UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the fiscal year ended December 31, 2004
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 of Incorporation) (I.R.S. Employer Identification No.)
121 SOUTH 13TH STREET, SUITE 201 68508
LINCOLN, NEBRASKA (Zip Code)
(Address of Principal Executive Offices)
Registrant's telephone number, including area code: (402) 458-2370
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS
Class A Common Stock, Par Value $0.01 per Share
NAME OF EACH EXCHANGE ON WHICH REGISTERED:
New York Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
None
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the Registrant is an accelerated filer.
Yes [X] No [ ]
The aggregate market value of the Registrant's voting common stock held by
non-affiliates of the Registrant on June 30, 2004 (the last business day of the
Registrant's most recently completed second fiscal quarter), based upon the
closing sale price of the Registrant's Class A Common Stock on that date of
$17.75, was $360,899,745. For purposes of this calculation, the Registrant's
directors, executive officers, and greater than 10 percent shareholders are
deemed to be affiliates.
As of February 15, 2005, there were 39,687,037 and 13,983,454 shares of Class
A Common Stock and Class B Common Stock, par value $0.01 per share, outstanding,
respectively.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement to be filed for its
2005 Annual Meeting of Shareholders scheduled to be held May 26, 2005 are
incorporated by reference into Part III of this Form 10-K.
This report contains forward-looking statements and information that are
based on management's current expectations as of the date of this document. When
used in this report, the words "anticipate," "believe," "estimate," "intend,"
and "expect," and similar expressions are intended to identify forward-looking
statements. These forward-looking statements are subject to risks,
uncertainties, assumptions, and other factors that may cause the actual results
to be materially different from those reflected in such forward-looking
statements. These factors include, among others, the risks and uncertainties set
forth in "Risk Factors" and elsewhere in this Form 10-K and changes in the terms
of student loans and the educational credit marketplace arising from the
implementation of or changes in applicable laws and regulations, which may
reduce the volume, average term, and costs of yields on student loans under the
Federal Family Education Loan Program (the "FFEL Program" or "FFELP") of the
U.S. Department of Education (the "Department") or result in loans being
originated or refinanced under non-FFELP programs or may affect the terms upon
which banks and others agree to sell FFELP loans to the Company. The Company
could also be affected by changes in the demand for educational financing or in
financing preferences of lenders, educational institutions, students, and their
families; changes in the general interest rate environment and in the
securitization markets for education loans, which may increase the costs or
limit the availability of financings necessary to initiate, purchase, or carry
education loans; losses from loan defaults; and changes in prepayment rates and
credit spreads. References to "the Company" refer to Nelnet, Inc. and its
subsidiaries.
PART I.
ITEM 1. BUSINESS
OVERVIEW
The Company is one of the leading education finance companies in the United
States and is focused on providing quality student loan products and services to
students and schools nationwide. The Company ranks among the nation's leaders in
terms of total net student loan assets with $13.5 billion as of December 31,
2004. Headquartered in Lincoln, Nebraska, the Company originates, consolidates,
securitizes, holds, and services student loans, principally loans originated
under the FFEL Program. A detailed description of the FFEL Program appears in
Appendix A to this annual report on Form 10-K (the "Report").
The Company offers a broad range of financial services and technology-based
products. The Company's products are designed to simplify the student loan
process by automating financial aid delivery, loan processing, and funds
disbursement. The Company's infrastructure, technological expertise, and breadth
of product and service offerings connect the key constituents of the student
loan process, including lenders, financial aid officers, guaranty agencies,
governmental agencies, student and parent borrowers, servicers, and the capital
markets, thereby streamlining the education finance process.
The Company's business is comprised of three primary product and service
offerings:
o ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS.
The Company provides student loan marketing, originations, acquisition,
and portfolio management. The Company owns a large portfolio of student
loan assets through a series of education lending subsidiaries. The
education lending subsidiaries primarily invest in student loans, through
an eligible lender trustee, made under Title IV of the Higher Education
Act of 1965, as amended (the "Higher Education Act"). Certain subsidiaries
also invest in non-federally insured student loans. The Company
obtains loans through direct origination or through acquisition of loans.
