenders;
o reducing default insurance rates and elimination of the
Exceptional Performer program;
o increasing lender origination fees;
o increasing annual and aggregate loan limits for certain Stafford
loans; and
o reducing interest rates for subsidized Stafford loans.
Neither the College Cost Reduction Act of 2007 nor the Higher Education Access
Act of 2007 has been enacted into law. The impact of these bills is difficult to
predict; however, if the proposed federal government spending cuts and increased
fees for FFEL Program participants are enacted, the Company's revenues would be
negatively impacted.
Management is estimating the impact of legislative changes to the Company's
operations based on information in the bills passed by Congress. Management
believes that the legislative changes will be effective October 1, 2007, or the
beginning of the next federal fiscal year. Management estimates that the annual
yield, including additional charges related to an increase in risk sharing, on
loans originated by the Company after the effective date will decrease 65 to 75
basis points compared to loans originated prior to the effective date of the
legislative changes. As a result, management is evaluating a variety of
strategies to modify its student loan business model including, but not limited
to, reducing or eliminating borrower benefits, reducing student loan
acquisitions costs, capitalizing on economies of scale, and reducing operating
expenses.
Management will evaluate the carrying amount of goodwill and intangible assets
assigned to its Asset Generation and Management operating segment as a result of
the changes in the student loan business environment. Intangible assets such as
loan origination rights, trade names, and covenants not to compete, goodwill,
and certain other assets will likely be impaired based on the legislative
changes and the student loan business model modifications the Company may
implement as a result of the legislative changes.
30
At the time the legislation becomes final, the Company will also recognize a
provision for loan losses related to the increase in risk share due to the
anticipated elimination of the Exceptional Performer program. Assuming the
elimination of the Exceptional Performer program and a default insurance rate of
97 percent, based on the balance of federally insured loans outstanding as of
June 30, 2007, this provision is expected to be approximately $17 to $18
million.
In addition to the College Cost Reduction Act of 2007 and the Higher Education
Access Act of 2007, other bills have been introduced in Congress which contain
provisions which could significantly impact participants in the FFEL Program.
Among other things, the proposals include:
o requiring disclosures relating to placement on "preferred lender
lists";
o banning various arrangements between lenders and schools;
o banning lenders from offering certain gifts to school employees;
o eliminating the school-as-lender program;
o encouraging borrowers to maximize their borrowing through
government loan programs prior to private loan programs with
higher interest rates;
o encouraging schools to participate in the Federal Direct Loan
Program through increased federal grant funds; and
o increasing the lender origination fee for consolidation loans.
As of the date of this Report, none of these bills has been enacted into law.
The impact of the proposed legislation is difficult to predict; however,
increased fees for FFEL Program lenders and decreased loan volume as a result of
increased participation in the Federal Direct Loan Program could have a negative
impact on the Company's revenues.
THREE AND SIX MONTHS ENDED JUNE 30, 2007 COMPARED TO THE THREE AND SIX MONTHS
ENDED JUNE 30, 2006
NET INTEREST INCOME
Three months ended June 30, Six months ended June 30,
------------------------------ ---------------------------------
2007 2006 $ Change 2007 2006 $ Change
--------- ---------- --------- ---------- ---------- ----------
Interest income:
Loan interest $ 417,086 362,742 54,344 814,140 688,402 125,738
Investment interest 18,783 24,249 (5,466) 40,208 43,726 (3,518)
--------- ---------- --------- ---------- ---------- ----------
Total interest income 435,869 386,991 48,878 854,348 732,128 122,220
Interest expense:
Interest on bonds and notes payable 367,893 300,844 67,049 718,388 559,793 158,595
--------- ---------- --------- ---------- ---------- ----------
Net interest income 67,976 86,147 (18,171) 135,960 172,335 (36,375)
Provision for loan losses 2,535 2,190 345 5,288 11,808 (6,520)
Net interest income after
--------- ---------- --------- ---------- ---------- ----------
provision for loan losses $ 65,441 83,957 (18,516) 130,672 160,527 (29,855)
========= ========== ========= ========== ========== ==========
Net interest income for the three and six months ended June 30, 2006 included
$13.9 million and $32.3 million, respectively, of 9.5% special allowance
payments. In accordance with the Company's Settlement Agreement with the
Department in January 2007, there were no 9.5% special allowance payments in
2007. Excluding the 9.5% special allowance payments, net interest income before
the allowance for loan losses decreased $4.3 million and $4.1 million,
respectively. Interest expense increased $3.6 million and $9.8 million,
respectively, as a result of additional issuances of unsecured debt used to fund
operating activities of the Company. The remaining change in net interest income
before the provision for loan losses is attributable to the growth in the
Company's student loan portfolio offset by a decrease in student loan yield as
discussed below in this Item 2 under "Asset Generation and Management Operating
Segment - Results of Operations". The provision for loan losses decreased for
the six months ended June 30, 2007 compared to 2006 as a result of the Company
recognizing $6.9 million in expense for provision for loan losses as a result of
HERA's enactment in February 2006.
OTHER INCOME
Three months ended June 30, Six months ended June 30,
------------------------------- --------------------------------
2007 2006 $ Change 2007 2006 $ Change
--------- --------- --------- ---------- --------- ----------
Loan and guaranty servicing income $ 31,610 28,926 2,684 62,076 59,216 2,860
Other fee-based income 38,262 16,074 22,188 78,291 34,229 44,062
Software services income 5,848 4,018 1,830 11,596 7,427 4,169
Other income 2,937 2,906 31 9,816 4,893 4,923
Derivative market value, foreign currency,
and put option adjustments 5,547 29,080 (23,533) (6,583) 68,343 (74,926)
Derivative settlements, net 5,196 6,702 (1,506) 9,436 11,446 (2,010)
--------- --------- --------- ---------- --------- ----------
Total other income $ 89,400 87,706 1,694 164,632 185,554 (20,922)
========= ========= ========= ========== ========= ==========
31
o Loan and guaranty servicing income increased due to an increase in
guaranty servicing income which was offset by a decrease in FFELP loan
servicing income.
o Other fee-based income increased largely due to business acquisitions
and an increase in the number of managed tuition payment plans.
o Software services income has increased as a result of new customers and
increased usage fees for existing customers.
o Other income for the six months ended June 30, 2007 compared to the same
period in 2006 increased as a result of a gain on the termination of the
Company's interest rate floor contracts in January 2007 and income
earned on certain investment activities.
o The change in derivative market value, foreign currency and put option
adjustments was caused by a change in the fair value of the Company's
derivative portfolio and foreign currency rate fluctuations which are
further discussed in Item 3, "Quantitative and Qualitative Disclosures
about Market Risk."
OPERATING EXPENSES
Three months Net change
ended Impact of after Three months ended
June 30, 2006 acquisitions acquistions June 30, 2007
-------------- ------------- ------------- ------------------
Salaries and benefits $ 54,753 6,130 (1,122) 59,761
Other expenses 40,720 12,787 887 54,394
Amortization of
intangible assets 5,817 935 (261) 6,491
-------------- ------------ -------------- ---------------
Total operating expenses $ 101,290 19,852 (496) 120,646
============== ============ ============== ===============
Operating expenses for the three months ended June 30, 2007 increased $19.9
million as a result of recent acquisitions. Excluding recent acquisitions,
operating expenses decreased slightly when compared to the same period in 2006.
Six months Net change
ended Impact of after Six months ended
June 30, 2006 acquisitions acquistions June 30, 2007
-------------- ------------- ------------- ------------------
Salaries and benefits $ 104,252 12,241 4,972 121,465
Other expenses 79,143 26,107 2,031 107,281
Amortization of
intangible assets 11,115 2,320 (306) 13,129
-------------- ------------ -------------- ---------------
Total operating expenses $ 194,510 40,668 6,697 241,875
============== ============ ============== ===============
Operating expenses for the six months ended June 30, 2007 increased $40.7
million as a result of recent acquisitions. Excluding recent acquisitions,
operating expenses increased $6.7 million. This increase occurred in the first
three months of 2007 compared to 2006 and was a result of (i) increased costs to
develop systems to support a larger organizational structure and (ii) organic
growth of the organization. The Company's costs to develop its corporate
structure include projects such as recruitment, development, and retention of
intellectual capital, technology enhancements to support a larger, more
diversified customer and employee base, and increased emphasis on marketing
services and products and developing the Company's brand.
INCOME TAXES
The Company's effective tax rate was 38.9% and 38.5% for the three and six
months ended June 30, 2007, respectively, compared to 37.0% for the same periods
in 2006. The effective tax rate increased due to the increased expense
recognized by the Company during 2007 compared to 2006 related to its
outstanding put options which are not deductible for tax purposes and also due
to certain enacted state tax law changes.
The Company adopted the provisions of Financial Accounting Standards Board
Interpretation No. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES--AN
INTERPRETATION OF FASB STATEMENT NO. 109 ("FIN 48") as discussed in note 10 in
the notes to the consolidated financial statements included in this Report. The
adoption of FIN 48 could increase the volatility of the Company's effective tax
rate because FIN 48 requires that any change in judgment or change in
measurement of a tax position taken in a prior period be recognized as a
discrete event in the period in which it occurs.
32
Additional information on the Company's results of operations is included with
the discussion of the Company's operating segments in this Item 2 under
"Operating Segments".
FINANCIAL CONDITION AS OF JUNE 30, 2007 COMPARED TO DECEMBER 31, 2006
As of Change
As of June 30, December 31 ------------------------
2007 2006 Dollars Percent
------------ ------------ ------------ ---------
Assets:
Student loans receivable, net $26,174,958 23,789,552 2,385,406 10.0 %
Cash, cash equivalents, and investments 1,367,257 1,773,751 (406,494) (22.9)
Goodwill 191,256 191,420 (164) (0.1)
Intangible assets, net 146,542 161,588 (15,046) (9.3)
Fair value of derivative instruments 192,326 146,099 46,227 31.6
Assets of discontinued operations -- 27,309 (27,309) (100.0)
Other assets 801,035 707,154 93,881 13.3
------------ ------------ ------------ ---------
Total assets $28,873,374 26,796,873 2,076,501 7.7 %
============ ============ ============ =========
Liabilities:
Bonds and notes payable $27,791,146 25,562,119 2,229,027 8.7 %
Fair value of derivative instruments 43,560 27,973 15,587 55.7
Other liabilities 427,490 534,931 (107,441) (20.1)
------------ ------------ ------------ ---------
Total liabilities 28,262,196 26,125,023 2,137,173 8.2
Shareholders' equity 611,178 671,850 (60,672) (9.0)
------------ ------------ ------------ ---------
Total liabilities and
shareholders' equity $28,873,374 26,796,873 2,076,501 7.7 %
============ ============ ============ =========
The Company's total assets increased during 2007 primarily due to an increase in
student loans receivable and related assets. The Company originated or acquired
$3.5 billion in student loans which was offset by repayments and loan sales. The
Company financed the increase of student loans through the issuance of bonds and
notes payable. Total equity increased $29.5 million as a result of net income
for the six months ended June 30, 2007 but was offset by the repurchase of 3.1
million shares of the Company's Class A common stock for $75.5 million. The
acquisition of Packers as discussed in note 9 to the consolidated financial
statements included in this Report resulted in a $12.5 million decrease in
equity. In addition, the Company paid a $0.07 dividend on its Class A and Class
B common stock in the first and second quarters of 2007 which reduced equity by
$6.9 million.
OPERATING SEGMENTS
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 Generation and Management, Student Loan and Guaranty Servicing,
Tuition Payment Processing and Campus Commerce, Enrollment Services and List
Management, and Software and Technical Services. The Company's operating
segments are defined by the products and services they offer or the types of
customers they serve, and they reflect the manner in which financial information
is currently evaluated by management. During 2006, the Company changed the
structure of its internal organization in a manner that caused the composition
of its operating segments to change. As a result, the presentation of segment
financial information for the three and six months ended June 30, 2006, has been
restated to conform to the current operating segment presentation. The
accounting policies of the Company's operating segments are the same as those
described in the summary of significant accounting policies included in the
Company's consolidated financial statements included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2006. Intersegment revenues
are charged by a segment to another segment that provides the product or
service. Intersegment revenues and expenses are included within each segment
consistent with the income statement presentation provided to management.
Changes in management structure or allocation methodologies and procedures may
result in changes in reported segment financial information.
The management reporting process measures the performance of the Company's
operating segments based on the management structure of the Company as well as
the methodology used by management to evaluate performance and allocate
resources. Management, including the Company's chief operating decision maker,
evaluates the performance of the Company's operating segments based on their
profitability. As discussed further below, management measures the profitability
of the Company's operating segments based on "base net income." Accordingly,
information regarding the Company's operating segments is provided based on
"base net income." The Company's "base net income" is not a defined term within
GAAP and may not be comparable to similarly titled measures reported by other
companies. Unlike financial accounting, there is no comprehensive, authoritative
guidance for management reporting.
33
In May 2007, the Company sold EDULINX, a Canadian student loan service provider
and subsidiary of the Company. As a result of this transaction, the results of
operations for EDULINX are reported as discontinued operations for all periods
presented. The operating results of EDULINX were included in the Student Loan
and Guaranty Servicing operating segment. The Company presents "base net income"
excluding discontinued operations since the operations and cash flows of EDULINX
have been eliminated from the ongoing operations of the Company. Therefore, the
results of operations for the Student Loan and Guaranty Servicing segment
exclude the operating results of EDULINX for all periods presented. See note 2
in the notes to the consolidated financial statements included in this Report
for additional information concerning EDULINX' detailed operating results that
have been segregated from continuing operations and reported as discontinued
operations.
"Base net income" is the primary financial performance measure used by
management to develop the Company's financial plans, track results, and
establish corporate performance targets and incentive compensation. While "base
net income" is not a substitute for reported results under GAAP, the Company
relies on "base net income" in operating its business because "base net income"
permits management to make meaningful period-to-period comparisons of the
operational and performance indicators that are most closely assessed by
management. Management believes this information provides additional insight
into the financial performance of the core business activities of the Company's
operating segments.
Accordingly, the tables presented below reflect "base net income" which is
reviewed and utilized by management to manage the business for each of the
Company's operating segments. Reconciliation of the segment totals to the
Company's consolidated operating results in accordance with GAAP are also
included in the tables below. Included below under "Non-GAAP Performance
Measures" is further discussion regarding "base net income" and its limitations,
including a table that details the differences between "base net income" and
GAAP net income by operating segment.
