UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 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 October 31, 2007, there were 37,969,791 and 11,495,377 shares of
Class A Common Stock and Class B Common Stock, par value $0.01 per share,
outstanding, respectively (excluding 11,068,604 shares of Class A Common
Stock held by a wholly owned subsidiary).
NELNET, INC.
FORM 10-Q
INDEX
SEPTEMBER 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 31
Item 3. Quantitative and Qualitative Disclosures about Market Risk 64
Item 4. Controls and Procedures 68
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 68
Item 1A. Risk Factors 69
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 73
Item 6. Exhibits 76
SIGNATURES 77
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
AS OF AS OF
SEPTEMBER 30, 2007 DECEMBER 31, 2006
------------------ -----------------
(UNAUDITED)
ASSETS:
Student loans receivable (net of allowance for loan losses
of $44,014 and $26,003, respectively) $ 26,596,123 23,789,552
Cash and cash equivalents:
Cash and cash equivalents - not held at a related party 28,641 34,963
Cash and cash equivalents - held at a related party 128,451 67,380
---------------- ----------------
Total cash and cash equivalents 157,092 102,343
Restricted cash 1,088,304 1,388,719
Restricted investments 113,132 129,132
Restricted cash - due to customers 93,244 153,557
Accrued interest receivable 629,327 503,365
Accounts receivable, net 60,670 49,227
Fair value of derivative instruments 173,546 146,099
Goodwill 164,695 191,420
Intangible assets, net 119,242 161,588
Property and equipment, net 58,399 62,285
Other assets 88,690 92,277
Assets of discontinued operations -- 27,309
---------------- ----------------
Total assets $ 29,342,464 26,796,873
================ ================
LIABILITIES:
Bonds and notes payable $ 28,234,147 25,562,119
Accrued interest payable 185,023 120,211
Other liabilities 235,087 253,431
Due to customers 93,244 153,557
Fair value of derivative instruments 3,070 27,973
Liabilities of discontinued operations -- 7,732
---------------- ----------------
Total liabilities 28,750,571 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 37,937,039 shares as of September 30,
2007 and 39,035,169 shares as of December 31, 2006 379 390
Class B, $0.01 par value. Authorized 60,000,000 shares;
issued and outstanding 11,495,377 shares as of September 30,
2007 and 13,505,812 shares as of December 31, 2006 115 135
Additional paid-in capital 106,790 182,846
Retained earnings 499,768 496,341
Unearned compensation (12,237) (5,168)
Employee notes receivable (2,922) (2,825)
Accumulated other comprehensive income, net of taxes -- 131
---------------- ----------------
Total shareholders' equity 591,893 671,850
---------------- ----------------
COMMITMENTS AND CONTINGENCIES
Total liabilities and shareholders' equity $ 29,342,464 26,796,873
================ ================
See accompanying notes to consolidated financial statements.
2
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------------- --------------------------
2007 2006 2007 2006
------------ ------------- ------------ ------------
INTEREST INCOME:
Loan interest $ 437,251 380,136 1,251,391 1,068,538
Investment interest 21,023 25,938 61,231 69,664
------------ ------------ ------------ ------------
Total interest income 458,274 406,074 1,312,622 1,138,202
INTEREST EXPENSE:
Interest on bonds and notes payable 393,875 333,766 1,112,263 893,559
------------ ------------ ------------ ------------
Net interest income 64,399 72,308 200,359 244,643
Less provision for loan losses 18,340 1,700 23,628 13,508
------------ ------------ ------------ ------------
Net interest income after provision for loan losses 46,059 70,608 176,731 231,135
------------ ------------ ------------ ------------
OTHER INCOME (EXPENSE):
Loan and guarantee servicing income 33,040 32,212 95,116 91,428
Other fee-based income 38,025 31,221 116,316 65,450
Software services income 5,426 4,399 17,022 11,826
Other income 7,520 13,578 17,336 18,471
Derivative market value, foreign currency,
and put option adjustments and derivative
settlements, net 16,113 (74,935) 18,966 4,854
------------- ------------ ------------ ------------
Total other income (expense) 100,124 6,475 264,756 192,029
------------- ------------ ------------ ------------
OPERATING EXPENSES:
Salaries and benefits 60,545 57,134 182,010 161,386
Other operating expenses:
Impairment of assets 49,504 - 49,504 -
Depreciation and amortization 15,084 10,042 36,741 27,959
Advertising and marketing 14,141 14,710 43,590 24,371
Professional and other services 9,336 6,075 28,219 17,327
Occupancy and communications 5,931 5,562 16,182 15,075
Postage and distribution 4,123 4,831 14,266 15,999
Trustee and other debt related fees 3,337 3,048 8,965 9,088
Other 11,444 12,886 35,843 37,593
------------- ------------ ------------ ------------
Total other operating expenses 112,900 57,154 233,310 147,412
------------- ------------ ------------ ------------
Total operating expenses 173,445 114,288 415,320 308,798
------------- ------------ ------------ ------------
Income (loss) before income taxes
and minority interest (27,262) (37,205) 26,167 114,366
Income tax expense (benefit) (10,664) (13,744) 9,906 42,336
------------- ------------ ------------ ------------
Income (loss) before minority interest (16,598) (23,461) 16,261 72,030
Minority interest in subsidiary income -- -- -- (242)
------------- ------------ ------------ ------------
Income (loss) from continuing operations (16,598) (23,461) 16,261 71,788
Income (loss) from discontinued operations,
net of tax 909 1,107 (2,416) 3,677
------------- ------------ ------------ ------------
Net income (loss) $ (15,689) (22,354) 13,845 75,465
============= ============ ============ ============
Earnings (loss) per share, basic and diluted:
Income (loss) from continuing operations (0.34) (0.44) 0.32 1.33
Income (loss) from discontinued operations 0.02 0.02 (0.04) 0.07
------------- ------------ ------------ ------------
Net income (loss) $ (0.32) (0.42) 0.28 1.40
============= ============ ============ ============
Weighted average shares outstanding - basic 49,018,091 53,348,466 49,810,552 53,959,075
============= ============ ============ ============
Weighted average shares outstanding - diluted 49,018,091 53,348,466 49,811,052 53,959,075
============= ============ ============ ============
See accompanying notes to consolidated financial statements.
3
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands, except share data)
(unaudited)
PREFERRED COMMON STOCK SHARES CLASS A CLASS B ADDITIONAL
STOCK ------------------------- PREFERRED COMMON COMMON PAID-IN
SHARES CLASS A CLASS B STOCK STOCK STOCK CAPITAL
--------- ------------ ------------ --------- --------- -------- ----------
Balance as of June 30, 2006 -- 40,118,981 13,942,954 $ -- 401 139 229,994
Comprehensive income:
Net income (loss) -- -- -- -- -- -- --
Other comprehensive income related
to foreign currency translation -- -- -- -- -- -- --
Total comprehensive income (loss)
Issuance of common stock, net of forfeitures -- 34,848 -- -- 1 -- 1,063
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (1,611,500) -- -- (16) -- (49,719)
Conversion of common stock -- 417,142 (417,142) -- 4 (4) --
Loan to employee for purchase of
common stock -- -- -- -- -- -- --
--------- ------------ ------------ --------- --------- -------- ----------
Balance as of September 30, 2006 -- 38,959,471 13,525,812 $ -- 390 135 181,338
========= ============ ============ ========= ========= ======== ==========
Balance as of June 30, 2007 -- 37,661,381 11,495,377 $ -- 377 115 98,702
Net income (loss) -- -- -- -- -- -- --
Cash dividend on Class A and Class B
common stock - $0.07 per share -- -- -- -- -- -- --
Reserve for uncertain income tax positions -- -- -- -- -- -- 2,519
Issuance of common stock, net of forfeitures -- 514,782 -- -- 5 -- 10,991
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (239,124) -- -- (3) -- (5,422)
--------- ------------ ------------ --------- --------- -------- ----------
Balance as of September 30, 2007 -- 37,937,039 11,495,377 $ -- 379 115 106,790
========= ============ ============ ========= ========= ======== ==========
Balance as of December 31, 2005 -- 40,040,841 13,962,954 $ -- 400 140 220,432
Net income -- -- -- -- -- -- --
Other comprehensive income related
to foreign currency translation -- -- -- -- -- -- --
Total comprehensive income
Issuance of common stock, net of forfeitures -- 421,688 -- -- 4 -- 23,276
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (1,940,200) -- -- (19) -- (62,370)
Conversion of common stock -- 437,142 (437,142) -- 5 (5) --
Loan to employee for purchase of
common stock -- -- -- -- -- -- --
--------- ------------ ------------ --------- --------- -------- ----------
Balance as of September 30, 2006 -- 38,959,471 13,525,812 $ -- 390 135 181,338
========= ============ ============ ========= ========= ======== ==========
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 dividends on Class A and Class B
common stock - $0.21 per share -- -- -- -- -- -- --
Adjustment to adopt provisions of
FASB Interpretation No. 48 -- -- -- -- -- -- --
Reserve for uncertain income tax positions -- -- -- -- -- -- 2,519
Issuance of common stock, net of forfeitures -- 667,055 -- -- 7 -- 14,801
Compensation expense for stock based awards -- -- -- -- -- -- --
Repurchase of common stock -- (3,301,194) -- -- (33) -- (80,874)
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 September 30, 2007 -- 37,937,039 11,495,377 $ -- 379 115 106,790
========= ============ ============ ========= ========= ======== ==========
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands, except share data)
(unaudited)(continued)
ACCUMULATED
UNEARNED EMPLOYEE OTHER TOTAL
RETAINED COMPEN- NOTES COMPREHENSIVE SHAREHOLDERS'
EARNINGS SATION RECEIVABLE INCOME EQUITY
--------- --------- --------- -------------- -------------
Balance as of June 30, 2006 526,005 (5,155) (501) 1,306 752,189
Comprehensive income:
Net income (loss) (22,354) -- -- -- (22,354)
Other comprehensive income related
to foreign currency translation -- -- -- (31) (31)
------------
Total comprehensive income (loss) (22,385)
Issuance of common stock, net of forfeitures -- (468) -- -- 596
Compensation expense for stock based awards -- 595 -- -- 595
Repurchase of common stock -- -- -- -- (49,735)
Conversion of common stock -- -- -- -- --
Loan to employee for purchase of
common stock -- -- 1 -- 1
--------- --------- --------- --------------- ------------
Balance as of September 30, 2006 503,651 (5,028) (500) 1,275 681,261
========= ========= ========= =============== ============
Balance as of June 30, 2007 518,910 (4,229) (2,697) -- 611,178
Net income (loss) (15,689) -- -- -- (15,689)
Cash dividend on Class A and Class B
common stock - $0.07 per share (3,453) -- -- -- (3,453)
Reserve for uncertain income tax positions -- -- -- -- 2,519
Issuance of common stock, net of forfeitures -- (9,583) (225) -- 1,188
Compensation expense for stock based awards -- 1,575 -- -- 1,575
Repurchase of common stock -- -- -- -- (5,425)
--------- --------- --------- --------------- ------------
Balance as of September 30, 2007 499,768 (12,237) (2,922) -- 591,893
========= ========= ========= =============== ============
Balance as of December 31, 2005 428,186 (86) -- 420 649,492
Comprehensive income:
Net income 75,465 -- -- -- 75,465
Other comprehensive income related
to foreign currency translation -- -- -- 855 855
--------------
Total comprehensive income 76,320
Issuance of common stock, net of forfeitures -- (6,448) -- -- 16,832
Compensation expense for stock based awards -- 1,506 -- -- 1,506
Repurchase of common stock -- -- -- -- (62,389)
Conversion of common stock -- -- -- -- --
Loan to employee for purchase of
common stock -- -- (500) -- (500)
--------- --------- --------- --------------- ------------
Balance as of September 30, 2006 503,651 (5,028) (500) 1,275 681,261
========= ========= ========= =============== ============
Balance as of December 31, 2006 496,341 (5,168) (2,825) 131 671,850
Comprehensive income:
Net income 13,845 -- -- -- 13,845
Other comprehensive income:
Foreign currency translation -- -- -- (322) (322)
Non-pension postretirement benefit
plan -- -- -- 191 191
--------------
Total comprehensive income 13,714
Cash dividends on Class A and Class B
common stock - $0.21 per share (10,357) -- -- -- (10,357)
Adjustment to adopt provisions of
FASB Interpretation No. 48 (61) -- -- -- (61)
Reserve for uncertain income tax positions -- -- -- -- 2,519
Issuance of common stock, net of forfeitures -- (10,174) (225) -- 4,409
Compensation expense for stock based awards -- 3,105 -- -- 3,105
Repurchase of common stock -- -- -- -- (80,907)
Conversion of common stock -- -- -- -- --
Acquisition of enterprise under common control -- -- -- -- (12,507)
Payments received on employee
stock notes receivable -- -- 128 -- 128
--------- --------- --------- --------------- ------------
Balance as of September 30, 2007 499,768 (12,237) (2,922) -- 591,893
========= ========= ========= =============== ============
See accompanying notes to consolidated financial statements.
4
NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------
2007 2006
------------- -------------
Net income $ 13,845 75,465
Income (loss) from discontinued operations (2,416) 3,677
------------- -------------
Income from continuing operations 16,261 71,788
Adjustments to reconcile income from continuing
operations to net cash provided
by operating activities, net of business acquisitions
Depreciation and amortization, including loan premiums and
deferred origination costs 223,552 103,506
Derivative market value adjustment (93,031) (23,165)
Foreign currency transaction adjustment 79,020 30,942
Change in value of put options issued in business acquisitions 2,145 3,821
Proceeds from termination of interest rate swaps 50,843 --
Proceeds from sale of floor contracts -- 8,580
Payments to terminate floor contracts (8,100) --
Impairment of assets 49,504 --
Loss on sale of business 8,132 --
Gain on sale of equity method investment (3,942) --
Gain on sale of student loans (2,778) (13,535)
Non-cash compensation expense 4,595 1,850
Deferred income tax (benefit) expense (30,374) 26,183
Provision for loan losses 23,628 13,508
Other non-cash items (2,900) 541
Increase in accrued interest receivable (125,929) (103,005)
Increase in accounts receivable (7,045) (3,176)
Decrease in other assets 7,450 9,680
Increase in accrued interest payable 64,812 53,620
Increase (decrease) in other liabilities 19,785 (10,694)
------------- -------------
Net cash flows from operating
activities - continuing operations 275,628 170,444
Net cash flows (used in) from operating
activities - discontinued operations (3,558) 8,203
------------- -------------
Net cash provided by operating activities 272,070 178,647
------------- -------------
Cash flows from investing activities,
net of business acquisitions:
Originations, purchases, and consolidations of
student loans, including loan premiums
and deferred origination costs (4,508,712) (4,910,997)
Purchases of student loans, including loan premiums,
from a related party (232,769) (498,771)
Net proceeds from student loan repayments, claims,
capitalized interest, and other 1,453,539 2,111,413
Proceeds from sale of student loans 393,379 560,916
Purchases of property and equipment, net (18,375) (18,069)
Decrease (increase) in restricted cash 300,415 (80,602)
Purchases of restricted investments (377,744) (590,009)
Proceeds from maturities of restricted investment 393,744 633,349
Distribution from equity method investment 747 --
Sale of business, net of cash sold 7,551 --
Business acquisitions, net of cash acquired 2,211 (99,388)
Proceeds from sale of equity method investment 10,000 --
------------- -------------
Net cash flows from investing
activities - continuing operations (2,576,014) (2,892,158)
Net cash flows from investing
activities - discontinued operations (294) (8,130)
------------- -------------
Net cash used in investing activities (2,576,308) (2,900,288)
------------- -------------
Cash flows from financing activities:
Payments on bonds and notes payable (4,496,077) (2,741,641)
Proceeds from issuance of bonds and notes payable 7,022,018 5,649,381
(Payments) proceeds from issuance of notes payable
due to a related party, net (56,917) 74,292
Payments of debt issuance costs (13,951) (14,770)
Dividends paid (10,357) --
Payment on settlement of put option (15,875) --
Proceeds from issuance of common stock 1,231 1,247
Repurchases of common stock (75,504) (62,389)
Payments received on employee stock notes receivable 128 --
Loan to employee for purchase of common stock -- (500)
------------- -------------
Net cash flows from financing
activities - continuing operations 2,354,696 2,905,620
Net cash flows from financing
activities - discontinued operations -- --
------------- -------------
Net cash provided by financing activities 2,354,696 2,905,620
------------- -------------
Effect of exchange rate fluctuations on cash 548 316
------------- -------------
Net increase in cash and cash equivalents 51,006 184,295
Cash and cash equivalents, beginning of period 106,086 103,650
------------- -------------
Cash and cash equivalents, end of period $ 157,092 287,945
============= =============
Supplemental disclosures of cash flow information:
Interest paid $ 920,966 818,317
============= =============
Income taxes paid, net of refunds $ 20,908 52,627
============= =============
See accompanying notes to consolidated financial statements.
5
NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF SEPTEMBER 30, 2007 AND FOR THE THREE MONTHS AND
NINE MONTHS ENDED SEPTEMBER 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 September 30, 2007 and for the three and nine
months ended September 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 nine months ended September
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 $8.1 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 operations for all periods presented. The segment results in note 15 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 NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- -------------------
2007 2006 2007 2006
--------- --------- -------- ----------
Operating income of discontinued operations $ -- 1,750 9,278 5,803
Income tax on operations -- (643) (3,562) (2,126)
Loss on disposal (6) -- (8,157) --
Income tax on disposal 915 -- 25 --
--------- --------- -------- ----------
Income (loss) from discontinued operations,
net of tax $ 909 1,107 (2,416) 3,677
========= ========= ======== ==========
6
The following operations of 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 NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
------------------------ ------------------------
2007 2006 2007 2006
----------- ------------ ---------- -------------
Net interest income -- 48 124 176
Other income -- 16,256 31,511 48,190
Operating expenses -- (14,554) (22,357) (42,563)
----------- ------------ ---------- -------------
Income before income taxes -- 1,750 9,278 5,803
Income tax expense -- 643 3,562 2,126
----------- ------------ ---------- -------------
Operating income of
discontinued
operations, net of tax -- 1,107 5,716 3,677
=========== ============ ========== =============
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. LEGISLATIVE DEVELOPMENTS
On September 27, 2007, the President signed into law the College Cost Reduction
and Access Act of 2007 (the "College Cost Reduction Act"). This legislation
contains provisions with significant implications for participants in the
Federal Family Education Loan Program ("FFEL Program" or "FFELP") by cutting
funding to the FFEL Program by $20 billion over the next five years as estimated
by the Congressional Budget Office. Among other things, this legislation:
o Reduces special allowance payments to for-profit lenders and
not-for-profit lenders by 0.55 percentage points and 0.40
percentage points, respectively, for both Stafford and
Consolidation loans disbursed on or after October 1, 2007;
o Reduces special allowance payments to for-profit lenders and
not-for-profit lenders by 0.85 percentage points and 0.70
percentage points, respectively, for PLUS loans disbursed on or
after October 1, 2007;
o Increases origination fees paid by lenders on all FFELP loan
types, from 0.5 percent to 1.0 percent, for all loans first
disbursed on or after October 1, 2007;
o Eliminates all provisions relating to Exceptional Performer
status, and the monetary benefit associated with it, effective
October 1, 2007; and
o Reduces default insurance to 95 percent of the unpaid principal
of such loans, for loans first disbursed on or after October 1,
2012.