The Company also provides marketing, sales, managerial, and administrative
support related to its asset generation activities.
o STUDENT LOAN AND GUARANTEE SERVICING. The Company services its student
loan portfolio and the portfolios of third parties. Servicing activities
include loan origination activities, application processing, borrower
updates, payment processing, due diligence procedures, and claim
processing. In December 2004, the Company purchased EDULINX Canada
Corporation ("EDULINX"). EDULINX is a Canadian corporation that engages in
servicing Canadian student loans. As of December 31, 2004, the Company
serviced or provided complete outsourcing of servicing activities as
follows:
Company % Third party % Total
--------- ------ ----------- ------ ---------
(dollars in millions)
FFELP and private loans $ 11,888 56% $ 9,188 44% $ 21,076
Canadian loans -- -- 7,213 100% 7,213
--------- ------ ---------- ------ ----------
Total $ 11,888 42% $ 16,401 58% $ 28,289
========= ====== ========== ====== ==========
The Company also provides servicing support to guaranty agencies, which
includes system software, hardware and telecommunication support, borrower
and loan updates, default aversion tracking services, claim processing
services, and post-default collection services. As of December 31, 2004,
the Company provided servicing support to agencies that guarantee more
than $19 billion of FFELP loans.
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o Servicing Software. The Company uses internally developed student loan
servicing software and also provides this software to third-party student
loan holders and servicers. As of December 31, 2004, the Company's
software was used to service more than $50 billion in student loans, which
included $29 billion serviced by third parties using the Company's
software.
The Company's primary product and service offerings constitute reportable
segments under Statement of Financial Accounting Standards ("SFAS") No. 131,
Disclosures about Segments of an Enterprise and Related Information ("SFAS No.
131"). In 2004, the Asset Management, Student Loan and Guarantee Servicing, and
Servicing Software segments generated 76.5%, 21.8%, and 1.7%, respectively, of
the Company's total segment revenues (excluding intersegment revenue) and 81.1%,
19.7%, and (0.8)%, respectively, of its segment net income (loss) before taxes.
As of December 31, 2004, the percent of assets applicable to the Asset
Management, Student Loan and Guarantee Servicing, and Servicing Software
segments (excluding intersegment and certain operating activity assets) was
97.7%, 2.2%, and 0.1%, respectively. For additional information on the Company's
segment reporting, see note 19 of the notes to the consolidated financial
statements, which are included in this Report.
The Company's earnings and earnings growth are directly affected by the size
of its portfolio of student loans, the interest rate characteristics of its
portfolio, the costs associated with financing and managing its portfolio, and
the costs associated with origination and acquisition of the student loans in
the portfolio. 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 cost of funding these loans. While the spread
may vary due to fluctuations in interest rates, special allowance payments from
the federal government ensure that the Company receives a minimum yield on its
student loans, so long as certain requirements are met. In addition, the Company
maintains an overall interest rate risk management strategy that incorporates
the use of derivative instruments to minimize the economic effect of interest
rate volatility. The Company also earns fees from student loan and guarantee
servicing and licensing and maintenance fees from its servicing software.
Earnings growth is primarily driven by the growth in the student loan portfolio
and growth in the Company's fee-based product and service offerings, coupled
with cost-effective financing and expense management.
As of December 31, 2004, over 99% of the student loans in the Company's
portfolio were federally insured loans, as opposed to the less than 1% of loans
in its portfolio that did not carry federal guarantees. At least 98% of the
principal and accrued interest of FFELP loans is guaranteed by the federal
government, provided that the Company meets certain procedures and standards
specified in the Higher Education Act. The Company believes it is in material
compliance with the procedures and standards as required in the Higher Education
Act. FFELP loans originated prior to October 1, 1993 carry a 100% guarantee on
the principal amount and accrued interest, and FFELP loans originated after that
date are guaranteed for 98% of the principal amount and accrued interest, unless
serviced by a servicer who has been designated as an Exceptional Performer by
the Department, allowing these student loans to carry a 100% guarantee.
Effective June 1, 2004, the Company was designated as an Exceptional Performer.
As of December 31, 2004, service providers designated as an Exceptional
Performer serviced more than 99% of the Company's federally insured loans. Of
this 99%, third parties serviced approximately 9%. For further information, see
Part II, Item 7, "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Overview -- Provision for Loan Losses."
HISTORY
The Company has a 27-year history dating back to the formation of UNIPAC
Service Corporation in 1978. UNIPAC was formed to service loans for Union Bank &
Trust Company, or Union Bank, of Lincoln, Nebraska and Packers Service
Corporation of Omaha, Nebraska. The Company grew its third-party student loan
servicing business to approximately $9.7 billion in loans in 2000, when it was
merged with Nelnet. The Company's immediate predecessor was formed in 1996 as a
student loan acquisition company, and, prior to the merger, it had built its
student loan portfolio through a series of spot portfolio acquisitions and later
through student loan company acquisitions.