SEGMENT RESULTS AND RECONCILIATIONS TO GAAP
Three months ended June 30, 2007
---------------------------------------------------------------------------------------------------------
Student Tuition Enrollment Elimina- "Base net
Asset Loan Payment Services Software Corporate tions income" GAAP
Generation and Processing and and Activity and Adjustments Results
and Guaranty and Campus List Technical Total and Reclass- to GAAP of Oper-
Management Servicing Commerce Management Services Segments Overhead ifications Results ations
---------------------------------------------------------------------------------------------------------
Total interest income $ 433,404 1,181 670 93 -- 435,348 554 (33) -- 435,869
Interest expense 358,341 -- 2 2 -- 358,345 9,581 (33) - 367,893
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Net interest income 75,063 1,181 668 91 -- 77,003 (9,027) -- -- 67,976
Less provision for
loan losses 2,535 -- -- -- -- 2,535 -- -- -- 2,535
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Net interest income
after provision
for loan losses 72,528 1,181 668 91 -- 74,468 (9,027) -- -- 65,441
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Other income (expense):
Loan and guarantee
servicing income 118 31,492 -- -- -- 31,610 -- -- -- 31,610
Other fee-based income 3,674 -- 9,405 24,923 -- 38,002 260 -- -- 38,262
Software services income -- -- -- 157 5,691 5,848 -- -- -- 5,848
Other income 1,115 5 25 -- -- 1,145 1,792 -- -- 2,937
Intersegment revenue -- 20,120 188 178 4,389 24,875 4,100 (28,975) -- --
Derivative
market value,
foreign currency,
and put option
adjustment -- -- -- -- -- -- -- -- 5,547 5,547
Derivative
settlements, net (461) -- -- -- -- (461) 5,657 -- -- 5,196
---------- -------- -------- -------- -------- --------- ------------------ ---------- ----------
Total other income
(expense) 4,446 51,617 9,618 25,258 10,080 101,019 11,809 (28,975) 5,547 89,400
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Operating expenses:
Salaries and benefits 7,167 22,023 5,082 9,022 5,857 49,151 12,272 (2,138) 476 59,761
Other expenses 7,246 8,404 2,333 14,589 751 33,323 21,071 -- 6,491 60,885
Intersegment expenses 22,034 3,750 25 29 403 26,241 596 (26,837) -- --
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Total operating
expenses 36,447 34,177 7,440 23,640 7,011 108,715 33,939 (28,975) 6,967 120,646
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Income (loss) before
income taxes 40,527 18,621 2,846 1,709 3,069 66,772 (31,157) -- (1,420) 34,195
Income tax expense
(benefit) (a) 15,400 7,076 1,082 649 1,167 25,374 (11,500) -- (568) 13,306
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Net income (loss)
from continuing
operations 25,127 11,545 1,764 1,060 1,902 41,398 (19,657) -- (852) 20,889
Income (loss) from
discontinued
operations,
net of tax -- -- -- -- -- -- -- -- (6,135) (6,135)
---------- -------- -------- -------- -------- --------- -------- -------- ---------- ----------
Net income $ 25,127 11,545 1,764 1,060 1,902 41,398 (19,657) -- (6,987) 14,754
========== ======== ======== ======== ======== ========= ======== ======== ========== ==========
(a) Income taxes are based on a percentage of net income before tax for the
individual operating segment.
34
Three months ended June 30, 2006
---------------------------------------------------------------------------------------------------------
Student Tuition Enrollment Elimina- "Base net
Asset Loan Payment Services Software Corporate tions income" GAAP
Generation and Processing and and Activity and Adjustments Results
and Guaranty and Campus List Technical Total and Reclass- to GAAP of Oper-
Management Servicing Commerce Management Services Segments Overhead ifications Results ations
---------------------------------------------------------------------------------------------------------
Total interest income $ 384,295 1,625 705 129 25 386,779 450 (238) -- 386,991
Interest expense 295,260 -- 1 -- -- 295,261 5,821 (238) -- 300,844
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Net interest income 89,035 1,625 704 129 25 91,518 (5,371) -- -- 86,147
Less provision for
loan losses 2,190 -- -- -- -- 2,190 -- -- -- 2,190
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Net interest income
after provision
for loan losses 86,845 1,625 704 129 25 89,328 (5,371) -- -- 83,957
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Other income (expense):
Loan and guarantee
servicing income -- 28,926 -- -- -- 28,926 -- -- -- 28,926
Other fee-based income 3,035 -- 7,019 6,020 -- 16,074 -- -- -- 16,074
Software services income 65 1 -- 34 3,918 4,018 -- -- -- 4,018
Other income 2,161 40 -- -- -- 2,201 705 -- -- 2,906
Intersegment revenue -- 15,671 228 13 4,465 20,377 155 (20,532) -- --
Derivative market value,
foreign currency, and
put option adjustments -- -- -- -- -- -- -- -- 29,080 29,080
Derivative settlements, net 6,702 -- -- -- -- 6,702 -- -- -- 6,702
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Total other income
(expense) 11,963 44,638 7,247 6,067 8,383 78,298 860 (20,532) 29,080 87,706
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Operating expenses:
Salaries and benefits 13,638 22,237 4,847 1,934 5,257 47,913 8,629 (2,266) 477 54,753
Other expenses 14,956 7,065 2,208 1,310 713 26,252 14,468 -- 5,817 46,537
Intersegment expenses 13,270 2,500 -- -- -- 15,770 2,496 (18,266) -- --
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Total operating
expenses 41,864 31,802 7,055 3,244 5,970 89,935 25,593 (20,532) 6,294 101,290
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Income (loss) before
income taxes 56,944 14,461 896 2,952 2,438 77,691 (30,104) -- 22,786 70,373
Income tax expense
(benefit) (a) 21,639 5,495 340 1,122 926 29,522 (12,048) -- 8,564 26,038
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Net income (loss) from
continuing operations 35,305 8,966 556 1,830 1,512 48,169 (18,056) -- 14,222 44,335
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- 1,418 1,418
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- -----------
Net income $35,305 8,966 556 1,830 1,512 48,169 (18,056) -- 15,640 45,753
========== ======== ======== ======== ======== ========== ======== ========= ========== ===========
(a) Income taxes are based on a percentage of net income before tax for the
individual operating segment.
35
Six months ended June 30, 2007
---------------------------------------------------------------------------------------------------------
Student Tuition Enrollment Elimina- "Base net
Asset Loan Payment Services Software Corporate tions income" GAAP
Generation and Processing and and Activity and Adjustments Results
and Guaranty and Campus List Technical Total and Reclass- to GAAP of Oper-
Management Servicing Commerce Management Services Segments Overhead ifications Results ations
---------------------------------------------------------------------------------------------------------
Total interest income $ 847,894 3,425 1,680 180 18 853,197 4,355 (3,204) -- 854,348
Interest expense 699,999 -- 7 4 -- 700,010 21,582 (3,204) -- 718,388
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Net interest income 147,895 3,425 1,673 176 18 153,187 (17,227) -- -- 135,960
Less provision for
loan losses 5,288 -- -- -- -- 5,288 -- -- -- 5,288
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Net interest income
after provision
for loan losses 142,607 3,425 1,673 176 18 147,899 (17,227) -- -- 130,672
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Other income (expense):
Loan and guarantee
servicing income 118 61,958 -- -- -- 62,076 -- -- -- 62,076
Other fee-based income 6,985 -- 21,176 49,870 -- 78,031 260 -- -- 78,291
Software services income -- -- -- 287 11,309 11,596 -- -- -- 11,596
Other income 5,944 11 28 -- -- 5,983 3,833 -- -- 9,816
Intersegment revenue -- 36,584 340 928 8,221 46,073 6,116 (52,189) -- --
Derivative market value,
foreign currency, and
put option adjustments -- -- -- -- -- -- -- -- (6,583) (6,583)
Derivative settlements, net (885) -- -- -- -- (885) 10,321 -- -- 9,436
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Total other income
(expense) 12,162 98,553 21,544 51,085 19,530 202,874 20,530 (52,189) (6,583) 164,632
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Operating expenses:
Salaries and benefits 14,446 45,027 10,000 18,391 12,332 100,196 24,978 (4,662) 953 121,465
Other expenses 15,511 17,654 4,493 29,148 1,535 68,341 38,940 -- 13,129 120,410
Intersegment expenses 38,670 7,068 399 185 403 46,725 802 (47,527) -- --
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Total operating expenses 68,627 69,749 14,892 47,724 14,270 215,262 64,720 (52,189) 14,082 241,875
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Income (loss) before
income taxes 86,142 32,229 8,325 3,537 5,278 135,511 (61,417) -- (20,665) 53,429
Income tax expense
(benefit) (a) 32,734 12,247 3,164 1,344 2,006 51,495 (23,826) -- (7,099) 20,570
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Net income (loss) from
continuing operations 53,408 19,982 5,161 2,193 3,272 84,016 (37,591) -- (13,566) 32,859
Income (loss) from
discontinued operations, net
of tax -- -- -- -- -- -- -- -- (3,325) (3,325)
--------- -------- -------- -------- -------- ---------- -------- -------- ---------- ----------
Net income $ 53,408 19,982 5,161 2,193 3,272 84,016 (37,591) -- (16,891) 29,534
========= ======== ======== ======== ======== ========== ======== ======== ========== ==========
(a) Income taxes are based on a percentage of net income before tax for the
individual operating segment.
36
Six months ended June 30, 2006
---------------------------------------------------------------------------------------------------------
Student Tuition Enrollment Elimina- "Base net
Asset Loan Payment Services Software Corporate tions income" GAAP
Generation and Processing and and Activity and Adjustments Results
and Guaranty and Campus List Technical Total and Reclass- to GAAP of Oper-
Management Servicing Commerce Management Services Segments Overhead ifications Results ations
---------------------------------------------------------------------------------------------------------
Total interest income $ 726,271 3,434 1,587 212 43 731,547 985 (404) -- 732,128
Interest expense 549,093 -- 2 -- -- 549,095 11,102 (404) -- 559,793
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net interest income 177,178 3,434 1,585 212 43 182,452 (10,117) -- -- 172,335
Less provision for
loan losses 11,808 -- -- -- -- 11,808 -- -- -- 11,808
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net interest income
after provision
for loan losses 165,370 3,434 1,585 212 43 170,644 (10,117) -- -- 160,527
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Other income (expense):
Loan and guarantee
servicing income -- 59,216 -- -- -- 59,216 -- -- -- 59,216
Other fee-based income 5,934 -- 16,673 11,622 -- 34,229 -- -- -- 34,229
Software services income 115 1 -- 40 7,271 7,427 -- -- -- 7,427
Other income 3,803 61 -- -- -- 3,864 1,029 -- -- 4,893
Intersegment revenue -- 30,184 228 765 8,385 39,562 196 (39,758) -- --
Derivative market value,
foreign currency, and
put option adjustments -- -- -- -- -- -- -- -- 68,343 68,343
Derivative settlements, net 11,446 -- -- -- -- 11,446 -- -- -- 11,446
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Total other income
(expense) 21,298 89,462 16,901 12,427 15,656 155,744 1,225 (39,758) 68,343 185,554
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Operating expenses:
Salaries and benefits 25,409 42,106 8,802 3,112 9,973 89,402 18,812 (4,757) 795 104,252
Other expenses 27,001 15,611 4,256 2,703 1,448 51,019 28,124 -- 11,115 90,258
Intersegment expenses 26,146 5,657 -- -- -- 31,803 3,198 (35,001) -- --
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Total operating
expenses 78,556 63,374 13,058 5,815 11,421 172,224 50,134 (39,758) 11,910 194,510
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Income (loss) before
income taxes 108,112 29,522 5,428 6,824 4,278 154,164 (59,026) -- 56,433 151,571
Income tax expense
(benefit) (a) 41,083 11,218 2,062 2,593 1,625 58,581 (24,053) -- 21,552 56,080
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net income (loss)
before minority
interest 67,029 18,304 3,366 4,231 2,653 95,583 (34,973) -- 34,881 95,491
Minority interest in
subsidiary income -- -- (242) -- -- (242) -- -- -- (242)
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net income (loss)
from continuing
operations 67,029 18,304 3,124 4,231 2,653 95,341 (34,973) -- 34,881 95,249
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- 2,570 2,570
---------- -------- -------- --------- -------- ---------- --------- -------- ----------- ----------
Net income (loss) $ 67,029 18,304 3,124 4,231 2,653 95,341 (34,973) -- 37,451 97,819
========== ======== ======== ========= ======== ========== ========= ======== =========== ==========
(a) Income taxes are based on a percentage of net income before tax for the
individual operating segment.
NON-GAAP PERFORMANCE MEASURES
In accordance with the Rules and Regulations of the Securities and Exchange
Commission ("SEC"), 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's operating segments on a non-GAAP performance measure referred to as
"base net income" for each operating segment. While "base net income" is not a
substitute for reported results under GAAP, the Company relies on "base net
income" to manage each operating segment because management believes these
measures provide additional information regarding the operational and
performance indicators that are most closely assessed by management.
"Base net income" is the primary financial performance measure used by
management to develop financial plans, allocate resources, track results,
evaluate performance, establish corporate performance targets, and determine
incentive compensation. Accordingly, financial information is reported to
management on a "base net income" basis by operating segment, as these are the
measures used regularly by the Company's chief operating decision maker. The
Company's board of directors utilizes "base net income" to set performance
targets and evaluate management's performance. The Company also believes
analysts, rating agencies, and creditors use "base net income" in their
evaluation of the Company's results of operations. While "base net income" is
not a substitute for reported results under GAAP, the Company utilizes "base net
income" in operating its business because "base net income" permits management
to make meaningful period-to-period comparisons by eliminating the temporary
volatility in the Company's performance that arises from certain items that are
primarily affected by factors beyond the control of management. Management
believes "base net income" provides additional insight into the financial
performance of the core business activities of the Company's operations.
37
LIMITATIONS OF "BASE NET INCOME"
While GAAP provides a uniform, comprehensive basis of accounting, for the
reasons discussed above, management believes that "base net income" is an
important additional tool for providing a more complete understanding of the
Company's results of operations. Nevertheless, "base net income" is subject to
certain general and specific limitations that investors should carefully
consider. For example, as stated above, unlike financial accounting, there is no
comprehensive, authoritative guidance for management reporting. The Company's
"base net income" is not a defined term within GAAP and may not be comparable to
similarly titled measures reported by other companies. Investors, therefore, may
not be able to compare the Company's performance with that of other companies
based upon "base net income". "Base net income" results are only meant to
supplement GAAP results by providing additional information regarding the
operational and performance indicators that are most closely monitored and used
by the Company's management and board of directors to assess performance and
information which the Company believes is important to analysts, rating
agencies, and creditors.
Other limitations of "base net income" arise from the specific adjustments that
management makes to GAAP results to derive "base net income" results. These
differences are described below.