7
The impact of this legislation will reduce the annual yield on FFELP loans
originated after October 1, 2007.
Upon passage of the College Cost Reduction Act, management evaluated the
carrying amount of goodwill and certain intangible assets. Based on the
legislative changes and the student loan business model modifications the
Company implemented as a result of the legislative changes (see note 4,
"Restructure"), the Company recorded an impairment charge of $39.4 million
during the third quarter of 2007. This charge is included in "impairment of
assets" on the Company's consolidated statements of operations. See note 8 for
additional information related to this impairment charge.
During the three month period ended September 30, 2007, the Company also
recorded an expense of $15.7 million to increase the Company's allowance for
loan losses related to the increase in risk share as a result of the elimination
of the Exceptional Performer program.
In October 2005, the Company entered into an agreement to amend an existing
contract with College Assist. College Assist is the Colorado state-designated
guarantor of FFELP student loans. Under the agreement, the Company provides
student loan servicing and guaranty operations and assumed the operational
expenses and employment of certain College Assist employees. College Assist pays
the Company a portion of the gross servicing and guaranty fees as consideration
for the Company providing these services on behalf of College Assist. As a
result of the passage of the College Cost Reduction Act, on October 2, 2007, the
Department notified College Assist of its decision to formally terminate the
Voluntary Flexible Agreement ("VFA") between the Department and College Assist
effective January 1, 2008. The termination of the VFA will have a negative
impact on the Company's guaranty income.
In addition to the College Cost Reduction Act, 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, rather than 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. RESTRUCTURE
On September 6, 2007, the Company announced a strategic initiative to create
efficiencies and lower costs in advance of the enactment of the College Cost
Reduction Act, which impacted the FFEL Program in which the Company
participates.
In anticipation of the federally driven cuts to the student loan programs,
management initiated a variety of strategies to modify the Company's student
loan business model, including lowering the cost of student loan acquisition,
creating efficiencies in the Company's asset generation business, and decreasing
operating expenses through a reduction in workforce and realignment of operating
facilities. These strategies will result in the net reduction of approximately
400 positions in the Company's overall workforce, including the elimination of
approximately 500 positions and the creation of approximately 100 positions at
the Company's larger facilities. In addition, the Company is simplifying its
operating structure to leverage its larger facilities and technology by closing
five small origination offices and downsizing its presence in Indianapolis.
Implementation of the plan began immediately and is expected to be substantially
completed during the fourth quarter of 2007.
The Company estimates that the charge to earnings associated with these
strategic decisions will be fully recognized during 2007 and will total
approximately $20.5 million, consisting of approximately $6.4 million in
severance costs, approximately $4.0 million in contract termination costs, and
approximately $10.1 million in non-cash charges primarily related to the
impairment of property and equipment.
8
During the three month period ended September 30, 2007, the Company recorded
restructuring charges of $15.0 million. Selected information relating to the
restructuring charge follows:
EMPLOYEE WRITE-DOWN
TERMINATION LEASE OF PROPERTY
BENEFITS TERMINATIONS AND EQUIPMENT TOTAL
------------ ------------- ------------- ----------
Restructuring costs recognized during the three
month period ended September 30, 2007 $ 4,788 (a) 168 (b) 10,060 (c) 15,016
Write-down of assets to net realizable value - - (10,060) (10,060)
Cash payments (2,542) - - (2,542)
---------- ------------- ------------- ----------
Restructuring accrual as of September 30, 2007 $ 2,246 168 - 2,414
========== ============= ============= ==========
(a) Employee termination benefits are included in "salaries and benefits" on
the consolidated statements of operations.
(b) Lease termination costs are included in "occupancy and communications"
on the consolidated statements of operations.
(c) Costs related to the write-down of property and equipment are included
in "impairment of assets" on the consolidated statements of operations.
Selected information relating to the restructuring charge by operating segment
and Corporate Activity and Overhead follows:
RESTRUCTURING COSTS
RECOGNIZED DURING
THE THREE MONTH WRITE-DOWN OF RESTRUCTURING
PERIOD ENDED ASSETS TO NET ACCRUAL AS OF
OPERATING SEGMENT SEPTEMBER 30, 2007 REALIZABLE VALUE CASH PAYMENTS SEPTEMBER 30, 2007
-------------------------------- ------------------ ---------------- ------------- ------------------
Asset Generation and Management $ 2,169 (248) (1,428) 493
Student Loan and Guaranty Servicing 1,231 - (389) 842
Tuition Payment Processing and
Campus Commerce - - - -
Enrollment Services and List
Management 737 - (509) 228
Software and Technical Services 58 - - 58
Corporate Activity and Overhead 10,821 (9,812) (216) 793
----------------- ---------------- ------------- ------------------
$ 15,016 (10,060) (2,542) 2,414
================= ================ ============= ==================
9
REMAINING
RESTRUCTURING COSTS
EXPECTED TO BE
RESTRUCTURING RECOGNIZED DURING
COSTS RECOGNIZED THE THREE MONTH
ESTIMATED DURING THE THREE PERIOD ENDING
TOTAL RESTRUCTURING MONTH PERIOD ENDED DECEMBER 31, 2007
OPERATING SEGMENT COSTS SEPTEMBER 30, 2007 (4TH QUARTER 2007)
------------------------------------ ------------------- ------------------- -------------------
Asset Generation and Management $ 2,688 2,169 519
Student Loan and Guaranty Servicing 1,818 1,231 587
Tuition Payment Processing and
Campus Commerce - - -
Enrollment Services and List
Management 969 737 232
Software and Technical Services 58 58 -
Corporate Activity and Overhead 14,920 10,821 4,099
------------------- ------------------- --------------------
$ 20,453 15,016 5,437
=================== =================== ====================
5. INDUSTRY 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. 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
U.S. Department of Education (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 based on provisions of the
Higher Education Act and regulations and guidance of the Department and related
interpretations. 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.
INDUSTRY INQUIRIES AND INVESTIGATIONS
On January 11, 2007, the Company received a letter from the New York Attorney
General (the "NYAG") requesting certain information and documents from the
Company in connection with the NYAG's investigation into preferred lender list
activities. Since January 2007, a number of state attorneys general, including
the NYAG, 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. A focus of the inquiries or investigations has 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 NYAG, 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.
10
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 NYAG to
adopt the NYAG's Code of Conduct, which is substantially similar to the Nelnet
Student Loan Code of Conduct. The NYAG's Code of Conduct 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.
On October 10, 2007, the Company received a subpoena from the NYAG requesting
certain information and documents from the Company in connection with the NYAG's
investigation into the direct-to-consumer marketing practices of student
lenders. The Company is cooperating with the request.
While the Company cannot predict the ultimate outcome of any inquiry or
investigation, the Company believes its activities have materially complied with
applicable law, including the Higher Education Act, the rules and regulations
adopted by the Department thereunder, and the Department's guidance regarding
those rules and regulations.
DEPARTMENT OF EDUCATION REVIEW
The Department periodically reviews participants in the FFEL Program for
compliance with program provisions. On June 28, 2007, the Department 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 had selected 47 schools and 27 lenders for
review. Specifically, the Department is reviewing the Company's practices in
connection with the prohibited 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'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 thereunder, and the
Department's guidance regarding those rules and regulations.
11
6. STUDENT LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
Student loans receivable consist of the following:
AS OF AS OF
SEPTEMBER 30, 2007 DECEMBER 31, 2006
------------------ -----------------
Federally insured loans $ 25,928,467 23,217,321
Non-federally insured loans 251,503 197,147
--------------- ---------------
26,179,970 23,414,468
Unamortized loan premiums and deferred origination costs 460,167 401,087
Allowance for loan losses - federally insured loans (23,907) (7,601)
Allowance for loan losses - non-federally insured loans (20,107) (18,402)
--------------- ---------------
$ 26,596,123 23,789,552
=============== ===============
Federally insured allowance as a percentage of
ending balance of federally insured loans 0.09% 0.03%
Non-federally insured allowance as a percentage of ending
balance of non-federally insured loans 7.99% 9.33%
Total allowance as a percentage of ending balance
of total loans 0.17% 0.11%
As discussed in note 3, during the three month period ended September 30, 2007,
the Company recorded an expense of $15.7 million to increase the Company's
allowance for loan losses related to the increase in risk share as a result of
the elimination of the Exceptional Performer Program.
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 nine months
ended September 30, 2007 and 2006, the Company sold $17.7 million and $103.7
million, and $353.2 million and $536.1 million (par value), respectively, of
student loans resulting in the recognition of gains of $0.5 million and $3.3
million, and $11.7 million and $13.5 million, respectively. The gain on the sale
of the student loans is included in "other income" on the consolidated
statements of operations.
7. 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 legislative 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.
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, CUnet, and Peterson's during 2007 which is
presented below.
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
12
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. Any payment of the
guaranty is reduced by the aggregate of any dividends or other distributions
made by the Company to the sellers. 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.
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
13
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.
In September 2007, the Company issued 62,446 restricted shares of its Class A
common stock valued at $1.1 million and paid cash of $0.1 million in
satisfaction of contingent consideration earned through June 30, 2007. The value
of the common shares issued was determined based on the closing market price of
the Company's common shares over the 2-day period before and after the date in
which the number of shares to be issued were known as determined per the terms
of the purchase agreement.
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 $38.7 million in cash, including $0.1 million of direct acquisition
costs. The final purchase price of Peterson's was subject to certain purchase
price adjustments as defined in the purchase 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 $36.5 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.
The following table summarizes the estimated fair values of the assets acquired
and liabilities assumed at the date of acquisition.
14
Accounts receivable $ 7,055
Intangible assets 18,920
Property and equipment 2,349
Other assets 2,375
Excess cost over fair value of net assets acquired (goodwill) 19,954
Other liabilities (14,173)
----------
$ 36,480
==========
As of the date of acquisition, the $18.9 million of acquired intangible assets
had a weighted-average useful life of approximately four years. The intangible
assets that made up this amount included database and content of $9.5 million
(5-year useful life), computer software of $6.2 million (3-year useful life),
customer relationships of $1.7 million (10-year useful life), trade names of
$0.8 million (3-year useful life), and a non-competition agreement of $0.7
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 $20.0 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.
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------------- ------------------------
2007 2006 2007 2006
------------- ------------ ----------- ------------
Net interest income $ 64,399 72,308 200,359 244,683
Other income (expense) (a) 100,124 9,314 264,756 227,462
Income (loss) from continuing operations (16,598) (23,844) 16,261 68,989
Net income (loss) (15,689) (22,737) 13,845 72,666
Weighted average shares outstanding - basic 49,018,091 53,348,466 49,810,552 53,996,958
Weighted average shares outstanding - diluted 49,018,091 53,348,466 49,811,052 53,996,958
Earnings (loss) per share, basic and diluted:
Income (loss) from continuing operations $ (0.34) (0.45) 0.32 1.28
Net income (loss) (0.32) (0.43) 0.28 1.35
(a) Other income (expense) includes derivative market value, foreign currency,
and put option adjustments and net derivative settlements.
15
8. INTANGIBLE ASSETS AND GOODWILL
Intangible assets consist of the following:
WEIGHTED
AVERAGE
REMAINING
USEFUL LIFE AS OF AS OF AS OF
SEPTEMBER 30, SEPTEMBER 30, DECEMBER 31,
2007 2007 2006
----------------- ------------ -------------
Amortizable intangible assets:
Customer relationships (net of accumulated amortization of $17,687
and $10,483, respectively) 120 $ 62,673 67,377
Covenants not to compete (net of accumulated amortization of
$10,446 and $9,559, respectively) 42 16,794 37,573
Loan origination rights (net of accumulated amortization of $7,768
and $7,238, respectively) 55 8,885 27,571
Database and content (net of accumulated amortization of $2,629) 37 6,851 --
Student lists (net of accumulated amortization of $5,294 and
$3,757, respectively) 17 2,903 4,440
Computer software (net of accumulated amortization of $4,166
and $1,354, respectively) 22 4,921 3,578
Trade names (net of accumulated amortization of $1,054 and
$327, respectively) 29 1,813 1,700
Other (net of accumulated amortization of $64 and $348, respectively) 101 210 2,250
----------------- ------------ -------------
Total - amortizable intangible assets 87 months 105,050 144,489
=================
Unamortizable intangible assets - trade names 14,192 17,099
------------ -------------
$ 119,242 161,588
============ =============
The Company recorded amortization expense on its intangible assets of $10.9
million and $6.2 million for the three months ended September 30, 2007 and 2006,
respectively, and $24.0 million and $17.3 million for the nine months ended
September 30, 2007 and 2006, respectively. The Company will continue to amortize
intangible assets over their remaining useful lives. As of September 30, 2007,
the Company estimates it will record amortization expense as follows:
2007 $ 6,158
2008 24,158
2009 20,244
2010 14,360
2011 9,680
2012 and thereafter 30,450
----------
$ 105,050
==========
16
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
Goodwill from prior period acquisition
allocated during the period -- -- -- (15,160) -- (15,160)
Impairment loss -- -- -- (11,401) -- (11,401)
----------- ----------- ---------- ---------- ---------- ---------
Balance as of September 30, 2007 $ 42,550 -- 58,086 55,463 8,596 164,695
=========== =========== ========== ========== ========== =========
As disclosed in note 3, as a result of the legislation signed into law on
September 27, 2007 and the student loan business model modifications the Company
implemented as a result of the legislative changes (see note 4), the Company
recorded an impairment charge of $39.4 million during the third quarter of 2007.
This charge is included in "impairment of assets" on the Company's consolidated
statements of operations. Information related to the impairment charge follows:
OPERATING IMPAIRMENT
ASSET SEGMENT CHARGE
------------------------------- -------------------------------- ------------
Amortizable intangible assets:
Covenants not to compete Asset Generation and Management $ 13,581
Loan origination rights Asset Generation and Management 11,555
Unamortizable intangible assets Asset Generation and Management 2,907
- trade names
Goodwill Enrollment Services and 11,401
List Management ------------
Total impairment charge related to legislative changes $ 39,444
============
The fair value of the intangible assets and reporting unit within the Enrollment
Services and List Management operating segment were estimated using the expected
present value of future cash flows.
Included in the impairment of loan origination rights was a charge of $1.3
million related to the Company's purchase of certain assets from the Rhode
Island Student Loan Authority ("RISLA"). The Company has had an agreement with
RISLA since March 2004, which included, among other things, rights to student
loan originations and providing administrative services in connection with
RISLA's operations. As a result of the recent political environment and the
legislative cuts to the FFEL Program, the Company and RISLA have mutually agreed
to end this agreement and transition the operations back to RISLA.
9. SALE OF PREMIERE CREDIT OF NORTH AMERICA, LLC ("PREMIERE")
On September 28, 2007, the Company sold its 50% membership interests in Premiere
for initial proceeds of $10.0 million. Premiere is a collection services company
that specializes in collection of education-related debt. The Company accounted
for Premiere using the equity method of accounting. The Company recognized a
gain on the sale of Premiere of $3.9 million which is included in "other income"
on the consolidated statements of operations. The initial proceeds and the
related gain from the sale exclude $3.5 million of contingent consideration that
will be passed to the Company if Premiere is awarded a collections contract as
defined in the purchase agreement. These additional proceeds will be recognized
by the Company as a gain in the period when such cash is received.
17
10. BONDS AND NOTES PAYABLE
The following tables summarize outstanding bonds and notes payable by type of
instrument:
AS OF SEPTEMBER 30, 2007
-------------------------------------------------
CARRYING INTEREST RATE
AMOUNT RANGE FINAL MATURITY
------------- ------------- -----------------
Variable-rate bonds and notes (a):
Bonds and notes based on indices $ 18,624,339 3.75% - 6.20% 05/01/11 - 05/01/42
Bonds and notes based on auction 2,385,795 3.85% - 6.79% 11/01/09 - 07/01/43
-------------
Total variable-rate bonds and notes 21,010,134
Commercial paper and other 6,349,995 5.27% - 6.06% 10/17/07 - 05/09/08
Fixed-rate bonds and notes (a) 217,780 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 125,000 6.09% 05/08/12
Other borrowings 56,238 5.10% - 5.45% 09/28/08 - 11/01/15
-------------
$ 28,234,147
=============
(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 and August 27, 2007 the Company consummated debt offerings of
student loan asset-backed notes of $2.4 billion and $1.5 billion, respectively,
with final maturity dates of 2037 and 2035, respectively. Notes issued in these
transactions carry interest rates based on a spread to LIBOR or auction rates.
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 FFELP loans purchased in connection with the program. As of September 30,
2007, the Company had $0.2 billion of Secured Liquidity Notes outstanding and an
additional $4.8 billion authorized for future issuance under this warehouse
program. However, during the third quarter of 2007, as a result of the
disruption of the credit markets, there was no market for the issuance of new
Secured Liquidity Notes and it is currently unlikely a market will exist in the
future. As a result, the Company wrote-off $1.3 million of debt issuance costs
related to this facility. This expense is included in "interest on bonds and
notes payable" on the Company's consolidated statements of operations.
During the third quarter 2007, as a result of there not being a market for the
Company's Secured Liquidity Notes, the Company increased its capacity on its
commercial paper conduit programs by $4.4 billion. As of September 30, 2007, the
Company had a loan warehousing capacity of $8.2 billion, of which $6.1 billion
was outstanding, through bank supported commercial paper conduit programs. The
Company had $2.1 billion in warehouse capacity available under its warehouse
facilities as of September 30, 2007.
18
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 September 30,
2007, there was $125.0 million outstanding on this line and $625.0 million
available for future use. The amended 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 September
30, 2007, there were no borrowings outstanding on this line.
As of September 30, 2007 and December 31, 2006, bonds and notes payable includes
$51.2 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 $54.0
million and $79.0 million for the three and nine months ended September 30,
2007, respectively, and the decrease of $7.2 million and the increase of $30.9
million for the three and nine months ended September 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
operations. Concurrently with the issuance of the Euro Notes, the Company
entered into cross-currency interest rate swaps which are further discussed in
note 11.
11. 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:
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.
19
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 September 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
==================== ================= ===================== =================== ============
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.
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 10. Under the terms of these
derivative instrument agreements, the Company receives from a counterparty a
spread to the EURIBOR index based on a notional amount of (euro)420.5 million
and (euro)352.7 million, respectively, and pays a spread to the LIBOR index
based on a notional amount of $500.0 million and $450.0 million, respectively.
In addition, under the terms of these agreements, all principal payments on the
Euro Notes will effectively be paid at the exchange rate in effect as of the
issuance of these notes.