In 2000, the Company created a vertically integrated platform that would be
able to compete in each sector of the student loan industry. Over the past five
years, the Company has acquired several education finance services and asset
management companies to complement its service offerings. For information about
the Company's recent acquisitions, see Part II, Item 7, "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Overview --
Acquisitions."
PRODUCT AND SERVICE OFFERINGS
ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS
The Company's asset management business, including student loan originations
and acquisitions, is its largest product and service offering and drives the
majority of its earnings. When the Company originates FFELP loans on its own
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behalf or when the Company acquires FFELP loans from others, it engages one or
more "eligible lenders," as defined in the Higher Education Act, to act as its
trustees to hold title to all such originated and acquired FFELP loans. These
eligible lender trustees hold the legal title to the FFELP loans, and the
Company holds 100% of the beneficial interests in those loans. The Company
originated or acquired, through student loan channels, $4.1 billion in student
loans in 2004. In addition, the Company acquired $136.1 million of student loans
through a business combination in April 2004. The Company often originates loans
using the Nelnet brand name but, in many cases, it uses well-known,
geographically strategic brand names of its branding partners, such as SunTrust
Bank, Education Solutions, and Union Bank. This strategy gives the Company the
flexibility to market the brand with the best recognition in a given region or
at a given college or university. The Company originates and acquires loans
through its direct channel, branding partner channel, forward flow channel, and
through spot purchases.
Through the direct channel, the Company originates student loans in one of
its brand names directly to students and parent borrowers. In 2004, 50.5% of the
Company's student loan channel additions were attributable to this channel,
including loans originated through consolidation. Student loans that the
Company originates through its direct channel are the most profitable student
loans because these loans typically cost less than loans acquired through the
other channels, and they remain in the Company's portfolio for a longer period
of time. Once a student's loans have entered the grace or repayment period, they
are eligible to be consolidated if they meet certain requirements. Loan
consolidation allows borrowers to make one payment per month and extend the loan
repayment period. In addition to these attributes, in recent years, historically
low interest rates have contributed to demand for consolidation loans. To meet
this demand, the Company has developed an extensive loan consolidation
department to serve borrowers with loans in the Company's portfolio as well as
borrowers whose loans are held by other lenders.
Through the branding partner channel, the Company acquires student loans from
lenders to whom it provides marketing and origination services established
through various contracts with FFELP lenders. In 2004, 24.3% of the Company's
student loan channel additions were attributable to this channel. The Company
frequently acts as an exclusive marketing agent for some branding partners in
specified geographic areas. The Company ordinarily purchases loans originated by
those branding partners pursuant to a commitment to purchase loans at a premium
above par, shortly following full disbursement of the loans. The Company
ordinarily retains rights to acquire loans subsequently made to the same
borrowers, or serial loans. Some branding partners, however, retain rights to
portions of their loan originations. Origination and servicing of loans made by
branding partners is primarily performed by the Company during the lives of loan
origination and servicing agreements so that loans do not need to be changed to
a different servicer upon purchase by the Company. The marketing agreements and
commitments to purchase loans are ordinarily for the same term, which are
commonly three to five years in duration. These agreements ordinarily contain
provisions for automatic renewal for successive terms, subject to termination by
notice at the end of a term or early termination for breach. The Company is
generally obligated to purchase all of the loans originated by the branding
partners under these commitments, although the branding partners are not
obligated to provide the Company with a minimum amount of loans.
In addition to the branding partner channel, the Company has established a
forward flow channel for acquiring FFELP loans from lenders to whom it provides
origination services, but provides no marketing services, or who agree to sell
loans to the Company under forward sale commitments. In 2004, 19.1% of the
Company's student loan channel additions were attributable to this channel.
These forward flow commitments frequently obligate the lender to sell all loans
made by the applicable lender, but in other instances are limited to sales of
loans originated in certain specific geographic regions or exclude loans that
are otherwise committed for sale to third parties. The Company is generally
obligated to purchase loans subject to forward flow commitments shortly
following full disbursement, although the forward flow lenders are not obligated
to provide the Company with a minimum amount of loans. The Company also
typically retains rights to purchase serial loans. The loans subject to purchase
are generally subject to a servicing agreement with the Company for the life of
each such loan. Such forward flow commitments ordinarily are for terms of three
to five years in duration.