The adjustments required to reconcile from the Company's "base net income"
measure to its GAAP results of operations relate to differing treatments for
derivatives, foreign currency transaction adjustments, discontinued operations,
and certain other items that management does not consider in evaluating the
Company's operating results. The following table reflects adjustments associated
with these areas by operating segment and Corporate Activity and Overhead for
the three and six months ended June 30, 2007 and 2006:
Three months ended June 30, 2007
-------------------------------------------------------------------------------------
Student Tuition Enrollment
Asset Loan Payment Services Software Corporate
Generation and Processing and and Activity
and Guaranty and Campus List Technical and
Management Servicing Commerce Management Services Overhead Total
----------- ---------- ----------- ----------- ----------- ----------- ----------
Derivative market value, foreign currency,
and put option adjustments $ 6,002 -- -- -- -- (11,549) (5,547)
Amortization of intangible assets 1,840 1,350 1,469 1,545 287 -- 6,491
Non-cash stock based compensation related
to business combinations -- -- -- -- -- 476 476
Income (loss) from discontinued
operations, net of tax -- 6,135 -- -- -- -- 6,135
Net tax effect (a) (2,980) (513) (558) (587) (109) 4,179 (568)
----------- ---------- ----------- ----------- ----------- ----------- ----------
Total adjustments to GAAP $ 4,862 6,972 911 958 178 (6,894) 6,987
=========== ========== =========== =========== =========== =========== ==========
Three months ended June 30, 2006
-------------------------------------------------------------------------------------
Student Tuition Enrollment
Asset Loan Payment Services Software Corporate
Generation and Processing and and Activity
and Guaranty and Campus List Technical and
Management Servicing Commerce Management Services Overhead Total
----------- ---------- ----------- ----------- ----------- ----------- ----------
Derivative market value, foreign currency,
and put option adjustments $ (28,865) -- -- -- -- (215) (29,080)
Amortization of intangible assets 2,229 1,165 1,693 610 120 -- 5,817
Non-cash stock based compensation related
to business combinations -- -- -- -- -- 477 477
Income (loss) from discontinued
operations, net of tax -- (1,418) -- -- -- -- (1,418)
Net tax effect (a) 10,122 (455) (643) (232) (46) (182) 8,564
----------- ---------- ----------- ----------- ----------- ----------- ----------
Total adjustments to GAAP $ (16,514) (708) 1,050 378 74 80 (15,640)
=========== ========== =========== =========== =========== =========== ==========
(a) Tax effect computed at 38%. The change in the value of the put option
(included in Corporate Activity and Overhead) is not tax effected as this is not
deductible for income tax purposes.
38
Six months ended June 30, 2007
----------------------------------------------------------------------------------------
Student Tuition Enrollment
Asset Loan Payment Services Software Corporate
Generation and Processing and and Activity
and Guaranty and Campus List Technical and
Management Servicing Commerce Management Services Overhead Total
---------- ----------- ------------ ------------ ---------- ---------- ----------
Derivative market value, foreign currency,
and put option adjustments $ 12,216 -- -- -- -- (5,633) 6,583
Amortization of intangible assets 3,825 2,394 2,938 3,355 617 -- 13,129
Non-cash stock based compensation related
to business combinations -- -- -- -- -- 953 953
Income (loss) from discontinued
operations, net of tax -- 3,325 -- -- -- -- 3,325
Net tax effect (a) (6,096) (910) (1,116) (1,275) (234) 2,532 (7,099)
---------- ----------- ------------ ------------ ---------- ---------- ----------
Total adjustments to GAAP $ 9,945 4,809 1,822 2,080 383 (2,148) 16,891
========== =========== ============ ============ ========== ========== ==========
Six months ended June 30, 2006
---------------------------------------------------------------------------------------
Student Tuition Enrollment
Asset Loan Payment Services Software Corporate
Generation and Processing and and Activity
and Guaranty and Campus List Technical and
Management Servicing Commerce Management Services Overhead Total
---------- ----------- ------------ ------------ ---------- ---------- ----------
Derivative market value, foreign currency,
and put option adjustments $ (68,660) -- -- -- -- 317 (68,343)
Amortization of intangible assets 4,456 2,331 2,868 1,220 240 -- 11,115
Non-cash stock based compensation related
to business combinations -- -- -- -- -- 795 795
Income (loss) from discontinued
operations, net of tax -- (2,570) -- -- -- -- (2,570)
Net tax effect (a) 24,398 (899) (1,089) (464) (92) (302) 21,552
---------- ----------- ------------ ------------ ---------- ---------- ----------
Total adjustments to GAAP $ (39,806) (1,138) 1,779 756 148 810 (37,451)
========== =========== ============ ============ ========== ========== ==========
(a) Tax effect computed at 38%. The change in the value of the put option
(included in Corporate Activity and Overhead) is not tax effected as this is not
deductible for income tax purposes.
DIFFERENCES BETWEEN GAAP AND "BASE NET INCOME"
Management's financial planning and evaluation of operating results does not
take into account the following items because their volatility and/or inherent
uncertainty affect the period-to-period comparability of the Company's results
of operations. 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 that are caused by the
change in fair value on derivatives in which the Company does not qualify for
"hedge treatment" under GAAP. Statement of Financial Accounting Standards No.
133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES ("SFAS No.
133"), requires that changes in fair value of derivative instruments be
recognized currently in earnings unless specific hedge accounting criteria, as
specified by SFAS No. 133, are met. The Company maintains an overall interest
rate risk management strategy that incorporates the use of derivative
instruments to reduce the economic effect of interest rate volatility.
Derivative instruments primarily used by the Company include interest rate
swaps, basis swaps, interest rate floor contracts, and cross-currency interest
rate swaps. Management has structured all of the Company's derivative
transactions with the intent that each is economically effective. However, the
Company does not qualify its derivatives for "hedge treatment" as defined by
SFAS No. 133, and the stand-alone derivative must be marked-to-market in the
income statement with no consideration for the corresponding change in fair
value of the hedged item. The Company believes these point-in-time estimates of
asset and liability values that are subject to interest rate fluctuations make
it difficult to evaluate the ongoing results of operations against its business
plan and affect the period-to-period comparability of the results of operations.
Included in "base net income" are the economic effects of the Company's
derivative instruments, which includes any cash paid or received being
recognized as an expense or revenue upon actual derivative settlements. These
settlements are included in "Derivative market value, foreign currency, and put
option adjustments and derivative settlements, net" on the Company's
consolidated statements of income.
39
"Base net income" excludes the foreign currency transaction gains or losses
caused by the re-measurement of the Company's Euro-denominated bonds to U.S.
dollars. In connection with the issuance of the Euro-denominated bonds, the
Company has entered into cross-currency interest rate swaps. Under the terms of
these agreements, the principal payments on the Euro-denominated notes will
effectively be paid at the exchange rate in effect at the issuance date of the
bonds. The cross-currency interest rate swaps also convert the floating rate
paid on the Euro-denominated bonds (EURIBOR index) to an index based on LIBOR.
Included in "base net income" are the economic effects of any cash paid or
received being recognized as an expense or revenue upon actual settlements of
the cross-currency interest rate swaps. These settlements are included in
"Derivative market value, foreign currency, and put option adjustments and
derivative settlements, net" on the Company's consolidated statements of income.
However, the gains or losses caused by the re-measurement of the
Euro-denominated bonds to U.S. dollars and the change in market value of the
cross-currency interest rate swaps are excluded from "base net income" as the
Company believes the point-in-time estimates of value that are subject to
currency rate fluctuations related to these financial instruments make it
difficult to evaluate the ongoing results of operations against the Company's
business plan and affect the period-to-period comparability of the results of
operations. The re-measurement of the Euro-denominated bonds correlates with the
change in fair value of the cross-currency interest rate swaps. However, the
Company will experience unrealized gains or losses related to the cross-currency
interest rate swaps if the two underlying indices (and related forward curve) do
not move in parallel.
"Base net income" also excludes the change in fair value of put options issued
by the Company for certain business acquisitions. The put options are valued by
the Company each reporting period using a Black-Scholes pricing model.
Therefore, the fair value of these options is primarily affected by the strike
price and term of the underlying option, the Company's current stock price, and
the dividend yield and volatility of the Company's stock. The Company believes
these point-in-time estimates of value that are subject to fluctuations make it
difficult to evaluate the ongoing results of operations against the Company's
business plans and affects the period-to-period comparability of the results of
operations.
The gains and/or losses included in "Derivative market value, foreign currency,
and put option adjustments and derivative settlements, net" on the Company's
consolidated statements of income are primarily caused by interest rate and
currency volatility, changes in the value of put options based on the inputs
used in the Black-Scholes pricing model, as well as the volume and terms of put
options and of derivatives not receiving hedge treatment. "Base net income"
excludes these unrealized gains and losses and isolates the effect of interest
rate, currency, and put option volatility on the fair value of such instruments
during the period. Under GAAP, the effects of these factors on the fair value of
the put options and the derivative instruments (but not the underlying hedged
item) tend to show more volatility in the short term.
AMORTIZATION OF INTANGIBLE ASSETS: "Base net income" excludes the amortization
of acquired intangibles, which arises primarily from the acquisition of definite
life intangible assets in connection with the Company's acquisitions, since the
Company feels that such charges do not drive the Company's operating performance
on a long-term basis and can affect the period-to-period comparability of the
results of operations.
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 because the Company believes such
charges do not drive its operating performance on a long-term basis and can
affect the period-to-period comparability of the results of operations. If the
Company did not enter into the employment agreements in connection with the
acquisition, the amount paid to these former shareholders of the acquired entity
would have been recorded by the Company as additional consideration of the
acquired entity, thus, not having an effect on the Company's results of
operations.
DISCONTINUED OPERATIONS: In May 2007, the Company sold EDULINX. As a result of
this transaction, the results of operations for EDULINX are reported as
discontinued operations for all periods presented. The Company presents "base
net income" excluding discontinued operations since the operations and cash
flows of EDULINX have been eliminated from the ongoing operations of the
Company.
ASSET GENERATION AND MANAGEMENT OPERATING SEGMENT - RESULTS OF OPERATIONS
The Asset Generation and 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.
In addition to the student loan portfolio, all costs and activity associated
with the generation of assets, funding of those assets, and maintenance of the
debt transactions are included in this segment. This includes derivative
activity and the related derivative market value and foreign currency
adjustments. The Company is also able to leverage its capital market expertise
by providing investment advisory services and other related services to third
parties through a licensed broker dealer subsidiary. Revenues and expenses for
those functions are also included in the Asset Generation and Management
segment.
40
STUDENT LOAN PORTFOLIO
The table below outlines the components of the Company's student loan portfolio:
As of June 30, 2007 As of December 31, 2006
----------------------- ------------------------
Dollars Percent Dollars Percent
------------- -------- ------------- ---------
Federally insured:
Stafford $ 6,630,133 25.3 % $ 5,724,586 24.1 %
PLUS/SLS 426,540 1.6 365,112 1.5
Consolidation 18,454,304 70.6 17,127,623 72.0
Non-federally insured 235,023 0.9 197,147 0.8
------------- -------- ------------- ---------
Total 25,746,000 98.4 23,414,468 98.4
Unamortized premiums and deferred
origination costs 456,098 1.7 401,087 1.7
Allowance for loan losses:
Allowance - federally insured (8,194) (0.0) (7,601) (0.0)
Allowance - non-federally insured (18,946) (0.1) (18,402) (0.1)
------------- -------- ------------- ---------
Net $ 26,174,958 100.0 % $ 23,789,552 100.0 %
============= ======== ============= =========
The Company's net student loan assets have increased $2.4 billion, or 10.0%, to
$26.2 billion as of June 30, 2007 compared to $23.8 billion as of December 31,
2006.
ORIGINATION AND ACQUISITION
The Company originates and acquires loans through various methods and channels
including: (i) direct-to-consumer channel (in which the Company originates
student loans directly with student and parent borrowers), (ii) campus based
origination channels, and (iii) spot purchases.
The Company will originate or acquire loans through its campus based channel
either directly under one of its brand names or through other originating
lenders. In addition to its brands, the Company acquires student loans from
lenders to whom the Company provides marketing and/or origination services
established through various contracts. Branding partners are lenders for which
the Company acts as a marketing agent in specified geographic areas. A forward
flow lender is one for whom the Company provides origination services but
provides no marketing services or whom simply agrees to sell loans to the
Company under forward sale commitments. The table below sets forth the activity
of loans originated or acquired through each of the Company's channels:
Three months ended June 30, Six months ended June 30,
--------------------------- ---------------------------
2007 2006 2007 2006
------------- ------------- ------------- -------------
Beginning balance $ 24,617,030 20,963,219 23,414,468 19,912,955
Direct channel:
Consolidation loan originations 836,711 1,045,094 1,900,949 2,069,929
Less consolidation of existing portfolio (438,993) (567,300) (912,788) (1,001,200)
------------- ------------- ------------- -------------
Net consolidation loan originations 397,718 477,794 988,161 1,068,729
Stafford/PLUS loan originations 141,882 151,017 496,709 457,165
Branding partner channel (a) (b) 255,703 326,764 457,993 556,914
Forward flow channel 392,174 579,701 768,115 931,513
Other channels (b) 560,796 424,620 766,714 668,573
------------- ------------- ------------- -------------
Total channel acquisitions 1,748,273 1,959,896 3,477,692 3,682,894
Repayments, claims, capitalized
interest, and other (397,556) (453,866) (633,363) (819,024)
Consolidation loans lost to external parties (187,350) (310,800) (426,754) (581,200)
Loans sold (34,397) (145,779) (86,043) (182,955)
------------- ------------- ------------- -------------
Ending balance $ 25,746,000 22,012,670 25,746,000 22,012,670
============= ============= ============= =============
41
(a) Included in the branding partner channel are private loan
originations of $17.8 million and $62.1 million for the three and six
months ended June 30, 2007, respectively, and $10.6 million and $21.1
million for the three and six months ended June 30, 2006,
respectively.
(b) Included in other channels for the six months ended June 30, 2006 is
$190.1 million of acquisitions that were previously presented as
branding partner channel acquisitions. This reclassification was made
for comparative purposes due to the nature of the transactions.
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 expired in December
2006. Total loans acquired from Nova were $19.8 million and $31.0 million for
the three and six months ended June 30, 2007, respectively, and $121.7 million
and $161.8 million for the three and six months ended June 30, 2006,
respectively, and $275.6 million for the year ended December 31, 2006. Loans
acquired from Nova are included in the forward flow channel in the above table.
As part of the Company's asset management strategy, the Company periodically
sells student loan portfolios to third parties. During the three and six months
ended June 30, 2007 and 2006, the Company sold $34.4 million (par value) and
$86.0 million (par value), and $145.8 (par value) and $183.0 (par value),
respectively, of student loans resulting in the recognition of gains of $1.0
million and $2.8 million, and $1.4 million and $1.9 million, respectively.