ACCOUNTING FOR DERIVATIVE FINANCIAL INSTRUMENTS
The Company accounts for derivative instruments under Statement of Financial
Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND
HEDGING ACTIVITIES ("SFAS No. 133"), which requires that every derivative
instrument be recorded on the balance sheet as either an asset or liability
measured at its fair value. Management has structured all of the Company's
derivative transactions with the intent that each is economically effective;
however, the Company's derivative instruments do not qualify for hedge
accounting under SFAS No. 133. As a result, the change in fair value of
derivative instruments is recorded in the consolidated statements of operations
at each reporting date.
The following table summarizes the net fair value of the Company's derivative
portfolio:
AS OF AS OF
SEPTEMBER 30, 2007 DECEMBER 31,2006
------------------ ----------------
Interest rate swaps $ -- 61,468
Basis swaps 18,481 591
Interest rate floor contracts -- (10,158)
Cross-currency interest
rate swaps 151,995 66,225
--------- ---------
Net fair value $170,476 118,126
========= =========
20
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
operations resulted in a gain of $72.7 million and $93.0 million for the three
and nine months ended September 30, 2007, respectively, and a loss of $83.5
million and a gain of $23.2 million for the three and nine months ended
September 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 operations:
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2007 2006 2007 2006
--------------- --------------- ------------- --------------
Interest rate swaps $ 1,729 12,226 16,803 29,151
Basis swaps (2,608) (145) (2,489) (656)
Cross-currency interest rate swaps (1,457) (5,115) (7,214) (10,083)
Other (a) -- (1,993) -- (1,993)
--------------- --------------- ------------- --------------
Derivative settlements, net $ (2,336) 4,973 7,100 16,419
=============== =============== ============== ===============
(a) During 2006, the Company issued junior subordinated hybrid securities
and entered into a derivative instrument to economically lock into a
fixed interest rate prior to the actual pricing of the transaction. Upon
pricing of these notes, the Company terminated this derivative
instrument. The consideration paid by the Company to terminate this
derivative was $2.0 million.
12. EARNINGS PER COMMON SHARE
Basic earnings per common share ("basic EPS") is calculated using the weighted
average number of shares of common stock outstanding during each period. SFAS
No. 128, EARNINGS PER SHARE ("SFAS No. 128"), requires that nonvested restricted
stock that vests solely upon continued service be excluded from basic EPS but
reflected in diluted earnings per common share ("diluted EPS") by application of
the treasury stock method.
A reconciliation of weighted average shares outstanding follows:
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- --------------------------------
2007 2006 2007 2006
--------------- --------------- --------------- ---------------
Weighted average shares outstanding 49,320,629 53,348,466 49,912,506 53,959,075
Less: Nonvested restricted stock -
vesting solely upon continued service 302,538 -- 101,954 --
--------------- --------------- --------------- ---------------
Weighted average shares outstanding used
to compute basic EPS 49,018,091 53,348,466 49,810,552 53,959,075
Diluted effect of nonvested restricted stock -- -- 500 --
--------------- --------------- --------------- ---------------
Weighted average shares used to compute
diluted eps 49,018,091 53,348,466 49,811,052 53,959,075
=============== =============== =============== ===============
No diluted effect of nonvested restricted stock is presented for the three
months ended September 30, 2007 as the Company reported a net loss and including
these shares would have been antidilutive for the period. The dilutive effect of
these shares if the Company had net income for the period was not significant.
13. 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.
21
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 of the USA ("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 are 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 three and nine
months ended September 30, 2007, the Company repurchased 239,124 shares and
3,301,194 shares of Class A common stock for $5.4 million (average price of
$22.67 per share) and $80.9 million (average price of $24.50 per share),
respectively, under this authority. These repurchases included 2,725,000 shares
repurchased in February 2007 from certain members of management of the Company
in private transactions and 238,237 shares that were subject to put option
agreements as discussed previously.
ISSUANCE OF SHARES FOR CUNET ACQUISITION
As discussed in note 7, "Business Acquisitions", in September 2007 the Company
issued a total of 62,446 shares of Class A common stock valued at $1.1 million
in satisfaction of contingent consideration for the acquisition of CUnet.
14. 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.
22
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. The reserve balance during the nine months ended September 30, 2007
decreased by $3.0 million due to a lapse of applicable statute of limitations,
of which $0.5 million impacted the effective tax rate. As the remaining $2.5
million was related to the Company's initial public offering, it resulted in an
addition to shareholders' equity. The Company currently anticipates uncertain
income tax positions will decrease by $1.2 million prior to September 30, 2008
as a result of a lapse of applicable statutes of limitations; however, actual
developments in this area could differ from those currently expected. All $1.2
million, 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 nine months ended September 30, 2007 was a
decrease of $0.3 million.
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 2004, or state and local examinations prior to 2003.
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 $5.0 million in
2007 in connection with the sale of EDULINX. The Company recognized $0.7 million
of additional income tax expense during the second quarter of 2007 related to
this repatriation. This expense is included in the loss on disposal of EDULINX
within discontinued operations. As of September 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. During the second quarter 2007, 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 ("SFAS No. 109"). The valuation allowance was
included in discontinued operations due to the fact that the transactions
surrounding the sale of EDULINX generated the carryforward. However, during
third quarter of 2007, facts and circumstances changed such that it was
determined by management that the foreign tax credit carryforward now met the
more-likely-than-not recognition criteria of SFAS No. 109. Therefore, the
valuation allowance was released and the deferred tax asset was recognized
during the third quarter as part of discontinued operations.
15. 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 nine months ended September 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's detailed operating results that
have been segregated from continuing operations and reported as discontinued
operations.
23
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.
24
SEGMENT RESULTS AND RECONCILIATIONS TO GAAP
THREE MONTHS ENDED SEPTEMBER 30, 2007
--------------------------------------------------------------------------------------------------------
STUDENT TUITION ENROLLMENT "BASE NET
ASSET LOAN PAYMENT SERVICES SOFTWARE CORPORATE ELIMINATION INCOME" GAAP
GENERATION AND PROCESSING AND AND ACTIVITY AND ADJUSTMENTS RESULTS
AND GUARANTY AND CAMPUS LIST TECHNICAL TOTAL AND RECLASS- TO GAAP OF
MANAGEMENT SERVICING COMMERCE MANAGEMENT SERVICES SEGMENTS OVERHEAD IFICATIONS RESULTS OPERATIONS
--------------------------------------------------------------------------------------------------------
Total interest income $ 454,053 1,182 990 110 -- 456,335 1,875 (533) 597 458,274
Interest expense 384,793 -- -- 1 -- 384,794 9,614 (533) -- 393,875
---------- -------- -------- -------- -------- ---------- -------- --------- --------- ---------
Net interest income 69,260 1,182 990 109 -- 71,541 (7,739) -- 597 64,399
Less provision for loan
losses 18,340 -- -- -- -- 18,340 -- -- -- 18,340
---------- -------- -------- -------- -------- ---------- -------- --------- --------- ---------
Net interest income after
provisionfor loan losses 50,920 1,182 990 109 -- 53,201 (7,739) -- 597 46,059
---------- -------- -------- -------- -------- ---------- -------- --------- --------- ---------
Other income (expense):
Loan and guarantee servicing
income 170 32,870 -- -- -- 33,040 -- -- -- 33,040
Other fee-based income 3,526 -- 10,316 23,471 -- 37,313 712 -- -- 38,025
Software services income -- -- -- 169 5,257 5,426 -- -- -- 5,426
Other income 1,673 -- 31 -- -- 1,704 5,816 -- -- 7,520
Intersegment revenue -- 22,237 168 (37) 4,805 27,173 1,492 (28,665) -- --
Derivative market value,
foreign currency,
and put option adjustments -- -- -- -- -- -- -- -- 18,449 18,449
Derivative settlements, net (4,065) -- -- -- -- (4,065) 1,729 -- -- (2,336)
--------- -------- -------- -------- -------- ---------- -------- ---------- --------- ----------
Total other income (expense) 1,304 55,107 10,515 23,603 10,062 100,591 9,749 (28,665) 18,449 100,124
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Operating expenses:
Salaries and benefits 6,154 21,961 5,312 8,095 6,537 48,059 9,691 2,292 503 60,545
Restructure expense -
severance and contract
termination costs 1,921 1,231 -- 737 58 3,947 1,009 (4,956) -- --
Impairment of assets 28,291 -- -- 11,401 -- 39,692 9,812 -- -- 49,504
Other expenses 7,429 8,565 2,029 13,809 689 32,521 19,822 168 10,885 63,396
Intersegment expenses 20,924 1,613 (15) 67 147 22,736 3,433 (26,169) -- --
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Total operating expenses 64,719 33,370 7,326 34,109 7,431 146,955 43,767 (28,665) 11,388 173,445
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Income (loss) before
income taxes (12,495) 22,919 4,179 (10,397) 2,631 6,837 (41,757) -- 7,658 (27,262)
Income tax expense
(benefit) (a) (4,748) 8,709 1,588 (3,951) 1,000 2,598 (16,233) -- 2,971 (10,664)
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Net income (loss)
from continuing operations (7,747) 14,210 2,591 (6,446) 1,631 4,239 (25,524) -- 4,687 (16,598)
Income (loss) from discontinued
operations, net of tax -- -- -- -- -- -- -- -- 909 909
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Net income (loss) $ (7,747) 14,210 2,591 (6,446) 1,631 4,239 (25,524) -- 5,596 (15,689)
========= ======== ======== ======== ======== ========== ======== ========= ========= ==========
(a) Income taxes are based on a percentage of net income before tax for
the individual operating segment.
25
THREE MONTHS ENDED SEPTEMBER 30, 2006
--------------------------------------------------------------------------------------------------------
STUDENT TUITION ENROLLMENT "BASE NET
ASSET LOAN PAYMENT SERVICES SOFTWARE CORPORATE ELIMINATION INCOME" GAAP
GENERATION AND PROCESSING AND AND ACTIVITY AND ADJUSTMENTS RESULTS
AND GUARANTY AND CAMPUS LIST TECHNICAL TOTAL AND RECLASS- TO GAAP OF
MANAGEMENT SERVICING COMMERCE MANAGEMENT SERVICES SEGMENTS OVERHEAD IFICATIONS RESULTS OPERATIONS
--------------------------------------------------------------------------------------------------------
Total interest income $ 402,014 2,471 1,098 144 24 405,751 498 (175) -- 406,074
Interest expense 327,166 -- 3 -- -- 327,169 6,772 (175) -- 333,766
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Net interest income 74,848 2,471 1,095 144 24 78,582 (6,274) -- -- 72,308
Less provision for loan losses 1,700 -- -- -- -- 1,700 -- -- -- 1,700
---------- ----------------- -------- -------- ---------- -------- --------- ---------- ----------
Net interest income
after provision
for loan losses 73,148 2,471 1,095 144 24 76,882 (6,274) -- -- 70,608
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Other income (expense):
Loan and guarantee
servicing income -- 32,212 -- -- -- 32,212 -- -- -- 32,212
Other fee-based income 2,538 -- 8,810 19,873 -- 31,221 -- -- -- 31,221
Software services income 67 -- -- 52 4,280 4,399 -- -- -- 4,399
Other income 12,917 7 -- -- -- 12,924 654 -- -- 13,578
Intersegment revenue -- 15,831 137 (9) 4,629 20,588 310 (20,898) -- --
Derivative market value,
foreign currency,
and put option adjustments -- -- -- -- -- -- -- -- (79,908) (79,908)
Derivative settlements, net 6,966 -- -- -- -- 6,966 (1,993) -- -- 4,973
---------- -------- -------- -------- -------- ---------- ------------------ ---------- ----------
Total other income
(expense) 22,488 48,050 8,947 19,916 8,909 108,310 (1,029) (20,898) (79,908) 6,475
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Operating expenses:
Salaries and benefits 14,367 20,320 4,285 5,437 5,736 50,145 10,052 (3,539) 476 57,134
Other expenses 11,627 8,495 1,901 13,344 766 36,133 14,832 -- 6,189 57,154
Intersegment expenses 12,813 3,729 497 -- -- 17,039 320 (17,359) -- --
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Total operating expenses 38,807 32,544 6,683 18,781 6,502 103,317 25,204 (20,898) 6,665 114,288
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Income (loss) before income 56,829 17,977 3,359 1,279 2,431 81,875 (32,507) -- (86,573) (37,205)
Income tax expense
(benefit) (a) 21,595 6,831 1,276 486 924 31,112 (13,302) -- (31,554) (13,744)
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Net income (loss)
from continuing operations 35,234 11,146 2,083 793 1,507 50,763 (19,205) -- (55,019) (23,461)
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- 1,107 1,107
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Net income (loss) $ 35,234 11,146 2,083 793 1,507 50,763 (19,205) -- (53,912) (22,354)
========== ======== ======== ======== ======== ========== ======== ========= ========== ==========
(a) Income taxes are based on a percentage of net income before tax for
the individual operating segment.
26
NINE MONTHS ENDED SEPTEMBER 30, 2007
--------------------------------------------------------------------------------------------------------
STUDENT TUITION ENROLLMENT "BASE NET
ASSET LOAN PAYMENT SERVICES SOFTWARE CORPORATE ELIMINATION INCOME" GAAP
GENERATION AND PROCESSING AND AND ACTIVITY AND ADJUSTMENTS RESULTS
AND GUARANTY AND CAMPUS LIST TECHNICAL TOTAL AND RECLASS- TO GAAP OF
MANAGEMENT SERVICING COMMERCE MANAGEMENT SERVICES SEGMENTS OVERHEAD IFICATIONS RESULTS OPERATIONS
--------------------------------------------------------------------------------------------------------
Total interest income 1,301,947 4,607 2,670 290 18 1,309,532 6,230 (3,737) 597 1,312,622
Interest expense 1,084,792 -- 7 5 -- 1,084,804 31,196 (3,737) -- 1,112,263
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Net interest income 217,155 4,607 2,663 285 18 224,728 (24,966) -- 597 200,359
Less provision for loan losses 23,628 -- -- -- -- 23,628 -- -- -- 23,628
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Net interest income after
provision
for loan losses 193,527 4,607 2,663 285 18 201,100 (24,966) -- 597 176,731
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Other income (expense):
Loan and guarantee
servicing income 288 94,828 -- -- -- 95,116 -- -- -- 95,116
Other fee-based income 10,511 -- 31,492 73,341 -- 115,344 972 -- -- 116,316
Software services income -- -- -- 456 16,566 17,022 -- -- -- 17,022
Other income 7,617 11 59 -- -- 7,687 9,649 -- -- 17,336
Intersegment revenue -- 58,821 508 891 13,026 73,246 7,608 (80,854) -- --
Derivative market value,
foreign currency,
and put option adjustments -- -- -- -- -- -- -- -- 11,866 11,866
Derivative settlements, net (4,950) -- -- -- -- (4,950) 12,050 -- -- 7,100
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Total other income
(expense) 13,466 153,660 32,059 74,688 29,592 303,465 30,279 (80,854) 11,866 264,756
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Operating expenses:
Salaries and benefits 20,600 66,988 15,312 26,486 18,869 148,255 34,669 (2,370) 1,456 182,010
Restructure expense -
severance and contract
termination costs 1,921 1,231 -- 737 58 3,947 1,009 (4,956) -- --
Impairment of assets 28,291 -- -- 11,401 -- 39,692 9,812 -- -- 49,504
Other expenses 22,940 26,219 6,522 42,957 2,224 100,862 58,762 168 24,014 183,806
Intersegment expenses 59,594 8,681 384 252 550 69,461 4,235 (73,696) -- --
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Total operating expenses 133,346 103,119 22,218 81,833 21,701 362,217 108,487 (80,854) 25,470 415,320
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Income (loss) before
income taxes 73,647 55,148 12,504 (6,860) 7,909 142,348 (103,174) -- (13,007) 26,167
Income tax expense
(benefit) (a) 27,986 20,956 4,752 (2,607) 3,006 54,093 (40,059) -- (4,128) 9,906
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Net income (loss)
from continuing
operations 45,661 34,192 7,752 (4,253) 4,903 88,255 (63,115) -- (8,879) 16,261
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- (2,416) (2,416)
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Net income (loss) $ 45,661 34,192 7,752 (4,253) 4,903 88,255 (63,115) -- (11,295) 13,845
========== ======== ======== ======== ========= ========== ======== ========= ========== ==========
(a) Income taxes are based on a percentage of net income before tax for
the individual operating segment.
27
NINE MONTHS ENDED SEPTEMBER 30, 2006
--------------------------------------------------------------------------------------------------------
STUDENT TUITION ENROLLMENT "BASE NET
ASSET LOAN PAYMENT SERVICES SOFTWARE CORPORATE ELIMINATION INCOME" GAAP
GENERATION AND PROCESSING AND AND ACTIVITY AND ADJUSTMENTS RESULTS
AND GUARANTY AND CAMPUS LIST TECHNICAL TOTAL AND RECLASS- TO GAAP OF
MANAGEMENT SERVICING COMMERCE MANAGEMENT SERVICES SEGMENTS OVERHEAD IFICATIONS RESULTS OPERATIONS
--------------------------------------------------------------------------------------------------------
Total interest income $1,128,285 5,905 2,685 356 67 1,137,298 1,483 (579) -- 1,138,202
Interest expense 876,259 -- 5 -- -- 876,264 17,874 (579) -- 893,559
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net interest income 252,026 5,905 2,680 356 67 261,034 (16,391) -- -- 244,643
Less provision for
loan losses 13,508 -- -- -- -- 13,508 -- -- -- 13,508
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net interest income after
provision
for loan losses 238,518 5,905 2,680 356 67 247,526 (16,391) -- -- 231,135
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Other income (expense):
Loan and guarantee
servicing income -- 91,428 -- -- -- 91,428 -- -- -- 91,428
Other fee-based income 8,472 -- 25,483 31,495 -- 65,450 -- -- -- 65,450
Software services income 182 1 -- 92 11,551 11,826 -- -- -- 11,826
Other income 16,720 68 -- -- -- 16,788 1,683 -- -- 18,471
Intersegment revenue -- 46,015 365 756 13,014 60,150 506 (60,656) -- --
Derivative market value,
foreign currency,
and put option adjustments -- -- -- -- -- -- -- -- (11,565) (11,565)
Derivative settlements, net 18,412 -- -- -- -- 18,412 (1,993) -- -- 16,419
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Total other income
(expense) 43,786 137,512 25,848 32,343 24,565 264,054 196 (60,656) (11,565) 192,029
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Operating expenses:
Salaries and benefits 39,776 62,426 13,087 8,549 15,709 139,547 28,864 (8,296) 1,271 161,386
Other expenses 38,628 24,106 6,157 16,047 2,214 87,152 42,956 -- 17,304 147,412
Intersegment expenses 38,959 9,386 497 -- -- 48,842 3,518 (52,360) -- --
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Total operating expenses 117,363 95,918 19,741 24,596 17,923 275,541 75,338 (60,656) 18,575 308,798
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Income (loss) before
income taxes 164,941 47,499 8,787 8,103 6,709 236,039 (91,533) -- (30,140) 114,366
Income tax expense
(benefit) (a) 62,678 18,049 3,338 3,079 2,549 89,693 (37,355) -- (10,002) 42,336
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net income (loss)
before minority interest 102,263 29,450 5,449 5,024 4,160 146,346 (54,178) -- (20,138) 72,030
Minority interest in
subsidiary income -- -- (242) -- -- (242) -- -- -- (242)
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net income (loss)
from continuing
operations 102,263 29,450 5,207 5,024 4,160 146,104 (54,178) -- (20,138) 71,788
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- 3,677 3,677
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net income (loss) $ 102,263 29,450 5,207 5,024 4,160 146,104 (54,178) -- (16,461) 75,465
========== ======== ======== ======== ======== ========== ======== ======== ========== ===========
(a) Income taxes are based on a percentage of net income before tax for
the individual operating segment.