The Company also acquires student loans through spot purchases, which
accounted for 6.1% of the Company's student loan channel additions in 2004.
4
The following table summarizes the composition of the Company's student loan
portfolio, exclusive of the unamortized costs of origination and acquisition, as
of December 31, 2004.
As of
December 31, 2004
(loan balances in
thousands)
Loans outstanding............................. $13,299,094
Federally insured loans:
Stafford ................................ $ 5,047,487
PLUS/SLS (a)............................. $ 252,910
Consolidation ........................... $ 7,908,292
Non-federally insured loans................... $ 90,405
Number of borrowers........................... 938,825
Average outstanding principal balance per
borrower...................................... $ 14,166
Number of loans............................... 2,345,597
Average outstanding principal balance per loan $ 5,670
Weighted average annual borrower interest rate 4.21%
Weighted average remaining term (months)...... 194
- ----------
(a) Supplemental loans for students, or SLS, are the predecessor to
unsubsidized Stafford loans.
The Company's Capital Markets and Portfolio Administration departments
provide financing options to fund the Company's student loan portfolio. As of
December 31, 2004, the Company had a student loan warehousing capacity of $4.3
billion through 364-day commercial paper conduit programs (of which $2.5 billion
was outstanding as of December 31, 2004). These transactions provide short-term
asset financing for the Company's loan originations as well as purchases of
student loan portfolios. The financings are constructed to offer short-term
capital and are annually renewable.
Short-term student loan warehousing allows the Company to buy and manage
student loans prior to transferring them into more permanent financing
arrangements. The large student loan warehousing capacity allows the Company to
pool student loans in order to maximize loan portfolio characteristics for
efficient financing and to properly time market conditions. Generally, loans
that best fit long-term financing vehicles are selected to be transferred into
long-term securitizations. The Company holds loans in short-term warehousing for
a period of time ranging from approximately one month to as many as 18 months,
at which point these loans are 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 that routinely price in line with SLM Corporation,
its largest competitor.
The Company had $11.8 billion in asset-backed securities issued and
outstanding as of December 31, 2004. These asset-backed securities allow the
Company to finance student loan assets over multiple years. In 2004, the Company
completed four asset-backed securitizations totaling $5.4 billion, which made
the Company the second largest issuer of student loan asset-backed securities
for the year.
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 pay bondholders.
The Company's original securitization transactions began in 1996, utilizing a
master trust structure, and were privately placed auction-rate note
securitizations. As the size and volume of the Company's securitizations
increased, the Company began publicly offering asset-backed securities under
shelf registration statements, using special purpose entities. When the Company
deemed long-term interest rates attractive, it issued fixed-rate debt backed by
cash flows from FFELP loans with fixed-rate floors, which effectively match the
funding of its assets and liabilities. In 2002, the Company began accessing the
term asset-backed securities market by issuing amortizing multi-tranche
LIBOR-indexed variable-rate debt securities. The Company has utilized financial
guarantees from monoline insurers and senior/subordinate structures to assist in
obtaining "AAA" ratings on its senior securitized debt in addition to cash
reserves and excess spread to assist in obtaining "A" and "AA" ratings on its
subordinated debt. The Company intends to continue to issue auction-rate notes,
variable-rate and fixed-rate term asset-backed securities, and debt securities
through other asset funding vehicles in order to minimize its cost of funds and
give it the most flexibility to optimize the return on its student loan assets.
5
The Company's subsidiary, Nelnet Capital LLC ("Nelnet Capital"), is a broker
dealer. Nelnet Capital sells certain tranches of the Company's auction-rate
securities in co-broker-dealer arrangements with certain third-party
broker-dealers. Nelnet Capital's fees received in conjunction with sales of the
Company's securities reduce the overall costs of issuance with respect to the
auction-rate securities.
STUDENT LOAN AND GUARANTEE SERVICING
The Company specializes in the servicing of FFEL Program loans, non-federally
insured student loans, and loans under the Canadian government-sponsored student
loan program. The Company's servicing division offers lenders across the U.S.
and Canada a complete line of education loan services, including recovery of
non-guaranteed loans, application processing, disbursement of funds, customer
service, account maintenance, federal reporting and billing collections, payment
processing, default aversion, and claim filing. The Company's student loan
division uses proprietary systems to manage the servicing process. These systems
provide for automated compliance with most Higher Education Act regulations as
well as regulations of the Canadian government-sponsored student loan program.