ACTIVITY IN THE ALLOWANCE FOR LOAN LOSSES
The provision for loan losses represents the periodic expense of maintaining an
allowance sufficient to absorb losses, net of recoveries, inherent in the
portfolio of student loans. An analysis of the Company's allowance for loan
losses is presented in the following table:
Three months ended June 30, Six months ended June 30,
----------------------------- ----------------------------
2007 2006 2007 2006
------------- -------------- ------------- -------------
Balance at beginning of period $ 26,224 22,225 26,003 13,390
Provision for loan losses:
Federally insured loans 1,665 200 3,118 7,468
Non-federally insured loans 870 1,990 2,170 4,340
------------- -------------- ------------- -------------
Total provision for loan losses 2,535 2,190 5,288 11,808
Charge-offs, net of recoveries:
Federally insured loans (1,330) (274) (2,525) (565)
Non-federally insured loans (289) 39 (455) (453)
------------- -------------- ------------- -------------
Net charge-offs (1,619) (235) (2,980) (1,018)
Sale of non-federally insured loans -- -- (1,171) --
------------- -------------- ------------- -------------
Balance at end of period $ 27,140 24,180 27,140 24,180
============= ============== ============= =============
Allocation of the allowance for loan losses:
Federally insured loans $ 8,194 7,001 8,194 7,001
Non-federally insured loans 18,946 17,179 18,946 17,179
------------- -------------- ------------- -------------
Total allowance for loan losses $ 27,140 24,180 27,140 24,180
============= ============== ============= =============
Net loan charge-offs as a percentage of average student loans 0.026 % 0.004 % 0.025 % 0.010 %
Total allowance as a percentage of average student loans 0.110 % 0.114 % 0.112 % 0.116 %
Total allowance as a percentage of ending balance of student loans 0.105 % 0.110 % 0.105 % 0.110 %
Non-federally insured allowance as a percentage of the ending
balance of non-federally insured loans 8.061 % 10.137 % 8.061 % 10.137 %
Average student loans $24,687,280 21,289,877 24,266,048 20,763,472
Ending balance of student loans 25,746,000 22,012,670 25,746,000 22,012,670
Ending balance of non-federally insured loans 235,023 169,473 235,023 169,473
During the three months ended March 31, 2006, the Company recognized a $6.9
million provision on its federally insured portfolio as a result of HERA which
was enacted into law on February 8, 2006.
42
Delinquencies have the potential to adversely impact the Company's earnings
through increased servicing and collection costs and account charge-offs. The
table below shows the Company's student loan delinquency amounts:
As of June 30, 2007 As of December 31, 2006
------------------------ -------------------------
Dollars Percent Dollars Percent
--------------- ------- --------------- --------
Federally Insured Loans:
Loans in-school/grace/deferment(1) $ 7,180,850 $ 6,271,558
Loans in forebearance(2) 2,800,659 2,318,184
Loans in repayment status:
Loans current 13,642,086 87.9 % 12,944,768 88.5 %
Loans delinquent 31-60 days(3) 605,957 3.9 623,439 4.3
Loans delinquent 61-90 days(3) 373,980 2.4 299,413 2.0
Loans delinquent 91 days or greater(4) 907,445 5.8 759,959 5.2
--------------- ------- --------------- --------
Total loans in repayment 15,529,468 100.0 % 14,627,579 100.0 %
--------------- ======= --------------- ========
Total federally insured loans $ 25,510,977 $ 23,217,321
=============== ===============
Non-Federally Insured Loans:
Loans in-school/grace/deferment(1) $ 113,449 $ 83,973
Loans in forebearance(2) 7,820 6,113
Loans in repayment status:
Loans current 107,413 94.5 % 101,084 94.4 %
Loans delinquent 31-60 days(3) 2,979 2.6 2,681 2.5
Loans delinquent 61-90 days(3) 1,509 1.3 1,233 1.2
Loans delinquent 91 days or greater(4) 1,853 1.6 2,063 1.9
--------------- ------- --------------- --------
Total loans in repayment 113,754 100.0 % 107,061 100.0 %
--------------- ======= --------------- ========
Total non-federally insured loans $ 235,023 $ 197,147
=============== ===============
----------
(1) Loans for borrowers who still may be attending school or engaging in other
permitted educational activities and are not yet required to make payments
on the loans, E.G., residency periods for medical students or a grace period
for bar exam preparation for law students.
(2) Loans for borrowers who have temporarily ceased making full payments due to
hardship or other factors, according to a schedule approved by the servicer
consistent with the established loan program servicing procedures and
policies.
(3) The period of delinquency is based on the number of days scheduled payments
are contractually past due and relate to repayment loans, that is,
receivables not charged off, and not in school, grace, deferment, or
forbearance.
(4) Loans delinquent 91 days or greater include loans in claim status, which are
loans which have gone into default and have been submitted to the guaranty
agency for FFELP loans, or, if applicable, the insurer for non-federally
insured loans, to process the claim for payment.
STUDENT LOAN SPREAD ANALYSIS
The following table analyzes the student loan spread on the Company's portfolio
of student loans and represents the spread on assets earned in conjunction with
the liabilities and derivative instruments used to fund the assets:
Three months ended June 30, Six months ended June 30,
----------------------------- ----------------------------
2007 2006 2007 2006
------------- ------------- ------------- --------------
Student loan yield 7.93 % 7.93 % 7.90 % 7.82 %
Consolidation rebate fees (0.78) (0.70) (0.78) (0.71)
Premium and deferred origination costs
amortization (0.37) (0.40) (0.36) (0.42)
------------- ------------- ------------- --------------
Student loan net yield 6.78 6.83 6.76 6.69
Student loan cost of funds (a) (5.50) (5.00) (5.48) (4.83)
------------- ------------- ------------- --------------
Student loan spread 1.28 1.83 1.28 1.86
Special allowance yield adjustment, net of
settlements on derivatives (b) -- (0.34) -- (0.35)
------------- ------------- ------------- --------------
Core student loan spread 1.28 % 1.49 % 1.28 % 1.51 %
============= ============= ============= ==============
Average balance of student loans $ 24,687,280 $ 21,289,877 $ 24,266,048 $ 20,763,472
Average balance of debt outstanding 26,158,525 23,126,198 25,770,551 22,465,046
43
(a) The student loan cost of funds includes the effects of net settlement
costs on the Company's derivative instruments used to hedge the
Company's student loan portfolio.
(b) The special allowance yield adjustment represents the impact on net
spread had certain 9.5% loans earned at statutorily defined rates under
a taxable financing. The special allowance yield adjustment includes net
settlements on derivative instruments that were used to hedge this loan
portfolio earning the excess yield. On January 19, 2007, the Company
entered into a Settlement Agreement with the Department to resolve the
audit by the OIG of the Company's portfolio of student loans receiving
9.5% special allowance payments. Under the terms of the Agreement, all
9.5% special allowance payments were eliminated for periods on and after
July 1, 2006. The Company had been deferring recognition of 9.5% special
allowance payments related to those loans subject to the OIG audit
effective July 1, 2006 pending satisfactory resolution of this issue.
The compression of the Company's core student loan spread has been primarily due
to (i) an increase in lower yielding consolidation loans and an increase in the
consolidation rebate fees; (ii) the elimination of 9.5% special allowance
payments on non-special allowance yield adjustment student loans as a result of
the Settlement Agreement with the Department; and (iii) the mismatch in the
reset frequency between the Company's floating rate assets and floating rate
liabilities. The Company's core student loan spread benefited in the rising
interest rate environment for the three and six months ended June 30, 2006
because the Company's cost of funds reset periodically on a discrete basis, in
advance, while the Company's student loans received a yield based on the average
daily interest rate over the period. As interest rates remained relatively flat
during the three and six months ended June 30, 2007, as compared to the same
period in 2006, the Company did not benefit from the rate reset discrepancy of
its assets and liabilities contributing to the compression.
As noted in Item 3, "Quantitative and Qualitative Disclosures about Market
Risk", the Company has a portfolio of student loans that are earning interest at
a fixed borrower rate which exceeds the statutorily defined variable lender rate
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. When excluding floor income, the Company's core student loan
spread was 1.23% for both the three and six months ended June 30, 2007, and
1.34% for the same periods in 2006.
THREE AND SIX MONTHS ENDED JUNE 30, 2007 COMPARED TO THE THREE AND SIX MONTHS
ENDED JUNE 30, 2006
Three months ended June 30, Six months ended June 30,
------------------------------ ------------------------------
2007 2006 $ Change 2007 2006 $ Change
-------- --------- --------- --------- --------- --------
Net interest income after the provision
for loan losses $72,528 86,845 (14,317) 142,607 165,370 (22,763)
Loan and guarantee servicing income 118 -- 118 118 -- 118
Other fee-based income 3,674 3,035 639 6,985 5,934 1,051
Software services income -- 65 (65) -- 115 (115)
Other income 1,115 2,161 (1,046) 5,944 3,803 2,141
Derivative settlements, net (461) 6,702 (7,163) (885) 11,446 (12,331)
-------- --------- --------- --------- --------- --------
Total other income 4,446 11,963 (7,517) 12,162 21,298 (9,136)
Salaries and benefits 7,167 13,638 (6,471) 14,446 25,409 (10,963)
Other expenses 7,246 14,956 (7,710) 15,511 27,001 (11,490)
Intersegment expenses 22,034 13,270 8,764 38,670 26,146 12,524
-------- --------- --------- --------- --------- --------
Total operating expenses 36,447 41,864 (5,417) 68,627 78,556 (9,929)
-------- --------- --------- --------- --------- --------
"Base net income" before income taxes 40,527 56,944 (16,417) 86,142 108,112 (21,970)
Income tax expense 15,400 21,639 (6,239) 32,734 41,083 (8,349)
-------- --------- --------- --------- --------- --------
"Base net income" $25,127 35,305 (10,178) 53,408 67,029 (13,621)
======== ========= ========= ========= ========= ========
After Tax Operating Margin 32.6% 35.7% 34.5% 35.9%
44
NET INTEREST INCOME AFTER THE PROVISION FOR LOAN LOSSES.
Three months ended June 30, Change
-------------------------- -----------------------
2007 2006 Dollars Percent
------------- ----------- ----------- -----------
Loan interest $ 487,465 421,201 66,264 15.73 %
Consolidation rebate fees (47,745) (37,335) (10,410) (27.88)
Amortization of loan premiums and
deferred origination costs (22,634) (21,124) (1,510) (7.15)
------------- ----------- ----------- -----------
Total loan interest 417,086 362,742 54,344 14.98
Investment interest 16,318 21,553 (5,235) (24.29)
------------- ----------- ----------- -----------
Total interest income 433,404 384,295 49,109 12.78
------------- ----------- ----------- -----------
Interest on bonds and notes payable 358,308 295,219 63,089 21.37
Intercompany interest 33 41 (8) (19.51)
Provision for loan losses 2,535 2,190 345 15.75
------------- ----------- ----------- -----------
Net interest income after provision for
loan losses $ 72,528 86,845 (14,317) (16.49)%
============= =========== =========== ===========
o Loan interest for the three months ended June 30, 2006 included $13.9
million of 9.5% special allowance payments. The Company received no 9.5%
special allowance payments for the three months ended June 30, 2007 as a
result of the Settlement Agreement with the Department.
o The average student loan portfolio increased $3.4 billion, or 16.0%, for
the three months ended June 30, 2007 compared to the same period in
2006. Student loan yield, excluding 9.5% special allowance payments,
increased to 7.93% in 2007 from 7.67% in 2006. The increase in student
loan yield is the result of a higher 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 9.5%
special allowance payments, increased $80.1 million as a result of these
factors.
o Consolidation rebate fees increased due to the $3.9 billion, or 27.1%,
increase in the consolidation loan portfolio.
o The amortization of loan premiums and deferred origination costs
increased $4.8 million, or 22.7%, as a result of loan portfolio growth.
In December 2006, the Company wrote-off $21.7 million of premiums on
loans earning 9.5% special allowance payments as a result of the
Settlement Agreement with the Department. For the three months ended
June 30, 2006, the Company recognized $1.7 million of premium
amortization related to these loans. The remaining decrease in
amortization was the result of certain premiums and loan costs that
became fully amortized in 2006.
o Investment income has decreased as a result of an overall decrease in
cash held in 2007 as compared to 2006. During the second quarter 2006,
proceeds from the issuance of a debt transaction were held as cash until
loans were available for securitization. As a result, the Company earned
investment interest on this cash until it was used to fund student
loans.
o Interest expense increased $63.1 million due to the $3.0 billion, or
13.1%, increase in average debt for the three months ended June 30, 2007
compared to the same period in 2006. In addition, the Company's cost of
funds (excluding net derivative settlements) increased to 5.49% for the
three months ended June 30, 2007 compared to 5.12% for the same period a
year ago.
45
Six months ended June 30, Change
------------------------- ------------------------
2007 2006 Dollars Percent
----------- ------------ ------------ -----------
Loan interest $ 951,998 804,269 147,729 18.37 %
Consolidation rebate fees (94,165) (72,881) (21,284) (29.20)
Amortization of loan premiums and
deferred origination costs (43,693) (42,986) (707) (1.64)
----------- ------------ ------------ -----------
Total loan interest 814,140 688,402 125,738 18.27
Investment interest 33,754 37,869 (4,115) (10.87)
----------- ------------ ------------ -----------
Total interest income 847,894 726,271 121,623 16.75
----------- ------------ ------------ -----------
Interest on bonds and notes payable 696,795 549,006 147,789 26.92
Intercompany interest 3,204 87 3,117 3,582.76
Provision for loan losses 5,288 11,808 (6,520) (55.22)
----------- ------------ ------------ -----------
Net interest income after provision for
loan losses $ 142,607 165,370 (22,763) (13.76)%
=========== ============ ============ ===========
o Loan interest for the six months ended June 30, 2006 included $32.3
million of 9.5% special allowance payments. The Company received no 9.5%
special allowance payments for the six months ended June 30, 2007 as a
result of the Settlement Agreement with the Department.
o The average student loan portfolio increased $3.5 billion, or 16.9%, for
the six months ended June 30, 2007 compared to the same period in 2006.
Student loan yield, excluding 9.5% special allowance payments, increased
to 7.90% in 2007 from 7.50% in 2006. The increase in student loan yield
is the result of a higher 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 9.5% special
allowance payments, increased $180.0 million as a result of these
factors.
o Consolidation rebate fees increased due to the $3.9 billion, or 27.1%,
increase in the consolidation loan portfolio.
o The amortization of loan premiums and deferred origination costs
increased $8.8 million, or 18.8%, as a result of loan portfolio growth.
In December 2006, the Company wrote-off $21.7 million of premiums on
loans earning 9.5% special allowance payments as a result of the
Settlement Agreement with the Department. For the six months ended June
30, 2006, the Company recognized $3.5 million of premium amortization
related to these loans. The remaining decrease in amortization was the
result of certain premiums and loan costs that became fully amortized in
2006.
o Investment income has decreased as a result of an overall decrease in
cash held in 2007 as compared to 2006. During the second quarter 2006,
proceeds from the issuance of a debt transaction were held as cash until
the loans were available for securitization. As a result, the Company
earned investment interest on this cash until it was used to fund
student loans.
o Interest expense increased $150.9 million due to the $3.3 billion, or
14.7%, increase in average debt for the six months ended June 30, 2007
compared to the same period in 2006. In addition, the Company's cost of
funds (excluding net derivative settlements) increased to 5.48% for the
six months ended June 30, 2007 compared to 4.93% for the same period a
year ago.
o The provision for loan losses decreased because the Company recognized a
$6.9 million provision in the first quarter of 2006 on its federally
insured portfolio as a result of HERA which was enacted into law on
February 8, 2006.