28
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 nine months ended September 30, 2007 and 2006:
29
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
----------------------------------------------------------------------------------------
THREE MONTHS ENDED SEPTEMBER 30, 2007
----------------------------------------------------------------------------------------
Derivative market value, foreign currency,
and put option adjustments (1) $ (20,017) -- -- -- -- 1,568 (18,449)
Amortization of intangible assets (2) 1,372 1,350 1,434 6,442 287 -- 10,885
Non-cash stock based compensation related --
to business combinations (3) -- -- -- -- -- 503 503
Variable-rate floor income (4) (597) -- -- -- -- -- (597)
Income (loss) from discontinued
operations, net of tax (5) -- (909) -- -- -- -- (909)
Net tax effect (6) 7,312 (513) (545) (2,448) (109) (726) 2,971
----------- ------------ ------------- ------------ ----------- ----------- ----------
Total adjustments to GAAP $ (11,930) (72) 889 3,994 178 1,345 (5,596)
=========== ============ ============= ============ =========== =========== ==========
THREE MONTHS ENDED SEPTEMBER 30, 2006
----------------------------------------------------------------------------------------
Derivative market value, foreign currency,
and put option adjustments (1) $ 76,404 -- -- -- -- 3,504 79,908
Amortization of intangible assets (2) 2,228 1,038 1,305 1,498 120 -- 6,189
Non-cash stock based compensation related
to business combinations (3) -- -- -- -- -- 476 476
Variable-rate floor income (4) -- -- -- -- -- -- --
Income (loss) from discontinued
operations, net of tax (5) -- (1,107) -- -- -- -- (1,107)
Net tax effect (6) (29,880) (382) (496) (569) (46) (181) (31,554)
----------- ------------ ------------- ------------ ----------- ----------- ----------
Total adjustments to GAAP $ 48,752 (451) 809 929 74 3,799 53,912
=========== ============ ============= ============ =========== =========== ==========
NINE MONTHS ENDED SEPTEMBER 30, 2007
----------------------------------------------------------------------------------------
Derivative market value, foreign currency,
and put option adjustments (1) $ (7,801) -- -- -- -- (4,065) (11,866)
Amortization of intangible assets (2) 5,197 3,744 4,372 9,797 904 -- 24,014
Non-cash stock based compensation related
to business combinations (3) -- -- -- -- -- 1,456 1,456
Variable-rate floor income (4) (597) -- -- -- -- -- (597)
Income (loss) from discontinued
operations, net of tax (5) -- 2,416 -- -- -- -- 2,416
Net tax effect (6) 1,216 (1,423) (1,661) (3,723) (343) 1,806 (4,128)
----------- ------------ ------------- ------------ ----------- ----------- ----------
Total adjustments to GAAP $ (1,985) 4,737 2,711 6,074 561 (803) 11,295
=========== ============ ============= ============ =========== =========== ==========
NINE MONTHS ENDED SEPTEMBER 30, 2006
----------------------------------------------------------------------------------------
Derivative market value, foreign currency,
and put option adjustments (1) $ 7,744 -- -- -- -- 3,821 11,565
Amortization of intangible assets (2) 6,684 3,369 4,173 2,718 360 -- 17,304
Non-cash stock based compensation related
to business combinations (3) -- -- -- -- -- 1,271 1,271
Variable-rate floor income (4) -- -- -- -- -- -- --
Income (loss) from discontinued
operations, net of tax (5) -- (3,677) -- -- -- -- (3,677)
Net tax effect (6) (5,482) (1,281) (1,585) (1,033) (138) (483) (10,002)
----------- ------------ ------------- ------------ ----------- ----------- ----------
Total adjustments to GAAP $ 8,946 (1,589) 2,588 1,685 222 4,609 16,461
=========== ============ ============= ============ =========== =========== ==========
30
(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 7, 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) Variable-rate floor income: Loans that reset annually on July 1
can generate excess spread income compared with the rate based on
the special allowance payment formula in declining interest rate
environments. The Company refers to this additional income as
variable-rate floor income. The Company excludes variable-rate
floor income from its base net income since its timing and amount
(if any) is uncertain, it has been eliminated by legislation for
all loans originated on and after April 1, 2006, and it is in
excess of expected spreads. In addition, because variable-rate
floor income is subject to the underlying rate for the subject
loans being reset annually on July 1, it is a factor beyond the
Company's control which can affect the period-to-period
comparability of results of operations.
(5) 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.
(6) 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 NINE MONTHS ENDED SEPTEMBER 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.
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,
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 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; the uncertain nature of the expected benefits from acquisitions and the
ability to successfully integrate operations; and the uncertain nature of
estimated expenses that may be incurred and cost savings that may result from
the Company's strategic restructuring initiatives. 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.
31
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
products and services to its customers throughout the education life cycle.
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
diversified education finance and service operations.
During the three and nine months ended September 30, 2007, the Company continued
to diversify its revenue streams, increase fee-based revenue, utilize its scale
and capacity to create efficiencies, and deploy capital by repurchasing shares
of the Company's stock and paying its first quarterly dividends. In addition,
the Company continues to have strong growth of student loan assets.
o Fee-based revenue for the three and nine months ended September 30,
2007 was 54% and 53% of total revenues, respectively, compared to 48%
and 41% of total revenues for the three and nine months ended
September 30, 2006, respectively.
o Fee-based revenue increased $8.7 million, or 13%, from $67.8 million
for the three months ended September 30, 2006 to $76.5 million for
the three months ended September 30, 2007. Fee-based revenue
increased $59.8 million, or 35%, from $168.7 million for the nine
months ended September 30, 2006 to $228.5 million for the nine months
ended September 30, 2007.
o Operating expenses, excluding acquisitions and restructuring and
legislative charges, decreased $1.8 million, or 1.6%, from $114.3
million for the three months ended September 30, 2006 to $112.5
million for the three months ended September 30, 2006.
o Operating expenses, excluding acquisitions and restructuring and
legislative charges, increased $4.9 million, or 1.6%, from $308.8
million for the nine months ended September 30, 2006 to $313.7
million for the nine months ended September 30, 2007.
o The Company repurchased 3.3 million shares of its Class A common
stock for $80.9 million during the nine months ended September 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 each March 15, 2007, June 15,
2007, and September 15, 2007. Total dividends paid in 2007 has been
$10.4 million.
o As of September 30, 2007, student loan assets were $26.6 billion, an
increase of $2.8 billion, or 11.8%, and $3.7 billion, or 16.0%,
compared to December 31, 2006 and September 30, 2006, respectively.
The following events occurred in 2007 that significantly affected the operating
results of the Company:
o The Company sold EDULINX and is reporting this transaction as
discontinued operations;
o The President signed into law the College Cost Reduction Act;
o The Company initiated a restructuring plan; and
o The debt and secondary markets experienced unprecedented disruptions.
Sale of EDULINX
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
$8.1 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.
Legislative Impact
On September 27, 2007, the President signed into law the College Cost Reduction
Act. This legislation contains provisions with significant implications for
participants in the FFEL Program by cutting funding to the FFEL Program by $20
billion over the next five years as estimated by the Congressional Budget
Office. Among other things, this legislation:
o Reduces special allowance payments to for-profit lenders and
not-for-profit lenders by 0.55 percentage points and 0.40 percentage
points, respectively, for both Stafford and Consolidation loans
disbursed on or after October 1, 2007;
o Reduces special allowance payments to for-profit lenders and
not-for-profit lenders by 0.85 percentage points and 0.70 percentage
points, respectively, for PLUS loans disbursed on or after October 1,
2007;
o Increases origination fees paid by lenders on all FFELP loan types,
from 0.5 percent to 1.0 percent, for all loans first disbursed on or
after October 1, 2007;
o Eliminates all provisions relating to Exceptional Performer status,
and the monetary benefit associated with it, effective October 1,
2007; and
32
o For loans first disbursed on or after October 1, 2012, reduces
default insurance to 95 percent of the unpaid principal of such
loans.
The impact of this legislation will reduce the annual yield on FFELP loans
originated after October 1, 2007.
Upon passage of the College Cost Reduction Act, management evaluated the
carrying amount of goodwill and certain intangible assets. Based on the
legislative changes and the student loan business model modifications the
Company implemented as a result of the legislative changes, the Company recorded
an impairment charge of $39.4 million during the third quarter of 2007.
During the three month period ended September 30, 2007, the Company also
recorded an expense of $15.7 million to increase the Company's allowance for
loan losses related to the increase in risk share as a result of the elimination
of the Exceptional Performer program.
In October 2005, the Company entered into an agreement to amend an existing
contract with College Assist. College Assist is the Colorado state-designated
guarantor of FFELP student loans. Under the agreement, the Company provides
student loan servicing and guaranty operations and assumed the operational
expenses and employment of certain College Assist employees. College Assist pays
the Company a portion of the gross servicing and guaranty fees as consideration
for the Company providing these services on behalf of College Assist. As a
result of the passage of the College Cost Reduction Act, on October 2, 2007, the
Department notified College Assist of its decision to formally terminate the
Voluntary Flexible Agreement ("VFA") between the Department and College Assist
effective January 1, 2008. The termination of the VFA will have a negative
impact on the Company's guaranty income.
RESTRUCTURING PLAN
On September 6, 2007, the Company announced a strategic initiative to create
efficiencies and lower costs in advance of the passage of the College Cost
Reduction Act.
In anticipation of the federally driven cuts to the student loan programs,
management initiated a variety of strategies to modify the Company's student
loan business model, including lowering the cost of student loan acquisition,
creating efficiencies in the Company's asset generation business, and decreasing
operating expenses through a reduction in workforce and realignment of operating
facilities. These strategies will result in the net reduction of approximately
400 positions in the Company's overall workforce, including the elimination of
approximately 500 positions and the creation of approximately 100 positions at
the Company's larger facilities. In addition, the Company is simplifying its
operating structure to leverage its larger facilities and technology by closing
five small origination offices and downsizing its presence in Indianapolis.
Implementation of the plan began immediately and is expected to be substantially
completed during the fourth quarter of 2007. The Company estimates these
restructuring activities will result in expense savings of as much as $25
million annually beginning in 2008.
The Company estimates that the charge to earnings associated with these
strategic decisions will be fully recognized during 2007 and will total
approximately $20.5 million. During the three month period ended September 30,
2007, the Company recorded restructuring charges of $15.0 million.
DISRUPTIONS IN THE DEBT AND SECONDARY MARKETS
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 has significant financing needs
that it meets through the capital markets, including the debt and secondary
markets. During the third quarter of 2007, these markets experienced
unprecedented disruptions - including reduced liquidity and increased credit
risk premiums for most market participants. These conditions increased the
Company's cost of debt during the third quarter 2007 and reduced the Company's
core student loan spread by 15 to 20 basis points compared to the second quarter
of 2007.
In accordance with generally accepted accounting principles, the Company
reported a net loss of $15.7 million and $22.4 million for the three months
ended September 30, 2007 and 2006, respectively, and net income of $13.8 million
and $75.5 million for the nine months ended September 30, 2007 and 2006,
respectively. The change in net income was driven primarily by the restructure
and legislative related charges, the change in the derivative market value,
foreign currency, and put option adjustments, and not receiving 9.5% special
allowance payments in accordance with the Company's Settlement Agreement with
the Department in January 2007.
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 legislative 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.
33
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 operations as net
interest income. The amortization of loan premiums, including capitalized costs
of origination, the consolidation loan rebate fee, and yield adjustments from
borrower benefit programs, are netted against loan interest income on the
Company's statements of operations. The amortization of debt issuance costs is
included in interest expense on the Company's statements of operations.
The Company's portfolio of FFELP loans originated prior to April 1, 2006 earns
interest at the higher of a variable rate based on the special allowance payment
(SAP) formula set by the 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. On September 27, 2007, the President signed into law the
College Cost Reduction Act. Among other things, this legislation:
o Reduces special allowance payments to for-profit lenders and
not-for-profit lenders by 0.55 percentage points and 0.40 percentage
points, respectively, for both Stafford and Consolidation loans
disbursed on or after October 1, 2007;
o Reduces special allowance payments to for-profit lenders and
not-for-profit lenders by 0.85 percentage points and 0.70 percentage
points, respectively, for PLUS loans disbursed on or after October 1,
2007;
o Increases origination fees paid by lenders on all FFELP loan types,
from 0.5 percent to 1.0 percent, for all loans first disbursed on or
after October 1, 2007;
o Eliminates all provisions relating to Exceptional Performer status,
and the monetary benefit associated with it, effective October 1,
2007; and
o Reduces default insurance to 95 percent of the unpaid principal of
such loans, for loans first disbursed on or after October 1, 2012.
Management estimates the impact of this legislation will reduce the annual yield
on FFELP loans originated after October 1, 2007 by 70 to 80 basis points. The
Company believes it can mitigate some of this reduction in annual yield by
creating efficiencies and lowering costs, modifying borrower benefits, and
reducing loan acquisition costs.
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.
34
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 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 received 99%
reimbursement (100% reimbursement prior to July 1, 2006) on all eligible FFELP
default claims submitted for reimbursement during the applicable period. Only
FFELP loans that were 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, were eligible for the 99% reimbursement.
On September 27, 2007, the President signed into law the College Cost Reduction
Act. Among other things, this legislation eliminates all provisions relating to
Exceptional Performer status, and the monetary benefit associated with it,
effective October 1, 2007. During the three month period ended September 30,
2007, the Company recorded an expense of $15.7 million to increase the Company's
allowance for loan losses related to the increase in risk share as a result of
the elimination of the Exceptional Performer program.
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. By a
letter dated September 28, 2007, the Department informed the Company that it was
redesignated as an Exceptional Performer for the period from June 1, 2006
through May 31, 2008. As stated above, the College Cost Reduction Act eliminates
the Exceptional Performer designation effective October 1, 2007. Accordingly,
the majority of claims submitted on or after October 1, 2007 are subject to
reimbursement at 97% or 98% of principal and accrued interest depending on
disbursement date of the loan.
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.
35
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. For the
three months ended September 30, 2007, operating expenses also includes employee
termination benefits, lease termination costs, and the write-down of property
and equipment related to the Company's restructuring plan and impairment charges
from the write-down of intangible assets and goodwill as a result of legislative
changes.
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE AND NINE
MONTHS ENDED SEPTEMBER 30, 2006
NET INTEREST INCOME
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMER 30,
------------------------------------- ------------------------------------
2007 2006 $ CHANGE 2007 2006 $ CHANGE
----------- ----------- ----------- ----------- ----------- -----------
Interest income:
Loan interest $ 437,251 380,136 57,115 1,251,391 1,068,538 182,853
Investment interest 21,023 25,938 (4,915) 61,231 69,664 (8,433)
----------- ----------- ----------- ----------- ----------- -----------
Total interest income 458,274 406,074 52,200 1,312,622 1,138,202 174,420
Interest expense:
Interest on bonds and notes payable 393,875 333,766 60,109 1,112,263 893,559 218,704
----------- ----------- ----------- ----------- ----------- -----------
Net interest income 64,399 72,308 (7,909) 200,359 244,643 (44,284)
Provision for loan losses 18,340 1,700 16,640 23,628 13,508 10,120
Net interest income after
----------- ----------- ----------- ----------- ----------- -----------
provision for loan losses $ 46,059 70,608 (24,549) 176,731 231,135 (54,404)
=========== =========== =========== =========== =========== ===========
Net interest income for the three and nine months ended September 30, 2006
included $2.8 million and $35.0 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 $5.2 million and $9.3 million,
respectively. Interest expense increased $3.2 million and $12.7 million for the
three and nine month periods ended September 30, 2007 compared to the same
periods in 2006 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 in this Item 2 under "Asset Generation and Management Operating
Segment - Results of Operations". The provision for loan losses increased for
the three and nine months ended September 30, 2007 compared to 2006 as a result
of the Company recognizing $15.7 million in expense for provision for loan
losses as a result of the elimination of the Exceptional Performer program.
During nine months ended September 30, 2006, the Company recognizing $6.9
million in expense for provision for loan losses as a result of HERA's enactment
in February 2006.
36
OTHER INCOME
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------- --------------------------------
2007 2006 $ CHANGE 2007 2006 $ CHANGE
---------- --------- ---------- --------- --------- ----------
Loan and guaranty servicing income $ 33,040 32,212 828 95,116 91,428 3,688
Other fee-based income 38,025 31,221 6,804 116,316 65,450 50,866
Software services income 5,426 4,399 1,027 17,022 11,826 5,196
Other income 7,520 13,578 (6,058) 17,336 18,471 (1,135)
Derivative market value, foreign currency,
and put option adjustments 18,449 (79,908) 98,357 11,866 (11,565) 23,431
Derivative settlements, net (2,336) 4,973 (7,309) 7,100 16,419 (9,319)
---------- --------- ---------- --------- --------- ----------
Total other income $ 100,124 6,475 93,649 264,756 192,029 72,727
========== ========= ========== ========= ========= ==========
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 due to business acquisitions, an
increase in the number of managed tuition payment plans, an increase in
campus commerce and related clients, and an increase in lead generation
services.
o Software services income has increased as a result of new customers,
additional projects for existing customers, and increased fees.
o Other income decreased as a result of a gain on the sale of student loan
assets of $11.7 million in July 2006, offset by a gain on the
termination of the Company's interest rate floor contracts of $2.1
million in January 2007, and a gain on the sale of Premiere of $3.9
million in September 2007. The remaining change is a result of 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."
o The change in derivative settlements is discussed in Item 3,
"Quantitative and Qualitative Disclosures about Market Risk."
OPERATING EXPENSES
NET CHANGE
IMPACT OF AFTER IMPACT OF
RESTRUCTURING ACQUISITIONS AND THREE MONTHS
THREE MONTHS ENDED IMPACT OF AND IMPAIRMENT RESTRUCTURING AND ENDED
SEPTEMBER 30, 2006 ACQUISITIONS CHARGES IMPAIRMENT CHARGES SEPTEMBER 30, 2007
------------------ ------------ -------------- ----------------- ------------------
Salaries and benefits $ 57,134 1,321 4,788 (2,698) 60,545
Other expenses 50,965 1,005 168 373 52,511
Amortization of
intangible assets 6,189 4,203 -- 493 10,885
Impairment of assets -- -- 49,504 -- 49,504
--------------- ------------- -------------- ---------------- ----------------
Total operating
expenses $ 114,288 6,529 54,460 (1,832) 173,445
=============== ============= ============== ================ ================
Operating expenses for the three months ended September 30, 2007 increased $6.5
million and $54.5 million as a result of recent acquisitions and restructuring
and impairment charges, respectively. Excluding recent acquisitions and
restructuring and impairment charges, operating expenses decreased $1.8 million,
or 1.6%, as a result of the Company capitalizing on the operating leverage of
its business structure and strategies.