Effective June 1, 2004, the Company was designated as an Exceptional
Performer by the Department in recognition of its exceptional level of
performance in servicing FFEL Program loans. As a result of this designation,
the Company and its FFELP third-party servicing customers receive 100%
reimbursement on all eligible FFEL Program default claims submitted for
reimbursement during the 12-month period following the effective date of its
designation. The Company and its third-party servicing customers are not subject
to the 2% risk-sharing loss for eligible claims submitted during this 12-month
period. The Company is entitled to receive this benefit as long as it continues
to meet the required servicing standards published by the Department. Compliance
with such standard is assessed on a quarterly basis.
As the Company expands its student loan origination and acquisition
activities, it may face increased competition with some of its servicing
customers. In the past, servicing customers have terminated their servicing
relationships with the Company, and the Company could in the future lose more
servicing customers as a result. However, due to the life-of-loan servicing
agreements, the Company does not expect the potential loss of customers to have
a material adverse effect on its results of operations for the foreseeable
future.
The Canadian student loan servicing business of EDULINX is highly
concentrated among a handful of servicing customers. In the event EDULINX does
not secure a renewal of its contract to service under the Canadian Student Loan
Program, this could result in a negative impact on EDULINX's business.
The Company also provides servicing support for guaranty agencies, which are
the organizations that serve as the intermediary between the U.S. federal
government and the lender of FFELP loans and who are responsible for paying the
claims made on defaulted loans. The Company's guarantee servicing division uses
a proprietary system to manage the servicing support process and to provide for
automated compliance with most Higher Education Act regulations.
SERVICING SOFTWARE
The Company's servicing software is focused on providing technology
solutions to education finance issues. The Company's subsidiaries, Idaho
Financial Associates, Inc. and Charter Account Systems, Inc., provide student
loan software and support for entities involved in the asset management aspects
of the student loan arena.
OTHER SERVICES
In addition to the Company's three primary product and service offerings, the
Company provides additional services through its 50% owned companies. These
services include customized software solutions for the administration and
management of the student loan process, collection services for educational
debt, and customer-focused electronic transaction processing and account and
bill presentment.
SOFTWARE PRODUCTS
The Company offers a suite of software products and services to provide a
total systems solution to its customers. This total systems solution is designed
to assist the Company's customers, hundreds of colleges, universities, and
lenders, in the origination, delivery, and management of the education finance
process, while simplifying the financial aid process. The Company also licenses
its servicing software products to third-party student loan holders and
servicers.
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The Company also offers a variety of borrower services to assist students and
parents in navigating the financial aid process. These services include the
Company's unique @theU higher education resource, which provides free
information on college planning and financial aid, paired with a loyalty program
to allow members to earn credit toward reducing the balance of a student loan
regardless of lender or servicer. Another product, Nelnet Notes, provides online
assistance to help borrowers better understand the financial aid process, as
well as broader money management issues.
The Company's software products, including Web site content and
functionality, have been primarily developed and maintained using internal
business and technical resources. External software consultants are utilized on
selected occasions when circumstances require specific technical knowledge or
experience. The Company capitalizes software costs under the provisions of
Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use. Material software developments or
enhancements that are considered to have useful lives of greater than one year
are capitalized and amortized over their useful lives. In addition, purchased
software is capitalized and amortized over the estimated useful life. Costs
related to maintaining the Company's existing software, including the costs of
programming, are expensed as incurred.
Costs associated with research and development related to the development of
computer software to be sold are expensed when incurred in accordance with SFAS
No. 86, Accounting for the Cost of Computer Software to be Sold, Leased, or
Otherwise Marketed.
INTEREST RATE RISK MANAGEMENT
Because the Company generates the majority of its earnings from its student
loan spread, the interest sensitivity of the balance sheet is a key
profitability driver. The majority of the student loans have variable-rate
characteristics in certain interest rate environments. Some of the student loans
include fixed-rate components depending upon the rate reset provisions, or, in
the case of consolidation loans, are fixed at the weighted average interest rate
of the underlying loans at the time of consolidation.