OTHER FEE-BASED INCOME. Borrower late fees increased $0.3 million and $0.8
million for the three and six months ended June 30, 2007 compared to 2006,
respectively, as a result of the increase in the average student loan portfolio.
OTHER INCOME. Other income for the three months ended June 30, 2007 compared to
2006 decreased $1.0 million as a result of a decrease in the gain on sale of
loans. For the six months ended June 30, 2007 compared to 2006, other income has
increased $2.1 million as a result of a gain on the termination of the Company's
interest rate floor contracts in January 2007.
OPERATING EXPENSES. Operating expenses decreased $5.4 million, or 12.9%, and
$9.9 million, or 12.6%, for the three and six months ended June 30, 2007
compared to 2006, respectively. The Company has reduced its cost to service
loans by converting loan volume acquired during certain 2005 acquisitions from
third party servicers to the Company's servicing platform resulting in
approximately $1.3 million and $3.2 million in savings for the three and six
months ended June 30, 2007, respectively. In addition, the Company has leveraged
its marketing efforts such that these operations benefit multiple operating
segments in the current period. In previous periods these efforts were focused
on primarily asset generation which resulted in higher costs for this operating
segment.
46
STUDENT LOAN AND GUARANTY SERVICING OPERATING SEGMENT - RESULTS OF OPERATIONS
The Student Loan and Guaranty 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 and business process
outsourcing 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 guaranty servicing, servicing support, and business process
outsourcing activities include providing software and data center services,
borrower and loan updates, default aversion tracking services, claim processing
services, and post-default collection services to guaranty agencies.
STUDENT LOAN SERVICING VOLUMES
The Company performs servicing activities for its own portfolio and third
parties. The following table summarizes the Company's loan servicing volumes for
FFELP and private loans (dollars in millions).
As of June 30, 2007 As of June 30, 2006
------------------------- ------------------------
Dollar Percent Dollar Percent
------------ ------------ ----------- ------------
Company $ 24,429 5.6 % $ 19,820 69.1 %
Third Party 7,884 24.4 8,856 30.9
------------ ------------ ----------- ------------
$ 32,313 100.0 % $ 28,676 100.0 %
============ ============ =========== ============
THREE AND SIX MONTHS ENDED JUNE 30, 2007 COMPARED TO THE THREE AND SIX MONTHS
ENDED JUNE 30, 2006
Three months ended June 30, Six months ended June 30,
--------------------------------- -------------------------------
2007 2006 $ Change 2007 2006 $ Change
---------- ---------- ----------- ---------- ---------- ---------
Net interest income after the provision
for loan losses $ 1,181 1,625 (444) 3,425 3,434 (9)
Loan and guaranty servicing income 31,492 28,926 2,566 61,958 59,216 2,742
Software services income -- 1 (1) -- 1 (1)
Other income 5 40 (35) 11 61 (50)
Intersegment revenue 20,120 15,671 4,449 36,584 30,184 6,400
---------- ---------- ----------- ---------- ---------- ---------
Total other income 51,617 44,638 6,979 98,553 89,462 9,091
Salaries and benefits 22,023 22,237 (214) 45,027 42,106 2,921
Other expenses 8,404 7,065 1,339 17,654 15,611 2,043
Intersegment expenses 3,750 2,500 1,250 7,068 5,657 1,411
---------- ---------- ----------- ---------- ---------- ---------
Total operating expenses 34,177 31,802 2,375 69,749 63,374 6,375
---------- ---------- ----------- ---------- ---------- ---------
"Base net income" before income taxes 18,621 14,461 4,160 32,229 29,522 2,707
Income tax expense 7,076 5,495 1,581 12,247 11,218 1,029
---------- ---------- ----------- ---------- ---------- ---------
"Base net income" $ 11,545 8,966 2,579 19,982 18,304 1,678
========== ========== =========== ========== ========== =========
After Tax Operating Margin 21.9% 19.4% 19.6% 19.7%
47
LOAN AND GUARANTY SERVICING INCOME. Loan and guaranty servicing income for the
three and six months ended June 30, 2007 increased from the same periods in 2006
as follows:
Three months ended June 30, Six months ended June 30,
----------------------------------------- ---------------------------------------
2007 2006 $ Change % Change 2007 2006 $ Change % Change
---------- ------- ---------- ---------- -------- -------- ---------- ----------
Origination and servicing of
FFEL Program loans $ 13,774 15,981 (2,207) (13.8)% $ 27,904 33,068 (5,164) (15.6)%
Origination and servicing of
of non-federally insured
student loans 2,335 2,296 39 1.7 4,656 4,480 176 3.9
Servicing and support outsourcing
for guaranty agencies 15,383 10,649 4,734 44.5 29,398 21,668 7,730 35.7
---------- -------- --------- ---------- -------- -------- --------- ----------
Loan and guaranty servicing income
to external parties $ 31,492 28,926 2,566 8.9 % $ 61,958 59,216 2,742 4.6 %
========== ======== ========= ========== ======== ======== ========= ==========
FFELP loan servicing income has decreased as a result of a decrease in the
volume of loans serviced. Guaranty servicing income has increased as a result of
an increase in the volume of guaranteed loans serviced.
OPERATING EXPENSES. For the three months ended June 30, 2007 compared to 2006,
the increase in operating expenses is the result of an increase in costs to
service a larger portfolio of guaranteed loans. In addition, for the six months
ended June 30, 2007 compared to 2006, operating expenses increased to due to
additional costs to integrate and reorganize entities acquired over the prior
two years.
TUITION PAYMENT PROCESSING AND CAMPUS COMMERCE OPERATING SEGMENT - RESULTS OF
OPERATIONS
The Company's Tuition Payment Processing and Campus Commerce operating segment
provides products and services to help institutions and education seeking
families manage the payment of education costs during the pre-college and
college stages of the education life cycle. 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 and
universities.
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 effective 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 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 effective date of acquisition.
48
THREE AND SIX MONTHS ENDED JUNE 30, 2007 COMPARED TO THE THREE AND SIX MONTHS
ENDED JUNE 30, 2006
Three months ended June 30, Six months ended June 30,
------------------------------- ----------------------------------
2007 2006 $ Change 2007 2006 $ Change
--------- --------- ----------- ---------- ---------- -----------
Net interest income after the provision
for loan losses $ 668 704 (36) 1,673 1,585 88
Other fee-based income 9,405 7,019 2,386 21,176 16,673 4,503
Other income 25 -- 25 28 -- 28
Intersegment revenue 188 228 (40) 340 228 112
--------- --------- ----------- ---------- ---------- -----------
Total other income 9,618 7,247 2,371 21,544 16,901 4,643
--------- --------- ----------- ---------- ---------- -----------
Salaries and benefits 5,082 4,847 235 10,000 8,802 1,198
Other expenses 2,333 2,208 125 4,493 4,256 237
Intersegment expenses 25 -- 25 399 -- 399
--------- --------- ----------- ---------- ---------- -----------
Total operating expenses 7,440 7,055 385 14,892 13,058 1,834
--------- --------- ----------- ---------- ---------- -----------
"Base net income" before income taxes 2,846 896 1,950 8,325 5,428 2,897
Income tax expense 1,082 340 742 3,164 2,062 1,102
--------- --------- ----------- ---------- ---------- -----------
"Base net income" before minority interest 1,764 556 1,208 5,161 3,366 1,795
Minority interest -- -- -- -- (242) 242
--------- --------- ----------- ---------- ---------- -----------
"Base net income" $ 1,764 556 1,208 5,161 3,124 2,037
========= ========= =========== ========== ========== ===========
After Tax Operating Margin 17.1% 7.0% 22.2% 18.2%
Other fee-based income increased for the three and six months ended June 30,
2007 compared to 2006 as a result of an increase in the number of managed
tuition payment plans. In addition, for the six months ended June 30, 2007, $0.7
million of the increase in other fee-based income is due to the timing of the
acquisition of infiNET. The increase in operating expenses was also the result
of the increase in the number of managed tuition payment plans. The timing of
the acquisition of infiNET resulted in a $0.5 million increase in operating
expenses for the six months ended June 30, 2007.
ENROLLMENT SERVICES AND LIST MANAGEMENT OPERATING SEGMENT - RESULTS OF
OPERATIONS
The Company's Enrollment Services and List Management 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
young adult market places. In addition, this segment offers products and
services that are focused on helping i) students plan and prepare for life after
high school and ii) colleges recruit and retain students.
Management believes the Company's Enrollment Services and List Management
operating segment will enhance the Company's position as a vertically-integrated
industry leader with a strong foundation for growth. The Company has focused on
growing and organically developing its product and service offerings as well as
enhancing them through various acquisitions. On June 30, 2006, the Company
purchased 100% of the membership interests of CUnet. On July 27, 2006, the
Company purchased certain assets and assumed certain liabilities (hereafter
referred to as "Peterson's") from Thomson Learning Inc. 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.
49
THREE AND SIX MONTHS ENDED JUNE 30, 2007 COMPARED TO THE THREE AND SIX MONTHS
ENDED JUNE 30, 2006
Three months ended June 30, Six months ended June 30,
---------------------------------- ---------------------------------
2007 2006 $ Change 2007 2006 $ Change
----------- ---------- ----------- ---------- --------- ----------
Net interest income after the provision
for loan losses $ 91 129 (38) 176 212 (36)
Other fee-based income 24,923 6,020 18,903 49,870 11,622 38,248
Software services income 157 34 123 287 40 247
Intersegment revenue 178 13 165 928 765 163
----------- ---------- ----------- ---------- --------- ----------
Total other income 25,258 6,067 19,191 51,085 12,427 38,658
Salaries and benefits 9,022 1,934 7,088 18,391 3,112 15,279
Other expenses 14,589 1,310 13,279 29,148 2,703 26,445
Intersegment expenses 29 -- 29 185 -- 185
----------- ---------- ----------- ---------- --------- ----------
Total operating expenses 23,640 3,244 20,396 47,724 5,815 41,909
----------- ---------- ----------- ---------- --------- ----------
"Base net income" before income taxes 1,709 2,952 (1,243) 3,537 6,824 (3,287)
Income tax expense 649 1,122 (473) 1,344 2,593 (1,249)
----------- ---------- ----------- ---------- --------- ----------
"Base net income" $ 1,060 1,830 (770) 2,193 4,231 (2,038)
=========== ========== =========== ========== ========= ==========
After Tax Operating Margin 4.2% 29.5% 4.3% 33.5%
Other fee-based income and total operating expenses increased $18.2 million and
$18.9 million for the three months ended June 30, 2007 compared to 2006 as a
result of the acquisition of Petersons and CUnet. For the six months ended June
30, 2007 compared to 2006, other fee-based income and total operating expenses
increased $37.4 million and $37.9 million as a result of the timing of these
acquisitions.
Other fee-based income for the three months ended June 30, 2007 compared to 2006
also increased $0.8 million due to an increase in merchandise revenue. For the
six months ended June 30, 2007 compared to 2006, there was a $1.0 million
increase in list income.
The increase in operating expenses, excluding the impact of acquisitions, was
$1.5 million and $4.0 million for the three and six months ended June 30, 2007
compared to the same periods in 2006. These increases were the result of further
developing resources and products for the Company's customers in this segment.
SOFTWARE AND TECHNICAL SERVICES OPERATING SEGMENT - RESULTS OF OPERATIONS
The Software and Technical Services segment provides information technology
products and full-service technical consulting, with core areas of business in
educational loan software solutions, business intelligence, technical consulting
services, and Enterprise Content Management (ECM) solutions.
50
THREE AND SIX MONTHS ENDED JUNE 30, 2007 COMPARED TO THE THREE AND SIX MONTHS
ENDED JUNE 30, 2006
Three months ended June 30, Six months ended June 30,
------------------------------- ------------------------------
2007 2006 $ Change 2007 2006 $ Change
---------- ---------- --------- --------- --------- ---------
Net interest income after the provision
for loan losses $ -- 25 (25) 18 43 (25)
Software services income 5,691 3,918 1,773 11,309 7,271 4,038
Intersegment revenue 4,389 4,465 (76) 8,221 8,385 (164)
---------- ---------- --------- --------- --------- ---------
Total other income 10,080 8,383 1,697 19,530 15,656 3,874
---------- ---------- --------- --------- --------- ---------
Salaries and benefits 5,857 5,257 600 12,332 9,973 2,359
Other expenses 751 713 38 1,535 1,448 87
Intersegment expenses 403 -- 403 403 -- 403
---------- ---------- --------- --------- --------- ---------
Total operating expenses 7,011 5,970 1,041 14,270 11,421 2,849
---------- ---------- --------- --------- --------- ---------
"Base net income" before income taxes 3,069 2,438 631 5,278 4,278 1,000
Income tax expense 1,167 926 241 2,006 1,625 381
---------- ---------- --------- --------- --------- ---------
"Base net income" $ 1,902 1,512 390 3,272 2,653 619
========== ========== ========= ========= ========= =========
After Tax Operating Margin 18.9% 18.0% 16.7% 16.9%
Software services income increased $1.8 million and $4.0 million for the three
and six months ended June 30, 2007 compared to the same periods in 2006 as a
result of new customers and increased usage fees for existing customers. The
increase in operating expenses was driven by additional salaries and benefits
costs to support the additional income.
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 $750.0 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.
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 June 30, 2007 the
Company had outstanding a $750.0 million unsecured line of credit with no
outstanding borrowings. The agreement terminates in May 2012.
On January 24, 2007, the Company established a $475.0 million unsecured
commercial paper program and in May 2007 increased the amount authorized for
issuance under the program to $725.0 million. Under the program, the Company may
issue commercial paper for general corporate purposes. The maturities of the
notes issued under this program will vary, but may not exceed 397 days from the
date of issue. Notes issued under this program will bear interest at rates that
will vary based on market conditions at the time of issuance. As of June 30,
2007, there was $307.7 million of notes outstanding under this program and
$417.3 million authorized for future issuance.
51
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
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 warehouse facilities 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.
In August 2006, the Company established a $5.0 billion loan warehouse program
through its wholly-owned subsidiary, Nelnet Student Asset Funding Extendible CP,
LLC ("Nelnet SAFE"), under which Nelnet SAFE may 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 June 30, 2007, the Company had $3.3 billion of Secured Liquidity
Notes outstanding and an additional $1.7 billion authorized for future issuance
under this warehouse program.