37
NET CHANGE
IMPACT OF AFTER IMPACT OF
RESTRUCTURING ACQUISITIONS AND NINE MONTHS
NINE MONTHS ENDED IMPACT OF AND IMPAIRMENT RESTRUCTURING AND ENDED
SEPTEMBER 30, 2006 ACQUISITIONS CHARGES IMPAIRMENT CHARGES SEPTEMBER 30, 2007
------------------ ------------ -------------- ----------------- ------------------
Salaries and benefits $ 161,386 13,562 4,788 2,274 182,010
Other expenses 130,108 27,112 168 2,404 159,792
Amortization of
intangibleassets 17,304 6,523 -- 187 24,014
Impairment of assets -- -- 49,504 -- 49,504
---------------- ---------------- --------------- ---------------- ---------------
Total operating
expenses $ 308,798 47,197 54,460 4,865 415,320
================ ================ =============== ================ ===============
Operating expenses for the nine months ended September 30, 2007 increased $47.2
million and $54.5 million as a result of recent acquisitions and restructuring
and impairment charges, respectively. Excluding recent acquisitions and
restructuring and impairment charges, operating expenses increased $4.9 million
as a result of a $7.2 million increase in the first quarter of 2007, a $0.5
million decrease in the second quarter of 2007, and a $1.8 million decrease in
the third quarter of 2007. The increase in the first quarter of 2007 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. The decreases in the second and third quarters of 2007 are a
result of the Company capitalizing on the operating leverage of its business
structure and strategies.
INCOME TAXES
The Company's effective tax rate was 39.1% for the three months ended September
30, 2007 compared to 36.9% for the same period in 2006. The Company had a net
loss during both of these periods. The increase in the tax benefit during 2007
was the result of the lapse of certain statute of limitations.
The Company's effective tax rate was 37.9% for the nine months ended September
30, 2007 compared to 37.0% for the same period in 2006. The Company had net
income during both of these periods. The effective tax rate increased due to
certain enacted state tax law changes. This increase was offset by the lapse of
certain statute of limitations and a decrease in expense recognized by the
Company during 2007 compared to 2006 related to its outstanding put options
which are not deductible for tax purposes.
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.
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".
38
FINANCIAL CONDITION AS OF SEPTEMBER 30, 2007 COMPARED TO DECEMBER 31, 2006
AS OF AS,OF CHANGE
SEPTEMBER 30, DECEMBER 31, -------------------------
2007 2006 DOLLARS PERCENT
------------- ------------- ------------- ---------
ASSETS:
Student loans receivable, net $ 26,596,123 23,789,552 2,806,571 11.8 %
Cash, cash equivalents, and investments 1,451,772 1,773,751 (321,979) (18.1)
Goodwill 164,695 191,420 (26,725) (14.0)
Intangible assets, net 119,242 161,588 (42,346) (26.2)
Fair value of derivative instruments 173,546 146,099 27,447 18.8
Assets of discontinued operations -- 27,309 (27,309) (100.0)
Other assets 837,086 707,154 129,932 (18.3)
------------- ------------- ------------- ---------
Total assets $ 29,342,464 26,796,873 2,545,591 9.5 %
============= ============= ============= =========
LIABILITIES:
Bonds and notes payable $ 28,234,147 25,562,119 2,672,028 10.5 %
Fair value of derivative instruments 3,070 27,973 (24,903) (89.0)
Other liabilities 513,354 534,931 (21,577) (4.0)
------------- ------------- ------------- ---------
Total liabilities 28,750,571 26,125,023 2,625,548 10.0
SHAREHOLDERS' EQUITY 591,893 671,850 (79,957) (11.9)
------------- ------------- ------------- ---------
Total liabilities and shareholders' equity $ 29,342,464 26,796,873 2,545,591 9.5 %
============= ============= ============= =========
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
$4.6 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 $13.8 million as a result of net income
for the nine months ended September 30, 2007 but was offset by the repurchase of
3.3 million shares of the Company's Class A common stock for $80.9 million. The
acquisition of Packers as discussed in note 13 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, second, and third quarters of 2007 which reduced
equity by $10.4 million.
OPERATING SEGMENTS
The Company has five operating segments as defined in 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 nine months ended September 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
in the notes to the consolidated financial statements included in this Report
for additional information concerning EDULINX's detailed operating results that
have been segregated from continuing operations and reported as discontinued
operations.
39
"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.
40
SEGMENT RESULTS AND RECONCILIATIONS TO GAAP
THREE MONTHS ENDED SEPTEMBER 30, 2007
--------------------------------------------------------------------------------------------------------
STUDENT TUITION ENROLLMENT "BASE NET
ASSET LOAN PAYMENT SERVICES SOFTWARE CORPORATE ELIMINATION INCOME" GAAP
GENERATION AND PROCESSING AND AND ACTIVITY AND ADJUSTMENTS RESULTS
AND GUARANTY AND CAMPUS LIST TECHNICAL TOTAL AND RECLASS- TO GAAP OF
MANAGEMENT SERVICING COMMERCE MANAGEMENT SERVICES SEGMENTS OVERHEAD IFICATIONS RESULTS OPERATIONS
--------------------------------------------------------------------------------------------------------
Total interest income $ 454,053 1,182 990 110 -- 456,335 1,875 (533) 597 458,274
Interest expense 384,793 -- -- 1 -- 384,794 9,614 (533) -- 393,875
---------- -------- -------- -------- -------- ---------- -------- --------- --------- ---------
Net interest income 69,260 1,182 990 109 -- 71,541 (7,739) -- 597 64,399
Less provision for loan
losses 18,340 -- -- -- -- 18,340 -- -- -- 18,340
---------- -------- -------- -------- -------- ---------- -------- --------- --------- ---------
Net interest income after
provisionfor loan losses 50,920 1,182 990 109 -- 53,201 (7,739) -- 597 46,059
---------- -------- -------- -------- -------- ---------- -------- --------- --------- ---------
Other income (expense):
Loan and guarantee servicing
income 170 32,870 -- -- -- 33,040 -- -- -- 33,040
Other fee-based income 3,526 -- 10,316 23,471 -- 37,313 712 -- -- 38,025
Software services income -- -- -- 169 5,257 5,426 -- -- -- 5,426
Other income 1,673 -- 31 -- -- 1,704 5,816 -- -- 7,520
Intersegment revenue -- 22,237 168 (37) 4,805 27,173 1,492 (28,665) -- --
Derivative market value,
foreign currency,
and put option adjustments -- -- -- -- -- -- -- -- 18,449 18,449
Derivative settlements, net (4,065) -- -- -- -- (4,065) 1,729 -- -- (2,336)
--------- -------- -------- -------- -------- ---------- -------- ---------- --------- ----------
Total other income (expense) 1,304 55,107 10,515 23,603 10,062 100,591 9,749 (28,665) 18,449 100,124
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Operating expenses:
Salaries and benefits 6,154 21,961 5,312 8,095 6,537 48,059 9,691 2,292 503 60,545
Restructure expense -
severance and contract
termination costs 1,921 1,231 -- 737 58 3,947 1,009 (4,956) -- --
Impairment of assets 28,291 -- -- 11,401 -- 39,692 9,812 -- -- 49,504
Other expenses 7,429 8,565 2,029 13,809 689 32,521 19,822 168 10,885 63,396
Intersegment expenses 20,924 1,613 (15) 67 147 22,736 3,433 (26,169) -- --
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Total operating expenses 64,719 33,370 7,326 34,109 7,431 146,955 43,767 (28,665) 11,388 173,445
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Income (loss) before
income taxes (12,495) 22,919 4,179 (10,397) 2,631 6,837 (41,757) -- 7,658 (27,262)
Income tax expense
(benefit) (a) (4,748) 8,709 1,588 (3,951) 1,000 2,598 (16,233) -- 2,971 (10,664)
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Net income (loss)
from continuing operations (7,747) 14,210 2,591 (6,446) 1,631 4,239 (25,524) -- 4,687 (16,598)
Income (loss) from discontinued
operations, net of tax -- -- -- -- -- -- -- -- 909 909
--------- -------- -------- -------- -------- ---------- -------- --------- --------- ----------
Net income (loss) $ (7,747) 14,210 2,591 (6,446) 1,631 4,239 (25,524) -- 5,596 (15,689)
========= ======== ======== ======== ======== ========== ======== ========= ========= ==========
(a) Income taxes are based on a percentage of net income before tax for
the individual operating segment.
41
THREE MONTHS ENDED SEPTEMBER 30, 2006
--------------------------------------------------------------------------------------------------------
STUDENT TUITION ENROLLMENT "BASE NET
ASSET LOAN PAYMENT SERVICES SOFTWARE CORPORATE ELIMINATION INCOME" GAAP
GENERATION AND PROCESSING AND AND ACTIVITY AND ADJUSTMENTS RESULTS
AND GUARANTY AND CAMPUS LIST TECHNICAL TOTAL AND RECLASS- TO GAAP OF
MANAGEMENT SERVICING COMMERCE MANAGEMENT SERVICES SEGMENTS OVERHEAD IFICATIONS RESULTS OPERATIONS
--------------------------------------------------------------------------------------------------------
Total interest income $ 402,014 2,471 1,098 144 24 405,751 498 (175) -- 406,074
Interest expense 327,166 -- 3 -- -- 327,169 6,772 (175) -- 333,766
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Net interest income 74,848 2,471 1,095 144 24 78,582 (6,274) -- -- 72,308
Less provision for loan losses 1,700 -- -- -- -- 1,700 -- -- -- 1,700
---------- ----------------- -------- -------- ---------- -------- --------- ---------- ----------
Net interest income
after provision
for loan losses 73,148 2,471 1,095 144 24 76,882 (6,274) -- -- 70,608
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Other income (expense):
Loan and guarantee
servicing income -- 32,212 -- -- -- 32,212 -- -- -- 32,212
Other fee-based income 2,538 -- 8,810 19,873 -- 31,221 -- -- -- 31,221
Software services income 67 -- -- 52 4,280 4,399 -- -- -- 4,399
Other income 12,917 7 -- -- -- 12,924 654 -- -- 13,578
Intersegment revenue -- 15,831 137 (9) 4,629 20,588 310 (20,898) -- --
Derivative market value,
foreign currency,
and put option adjustments -- -- -- -- -- -- -- -- (79,908) (79,908)
Derivative settlements, net 6,966 -- -- -- -- 6,966 (1,993) -- -- 4,973
---------- -------- -------- -------- -------- ---------- ------------------ ---------- ----------
Total other income
(expense) 22,488 48,050 8,947 19,916 8,909 108,310 (1,029) (20,898) (79,908) 6,475
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Operating expenses:
Salaries and benefits 14,367 20,320 4,285 5,437 5,736 50,145 10,052 (3,539) 476 57,134
Other expenses 11,627 8,495 1,901 13,344 766 36,133 14,832 -- 6,189 57,154
Intersegment expenses 12,813 3,729 497 -- -- 17,039 320 (17,359) -- --
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Total operating expenses 38,807 32,544 6,683 18,781 6,502 103,317 25,204 (20,898) 6,665 114,288
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Income (loss) before income 56,829 17,977 3,359 1,279 2,431 81,875 (32,507) -- (86,573) (37,205)
Income tax expense
(benefit) (a) 21,595 6,831 1,276 486 924 31,112 (13,302) -- (31,554) (13,744)
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Net income (loss)
from continuing operations 35,234 11,146 2,083 793 1,507 50,763 (19,205) -- (55,019) (23,461)
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- 1,107 1,107
---------- -------- -------- -------- -------- ---------- -------- --------- ---------- ----------
Net income (loss) $ 35,234 11,146 2,083 793 1,507 50,763 (19,205) -- (53,912) (22,354)
========== ======== ======== ======== ======== ========== ======== ========= ========== ==========
(a) Income taxes are based on a percentage of net income before tax for
the individual operating segment.
42
NINE MONTHS ENDED SEPTEMBER 30, 2007
--------------------------------------------------------------------------------------------------------
STUDENT TUITION ENROLLMENT "BASE NET
ASSET LOAN PAYMENT SERVICES SOFTWARE CORPORATE ELIMINATION INCOME" GAAP
GENERATION AND PROCESSING AND AND ACTIVITY AND ADJUSTMENTS RESULTS
AND GUARANTY AND CAMPUS LIST TECHNICAL TOTAL AND RECLASS- TO GAAP OF
MANAGEMENT SERVICING COMMERCE MANAGEMENT SERVICES SEGMENTS OVERHEAD IFICATIONS RESULTS OPERATIONS
--------------------------------------------------------------------------------------------------------
Total interest income 1,301,947 4,607 2,670 290 18 1,309,532 6,230 (3,737) 597 1,312,622
Interest expense 1,084,792 -- 7 5 -- 1,084,804 31,196 (3,737) -- 1,112,263
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Net interest income 217,155 4,607 2,663 285 18 224,728 (24,966) -- 597 200,359
Less provision for loan losses 23,628 -- -- -- -- 23,628 -- -- -- 23,628
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Net interest income after
provision
for loan losses 193,527 4,607 2,663 285 18 201,100 (24,966) -- 597 176,731
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Other income (expense):
Loan and guarantee
servicing income 288 94,828 -- -- -- 95,116 -- -- -- 95,116
Other fee-based income 10,511 -- 31,492 73,341 -- 115,344 972 -- -- 116,316
Software services income -- -- -- 456 16,566 17,022 -- -- -- 17,022
Other income 7,617 11 59 -- -- 7,687 9,649 -- -- 17,336
Intersegment revenue -- 58,821 508 891 13,026 73,246 7,608 (80,854) -- --
Derivative market value,
foreign currency,
and put option adjustments -- -- -- -- -- -- -- -- 11,866 11,866
Derivative settlements, net (4,950) -- -- -- -- (4,950) 12,050 -- -- 7,100
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Total other income
(expense) 13,466 153,660 32,059 74,688 29,592 303,465 30,279 (80,854) 11,866 264,756
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Operating expenses:
Salaries and benefits 20,600 66,988 15,312 26,486 18,869 148,255 34,669 (2,370) 1,456 182,010
Restructure expense -
severance and contract
termination costs 1,921 1,231 -- 737 58 3,947 1,009 (4,956) -- --
Impairment of assets 28,291 -- -- 11,401 -- 39,692 9,812 -- -- 49,504
Other expenses 22,940 26,219 6,522 42,957 2,224 100,862 58,762 168 24,014 183,806
Intersegment expenses 59,594 8,681 384 252 550 69,461 4,235 (73,696) -- --
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Total operating expenses 133,346 103,119 22,218 81,833 21,701 362,217 108,487 (80,854) 25,470 415,320
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Income (loss) before
income taxes 73,647 55,148 12,504 (6,860) 7,909 142,348 (103,174) -- (13,007) 26,167
Income tax expense
(benefit) (a) 27,986 20,956 4,752 (2,607) 3,006 54,093 (40,059) -- (4,128) 9,906
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Net income (loss)
from continuing
operations 45,661 34,192 7,752 (4,253) 4,903 88,255 (63,115) -- (8,879) 16,261
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- (2,416) (2,416)
---------- -------- -------- -------- --------- ---------- -------- --------- ---------- ----------
Net income (loss) $ 45,661 34,192 7,752 (4,253) 4,903 88,255 (63,115) -- (11,295) 13,845
========== ======== ======== ======== ========= ========== ======== ========= ========== ==========
(a) Income taxes are based on a percentage of net income before tax for
the individual operating segment.
43
NINE MONTHS ENDED SEPTEMBER 30, 2006
--------------------------------------------------------------------------------------------------------
STUDENT TUITION ENROLLMENT "BASE NET
ASSET LOAN PAYMENT SERVICES SOFTWARE CORPORATE ELIMINATION INCOME" GAAP
GENERATION AND PROCESSING AND AND ACTIVITY AND ADJUSTMENTS RESULTS
AND GUARANTY AND CAMPUS LIST TECHNICAL TOTAL AND RECLASS- TO GAAP OF
MANAGEMENT SERVICING COMMERCE MANAGEMENT SERVICES SEGMENTS OVERHEAD IFICATIONS RESULTS OPERATIONS
--------------------------------------------------------------------------------------------------------
Total interest income $1,128,285 5,905 2,685 356 67 1,137,298 1,483 (579) -- 1,138,202
Interest expense 876,259 -- 5 -- -- 876,264 17,874 (579) -- 893,559
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net interest income 252,026 5,905 2,680 356 67 261,034 (16,391) -- -- 244,643
Less provision for
loan losses 13,508 -- -- -- -- 13,508 -- -- -- 13,508
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net interest income after
provision
for loan losses 238,518 5,905 2,680 356 67 247,526 (16,391) -- -- 231,135
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Other income (expense):
Loan and guarantee
servicing income -- 91,428 -- -- -- 91,428 -- -- -- 91,428
Other fee-based income 8,472 -- 25,483 31,495 -- 65,450 -- -- -- 65,450
Software services income 182 1 -- 92 11,551 11,826 -- -- -- 11,826
Other income 16,720 68 -- -- -- 16,788 1,683 -- -- 18,471
Intersegment revenue -- 46,015 365 756 13,014 60,150 506 (60,656) -- --
Derivative market value,
foreign currency,
and put option adjustments -- -- -- -- -- -- -- -- (11,565) (11,565)
Derivative settlements, net 18,412 -- -- -- -- 18,412 (1,993) -- -- 16,419
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Total other income
(expense) 43,786 137,512 25,848 32,343 24,565 264,054 196 (60,656) (11,565) 192,029
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Operating expenses:
Salaries and benefits 39,776 62,426 13,087 8,549 15,709 139,547 28,864 (8,296) 1,271 161,386
Other expenses 38,628 24,106 6,157 16,047 2,214 87,152 42,956 -- 17,304 147,412
Intersegment expenses 38,959 9,386 497 -- -- 48,842 3,518 (52,360) -- --
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Total operating expenses 117,363 95,918 19,741 24,596 17,923 275,541 75,338 (60,656) 18,575 308,798
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Income (loss) before
income taxes 164,941 47,499 8,787 8,103 6,709 236,039 (91,533) -- (30,140) 114,366
Income tax expense
(benefit) (a) 62,678 18,049 3,338 3,079 2,549 89,693 (37,355) -- (10,002) 42,336
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net income (loss)
before minority interest 102,263 29,450 5,449 5,024 4,160 146,346 (54,178) -- (20,138) 72,030
Minority interest in
subsidiary income -- -- (242) -- -- (242) -- -- -- (242)
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net income (loss)
from continuing
operations 102,263 29,450 5,207 5,024 4,160 146,104 (54,178) -- (20,138) 71,788
Income (loss) from
discontinued operations,
net of tax -- -- -- -- -- -- -- -- 3,677 3,677
---------- -------- -------- -------- -------- ---------- -------- -------- ---------- -----------
Net income (loss) $ 102,263 29,450 5,207 5,024 4,160 146,104 (54,178) -- (16,461) 75,465
========== ======== ======== ======== ======== ========== ======== ======== ========== ===========
(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.
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.
44
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 nine months ended September 30, 2007 and 2006:
45
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
----------------------------------------------------------------------------------------
THREE MONTHS ENDED SEPTEMBER 30, 2007
----------------------------------------------------------------------------------------
Derivative market value, foreign currency,
and put option adjustments $ (20,017) -- -- -- -- 1,568 (18,449)
Amortization of intangible assets 1,372 1,350 1,434 6,442 287 -- 10,885
Non-cash stock based compensation related --
to business combinations -- -- -- -- -- 503 503
Variable-rate floor income (597) -- -- -- -- -- (597)
Income (loss) from discontinued
operations, net of tax -- (909) -- -- -- -- (909)
Net tax effect (a) 7,312 (513) (545) (2,448) (109) (726) 2,971
----------- ------------ ------------- ------------ ----------- ----------- ----------
Total adjustments to GAAP $ (11,930) (72) 889 3,994 178 1,345 (5,596)
=========== ============ ============= ============ =========== =========== ==========
THREE MONTHS ENDED SEPTEMBER 30, 2006
----------------------------------------------------------------------------------------
Derivative market value, foreign currency,
and put option adjustments $ 76,404 -- -- -- -- 3,504 79,908
Amortization of intangible assets 2,228 1,038 1,305 1,498 120 -- 6,189
Non-cash stock based compensation related
to business combinations -- -- -- -- -- 476 476
Variable-rate floor income -- -- -- -- -- -- --
Income (loss) from discontinued
operations, net of tax -- (1,107) -- -- -- -- (1,107)
Net tax effect (a) (29,880) (382) (496) (569) (46) (181) (31,554)
----------- ------------ ------------- ------------ ----------- ----------- ----------
Total adjustments to GAAP $ 48,752 (451) 809 929 74 3,799 53,912
=========== ============ ============= ============ =========== =========== ==========
NINE MONTHS ENDED SEPTEMBER 30, 2007
----------------------------------------------------------------------------------------
Derivative market value, foreign currency,
and put option adjustments $ (7,801) -- -- -- -- (4,064) (11,866)
Amortization of intangible assets 5,197 3,744 4,372 9,797 904 -- 24,014
Non-cash stock based compensation related --
to business combinations -- -- -- -- -- 1,456 1,456
Variable-rate floor income (597) -- -- -- -- -- (597)
Income (loss) from discontinued
operations, net of tax -- 2,416 -- -- -- -- 2,416
Net tax effect (a) 1,216 (1,423) (1,661) (3,723) (343) 1,806 (4,128)
----------- ------------ ------------- ------------ ----------- ----------- ----------
Total adjustments to GAAP $ (1,985) 4,737 2,711 6,074 561 (803) 11,295
=========== ============ ============= ============ =========== =========== ==========
NINE MONTHS ENDED SEPTEMBER 30, 2006
----------------------------------------------------------------------------------------
Derivative market value, foreign currency,
and put option adjustments $ 7,744 -- -- -- -- 3,821 11,565
Amortization of intangible assets 6,684 3,369 4,173 2,718 360 -- 17,304
Non-cash stock based compensation related
to business combinations -- -- -- -- -- 1,271 1,271
Variable-rate floor income -- -- -- -- -- -- --
Income (loss) from discontinued
operations, net of tax -- (3,677) -- -- -- -- (3,677)
Net tax effect (a) (5,482) (1,281) (1,585) (1,033) (138) (483) (10,002)
----------- ------------ ------------- ------------ ----------- ----------- ----------
Total adjustments to GAAP $ 8,946 (1,589) 2,588 1,685 222 4,609 16,461
=========== ============ ============= ============ =========== =========== ==========
46
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. 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 operations.
"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
operations. 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 operations 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.
47
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.
VARIABLE-RATE FLOOR INCOME: Loans that reset annually on July 1 can generate
excess spread income compared with the rate based on the special allowance
payment formula in declining interest rate environments. The Company refers to
this additional income as variable-rate floor income. The Company excludes
variable-rate floor income from its base net income since its timing and amount
(if any) is uncertain, it has been eliminated by legislation for all loans
originated on and after April 1, 2006, and it is in excess of expected spreads.
In addition, because variable-rate floor income is subject to the underlying
rate for the subject loans being reset annually on July 1, it is a factor beyond
the Company's control which can affect the period-to-period comparability of
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.
STUDENT LOAN PORTFOLIO
The table below outlines the components of the Company's student loan portfolio:
AS OF SEPTEMBER 30, 2007 AS OF DECEMBER 31, 2006
------------------------ ------------------------
DOLLARS PERCENT DOLLARS PERCENT
------------- --------- -------------- --------
Federally insured:
Stafford $ 6,683,801 25.1 % $ 5,724,586 24.1 %
PLUS/SLS 419,940 1.6 365,112 1.5
Consolidation 18,824,726 70.9 17,127,623 72.0
Non-federally insured 251,503 0.9 197,147 0.8
------------- --------- -------------- --------
Total 26,179,970 98.5 23,414,468 98.4
Unamortized premiums and deferred
origination costs 460,167 1.7 401,087 1.7
Allowance for loan losses:
Allowance - federally insured (23,907) (0.1) (7,601) (0.0)
Allowance - non-federally insured (20,107) (0.1) (18,402) (0.1)
------------- --------- -------------- --------
Net $26,596,123 100.0 % $ 23,789,552 100.0 %
============= ========= ============== ========
The Company's net student loan assets have increased $2.8 billion, or 11.8%, to
$26.6 billion as of September 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:
48
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2007 2006 2007 2006
-------------- -------------- ------------- ---------------
Beginning balance $ 25,746,000 22,012,670 23,414,468 19,912,955
Direct channel:
Consolidation loan originations 914,842 1,493,981 2,815,791 3,563,910
Less consolidation of existing portfolio (537,539) (726,700) (1,450,326) (1,727,900)
-------------- -------------- ------------- ---------------
Net consolidation loan originations 377,303 767,281 1,365,465 1,836,010
Stafford/PLUS loan originations 426,740 385,997 923,450 843,162
Branding partner channel (a) (b) 125,220 94,229 583,213 841,258
Forward flow channel 178,226 336,775 946,342 1,268,288
Other channels (b) 24,373 2,070 791,087 480,528
-------------- -------------- ------------- ---------------
Total channel acquisitions 1,131,862 1,586,352 4,609,557 5,269,246
Repayments, claims, capitalized
interest, and other (192,700) (368,789) (826,066) (1,187,813)
Consolidation loans lost to external parties (200,719) (342,400) (627,473) (923,600)
Loans sold (17,661) (353,172) (103,704) (536,127)
Participations, net (286,812) -- (286,812) --
-------------- -------------- ------------- ---------------
Ending balance $ 26,179,970 22,534,661 26,179,970 22,534,661
============== ============== ============= ===============
(a) Included in the branding partner channel are private loan originations
of $22.1 million and $84.2 million for the three and nine months ended
September 30, 2007, respectively, and $14.9 million and $36.0 million
for the three and nine months ended September 30, 2006, respectively.
(b) Included in other channels for the nine months ended September 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 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 $11.9 million and $42.8 million for
the three and nine months ended September 30, 2007, respectively, and $74.9
million and $236.7 million for the three and nine months ended September 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.
On September 27, 2007, the President signed into law the College Cost Reduction
Act. The adoption of the Act has resulted in a reduction in the yields on
student loans and, accordingly, a reduction in the amount of the premium the
Company will be able to pay lenders under its forward flow commitments and
branding partner arrangements. As a result, the Company has been working with
its forward flow and branding partner clients to renegotiate the premiums
payable under its agreements. There can be no assurance that the Company will be
successful in renegotiating the premiums under these agreements and,
accordingly, the Company may be required to terminate commitments which are not
economically reasonable. As a result, the Company may experience a decrease in
its forward flow and branding partner loan volume. The Company has also had to
terminate its affinity and referral programs and accordingly may experience a
decrease in loan volume as a result.
As part of the Company's asset management strategy, the Company periodically
sells student loan portfolios to third parties. During the three and nine months
ended September 30, 2007 and 2006, the Company sold $17.7 million and $103.7
million, and $353.2 million and $536.1 million (par value), respectively, of
student loans resulting in the recognition of gains of $0.5 million and $3.3
million, and $11.7 million and $13.5 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:
49
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
--------------------------- --------------------------
2007 2006 2007 2006
------------ ------------- ------------ ------------
Balance at beginning of period $ 27,140 24,180 26,003 13,390
Provision for loan losses:
Federally insured loans 17,040 800 20,158 8,268
Non-federally insured loans 1,300 900 3,470 5,240
------------ ------------- ------------ ------------
Total provision for loan losses 18,340 1,700 23,628 13,508
Charge-offs, net of recoveries:
Federally insured loans (1,327) (284) (3,852) (849)
Non-federally insured loans (139) (502) (594) (955)
------------ ------------- ------------ ------------
Net charge-offs (1,466) (786) (4,446) (1,804)
Sale of non-federally insured loans -- -- (1,171) --
------------ ------------- ------------ ------------
Balance at end of period $ 44,014 25,094 44,014 25,094
============ ============= ============ ============
Allocation of the allowance for loan losses:
Federally insured loans $ 23,907 7,517 23,907 7,517
Non-federally insured loans 20,107 17,577 20,107 17,577
------------ ------------- ------------ ------------
Total allowance for loan losses $ 44,014 25,094 44,014 25,094
============ ============= ============ ============
Net loan charge-offs as a percentage of average student loans 0.023 % 0.014 % 0.024 % 0.011 %
Total allowance as a percentage of average student loans 0.170 % 0.113 % 0.177 % 0.118 %
Total allowance as a percentage of ending balance
of student loans 0.168 % 0.111 % 0.168 % 0.111 %
Non-federally insured allowance as a percentage of the ending
balance of non-federally insured loans 7.995 % 9.740 % 7.995 % 9.740 %
Average student loans $25,866,660 22,170,118 24,799,585 21,268,972
Ending balance of student loans 26,179,970 22,534,661 26,179,970 22,534,661
Ending balance of non-federally insured loans 251,503 180,462 251,503 180,462
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. During the three months ended
September 30, 2007, the Company recorded an expense of $15.7 million to increase
the Company's allowance for loan losses related to the increase in risk share as
a result of the elimination of the Exceptional Performer program.
50
Delinquencies have the potential to adversely impact the Company's earnings
through increased servicing and collection costs and account charge-offs. The
table below shows the Company's student loan delinquency amounts:
AS OF SEPTEMBER 30, 2007 AS OF DECEMBER 31, 2006
------------------------ ------------------------
DOLLARS PERCENT DOLLARS PERCENT
-------------- -------- -------------- -------
Federally Insured Loans:
Loans in-school/grace/deferment(1) $ 7,752,839 $ 6,271,558
Loans in forebearance(2) 2,911,031 2,318,184
Loans in repayment status:
Loans current 13,354,390 87.5 % 12,944,768 88.5 %
Loans delinquent 31-60 days(3) 631,940 4.1 623,439 4.3
Loans delinquent 61-90 days(3) 328,251 2.2 299,413 2.0
Loans delinquent 91 days or greater(4) 950,016 6.2 759,959 5.2
-------------- -------- -------------- -------
Total loans in repayment 15,264,597 100.0 % 14,627,579 100.0 %
-------------- ======== -------------- =======
Total federally insured loans $ 25,928,467 $ 23,217,321
============== ==============
NON-FEDERALLY INSURED LOANS:
Loans in-school/grace/deferment(1) $ 118,390 $ 83,973
Loans in forebearance(2) 8,731 6,113
Loans in repayment status:
Loans current 116,445 93.6 % 101,084 94.4 %
Loans delinquent 31-60 days(3) 3,816 3.1 2,681 2.5
Loans delinquent 61-90 days(3) 1,940 1.5 1,233 1.2
Loans delinquent 91 days or greater(4) 2,181 1.8 2,063 1.9
-------------- -------- -------------- -------
Total loans in repayment 124,382 100.0 % 107,061 100.0 %
-------------- ======== -------------- =======
Total non-federally insured loans $ 251,503 $ 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 SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2007 2006 2007 2006
-------------- --------------- ------------- ---------------
Student loan yield 7.83 % 7.91 % 7.87 % 7.84 %
Consolidation rebate fees (0.76) (0.72) (0.77) (0.71)
Premium and deferred origination costs amortization (0.36) (0.39) (0.36) (0.41)
-------------- --------------- ------------- ---------------
Student loan net yield 6.71 6.80 6.74 6.72
Student loan cost of funds (a) (5.65) (5.32) (5.54) (4.99)
-------------- --------------- ------------- ---------------
Student loan spread 1.06 1.48 1.20 1.73
Variable-rate floor income (0.01) -- -- --
Special allowance yield adjustment, net of
settlements on derivatives (b) -- (0.14) -- (0.28)
-------------- --------------- ------------- ---------------
Core student loan spread 1.05 % 1.34 % 1.20 % 1.45 %
============== =============== ============= ===============
Average balance of student loans $ 25,866,660 22,170,118 24,799,585 21,268,972
Average balance of debt outstanding 27,321,874 23,881,928 26,293,342 22,984,011
51
(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 during the three and
nine month periods ended September 30, 2007 compared to the same periods in 2006
has been primarily due to (i) the increase in the cost of debt as a result of
the disruptions in the debt and secondary capital markets in the third quarter
of 2007; (ii) an increase in lower yielding consolidation loans and an increase
in the consolidation rebate fees; and (iii) 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. Additional compression
during the nine month period ended September 30, 2007 compared to the nine
months ended September 30, 2006 was due to 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 first six months in 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 first six months of 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 1.04% and 1.16% for the three and nine months ended September 30,
2007, respectively, and 1.20% and 1.29% for the same periods in 2006,
respectively.
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE AND NINE
MONTHS ENDED SEPTEMBER 30, 2006
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------- ----------------------------------
2007 2006 $ Change 2007 2006 $ Change
---------- --------- --------- ---------- ---------- ----------
Net interest income after the provision
for loan losses $ 50,920 73,148 (22,228) 193,527 238,518 (44,991)
Loan and guarantee servicing income 170 -- 170 288 -- 288
Other fee-based income 3,526 2,538 988 10,511 8,472 2,039
Software services income -- 67 (67) -- 182 (182)
Other income 1,673 12,917 (11,244) 7,617 16,720 (9,103)
Derivative settlements, net (4,065) 6,966 (11,031) (4,950) 18,412 (23,362)
---------- --------- --------- ---------- ---------- ----------
Total other income 1,304 22,488 (21,184) 13,466 43,786 (30,320)
Salaries and benefits 6,154 14,367 (8,213) 20,600 39,776 (19,176)
Restructure expense - severance and contract
termination costs 1,921 -- 1,921 1,921 -- 1,921
Impairment of assets 28,291 -- 28,291 28,291 -- 28,291
Other expenses 7,429 11,627 (4,198) 22,940 38,628 (15,688)
Intersegment expenses 20,924 12,813 8,111 59,594 38,959 20,635
---------- --------- --------- ---------- ---------- ----------
Total operating expenses 64,719 38,807 25,912 133,346 117,363 15,983
---------- --------- --------- ---------- ---------- ----------
"Base net income (loss)" before income taxes (12,495) 56,829 (69,324) 73,647 164,941 (91,294)
Income tax expense (benefit) (4,748) 21,595 (26,343) 27,986 62,678 (34,692)
---------- --------- --------- ---------- ---------- ----------
"Base net income (loss)" $ (7,747) 35,234 (42,981) 45,661 102,263 (56,602)
========== ========= ========= ========== ========== ==========
After Tax Operating Margin (14.8%) 36.8% 22.1% 36.2%
After Tax Operating Margin -
excluding restructure expense,
impairment of assets, and provision
for loan losses related to the loss of
Exceptional Performer 39.7% 36.8% 35.8% 36.2%
52
NET INTEREST INCOME AFTER THE PROVISION FOR LOAN LOSSES
THREE MONTHS
ENDED SEPTEMBER 30, CHANGE
----------------------- ---------------------
2007 2006 DOLLARS PERCENT
---------- ----------- --------- ----------
Loan interest $ 509,596 441,678 67,918 15.38 %
Consolidation rebate fees (49,492) (39,973) (9,519) (23.81)
Amortization of loan premiums and
deferred origination costs (23,450) (21,569) (1,881) (8.72)
---------- ----------- --------- ----------
Total loan interest 436,654 380,136 56,518 14.87
Investment interest 17,399 21,878 (4,479) (20.47)
---------- ----------- --------- ----------
Total interest income 454,053 402,014 52,039 12.94
---------- ----------- --------- ----------
Interest on bonds and notes payable 384,793 327,166 57,627 17.61
Intercompany interest -- -- -- --
Provision for loan losses 18,340 1,700 16,640 978.82
---------- ----------- --------- ----------
Net interest income after provision for
loan losses $ 50,920 73,148 (22,228) (30.39)%
========== =========== ========= ==========
o Loan interest for the three months ended September 30, 2006 included
$2.8 million of 9.5% special allowance payments. The Company received no
9.5% special allowance payments for the three months ended September 30,
2007 as a result of the Settlement Agreement with the Department.
o The average student loan portfolio increased $3.7 billion, or 16.7%, for
the three months ended September 30, 2007 compared to the same period in
2006. Student loan yield, excluding 9.5% special allowance payments,
decreased to 7.83% in 2007 from 7.85% in 2006. Loan interest income,
excluding the 9.5% special allowance payments, increased $70.7 million
as a result of these factors.
o Consolidation rebate fees increased due to the $3.2 billion, or 20.1%,
increase in the consolidation loan portfolio.
o The amortization of loan premiums and deferred origination costs
increased $1.9 million, or 8.7%, 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
September 30, 2006, the Company recognized $1.6 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 third quarter of 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 $57.6 million due to the $3.4 billion, or
14.4%, increase in average debt for the three months ended September 30,
2007 compared to the same period in 2006. In addition, the Company's
cost of funds (excluding net derivative settlements) increased to 5.59%
for the three months ended September 30, 2007 compared to 5.44% for the
same period a year ago.
o The provision for loan loss increased because the Company recognized a
$15.7 million provision in the third quarter of 2007 on its federally
insured portfolio as a result of the College Cost Reduction Act which
was enacted into law on September 27, 2007.