The Company also utilizes bank supported commercial paper conduit programs for
loan warehousing. The Company had a loan warehousing capacity of $3.8 billion as
of June 30, 2007, of which $3.1 billion was outstanding and $0.7 billion was
available for future use, under these programs. The conduit programs terminate
at various times beginning in 2007 through 2010. In addition, 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.
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.
ASSET-BACKED SECURITIZATIONS
Of the $27.8 billion of debt outstanding as of June 30, 2007, $20.5 billion was
issued under asset-backed securitizations. 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. During 2006, the
Company completed asset-backed securities transactions that included certain
notes issued with initial spreads to the 3-month EURIBOR. The interest rate on
student loans being financed is generally set based upon a spread to commercial
paper or U.S. Treasury bills.
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 the Company's prospectus supplement.
52
On September 27, 2006 the Company consummated a debt offering under its
universal shelf consisting of $200.0 million aggregate principal amount of
Junior Subordinated Hybrid Securities ("Hybrid Securities"). The Hybrid
Securities are unsecured obligations of the Company. The interest rate on the
Hybrid Securities from the date they were issued through the optional redemption
date, 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 Hybrid Securities will be equal to three-month LIBOR plus 3.375%,
payable quarterly. The principal amount of the Hybrid Securities 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 Hybrid Securities' 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 Hybrid Securities in full whether or not the Company has sold qualifying
capital securities. At the Company's option, the Hybrid Securities 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 June 30, 2007, the Company has $275.0 million remaining under its
universal shelf.
The following table summarizes the Company's bonds and notes outstanding as of
June 30, 2007:
Interest rate
Carrying Percent of range on carrying
amount total amount Final maturity
------------- --------- ------------------ --------------------
Variable-rate bonds and notes (a):
Bond and notes based on indices $ 16,979,962 61.1 % 3.75% - 6.06% 05/01/11 - 05/01/42
Bonds and notes based on EURIBOR 1,045,348 3.8 4.09% - 4.19% 08/25/36 - 01/26/37
Bond and notes based on auction 2,261,395 8.1 3.07% - 5.40% 11/01/09 - 07/01/43
------------- --------
Total variable-rate bonds and notes 20,286,705 73.0
Commerical paper and other 6,444,656 23.2 5.32% - 5.60% 10/17/07 - 05/09/08
Fixed-rate bonds and notes (a) 219,617 0.8 5.20% - 6.68% 11/01/09 - 05/01/29
Unsecured fixed-rate debt 475,000 1.7 5.13% - 7.40% 06/01/10 - 09/29/36
Unsecured line of credit 307,710 1.1 5.39% - 5.50% 05/08/12
Other borrowings 57,458 0.2 5.10% - 5.80% 06/28/08 - 11/01/15
------------- --------
Total $ 27,791,146 100.0 %
============= ========
--------------------------------
(a) Issued in securitization transactions.
The Company is committed under non-cancelable operating leases for certain
office and warehouse space and equipment. The Company's contractual obligations
as of June 30, 2007 were as follows:
Less than More than
Total 1 year 1 to 3 years 3 to 5 years 5 years
------------- ------------ ------------- ----------- -----------
Bonds and notes payable $ 27,791,146 6,509,009 353,847 360,128 20,568,162
Operating lease obligations 40,123 9,891 16,080 9,250 4,902
Other 24,165 8,201 15,964 -- --
------------- ----------- ----------- ----------- ------------
Total $ 27,855,434 6,527,101 385,891 369,378 20,573,064
============= =========== =========== =========== ============
The Company had an $11.2 million reserve as of June 30, 2007 for uncertain
income tax positions related to the January 1, 2007 adoption of FIN 48. This
obligation is not included in the above table as the timing and resolution of
the income tax positions cannot be reasonably estimated at this time.
The Company's bonds and notes payable due in less than one year include $6.4
billion under its loan warehouse facilities. Historically, the Company has been
able to renew its commercial paper conduit programs, including the underlying
liquidity agreements, and therefore the Company does not believe the renewal of
these contracts presents a significant risk to its liquidity.
The Company has commitments with its branding partners and forward flow lenders
which obligate the Company to purchase loans originated under specific criteria,
although the branding partners and forward flow lenders are typically not
obligated to provide the Company with a minimum amount of loans. Branding
partners are those entities from whom the Company acquires student loans and
provides marketing and origination services. Forward flow lenders are those
entities from whom the Company acquires student loans and provides origination
services. These commitments generally run for periods ranging from one to five
years and are generally renewable. Commitments to purchase loans under these
arrangements are not included in the table above.
As a result of the Company's acquisitions, the Company has certain contractual
obligations or commitments as follows:
o LoanSTAR - As part of the agreement for the acquisition of the capital
stock of LoanSTAR from the Greater Texas Foundation ("Texas
Foundation"), 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 million through October 2010. The
sales price for such loans is the fair value mutually agreed upon
between the Company and the Texas Foundation. To satisfy this
obligation, the Company sells loans to the Texas Foundation on a
quarterly basis.
53
o SMG/NHR - Contingent payments of $4.0 million to $24.0 million payable
in annual installments through April 2008 based on the operating results
of SMG and NHR. As of June 30, 2007, the Company has made payments of
$6.0 million related to this contingency and has accrued an additional
$6.9 which is included in the table above.
o infiNET - Stock price guarantee of $104.8375 per share on 95,380 shares
of Class A Common Stock 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 was subject to a put option arrangement whereby
during the 30-day period beginning February 28, 2010, the holders of
such shares could require the Company to repurchase all or part of the
shares at a price of $83.95 per share. The value of this put option as
of June 30, 2007 was $11.9 million and is included in "other" in the
above table. On July 19, 2007, the Company paid $15.9 million to redeem
the 238,237 shares that were subject to this put option agreement.
o CUnet - Contingent payments not to exceed $80.0 million due in annual
installments through December 2010 based on the aggregate cumulative net
income before taxes of CUnet. In partial satisfaction of the contingent
consideration, the Company will issue shares of Class A Common Stock.
These contingency payments are not included in the table above.
o 5280 - 258,760 shares of Class A Common Stock issued as part of the
original purchase price is subject to a put option arrangement whereby
during the 30-day period ending November 30, 2008, the holders may
require the Company to repurchase all or part of the shares at a price
of $37.10 per share. The value of this put option as of June 30, 2007
was $3.0 million and is included in "other" in the above table.
DIVIDENDS
During each of the first two quarters of 2007, the Company paid a cash dividend
of $0.07 per share on the Company's Class A and Class B Common Stock. The
Company intends to continue making a quarterly dividend payment in the future.
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, 2006, 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.
Management bases the allowance for the federally insured loan portfolio 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.
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.
54
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 principal reductions for timely payments ("borrower
benefits") and other yield adjustments. The estimate of the borrower benefits
discount is dependent on the estimate of the number of borrowers who will
eventually qualify for these benefits. For competitive purposes, the Company
frequently changes the borrower benefit programs in both amount and
qualification factors. These programmatic changes must be reflected in the
estimate of the borrower benefit discount. Loan premiums, deferred origination
costs, and borrower benefits are included in the carrying value of the student
loan on the consolidated balance sheet and are amortized over the estimated life
of the loan in accordance with SFAS No. 91, ACCOUNTING FOR NON-REFUNDABLE FEES
AND COSTS ASSOCIATED WITH ORIGINATING OR ACQUIRING LOANS AND INITIAL DIRECT
COSTS OF LEASES. The most sensitive estimate for loan premiums, deferred
origination costs, and borrower benefits is the estimate of the constant
repayment rate ("CPR"). CPR is a variable in the life of loan estimate that
measures the rate at which loans in a portfolio pay before their stated
maturity. The CPR is directly correlated to the average life of the portfolio.
CPR equals the percentage of loans that prepay annually as a percentage of the
beginning of period balance. A number of factors can affect the CPR estimate
such as the rate of consolidation activity and default rates. Should any of
these factors change, the estimates made by management would also change, which
in turn would impact the amount of loan premium and deferred origination cost
amortization recognized by the Company in a particular period.
PURCHASE PRICE ACCOUNTING RELATED TO BUSINESS AND CERTAIN ASSET ACQUISITIONS
The Company has completed several business and asset acquisitions which have
generated significant amounts of goodwill and intangible assets and related
amortization. The values assigned to goodwill and intangibles, as well as their
related useful lives, are subject to judgment and estimation by the Company.
Goodwill and intangibles related to acquisitions are determined and based on
purchase price allocations. Valuation of intangible assets is generally based on
the estimated cash flows related to those assets, while the initial value
assigned to goodwill is the residual of the purchase price over the fair value
of all identifiable assets acquired and liabilities assumed. Thereafter, the
value of goodwill cannot be greater than the excess of fair value of the
Company's reportable unit over the fair value of the identifiable assets and
liabilities, based on an annual impairment test. Useful lives are determined
based on the expected future period of the benefit of the asset, the assessment
of which considers various characteristics of the asset, including historical
cash flows. Due to the number of estimates involved related to the allocation of
purchase price and determining the appropriate useful lives of intangible
assets, management has identified purchase price accounting as a critical
accounting policy.
RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157, FAIR VALUE MEASUREMENTS ("SFAS
No. 157"). 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. As of the filing of this Report, management believes that
SFAS No. 157 will not have a material effect on the financial position and
results of operations of the Company.
In February 2007, the FASB issued SFAS No. 159, THE FAIR VALUE OPTION FOR
FINANCIAL ASSETS AND FINANCIAL LIABILITIES - INCLUDING AN AMENDMENT OF FASB
STATEMENT NO. 115 ("SFAS. No. 159"), which permits entities to choose to measure
many financial instruments at fair value. The Statement allows entities to
achieve an offset accounting effect for certain changes in fair value of related
assets and liabilities without having to apply complex hedge accounting
provisions, and is expected to expand the use of fair value measurement
consistent with the Board's long-term objectives for financial instruments. This
Statement is effective as of the beginning of an entity's first fiscal year that
begins after November 15, 2007. Early adoption is permitted. Retrospective
application to fiscal years preceding the effective date (or early adoption
date) is prohibited. Management is currently evaluating SFAS No. 159 to assess
its impact on the Company's financial statements.
55
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 June 30, 2007 As of December 31, 2006
---------------------- ------------------------
Dollars Percent Dollars Percent
------------- -------- -------------- ---------
Fixed-rate loan assets $ 756,037 2.9 % $ 787,378 3.4 %
Variable-rate loan assets 24,989,963 97.1 22,627,090 96.6
------------- -------- -------------- ---------
Total $ 25,746,000 100.0 % $ 23,414,468 100.0 %
============= ======== ============== =========
Fixed-rate debt instruments $ 694,617 2.5 % $ 878,431 3.4 %
Variable-rate debt instruments 27,096,529 97.5 24,683,688 96.6
------------- -------- -------------- ---------
Total $ 27,791,146 100.0 % $ 25,562,119 100.0 %
============= ======== ============== =========
The following table shows the Company's student loan assets currently earning at
a fixed rate as of June 30, 2007:
Borrower/ Estimated
lender variable Current
Fixed interest weighted conversion balance of
rate range average yield rate (a) fixed rate assets (b)
----------------- --------------- ---------------- -------------------
8.0 - 9.0% 8.23% 5.59% $ 362,152
> 9.0% 9.05 6.41 393,885
-------------------
$ 756,037
===================
-------------------
(a) The estimated variable conversion rate is the estimated short-term
interest rate at which loans would convert to variable rate.
(b) As of June 30, 2007, the Company had $219.6 million of fixed rate debt
that was used by the Company to hedge fixed-rate student loan assets. The
weighted average interest rate paid by the Company on this debt as of
June 30, 2007 was 6.18%.
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. This excess income is referred to as
"floor income." Therefore, absent utilizing derivative instruments, in a low
interest rate environment, a rise in interest rates will have an adverse effect
on earnings. For the three and six months ended June 30, 2007, loan interest
income includes approximately $2.7 million and $6.2 million of floor income,
respectively. In higher interest rate environments, where the interest rate
rises above the borrower rate and the fixed-rate loans become variable rate and
are effectively matched with variable-rate debt, the impact of rate fluctuations
is substantially reduced.
The Company attempts to match the interest rate characteristics of pools of loan
assets with debt instruments of substantially similar characteristics,
particularly in rising interest rate environments. Due to the variability in
duration of the Company's assets and varying market conditions, the Company does
not attempt to perfectly match the interest rate characteristics of the entire
loan portfolio with the underlying debt instruments. The Company has adopted a
policy of periodically reviewing the mismatch related to the interest rate
characteristics of its assets and liabilities and the Company's outlook as to
current and future market conditions. Based on those factors, the Company will
periodically use derivative instruments as part of its overall risk management
strategy to manage risk arising from its fixed-rate and variable-rate financial
instruments. 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.
56
INTEREST RATE SWAPS
As discussed under Item 2, "Management's Discussion and Analysis of Financial
Condition and Results of Operation", the Company entered into a Settlement
Agreement with the Department to resolve the audit by the OIG of the Company's
portfolio of student loans receiving the 9.5% special allowance payments. Under
the terms of the Agreement, the Company will no longer receive 9.5% special
allowance payments.
In consideration of not receiving the 9.5% special allowance payments on a
prospective basis, in December 2006 the Company entered into a series of
off-setting interest rate swaps that mirror the $2.45 billion in pre-existing
interest rate swaps that the Company had utilized to hedge its loan portfolio
receiving 9.5% special allowance payments against increases in interest rates.
During the 2nd quarter 2007, the Company entered into a series of off-setting
interest rate swaps that mirrored the remaining interest rate swaps utilized to
hedge the Company's student loan portfolio against increases in interest rates.
The net effect of the offsetting derivatives was to lock in a series of future
income streams on underlying trades through their respective maturity dates. The
following table summarizes these derivatives as of June 30, 2007:
Weighted Weighted
average fixed average fixed
Notional rate paid by Notional rate received by
Maturity Amount the Company Amount the Company
------------ ------------ --------------------- ------------ -----------------
2007 $ 512,500 3.42 % $ 512,500 5.25 %
2008 462,500 3.76 462,500 5.34
2009 312,500 4.01 312,500 5.37
2010 1,137,500 4.25 1,137,500 4.75
2011 -- -- -- --
2012 275,000 4.31 275,000 4.76
2013 525,000 4.36 525,000 4.80
------------ --------------------- ------------ -----------------
$ 3,225,000 4.05 % $ 3,225,000 4.98 %
============ ===================== ============ =================
In August 2007, the Company terminated all interest rate swaps summarized above
for net proceeds of $50.8 million.
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 were November 25, 2006, December 25, 2006,
and January 25, 2007.
During 2007, the Company entered into basis swaps in which the Company receives
three-month LIBOR set discretely in advance and pays a daily weighted average
three-month LIBOR less a spread as defined in the individual agreements. The
Company entered into theses derivatives instruments to better match the interest
rate characteristics on its student loan assets and the debt funding such
assets. The following table summarizes these derivatives as of June 30, 2007:
Notional Amount
------------------------------------------------------------------------------------------
Effective date in Effective date in Effective date in Effective date in
Maturity second quarter 2007 third quarter 2007 second quarter 2008 third quarter 2008 Total
--------- -------------------- ----------------- ------------------- ------------------- ----------
2008 $ 2,000,000 2,000,000 -- -- 4,000,000
2009 2,000,000 4,000,000 -- -- 6,000,000
2010 500,000 3,000,000 2,000,000 1,000,000 6,500,000
2011 1,350,000 2,700,000 -- -- 4,050,000
2012 500,000 1,000,000 800,000 1,600,000 3,900,000
------------------ ----------------- ----------------- ----------------- -----------
$ 6,350,000 12,700,000 2,800,000 2,600,000 24,450,000
================== ================= ================= ================= ===========
57
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. On January 30, 2007, the Company paid $8.1
million to terminate these contracts and recognized a gain of $2.1 million.
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 derivatives are included
in "derivative market value, foreign currency, and put option adjustments and
derivative settlements, net" in the Company's consolidated statements of income
and resulted in a gain of $16.7 million and $20.3 million for the three and six
months ended June 30, 2007, respectively, and a gain of $56.4 million and $106.7
million for the three and six months ended June 30, 2006, respectively.
The following summarizes the derivative settlements included in "derivative
market value, foreign currency, and put option adjustments and derivative
settlements, net" on the consolidated statements of income:
Three months Six months
ended June 30, ended June 30,
------------------------ -----------------------
2007 2006 2007 2006
------------ ----------- ----------- -----------
Interest rate and basis swap derivatives- loan portfolio $ 1,977 2,797 4,872 4,529
Interest rate swap derivatives- other (a) 5,657 -- 10,321 --
Special allowance yield adjustment derivatives (a) -- 7,721 -- 11,885
Cross-currency interest rate swaps (2,438) (3,816) (5,757) (4,968)
------------ ----------- ----------- -----------
Derivative settlements, net $ 5,196 6,702 9,436 11,446
============ =========== =========== ===========
(a) Derivative settlements for interest rate swaps "other" include
settlements on the portfolio of derivatives that the Company had used to
hedge 9.5% special allowance payments and the portfolio of off-setting
interest rate swaps the Company entered into during the fourth quarter
2006. The new derivatives mirror the 9.5% special allowance payment
derivatives. Settlements on the 9.5% special allowance derivatives were
classified as special allowance yield adjustment derivatives through
September 30, 2006.
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.
58
Three months ended June 30, 2007
----------------------------------------------------------------------------------
Change from decrease of 100 Change from increase of 100 Change from increase of
basis points basis points 200 basis points
------------------------- ------------------------ -------------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ---------- ------------- --------- ------------ -----------
Effect on earnings:
Increase in pre-tax net income before
impact of derivative settlements $ 6,519 21.1 % $ 535 1.7 % $ 2,192 7.1 %
Impact of derivative settlements (1,932) (6.3) 1,932 6.3 3,864 12.5
-------------- ---------- ------------- -------- ------------- -----------
Increase in net income before taxes $ 4,587 14.8 % $ 2,467 8.0 % 6,056 19.6 %
============== ========== ============= ======== ============= ===========
Increase in basic and diluted
earning per share $ 0.06 $ 0.03 $ 0.07
============== ============= =============
Three months ended June 30, 2006
----------------------------------------------------------------------------------
Change from decrease of 100 Change from increase of 100 Change from increase of
basis points basis points 200 basis points
------------------------- ----------------------- -------------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ---------- ------------ --------- ------------ -----------
Effect on earnings:
Increase (decrease) in pre-tax net income
before impact of derivative settlements $ 8,743 12.0 % $ (7,103) (9.8) % $ (9,597) (13.2)%
Impact of derivative settlements (9,567) (13.2) 9,567 13.2 19,135 26.4
------------ ---------- ------------ ---------- -------------- ---------
(Decrease) increase in net income
before taxes $ (824) (1.2) % $ 2,464 3.4 % 9,538 13.2 %
============ ========== ============ ========== ============== =========
(Decrease) increase in basic and diluted
earning per share $ (0.01) $ 0.03 $ 0.11
============ ============ ==============
Six months ended June 30, 2007
----------------------------------------------------------------------------------
Change from decrease of 100 Change from increase of 100 Change from increase of
basis points basis points 200 basis points
------------------------- ------------------------ -------------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ---------- ------------- --------- ------------ -----------
Effect on earnings:
Increase in pre-tax net income before
impact of derivative settlements $ 10,733 19.7 % $ 3,558 6.5 % $ 9,357 17.1 %
Impact of derivative settlements (3,843) (7.1) 3,843 7.1 7,686 14.1
-------------- ---------- ------------- -------- ------------- -----------
Increase in net income before taxes $ 6,890 12.6 % $ 7,401 16.6 % 17,043 31.2 %
============== ========== ============= ======== ============= ===========
Increase in basic and diluted
earning per share $ 0.08 $ 0.09 $ 0.21
============== ============= =============
Six months ended June 30, 2006
----------------------------------------------------------------------------------
Change from decrease of 100 Change from increase of 100 Change from increase of
basis points basis points 200 basis points
------------------------- ----------------------- -------------------------
Dollar Percent Dollar Percent Dollar Percent
------------- ---------- ------------ --------- ------------ -----------
Effect on earnings:
Increase (decrease) in pre-tax net income
before impact of derivative settlements $ 16,408 10.5 % $ (13,389) (8.6) % $ (22,324) (14.3)%
Impact of derivative settlements (19,030) (12.2) 19,030 12.2 38,060 24.5
------------ ---------- ------------ ---------- -------------- ---------
(Decrease) increase in net income
before taxes $ (2,622) (1.7)% $ 5,641 3.6 % 15,736 10.2 %
============ ========== ============ ========== ============== =========
(Decrease) increase in basic and diluted
earning per share $ (0.03) $ 0.07 $ 0.18
============ ============ ==============
FOREIGN CURRENCY EXCHANGE RISK
During 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 and derivative settlements, net" in the
Company's consolidated statements of income.
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.
59
For the three and six months ended June 30, 2007, the Company recorded an
expense of $11.3 million and $25.0 million, respectively, as a result of
re-measurement of the Euro Notes and income of $15.8 million and $27.0 million,
respectively, for the increase in the fair value of the related derivative
instrument. For the three and six months ended June 30, 2006, the Company
recorded an expense of $27.6 million and $38.1 million, respectively, as a
result of the re-measurement of the Euro Notes and income of $28.5 million and
$36.2 million, respectively, for the increase in the fair value of the related
derivative instrument. Both of these amounts are included in "derivative market
value, foreign currency, and put option adjustments and derivative settlements,
net" on the Company's consolidated statement of income.
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 chief executive and the chief financial officers, 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 chief executive and chief financial officers 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.
NEW YORK STATE ATTORNEY GENERAL REQUEST FOR INFORMATION
On January 11, 2007 the Company received a letter from the New York Attorney
General requesting certain information and documents from the Company in
connection with the New York Attorney General's investigation into preferred
lender list activities. Since that time other state attorneys general and the
U.S. Senate Committee on Health, Education, Labor, and Pensions have announced
or reportedly have initiated broad inquiries or investigations of the activities
of various participants in the student loan industry, including activities which
may involve perceived conflicts of interest. Such inquiries or investigations,
including the investigation by the New York Attorney General, are discussed
immediately below.
INDUSTRY INVESTIGATIONS
Since January 2007, a number of state attorneys general and the U.S. Senate
Committee on Health, Education, Labor, and Pensions have announced or are
reportedly conducting broad inquiries or investigations of the activities of
various participants in the student loan industry, including activities which
may involve perceived conflicts of interest. The general focus of the inquiries
or investigations to date has primarily been on any financial arrangements among
student loan lenders and other industry participants which may facilitate
60
increased volumes of student loans for particular lenders. Like many other
student loan lenders, the Company has received informal requests for information
from certain state attorneys general and the Chairman of the U.S. Senate
Committee on Health, Education, Labor, and Pensions in connection with their
inquiries or investigations. In addition, the Company has received subpoenas for
information from the New York Attorney General, the New Jersey Attorney General,
and the Ohio Attorney General. In each case the Company is cooperating with the
requests and subpoenas for information that it has received.
On April 20, 2007, the Company announced that it had agreed with the Nebraska
Attorney General to voluntarily adopt a Nelnet Student Loan Code of Conduct,
post a review of the Company's business practices on its website, and commit $1
million to help educate students and families on how to plan and pay for their
education.
On July 31, 2007, the Company announced that it had agreed with the New York
Attorney General to adopt the New York Attorney General's Code of Conduct, which
is substantially similar to the Nelnet Student Loan Code of Conduct, but which
also includes an agreement to eliminate two services the Company had previously
announced plans to discontinue - the Company's outsourcing of calls for
financial aid offices and its agreements with college alumni associations
providing for marketing of consolidation loans to the associations' members. As
part of the agreement, the Company agreed to contribute $2.0 million to a
national fund for educating high school seniors and their parents regarding the
financial aid process. One million dollars of the national fund contribution
will come from the money the Company committed to helping educate students and
families in connection with the Company's agreement with the Nebraska Attorney
General.
While the Company cannot predict the ultimate outcome of any other inquiry or
investigation, the Company believes its activities have materially complied with
the Higher Education Act, the rules and regulations adopted by the Department of
Education thereunder, and the Department's guidance regarding those rules and
regulations.
DEPARTMENT OF EDUCATION REVIEW
The Department of Education periodically reviews participants in the FFEL
Program for compliance with program provisions. On June 28, 2007, the Department
of Education notified the Company that it would be conducting a review of the
Company's administration of the FFEL Program under the Higher Education Act. The
Company understands that as of July 23, 2007, the Department of Education has
selected 47 schools and 27 lenders for review. Specifically, the Department is
reviewing the Company's practices in connection with the inducement provisions
of the Higher Education Act and the provisions of the Higher Education Act and
the associated regulations which allow borrowers to have a choice of lenders.
The Company is cooperating with the Department of Education's review. While the
Company cannot predict the ultimate outcome of the review , the Company believes
its activities have materially complied with the Higher Education Act, the rules
and regulations adopted by the Department of Education thereunder, and the
Department's guidance regarding those rules and regulations.
DEPARTMENT OF JUSTICE MATTER
In connection with the settlement with the Department of Education, the Company
was informed by the Department of Education that a civil attorney with the
Department of Justice had opened a file regarding the issues set forth in the
OIG report, which the Company understands is common procedure following an OIG
audit report. The Company has engaged in discussions and provided information to
the Department of Justice in connection with the review. While the Company is
unable to predict the ultimate outcome of the review, the Company believes its
practices complied with the provisions of the Higher Education Act and the rules
and regulations adopted by the Department of Education thereunder.
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, 2006 in response to
Item 1A of Part I of such Form 10-K except as set forth below.
CHANGES IN LEGISLATION AND REGULATIONS COULD HAVE A NEGATIVE IMPACT UPON THE
COMPANY'S BUSINESS AND MAY AFFECT ITS PROFITABILITY.
Funds for payment of interest subsidy payments, special allowance payments, and
other payments under the FFEL Program are subject to annual budgetary
appropriations by Congress. Federal budget legislation has in the past contained
provisions that restricted payments made under the FFEL Program to achieve
reductions in federal spending. Future federal budget legislation may adversely
affect expenditures by the Department of Education, and the financial condition
of the guaranty agencies.
Furthermore, Congressional amendments to the Higher Education Act or other
relevant federal laws, and rules and regulations promulgated by the Secretary of
Education, may adversely impact holders of FFELP loans. For example, changes
might be made to the rate of interest paid on FFELP loans, to the level of
insurance provided by guaranty agencies, or to the servicing requirements for
FFELP loans. Such changes could have a material adverse effect on the Company
and its results of operations.
61
Recently the U.S. House of Representatives passed the College Cost Reduction Act
of 2007 and the U.S. Senate passed the Higher Education Access Act of 2007. Both
of these bills contain provisions with significant implications for participants
in the FFEL Program. Among other things, these bills include the following
provisions:
o reducing special allowance payments to lenders;
o reducing default insurance rates and elimination of the
Exceptional Performer program;
o increasing lender origination fees;
o increasing annual and aggregate loan limits for certain Stafford
loans; and
o reducing interest rates for subsidized Stafford loans.
Neither the College Cost Reduction Act of 2007 nor the Higher Education Access
Act of 2007 has been enacted into law. The impact of these bills is difficult to
predict; however, if the proposed federal government spending cuts and increased
fees for FFEL Program participants are enacted, the Company's revenues would be
negatively impacted.
In addition to the College Cost Reduction Act of 2007 and the Higher Education
Access Act of 2007, other bills have been introduced in Congress which contain
provisions which could significantly impact participants in the FFEL Program.
Among other things, the proposals include:
o requiring disclosures relating to placement on "preferred lender
lists";
o banning various arrangements between lenders and schools;
o banning lenders from offering certain gifts to school employees;
o eliminating the school-as-lender program;
o encouraging borrowers to maximize their borrowing through
government loan programs prior to private loan programs with
higher interest rates;
o encouraging schools to participate in the Federal Direct Loan
Program through increased federal grant funds; and
o increasing the lender origination fee for consolidation loans.
As of the date of this Report, none of these bills has been enacted into law.
The impact of the proposed legislation is difficult to predict; however,
increased fees for FFEL Program lenders and decreased loan volume as a result of
increased participation in the Federal Direct Loan Program could have a negative
impact on the Company's revenues.
HERA was enacted into law on February 8, 2006, and effectively reauthorized the
Title IV provisions of the FFEL Program through 2012. HERA did not reauthorize
the entire Higher Education Act, which is set to expire on October 31, 2007 (as
a result of the Second Higher Education Extension Act of 2007). Therefore,
further action will be required by Congress to reauthorize the remaining titles
of the Higher Education Act. Reauthorization could result in the Company's
revenues being negatively impacted.
The Company cannot predict the outcome of this or any other legislation
impacting the FFEL Program and recognizes that a level of political and
legislative risk always exists within the industry. This could include changes
in legislation further impacting lender margins, fees paid to the Department,
new policies affecting the competition between the FDL and FFEL Programs, or
additional lender risk sharing. See Part I, Item II, "Results of Operations -
Recent Developments - Proposed Legislation Related to the Higher Education Act."
In addition to changes to the FFEL Program and the Higher Education Act, various
state laws targeted at student lending companies have been proposed or are in
the process of being enacted. Many of these laws propose or require changes to
lending and business practices of student lenders. These laws could have a
negative impact on the Company's operations by requiring changes to the
Company's business practices and operations. Changes to privacy and direct mail
legislation could also negatively impact the Company, in particular the
Company's lead generation activities. Changes in such legislation could restrict
the Company's ability to collect information for its lead generation activities
and its ability to use the information it collects. In addition, changes to
privacy and direct mail legislation could cause the Company to incur expenses
related to implementation of any required changes to the Company's compliance
programs.