53
NINE MONTHS
ENDED SEPTEMBER 30, CHANGE
------------------------- ----------------------
2007 2006 Dollars Percent
------------ ------------ ----------- ----------
Loan interest $ 1,461,594 1,245,947 215,647 17.31 %
Consolidation rebate fees (143,657) (112,854) (30,803) (27.29)
Amortization of loan premiums and
deferred origination costs (67,143) (64,555) (2,588) (4.01)
------------ ------------ ----------- ----------
Total loan interest 1,250,794 1,068,538 182,256 17.06
Investment interest 51,153 59,747 (8,594) (14.38)
------------ ------------ ----------- ----------
Total interest income 1,301,947 1,128,285 173,662 15.39
------------ ------------ ----------- ----------
Interest on bonds and notes payable 1,081,588 876,172 205,416 23.44
Intercompany interest 3,204 87 3,117 3,582.76
Provision for loan losses 23,628 13,508 10,120 74.92
------------ ------------ ----------- ----------
Net interest income after provision for
loan losses $ 193,527 238,518 (44,991) (18.86)%
============ ============ =========== ==========
o Loan interest for the nine months ended September 30, 2006 included
$35.0 million of 9.5% special allowance payments. The Company received
no 9.5% special allowance payments for the nine months ended September
30, 2007 as a result of the Settlement Agreement with the Department.
o The average student loan portfolio increased $3.5 billion, or 16.6%, for
the nine months ended September 30, 2007 compared to the same period in
2006. Student loan yield, excluding 9.5% special allowance payments,
increased to 7.87% in 2007 from 7.61% 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 $250.7 million as a result of
these factors.
o Consolidation rebate fees increased due to the $3.2 billion, or 20.1%,
increase in the consolidation loan portfolio.
o The amortization of loan premiums and deferred origination costs
increased $2.6 million, or 4.0%, 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 nine months ended
September 30, 2006, the Company recognized $5.0 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 and third
quarter of 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 due to the $3.3 billion, or 14.4%, increase
in average debt for the nine months ended September 30, 2007 compared to
the same period in 2006. In addition, the Company's cost of funds
(excluding net derivative settlements) increased to 5.52% for the nine
months ended September 30, 2007 compared to 5.10% for the same period a
year ago.
o The provision for loan losses increased because the Company recognized a
$15.7 million provision in the third quarter of 2007 on its federally
insured portfolio as a result of the College Cost Reduction Act, offset
by a $6.9 million provision the Company recognized 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 $1.0
million for the three and nine months ended September 30, 2007 compared to 2006,
respectively, as a result of the increase in the average student loan portfolio.
In addition, income from providing investment advisory services and services to
third parties through the Company's licensed broker dealer increased in 2007
compared to 2006.
OTHER INCOME. Other income decreased $11.2 million and $9.1 million for the
three and nine months ended September 30, 2007 compared to 2006, respectively,
as a result of a decrease in the gain on sale of loans, offset by a gain on the
termination of the Company's interest rate floor contracts of $2.1 million in
January 2007.
OPERATING EXPENSES. Excluding the restructure expense of $1.9 million and the
impairment of assets of $28.3 million, operating expenses decreased $4.3
million, or 11.1%, and $14.2 million, or 12.1%, for the three and nine months
ended September 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.
These reductions were offset by an increase in the cost to service loans as a
result of loan growth.
54
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 SEPTEMBER 30, 2007 AS OF SEPTEMBER 30, 2006
-------------------------- --------------------------
DOLLAR PERCENT DOLLAR PERCENT
------------ ------------ ------------ ------------
Company $ 25,491 76.1 % $ 20,600 69.4 %
Third Party 8,026 23.9 9,097 30.6
------------ ------------ ------------ ------------
$ 33,517 100.0 % $ 29,697 100.0 %
============ ============ ============ ============
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE AND NINE
MONTHS ENDED SEPTEMBER 30, 2006
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------- -------------------------------
2007 2006 $ CHANGE 2007 2006 $ CHANGE
----------- --------- ----------- --------- --------- ----------
Net interest income after the provision
for loan losses $ 1,182 2,471 (1,289) 4,607 5,905 (1,298)
Loan and guarantee servicing income 32,870 32,212 658 94,828 91,428 3,400
Software services income -- -- -- -- 1 (1)
Other income -- 7 (7) 11 68 (57)
Intersegment revenue 22,237 15,831 6,406 58,821 46,015 12,806
----------- --------- ----------- --------- --------- ----------
Total other income 55,107 48,050 7,057 153,660 137,512 16,148
Salaries and benefits 21,961 20,320 1,641 66,988 62,426 4,562
Restructure expense - severance and contract
termination costs 1,231 -- 1,231 1,231 -- 1,231
Other expenses 8,565 8,495 70 26,219 24,106 2,113
Intersegment expenses 1,613 3,729 (2,116) 8,681 9,386 (705)
----------- --------- ----------- --------- --------- ----------
Total operating expenses 33,370 32,544 826 103,119 95,918 7,201
----------- --------- ----------- --------- --------- ----------
"Base net income" before income taxes 22,919 17,977 4,942 55,148 47,499 7,649
Income tax expense 8,709 6,831 1,878 20,956 18,049 2,907
----------- --------- ----------- --------- --------- ----------
"Base net income" $ 14,210 11,146 3,064 34,192 29,450 4,742
=========== ========= =========== ========= ========= ==========
After Tax Operating Margin 25.2% 22.1% 21.6% 20.5%
After Tax Operating Margin -
excluding restructure expense 26.6% 22.1% 22.1% 20.5%
55
LOAN AND GUARANTEE SERVICING INCOME. Loan and guaranty servicing income for the
three and nine months ended September 30, 2007 increased from the same periods
in 2006 as follows:
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------------- --------------------------------------
2007 2006 $ CHANGE % CHANGE 2007 2006 $ CHANGE % CHANGE
---------- -------- -------- --------- --------- --------- -------- ---------
Origination and servicing of
FFEL Program loans $ 14,785 17,956 (3,171) (17.7)% $ 42,689 51,024 (8,335) (16.3)%
Origination and servicing of
of non-federally insured student loans 3,173 2,748 425 15.5 7,830 7,228 602 8.3
Servicing and support outsourcing for
guaranty agencies 14,912 11,508 3,404 29.6 44,309 33,176 11,133 33.6
---------- -------- -------- --------- --------- --------- -------- ---------
Loan and guarantee servicing income
to external parties $ 32,870 32,212 658 2.0 % $ 94,828 91,428 3,400 3.7 %
========== ======== ======== ========= ========= ========= ======== =========
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 September 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. During the third quarter of
2007, the Company began to see improvements in operating margin as a result of
(i) reducing certain fixed costs; (ii) achieving operating leverage; and (iii)
realizing operational benefits from integration activities. These integration
activities included servicing platform and certain system conversions which have
increased operating costs 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.
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. 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.
56
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE AND NINE
MONTHS ENDED SEPTEMBER 30, 2006
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------- -------------------------------
2007 2006 $ CHANGE 2007 2006 $ CHANGE
---------- ---------- ----------- -------- --------- ----------
Net interest income after the provision
for loan losses $ 990 1,095 (105) 2,663 2,680 (17)
Other fee-based income 10,316 8,810 1,506 31,492 25,483 6,009
Other income 31 -- 31 59 -- 59
Intersegment revenue 168 137 31 508 365 143
---------- ---------- ----------- -------- --------- ----------
Total other income 10,515 8,947 1,568 32,059 25,848 6,211
---------- ---------- ----------- -------- --------- ----------
Salaries and benefits 5,312 4,285 1,027 15,312 13,087 2,225
Other expenses 2,029 1,901 128 6,522 6,157 365
Intersegment expenses (15) 497 (512) 384 497 (113)
---------- ---------- ----------- -------- --------- ----------
Total operating expenses 7,326 6,683 643 22,218 19,741 2,477
---------- ---------- ----------- -------- --------- ----------
"Base net income" before income taxes 4,179 3,359 820 12,504 8,787 3,717
Income tax expense 1,588 1,276 312 4,752 3,338 1,414
---------- ---------- ----------- -------- --------- ----------
"Base net income" before minority interest 2,591 2,083 508 7,752 5,449 2,303
Minority interest -- -- -- -- (242) 242
---------- ---------- ----------- -------- --------- ----------
"Base net income" $ 2,591 2,083 508 7,752 5,207 2,545
========== ========== =========== ======== ========= ==========
After Tax Operating Margin 22.5% 20.7% 22.3% 19.1%
Other fee-based income increased for the three and nine months ended September
30, 2007 compared to 2006 as a result of an increase in the number of managed
tuition payment plans as well as an increase in campus commerce and clients. In
addition, for the nine months ended September 30, 2007, approximately $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 and increase in
campus commerce sales. In addition, the timing of the acquisition of infiNET
resulted in a $0.5 million increase in operating expenses for the nine months
ended September 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.
57
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE AND NINE
MONTHS ENDED SEPTEMBER 30, 2006
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------- --------------------------------
2007 2006 $ CHANGE 2007 2006 $ CHANGE
---------- ---------- ----------- --------- ---------- ----------
Net interest income after the provision
for loan losses $ 109 144 (35) 285 356 (71)
Other fee-based income 23,471 19,873 3,598 73,341 31,495 41,846
Software services income 169 52 117 456 92 364
Intersegment revenue (37) (9) (28) 891 756 135
---------- ---------- ----------- --------- ---------- ----------
Total other income 23,603 19,916 3,687 74,688 32,343 42,345
Salaries and benefits 8,095 5,437 2,658 26,486 8,549 17,937
Restructure expense - severance and contract
termination costs 737 -- 737 737 -- 737
Impairment of assets 11,401 -- 11,401 11,401 -- 11,401
Other expenses 13,809 13,344 465 42,957 16,047 26,910
Intersegment expenses 67 -- 67 252 -- 252
---------- ---------- ----------- --------- ---------- ----------
Total operating expenses 34,109 18,781 15,328 81,833 24,596 57,237
---------- ---------- ----------- --------- ---------- ----------
"Base net income (loss)" before income taxes (10,397) 1,279 (11,676) (6,860) 8,103 (14,963)
Income tax expense (benefit) (3,951) 486 (4,437) (2,607) 3,079 (5,686)
---------- ---------- ----------- --------- ---------- ----------
"Base net income (loss)" $ (6,446) 793 (7,239) (4,253) 5,024 (9,277)
========== ========== =========== ========= ========== ==========
After Tax Operating Margin (27.2%) 4.0% (5.7%) 15.4%
After Tax Operating Margin -
excluding restructure expense and
impairment of assets 4.6% 4.0% 4.4% 15.4%
Other fee-based income increased $2.3 million and $39.8 million for the three
and nine months ended September 30, 2007 compared to 2006 as a result of the
acquisition of Peterson's and CUnet, respectively. The remaining increase is a
result of an increase in lead generation services.
Operating expenses increased $2.3 million and $39.8 million for the three and
nine months ended September 30, 2007 compared to 2006 as a result of the
acquisitions of Peterson's and CUnet, respectively. Included in operating
expenses for the three months ended September 30, 2007, is an impairment charge
of $11.4 million recognized by the Company as a result of the passage of the
College Cost Reduction Act. See notes 3 and 8 in the notes to the consolidated
financial statements included in this Report for additional information
concerning this impairment charge. The increase in operating expenses, excluding
the impact of acquisitions, the impairment charge, and certain restructuring
charges taken during the third quarter of 2007 was $0.9 million and $5.3 million
for the three and nine months ended September 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 and increase in costs
to support the increase in revenue.
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.
58
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE THREE AND NINE
MONTHS ENDED SEPTEMBER 30, 2006
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------ ----------------------------------
2007 2006 $ CHANGE 2007 2006 $ CHANGE
--------- --------- -------- --------- ---------- ----------
Net interest income after the provision
for loan losses $ -- 24 (24) 18 67 (49)
Software services income 5,257 4,280 977 16,566 11,551 5,015
Intersegment revenue 4,805 4,629 176 13,026 13,014 12
--------- --------- -------- --------- ---------- ----------
Total other income 10,062 8,909 1,153 29,592 24,565 5,027
--------- --------- -------- --------- ---------- ----------
Salaries and benefits 6,537 5,736 801 18,869 15,709 3,160
Restructure expense - severance and contract
termination costs 58 -- 58 58 -- 58
Other expenses 689 766 (77) 2,224 2,214 10
Intersegment expenses 147 -- 147 550 -- 550
--------- --------- -------- --------- ---------- ----------
Total operating expenses 7,431 6,502 929 21,701 17,923 3,778
--------- --------- -------- --------- ---------- ----------
"Base net income" before income taxes 2,631 2,431 200 7,909 6,709 1,200
Income tax expense 1,000 924 76 3,006 2,549 457
--------- --------- -------- --------- ---------- ----------
"Base net income" $ 1,631 1,507 124 4,903 4,160 743
========= ========= ======== ========= ========== ==========
After Tax Operating Margin 16.2% 16.9% 16.6% 16.9%
After Tax Operating Margin -
excluding restructure expense 16.6% 16.9% 16.7% 16.9%
Software services income increased $1.0 million and $5.0 million for the three
and nine months ended September 30, 2007 compared to the same periods in 2006 as
a result of new customers, additional projects for existing customers, and
increased fees. The increase in operating expenses was driven by additional
costs associated with salaries and benefits to support the additional income.
The decrease in operating margin in 2007 was due to lower margin on intersegment
revenue.
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 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 September 30, 2007 the
Company had $125.0 million outstanding on a $750.0 million unsecured line of
credit with $625.0 million available for future use. 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 September
30, 2007, there were no borrowings outstanding on this line.
59
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 September 30, 2007, the Company had $0.2 billion of Secured
Liquidity Notes outstanding and an additional $4.8 billion authorized for future
issuance under this warehouse program. However, during the third quarter of
2007, as a result of the disruption of the credit markets, there was no market
for the issuance of new Secured Liquidity Notes and it is currently unlikely a
market will exist in the future. As a result, the Company wrote-off $1.3 million
of debt issuance costs related to this facility. This expense is included in
"interest on bonds and notes payable" on the Company's consolidated statements
of operations.
The Company also utilizes bank supported commercial paper conduit programs for
loan warehousing. During the third quarter 2007, as a result of there not being
a market for the Company's Secured Liquidity Notes, the Company increased its
capacity in these programs by $4.4 billion. The Company had a loan warehousing
capacity of $8.2 billion as of September 30, 2007, of which $6.1 billion was
outstanding and $2.1 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.
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 $28.2 billion of debt outstanding as of September 30, 2007, $21.2 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.
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%,
60
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 September 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
September 30, 2007:
CARRYING INTEREST RATE
AMOUNT RANGE FINAL MATURITY
------------ ------------- ----------------
Variable-rate bonds and notes (a):
Bonds and notes based on indices $18,624,339 3.75% - 6.20% 05/01/11 - 05/01/42
Bonds and notes based on auction 2,385,795 3.85% - 6.79% 11/01/09 - 07/01/43
------------
Total variable-rate bonds and notes 21,010,134
Commercial paper and other 6,349,995 5.27% - 6.06% 10/17/07 - 05/09/08
Fixed-rate bonds and notes (a) 217,780 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 125,000 6.09% 05/08/12
Other borrowings 56,238 5.10% - 5.45% 09/28/08 - 11/01/15
------------
$28,234,147
============
(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 September 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 $ 28,234,147 6,538,922 353,654 129,961 21,211,610
Operating lease obligations 52,972 10,454 19,878 13,085 9,555
Other 13,804 8,150 5,654 -- --
-------------- ----------- ----------- ----------- -----------
Total $ 28,300,923 6,557,526 379,186 143,046 21,221,165
============== =========== =========== =========== ===========
The Company had a $7.8 million reserve as of September 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 $6.3
billion under its loan warehouse facilities. Historically, the Company has been
able to renew its commercial paper conduit programs, including the underlying
liquidity agreements.
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.
61
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.
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 September 30, 2007, the Company has made payments
of $6.0 million related to this contingency and has accrued an
additional $6.9 million 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 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 8, 2008, the holders may
require the Company to repurchase all or part of the shares at a price
of $37.10 per share. The value of this put option as of September 30,
2007 was $4.6 million and is included in "other" in the above table.
DIVIDENDS
During each of the first three 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 currently plans to continue making a quarterly dividend payment in
the future, subject to future earnings, capital requirements, financial
condition, and other factors.
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
62
level of the Company's future provision for loan losses. The Company places a
non-federally insured loan on nonaccrual status and charges off the loan when
the collection of principal and interest is 120 days past due.
The allowance for federally insured and non-federally insured loans is
maintained at a level management believes is adequate to provide for estimated
probable credit losses inherent in the loan portfolio. This evaluation is
inherently subjective because it requires estimates that may be susceptible to
significant changes.
STUDENT LOAN INCOME
The Company recognizes student loan income as earned, net of amortization of
loan premiums and deferred origination costs. Loan income is recognized based
upon the expected yield of the loan after giving effect to borrower utilization
of incentives such as 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.
63
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
The Company's primary market risk exposure arises from fluctuations in its
borrowing and lending rates, the spread between which could impact the Company
due to shifts in market interest rates. Because the Company generates a
significant portion of its earnings from its student loan spread, the interest
sensitivity of the balance sheet is a key profitability driver.
The Company's portfolio of FFELP loans originated prior to April 1, 2006 earns
interest at the higher of a variable rate based on the special allowance payment
(SAP) formula set by the Department and the borrower rate. The SAP formula is
based on an applicable index plus a fixed spread that is dependent upon when the
loan was originated, the loan's repayment status, and funding sources for the
loan. As a result of one of the provisions of HERA, the Company's portfolio of
FFELP loans originated on or after April 1, 2006 earns interest at a variable
rate based on the SAP formula. For the portfolio of loans originated on or after
April 1, 2006, when the borrower rate exceeds the variable rate based on the SAP
formula, the Company must return the excess to the Department.
The following table sets forth the Company's loan assets and debt instruments by
rate characteristics:
AS OF SEPTEMBER 30, 2007 AS OF DECEMBER 31, 2006
-------------------------- -------------------------
DOLLARS PERCENT DOLLARS PERCENT
-------------- ---------- -------------- ---------
Fixed-rate loan assets $ 739,618 2.8 % $ 787,378 3.4 %
Variable-rate loan assets 25,440,352 97.2 22,627,090 96.6
-------------- ---------- -------------- ---------
Total $ 26,179,970 100.0 % $ 23,414,468 100.0 %
============== ========== ============== =========
Fixed-rate debt instruments $ 692,780 2.5 % $ 878,431 3.4 %
Variable-rate debt instruments 27,541,367 97.5 24,683,688 96.6
-------------- ---------- -------------- ---------
Total $ 28,234,147 100.0 % $ 25,562,119 100.0 %
============== ========== ============== =========
The following table shows the Company's student loan assets currently earning at
a fixed rate as of September 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% 8.24% 5.60% $ 357,752
> 9.0% 9.05 6.41 381,866
-------------------
$ 739,618
===================
-------------------
(a) The estimated variable conversion rate is the estimated short-term
interest rate at which loans would convert to variable rate.
(b) As of September 30, 2007, the Company had $217.8 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 September 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 nine months ended September 30, 2007 and 2006,
loan interest income includes approximately $0.8 million and $7.0 million and
$3.6 million and $16.3 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.
64
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:
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 September 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
================== ================== ================= ================= ==============
65
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.