THE COMPANY COULD BE SANCTIONED IF IT CONDUCTS ACTIVITIES WHICH ARE CONSIDERED
PROHIBITED INDUCEMENTS UNDER THE HIGHER EDUCATION ACT.
The Higher Education Act generally prohibits a lender from providing certain
inducements to educational institutions or individuals in order to secure
applicants for FFELP loans. The Company has structured its relationships and
product offerings in a manner intended to comply with the Higher Education Act
and the available communications and guidance from the Department.
If the Department were to change its position on any of these matters, the
Company may have to change the way it markets products and services and a new
marketing strategy may not be as effective. If the Company fails to respond to
the Department's change in position, the Department could potentially impose
sanctions upon the Company that could negatively impact the Company's business.
62
Legislation has been introduced in Congress modifying the inducement provisions
of the Higher Education Act, and the Department of Education has proposed new
inducement regulations. As a result, the Company has modified, or intends to
modify, its business practices to comply with the inducement provisions as
ultimately enacted or adopted, including the termination of the Company's
affinity relationships. Changes to the Company's business practices in order to
comply with the new inducement provisions may negatively impact the Company's
business.
On June 28, 2007, the Department of Education notified the Company that it would
be conducting a review of the Company's administration of the FFEL Program under
the Higher Education Act. The Company understands that as of July 23, 2007, the
Department of Education has selected 47 schools and 27 lenders for review.
Specifically, the Department is reviewing the Company's practices in connection
with the inducement provisions of the Higher Education Act and the provisions of
the Higher Education Act and the associated regulations which allow borrowers to
have a choice of lenders. The Company is cooperating with the Department of
Education's review.
CERTAIN PARTICIPANTS IN THE COMPANY'S STOCK COMPENSATION AND BENEFIT PLANS MAY
HAVE RESCISSION RIGHTS WITH RESPECT TO SHARES OF STOCK ACQUIRED UNDER THOSE
PLANS.
The Company recently discovered that as a result of inadvertent issues related
to the delivery of documents to participants, certain participants in the
Company's Employee Share Purchase Plan, Restricted Stock Plan, Directors Stock
Compensation Plan, and Employee Stock Purchase Loan Plan may not have during
certain time frames actually received all of the information required to
constitute a fully compliant prospectus under the Securities Act of 1933. While
the issuance of shares under those plans has been registered with the Securities
and Exchange Commission under registration statements on Form S-8, it is a
violation of Section 5 of the Securities Act of 1933 to sell a security for
which a registration statement has been filed unless accompanied or preceded by
a prospectus that meets the requirements of Section 10 of the Securities Act of
1933.
Section 12 of the Securities Act of 1933 generally provides for a one-year
rescission right for an investor who acquires a security from a seller who does
not comply with the prospectus delivery requirements of Section 5 of the
Securities Act of 1933. As such, an investor successfully asserting a rescission
right during the one-year time period has the right to require an issuer to
repurchase the securities acquired by the investor at the price paid by the
investor for the securities (or if such security has been disposed of, to
receive damages with respect to any loss on such disposition), plus interest
from the date of acquisition. These rights may apply to affected participants in
the Company's plans. The Company believes that its potential liability for
rescission claims or other damages is not material to the Company's financial
condition; however, the Company's potential liability could become material to
results of operations for a particular period if, during the one-year period
following non-compliant sales, the market price of the shares of Class A common
stock falls significantly below the affected participants' acquisition prices.
THE COMPANY IS SUBJECT TO VARIOUS MARKET RISKS WHICH MAY HAVE AN ADVERSE IMPACT
UPON ITS BUSINESS AND OPERATIONS AND MAY HAVE A NEGATIVE EFFECT ON THE COMPANY'S
PROFITABILITY.
The Company's primary market risk exposure arises from fluctuations in its
borrowing and lending rates, the spread between which could be impacted by
shifts in market interest rates. The Company issues asset-backed securities, the
vast majority being variable-rate, to fund its student loan assets. The
variable-rate debt is generally indexed to 3-month LIBOR, set by auction or
through a remarketing process. The income generated by the Company's student
loan assets is generally driven by short-term indices (Treasury bills and
commercial paper) that are different from those which affect the Company's
liabilities (generally LIBOR), which creates basis risk. Moreover, the Company
also faces basis risk due to the timing of the interest rate resets on its
liabilities, which may occur as infrequently as every quarter, and the timing of
the interest rate resets on its assets, which generally occur daily. In a
declining interest rate environment, this may cause the Company's student loan
spread to compress, while in a rising rate environment, it may cause it to
increase. The Company uses derivative instruments to hedge the basis risk due to
the timing of the interest rate resets on its assets and liabilities. However,
the Company does not generally hedge the basis risk due to the different
interest rate indices associated with its assets and liabilities since the
relationship between the indices for most of the Company's assets and
liabilities is highly correlated. Nevertheless, the basis between the indices
may widen from time to time, which would impact the net spread on the portfolio.
FUTURE LOSSES DUE TO DEFAULTS ON LOANS HELD BY THE COMPANY PRESENT CREDIT RISK
WHICH COULD ADVERSELY AFFECT THE COMPANY'S EARNINGS.
As of June 30, 2007, more than 99% of the Company's student loan portfolio was
comprised of federally insured loans. These loans currently benefit from a
federal guaranty of their principal balance and accrued interest. As a result of
the Company's Exceptional Performer designation, the Company received 99%
reimbursement on all eligible FFELP default claims submitted for reimbursement
during the applicable designation period. The Company is entitled to receive
this benefit as long as (i) the Exceptional Performer program is not eliminated
as currently anticipated as a result of recent legislation; and (ii) the Company
and/or its service providers continue to meet the required servicing standards
published by the Department. Compliance with such standards is assessed on a
quarterly basis. In addition, service providers must apply for re-designation as
an Exceptional Performer with the Department on an annual basis.
63
In June 2006, the Company submitted its application for Exceptional Performer
re-designation to the Department to continue receiving reimbursements at the 99%
level for the 12-month period from June 1, 2006 through May 31, 2007. As of the
date of this Report, the Department has not notified the Company of its
redesignation. 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; however, legislation has been proposed which would
eliminate the Exceptional Performer program. 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. If the Exceptional Performer program
is eliminated, the Company would have to establish a provision for loan losses
related to the risk sharing on those FFELP loans that are serviced by servicers
designated as Exceptional Performers (including those that the Company services
internally). Based on the balance of federally insured loans outstanding as of
June 30, 2007, this provision would be approximately $17 to $18 million.
THE VOLUME OF AVAILABLE STUDENT LOANS MAY DECREASE IN THE FUTURE AND MAY
ADVERSELY AFFECT THE COMPANY'S INCOME.
The Company's student loan originations generally are limited to students
attending eligible educational institutions in the United States. Volume of
originations are greater at some schools than others, and the Company's ability
to remain an active lender at a particular school with concentrated volumes is
subject to a variety of risks, including the fact that each school has the
option to remove the Company from its "preferred lender" list or to add other
lenders to its "preferred lender" list, the risk that a school may enter the FDL
Program, or the risk that a school may begin making student loans itself. The
Company acquires student loans through forward flow commitments with other
student loan lenders, but each of these commitments has a finite term.
Legislation has been proposed which would have the effect of reducing the amount
of the premium the Company will be able to pay lenders under its forward flow
commitments. As a result, the Company will need to renegotiate the premiums
payable under its existing forward flow agreements. There can be no assurance
that the Company will be able to renegotiate the premiums under the forward flow
commitments and, accordingly, may be required to terminate commitments which are
not economic. As a result, the Company may experience a decrease in its forward
flow loan volume. In addition, upon expiration of these agreements, there can be
no assurance that these lenders will renew or extend their existing forward flow
commitments on terms that are favorable to the Company, if at all, following
their expiration.
IF REGULATORY AUTHORITIES PROHIBIT STUDENT LENDERS FROM ENGAGING IN NON-LENDING
ACTIVITIES, THE COMPANY MAY NO LONGER BE ALLOWED TO OFFER CERTAIN PRODUCTS AND
SERVICES WHICH COULD NEGATIVELY IMPACT THE COMPANY'S REVENUES.
As a diversified education services company, the Company offers many products
and services which are not related to the FFEL Program. Recently, various
regulatory authorities have started to examine the relationships between student
lending companies and their customers. See Part II, Item 1 - "Legal
Proceedings." In the event state and/or federal authorities adopt restrictions
on the products and services which may be offered by student lending companies,
the Company may have to cease offering certain products and services or may be
limited to marketing those products and services to customers which do not
participate in the FFEL Program. Any restrictions on the Company's ability to
market or sell products or services may have a negative impact on the Company's
revenues.
NEGATIVE PUBLICITY THAT MAY BE ASSOCIATED WITH THE STUDENT LENDING INDUSTRY,
INCLUDING NEGATIVE PUBLICITY ABOUT THE COMPANY, MAY HARM THE COMPANY'S
REPUTATION AND ADVERSELY AFFECT OPERATING RESULTS.
Recently, the student lending industry has been the subject of various
investigations and reports. The publicity associated with these investigations
and reports may have a negative impact on the Company's reputation. To the
extent that potential or existing customers decide not to utilize the Company's
products or services as a result of such publicity, the Company's operating
results may be adversely affected.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table summarizes the repurchases of Class A common stock during
the second quarter of 2007 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.
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)
------------------------------ -------------- ------------- ------------------- -------------------
April 1 - April 30, 2007 463 $ 24.62 463 6,380,749
May 1 - May 31, 2007 305 25.42 305 6,457,520
June 1 - June 30, 2007 230 25.56 230 6,518,802
-------------- ------------- -------------------
Total 998 $ 25.08 998
============== ============= ===================
64
(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
April, May, or June 2007. All shares of Class A common stock
purchased pursuant to the 2006 Plan in April, May, and June were
Class A common stock purchased from employees whose shares were
originally acquired pursuant to the Company's matching
provisions in the Company's 401(k) plan.
(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). On
February 7, 2007, the Company's Board of Directors increased the
total shares the Company is allowed to buy back to 10 million.
(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.
(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 Approximate Approximate
dollar value of Closing price number of number of
Maximum shares that may on the last shares that may shares that may
number of shares yet be trading day of yet be yet be
that may yet be purchased the Company's purchased 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
------------------- -----------------------------------------------------------------------------------
April 30, 2007 4,998,265 $ 37,175,000 $ 26.89 1,382,484 6,380,749
May 31, 2007 4,997,960 37,175,000 25.47 1,459,560 6,457,520
June 30, 2007 4,997,730 37,175,000 24.44 1,521,072 6,518,802
WORKING CAPITAL AND DIVIDEND RESTRICTIONS/LIMITATIONS
The Company's credit facilities, including its revolving line of credit which is
available through May of 2012, 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.
On September 27, 2006 the Company consummated a debt offering of $200.0 million
aggregate principal amount of Junior Subordinated Hybrid Securities ("Hybrid
Securities"). So long as any Hybrid Securities 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 Hybrid Securities 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 Hybrid
Securities; or
65
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 Hybrid Securities.
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 Hybrid Securities 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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's annual meeting of shareholders held on May 24, 2007, the
following proposals were approved by the margins indicated:
1. To elect seven directors to serve on the Company's Board of Directors
for one-year terms or until their successors are elected and qualified.
All directors seeking election were in attendance at the annual meeting.
Number of Shares
-----------------------------------
Votes For Votes Withheld
---------------- -----------------
James P. Abel 110,664,343 642,645
Stephen F. Butterfield 110,990,114 316,874
Michael S. Dunlap 110,935,514 371,474
Thomas E. Henning 110,662,718 644,270
Brian J. O'Connor 110,661,003 645,985
Michael D. Reardon 110,662,522 644,466
James H. Van Horn 107,930,019 3,376,969
2. To ratify the appointment of KPMG LLP as independent auditors for 2007.
Number of Shares
---------------------------------------------------------
Votes For Votes Against Abstain
----------------- ------------------ ------------------
110,385,133 896,770 25,083
3. To approve the Executive Officers' Bonus Plan.
Number of Shares
---------------------------------------------------------
Votes For Votes Against Abstain
----------------- ------------------ ------------------
109,303,989 1,807,054 21,808
4. To approve an amendment to the Company's Articles of Incorporation to
provide for majority voting in the election of Directors.
Number of Shares
---------------------------------------------------------
Votes For Votes Against Abstain
----------------- ------------------ ------------------
105,988,782 5,121,401 22,672
66
5. To approve the issuance of up to 11,068,604 shares of Class A common
stock for the acquisition of Packers Service Group, Inc., whose
principal asset is 11,068,604 shares of Class A common stock.
Number of Shares
---------------------------------------------------------
Votes For Votes Against Abstain
----------------- ------------------ ------------------
103,868,475 4,218,037 22,571
6. To approve an amendment to the Restricted Stock Plan to increase the
authorized number of shares of Class A common stock that may be issued
under the plan from a total of 1,000,000 shares to a total of 2,000,000
shares.
Number of Shares
---------------------------------------------------------
Votes For Votes Against Abstain
----------------- ------------------ ------------------
107,507,578 567,814 33,692
ITEM 6. EXHIBITS
2.1 Agreement and Plan of Merger dated as of May 31, 2007 among
Nelnet, Inc., Nelnet Academic Services, LLC and Packers Service
Group, Inc., filed as Exhibit 2.1 to the registrant's Current
Report on Form 8-K filed on June 6, 2007 and incorporated herein
by reference.
3.1* Articles of Amendment to Second Amended and Restated Articles of
Incorporation of Nelnet, Inc.
4.1 Indenture of Trust by and between Nelnet Student Loan Trust
2007-1 and Zions First National Bank, dated as of May 1, 2007,
filed as Exhibit 4.1 to Nelnet Student Loan Trust 2007-1's
Current Report on Form 8-K filed on May 24, 2007 and
incorporated herein by reference.
4.2* First Supplemental Indenture dated as of July 1, 2007 between
Nelnet Student Loan Trust 2004-4 and Zions First National Bank,
as Trustee.
10.1+ Nelnet, Inc. Restricted Stock Plan, as amended through May 24,
2007, filed as Exhibit 10.1 to the registrant's Current Report
on Form 8-K filed on May 31, 2007 and incorporated herein by
reference.
31.1* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002 of Chief Executive Officer Michael S. Dunlap.
31.2* 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
+ Indicates a compensatory plan or arrangement.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NELNET, INC.
Date: August 9, 2007 By: /S/ MICHAEL S. DUNLAP
-------------------------------
Name: Michael S. Dunlap
Title: Chairman and Chief
Executive Officer
By: /S/ TERRY J. HEIMES
-------------------------------
Name: Terry J. Heimes
Title: Chief Financial Officer
68