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
operations and resulted in a gain of $72.7 million and $93.0 million for the
three and nine months ended September 30, 2007, respectively, and a loss of
$83.5 million and a gain of $23.2 million for the three and nine months ended
September 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 operations:
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
--------------------- --------------------
2007 2006 2007 2006
----------- -------- -------- ----------
Interest rate swaps derivatives- loan portfolio $ -- 4,317 4,753 9,357
Basis swaps - loan portfolio (2,608) (145) (2,489) (656)
Interest rate swaps - other (a) 1,729 -- 12,050 --
Special allowance yield adjustment derivatives (a) -- 7,909 -- 19,794
Cross-currency interest rate swaps (1,457) (5,115) (7,214) (10,083)
Other (b) -- (1,993) -- (1,993)
----------- -------- -------- ----------
Derivative settlements, net $ (2,336) 4,973 7,100 16,419
=========== ======== ======== ==========
(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 4th quarter
2006. Settlements on the 9.5% special allowance derivatives were
classified in the special allowance yield adjustment derivatives line
item through September 30, 2006. Also included in derivative settlements
for interest rate swaps "other" are the off-setting derivatives entered
into in the 2nd quarter 2007.
(b) During 2006, the Company issued junior subordinated hybrid securities
and entered into a derivative instrument to economically lock into a
fixed interest rate prior to the actual pricing of the transaction. Upon
pricing of these notes, the Company terminated this derivative
instrument. The consideration paid by the Company to terminate this
derivative was $2.0 million.
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.
66
THREE MONTHS ENDED SEPTEMBER 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 $ 7,557 27.7 % $ 159 0.6 % $ 1,395 5.1 %
Impact of derivative settlements - - - - - -
------------- ----------- ------------- --------- ------------ ----------
Increase in net income before taxes $ 7,557 27.7 % 159 0.6 % 1,395 5.1 %
============= =========== ============= ========= ============ ==========
Increase in basic and diluted
earning per share $ 0.09 $ - $ 0.02
============= ============= ============
THREE MONTHS ENDED SEPTEMBER 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 $ 7,836 22.1 % $ (490) (1.4)% $ 1,029 2.9 %
Impact of derivative settlements (8,759) (24.7) 8,759 24.7 17,518 49.4
------------- ----------- ------------- ---------- ------------ ----------
(Decrease) increase in net income
before taxes $ (923) (2.6) % 8,269 23.3 % 18,547 52.3 %
============= =========== ============= ========== ============ ==========
(Decrease) increase in basic and diluted
earning per share $ (0.01) $ 0.10 0.22
============= ============= ============
NINE MONTHS ENDED SEPTEMBER 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 $ 15,170 58.0 % $ 8,858 33.9 % $ 20,980 80.2 %
Impact of derivative settlements - - - - - -
------------- ----------- ------------- --------- ------------ ----------
Increase in net income before taxes $ 15,170 58.0 % 8,858 33.9 % 20,980 80.2 %
============= =========== ============= ========= ============ ==========
Increase in basic and diluted
earning per share $ 0.20 $ 0.12 $ 0.27
============= ============= ============
NINE MONTHS ENDED SEPTEMBER 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 in pre-tax income
before impact of derivative
settlements $ 31,837 26.5 % $ 5,228 4.4 % $ 15,741 13.1 %
Impact of derivative settlements (25,991) (21.6) 25,991 21.6 51,982 43.3
------------- ----------- ------------- ---------- ------------ ----------
Increase in net income
before taxes $ 5,846 4.9 % 31,219 26.0 % 67,723 56.4 %
============= =========== ============= ========== ============ ==========
Increase in basic and diluted
earning per share $ 0.07 $ 0.36 0.79
============= ============= ============
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 operations.
The Company entered into cross-currency interest rate swaps in connection with
the issuance of the Euro Notes. Under the terms of these derivative instrument
agreements, the Company receives from a counterparty a spread to the EURIBOR
index based on notional amounts of (euro)420.5 million and (euro)352.7 million
and pays a spread to the LIBOR index based on notional amounts of $500.0 million
and $450.0 million, respectively. In addition, under the terms of these
agreements, all principal payments on the Euro Notes will effectively be paid at
the exchange rate in effect as of the issuance of the notes. The Company did not
qualify these derivative instruments as hedges under SFAS No. 133; consequently,
the change in fair value is included in the Company's operating results.
67
For the three and nine months ended September 30, 2007, the Company recorded an
expense of $54.0 million and $79.0 million, respectively, as a result of
re-measurement of the Euro Notes and income of $58.8 million and $85.8 million,
respectively, for the increase in the fair value of the related derivative
instrument. For the three and nine months ended September 30, 2006, the Company
recorded income of $7.1 million and an expense of $30.9 million, respectively,
as a result of the re-measurement of the Euro Notes and an expense of $12.4
million and income of $23.8 million, respectively, for the change 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 statements of
operations.
ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
Under supervision and with the participation of certain members of the Company's
management, including the 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.
INDUSTRY INVESTIGATIONS
On January 11, 2007, the Company received a letter from the New York Attorney
General (the "NYAG") requesting certain information and documents from the
Company in connection with the NYAG's investigation into preferred lender list
activities. Since January 2007, a number of state attorneys general, including
the NYAG, 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. A focus of the inquiries or investigations has 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 NYAG, 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.
68
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 NYAG to
adopt the NYAG's Code of Conduct, which is substantially similar to the Nelnet
Student Loan Code of Conduct. The NYAG's Code of Conduct 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.
On October 10, 2007, the Company received a subpoena from the NYAG requesting
certain information and documents from the Company in connection with the NYAG's
investigation into the direct-to-consumer marketing practices of student
lenders. The Company is cooperating with the request.
While the Company cannot predict the ultimate outcome of any inquiry or
investigation, the Company believes its activities have materially complied with
applicable law, including 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 had
selected 47 schools and 27 lenders for review. Specifically, the Department is
reviewing the Company's practices in connection with the prohibited 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 Company's settlement with the Department of Education in
January 2007 to resolve the OIG audit report with respect to the Company's
student loan portfolio receiving special allowance payments at a minimum 9.5%
interest rate, 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 applicable law,
including the provisions of 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.
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.
On September 27, 2007, the President signed into law the College Cost Reduction
Act. This legislation contains provisions with significant implications for
participants in the FFEL Program by cutting funding to the FFELP Program by $20
billion over the next five years (as estimated by the Congressional Budget
Office). Among other things, this legislation:
o Reduces special allowance payments to for-profit lenders and
not-for-profit lenders by 0.55 percentage points and 0.40 percentage
points, respectively, for both Stafford and Consolidation loans
disbursed on or after October 1, 2007;
o Reduces special allowance payments to for-profit lenders and
not-for-profit lenders by 0.85 percentage points and 0.70 percentage
points, respectively, for PLUS loans disbursed on or after October 1,
2007;
69
o Increases origination fees paid by lenders on all FFELP loan types,
from 0.5 percent to 1.0 percent, for all loans first disbursed on or
after October 1, 2007;
o Eliminates all provisions relating to Exceptional Performer status,
and the monetary benefit associated with it, effective October 1,
2007; and
o Reduces default insurance to 95 percent of the unpaid principal of
such loans, for loans first disbursed on or after October 1, 2012.
The adoption of the College Cost Reduction Act has resulted in reduced annual
yields on FFELP loans originated after October 1, 2007.
In October 2005, the Company entered into an agreement to amend an existing
contract with College Assist. College Assist is the Colorado state-designated
guarantor of FFELP student loans. Under the agreement, the Company provides
student loan servicing and guaranty operations and assumed the operational
expenses and employment of certain College Assist employees. College Assist pays
the Company a portion of the gross servicing and guaranty fees as consideration
for the Company providing these services on behalf of College Assist. As a
result of the passage of the College Cost Reduction Act, on October 2, 2007, the
Department notified College Assist of its decision to formally terminate the
Voluntary Flexible Agreement ("VFA") between the Department and College Assist
effective January 1, 2008. The termination of the VFA will have a negative
impact on the Company's guaranty income.
In addition to the College Cost Reduction Act, 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, rather than 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 other bills have 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 March 31, 2008 (as a
result of the Third 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 Federal Direct Loan and FFEL
Programs, additional lender risk sharing, or the elimination of the FFEL Program
in its entirety.
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.
Legislation has been introduced in Congress modifying the prohibited inducement
provisions of the Higher Education Act, and the Department of Education
published new regulations on November 1, 2007 relating to prohibited inducements
that go into effect on July 1, 2008. The Department has requested that companies
begin complying with the new regulations immediately even though they are not
yet in effect. As a result, the Company has modified, or intends to modify, its
business practices to comply with the prohibited inducement provisions as
ultimately enacted or adopted, including the termination of the Company's
affinity relationships and referral programs. Termination of these programs may
result in decreased loan volume for the Company. In addition, changes to the
Company's business practices in order to comply with the new prohibited
inducement provisions may negatively impact the Company's business.
70
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 had selected 47 schools and 27 lenders for review.
Specifically, the Department is reviewing the Company's practices in connection
with the prohibited 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.
DEBT AND SECONDARY MARKET CONDITIONS COULD HAVE A MATERIAL ADVERSE IMPACT ON THE
COMPANY'S EARNINGS AND FINANCIAL CONDITION.
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 has significant financing needs
that it meets through the capital markets, including the debt and secondary
markets. These markets are currently experiencing unprecedented disruptions,
which could have an adverse impact on the Company's earnings and financial
condition, particularly in the short term.
Current conditions in the debt markets include reduced liquidity and increased
credit risk premiums for most market participants. These conditions can increase
the cost and reduce the availability of debt in the capital markets. The Company
attempts to mitigate the impact of debt market disruptions by obtaining adequate
committed and uncommitted facilities from a variety of reliable sources.
During the third quarter of 2007, the Company increased its warehouse capacity
as a result of the disruptions in the capital markets. As of September 30, 2007,
the Company has loan warehousing capacity of $8.2 billion, of which $6.1 billion
is outstanding, through bank supported commercial paper conduit programs. The
Company has $2.1 billion in warehouse capacity available under its warehouse
facilities.
The Company continues to seek other sources of liquidity. There can be no
assurance, however, that the Company will be successful in these efforts, that
such facilities will be adequate, or that the cost of debt will allow the
Company to operate at profitable levels. Since the Company is dependent on the
availability of credit to finance its operations, disruptions in the debt
markets or a reduction in the Company's credit ratings could have an adverse
impact on the Company's earnings and financial condition, particularly in the
short term.
The secondary markets are also currently experiencing unprecedented disruptions
resulting from reduced investor demand for student loan asset-backed securities
and increased investor yield requirements for those securities. These conditions
may continue or worsen in the future. While management of the Company believes
the Company's capital and liquidity positions are currently strong and the
Company has sufficient capacity to continue to grow its student loan portfolio,
the Company's ability to acquire and hold student loans is not unlimited. As a
result, a prolonged period of secondary market illiquidity may affect the
Company's loan acquisition volumes and could have an adverse impact on the
Company's future earnings and financial condition.
During the third quarter of 2007, similar to all companies that access the debt
and liquidity markets, the Company experienced an increase in interest rates on
its outstanding warehouse facilities as well as reset rates on its longer term
financings. The disruption in the credit markets which is causing an increase in
borrowing rates for the Company has caused compression in the Company's student
loan spread during the third quarter of 2007 and is expected to continue through
the fourth quarter of 2007.
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.
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.
In April 2007, the Company 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.
71
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.
FUTURE LOSSES DUE TO DEFAULTS ON LOANS HELD BY THE COMPANY PRESENT CREDIT RISK
WHICH COULD ADVERSELY AFFECT THE COMPANY'S EARNINGS.
As of September 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
through September 30, 2007.
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. By a
letter dated September 28, 2007, the Department informed the Company that
Nelnet, Inc. has been designated as an Exceptional Performer for the period from
June 1, 2006 through May 31, 2008.
On September 27, 2007, the President signed into law the College Cost Reduction
Act. Among other things, this legislation eliminates all provisions relating to
Exceptional Performer status, and the monetary benefit associated with it,
effective October 1, 2007. Accordingly, the Act eliminated the Company's
Exceptional Performer designation effective October 1, 2007. Accordingly, the
majority of claims submitted on or after October 1, 2007 are subject to
reimbursement at 97% or 98% of principal and accrued interest depending on the
disbursement date of the loan. As a result, during the three month period ended
September 30, 2007, the Company recorded an expense of $15.7 million to increase
the Company's allowance for loan losses related to the increase in risk share as
a result of the elimination of the Exceptional Performer program.
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, and the risk that a school may enter the
Federal Direct Loan Program. Additionally new regulations adopted by the
Department relating to "preferred lender lists" may have the effect of reducing
the Company's loan volume. The Company acquires student loans through forward
flow commitments and branding partner arrangements with other student loan
lenders, but each of these commitments has a finite term. The passage of the
College Cost Reduction Act has resulted in a reduction in the yields on student
loans and, accordingly, a reduction in the amount of the premium the Company
will be able to pay lenders under its forward flow commitments and branding
partner arrangements. As a result, the Company has been working with its forward
flow and branding partner clients to renegotiate the premiums payable under its
agreements. There can be no assurance that the Company will be successful in
renegotiating the premiums under these agreements and, accordingly, the Company
may be required to terminate commitments which are not economically reasonable.
As a result, the Company may experience a decrease in its forward flow and
branding partner 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 or branding partner relationships on terms that are
favorable to the Company, if at all, following their expiration.
New regulations adopted by the Department of Education relating to inducements
specify that referral arrangements are prohibited. Although the Company's
referral arrangements complied with the provisions of the Higher Education Act
and the Department of Education's regulations and guidance thereunder, the
Company will be required, as a result of the new regulations, to terminate any
remaining referral arrangements, which may result in a reduction of the
Company's loan volume.
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.
72
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.
ELIMINATION OF THE FFEL PROGRAM WOULD HAVE A SIGNIFICANT NEGATIVE EFFECT ON THE
COMPANY'S EARNINGS AND OPERATIONS.
In connection with the 2008 presidential election, certain candidates have
proposed the elimination of the FFEL Program. Elimination of the FFEL Program
would significantly impact the Company's operations and profitability by, among
other things, reducing the Company's interest revenues as a result of the
inability to add new FFELP loans to the Company's portfolio and reducing
third-party servicing fees as a result of reduced FFELP loan servicing and
origination volume from the Company's third-party servicing customers. The
Company cannot predict whether any such proposals will ultimately be enacted.
IF MANAGEMENT DOES NOT EFFECTIVELY EXECUTE THE COMPANY'S RESTRUCTURING PROGRAM,
THIS COULD ADVERSELY AFFECT THE COMPANY'S OPERATIONS, REVENUE, AND THE ABILITY
TO COMPETE.
On September 6, 2007, the Company announced a strategic restructuring initiative
to create efficiencies and lower costs in advance of the enactment of this
legislation. The College Cost Reduction Act made severe cuts to the FFEL
Program, which has significant implications for participants in the FFEL
Program, including the Company. In the third quarter of 2007, the Company
recorded $15.0 million of charges related to restructuring and $55.2 million of
charges and expenses as a result of the legislation.
The Company continues to implement its restructuring initiatives, including
lowering the cost of student loan acquisition, creating efficiencies in its
asset generation business, and decreasing operating expenses through a reduction
in workforce and realignment of operating facilities. The Company expects these
initiatives to be substantially completed during the fourth quarter of 2007.
If the Company is unable to successfully implement its reorganization
initiatives or if those initiatives do not have the desired effects or result in
the projected efficiencies, the Company may incur additional or unexpected
expenses which would adversely affect the Company's operations and revenues.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
UNREGISTERED SALES OF EQUITY SECURITIES
Effective as of September 19, 2007, the Company issued a total of 62,446
restricted shares of the Company's Class A common stock to the five former
owners of CUnet, pursuant to the contingent acquisition consideration provisions
of the purchase agreement for the Company's acquisition of CUnet in 2006. Such
shares were valued under the agreement at a total of $1.1 million. For further
information about the nature of this transaction, see note 7 of the notes to the
consolidated financial statements in this Report.
The issuance of the shares was not registered under the Securities Act of 1933
(the "Securities Act") in reliance on the exemption from registration provided
by Section 4(2) of the Securities Act. The facts relied upon to make such
exemption available include the limited number of individuals to whom the shares
were issued and the limited manner of offering, the representations in the
purchase agreement by each such individual as to their status as an "accredited
investor" as defined in Regulation D under the Securities Act, and the
restricted status of the shares as evidenced by a customary restrictive legend
on the certificates for the shares.
PURCHASE OF EQUITY SECURITIES
The following table summarizes the repurchases of Class A common stock during
the third 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.
73
TOTAL NUMBER OF MAXIMUM NUMBER
SHARES PURCHASED OF SHARES THAT MAY
TOTAL NUMBER AVERAGE AS PART OF PUBLICLY YET BE PURCHASED
OF SHARES PRICE PAID ANNOUNCED PLANS UNDER THE PLANS
PERIOD PURCHASED (1) PER SHARE OR PROGRAMS (2) (3) OR PROGRAMS (4)
-------------------------------- -------------- ------------ --------------------- ------------------
July 1 - July 31, 2007 238,495 $ 23.71 258 6,895,073
August 1 - August 31, 2007 478 18.73 478 6,851,056
September 1 - September 30, 2007 151 18.36 151 6,784,374
-------------- ------------ ---------------------
Total 239,124 $ 22.67 887
============== ============ =====================
(1) The total number of shares includes: (i) shares purchased
pursuant to the 2006 Plan discussed in footnote (2) below; and
(ii) shares repurchased pursuant to the 2006 ESLP discussed in
footnote (3) below, of which there were none for the months of
July, August, or September 2007. All shares of Class A common
stock purchased pursuant to the 2006 Plan in July, August, and
September were shares that had been issued to the Company's
401(k) plan and allocated to employee participant accounts
pursuant to the plan's provisions for Company matching
contributions in shares of Company stock, and were purchased by
the Company from the plan pursuant to employee participant
instructions to dispose of such shares, except for 238,237 shares
purchased by the Company in July in connection with a put option
settlement as discussed in note 13 of the notes to the
consolidated financial statements included in this Report. These
shares were originally issued by the Company in February 2006 in
consideration for the purchase of FACTS.
(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
------------------- -----------------------------------------------------------------------------------
July 31, 2007 4,759,235 $ 36,950,000 $ 17.30 2,135,838 6,895,073
August 31, 2007 4,758,757 36,950,000 17.66 2,092,299 6,851,056
September 30, 2007 4,758,606 36,950,000 18.24 2,025,768 6,784,374
74
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
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.
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ITEM 6. EXHIBITS
4.1* Indenture of Trust, dated as of August 1, 2007, by and between
Nelnet Student Loan Trust 2007-2 and Zions First National
Bank, as indenture trustee and eligible lender trustee.
10.1 Real Estate Purchase Agreement dated as of October 31, 2007
between Union Bank and Trust Company and First National Life
Insurance Company of the USA, filed as Exhibit 10.1 to the
registrant's Current Report on Form 8-K filed on November 2,
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
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NELNET, INC.
Date: November 9, 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
77