Historically, the Company has followed a policy of funding the majority of
its student loan portfolio with variable-rate debt. In a low interest rate
environment, the FFELP loan portfolio yields excess income primarily due to the
reduction in interest rates on the variable-rate liabilities that fund student
loans at a fixed borrower rate and also due to consolidation loans earning
interest at a fixed rate to the borrower. Therefore, absent utilizing derivative
instruments, in a low interest rate environment, a rise in interest rates will
have an adverse effect on earnings. In higher interest rate environments, where
the interest rate rises above the borrower rate and the fixed-rate loans become
variable-rate and are effectively matched with variable-rate debt, the impact of
rate fluctuations is substantially reduced.
The 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 markets. 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. For further information, see Part II, Item 7A, "Quantitative and
Qualitative Disclosures about Market Risk -- Interest Rate Risk."
INTELLECTUAL PROPERTY
The Company owns numerous trademarks and service marks ("Marks") to identify
its various products and services. As of December 31, 2004, the Company had 10
pending and 42 registered Marks. The Company actively asserts its rights to
these Marks when it believes potential infringement may exist. The Company
believes its Marks have developed and continue to develop strong brand-name
recognition in the industry and the consumer marketplace. Each of the Marks has,
upon registration, an indefinite duration so long as the Company continues to
use the Mark on or in connection with such goods or services as the Mark
identifies. In order to protect the indefinite duration, the Company makes
filings to continue registration of the Marks. The Company owns one patent
application that has been published, but has not yet been issued, with respect
to a customer-loyalty program and has also actively asserted its rights
thereunder in situations where the Company believes its claims may be infringed
upon. The Company owns many copyright-protected works, including its various
computer system codes and displays, Web sites, publications, and marketing
collateral. The Company also has trade secret rights to many of its processes
and strategies and its software product designs. The Company's software products
are protected by both registered and common law copyrights, as well as strict
confidentiality and ownership provisions placed in license agreements which
restrict the ability to copy, distribute, or disclose the software products. The
Company also has adopted internal procedures designed to protect the Company's
intellectual property.
7
The Company seeks federal and/or state protection of intellectual property
when deemed appropriate, including patent, trademark/service mark, and
copyright. The decision whether to seek such protection may depend on the
perceived value of the intellectual property, the likelihood of securing
protection, the cost of securing and maintaining that protection, and the
potential for infringement. The Company's employees are trained in the
fundamentals of intellectual property, intellectual property protection, and
infringement issues. The Company's employees are also required to sign
agreements requiring, among other things, confidentiality of trade secrets,
assignment of inventions, and non-solicitation of other employees
post-termination. Consultants, suppliers, and other business partners are also
required to sign nondisclosure agreements to protect the Company's proprietary
rights.
SEASONALITY
Origination of student loans is generally subject to seasonal trends, which
correspond to the beginning of each semester of the school year. Stafford and
PLUS loans are disbursed as directed by the school and are usually divided into
two or three equal disbursements released at specified times during the school
year. The two periods of August through October and December through March
account for approximately 80% of the Company's total annual Stafford and PLUS
disbursements. While applications and disbursements are seasonal, the Company's
earnings are generally not tied to this cycle. Due to the Company's portfolio
size and the volume of its acquisitions through its branding and forward flow
channels, new disbursements or run-off for any given month will not materially
change the net interest earnings of the portfolio.
CUSTOMERS
As of December 31, 2004, the Company provided student loan servicing either
directly or through its proprietary software to more than 2.8 million borrowers
and currently has direct and indirect relationships with hundreds of colleges
and universities. As of December 31, 2004, the Company had
servicing agreements with more than 300 customers and software license
agreements with more than 35 licensees. Notwithstanding the depth of its
customer base, the Company's business is subject to some vulnerability arising
from concentrations of loan origination volume with borrowers attending certain
schools, loan origination volume generated by certain branding partners, loan
and guarantee servicing volume generated by certain loan servicing customers and
guaranty agencies, and software licensing volume generated by certain licensees.
The Company's ability to maintain strong relationships with significant schools,
branding partners, servicing customers, guaranty agencies, and software
licensees is subject to a variety of risks. Termination of such a strong
relationship could result in a material adverse effect on the Company's
business. The Company cannot assure that its forward flow channel lenders or
branding partners will continue their relationships with the Company, which
could result in an adverse effect on the Company's volume derived from one of
its loan acquisition channels.
The business of servicing Canadian student loans by EDULINX is limited to a
small group of servicing customers and the agreement with the largest of such
customers is currently scheduled to expire in February 2006. EDULINX cannot
guarantee that it will obtain a renewal of this largest servicing agreement or
that it will maintain its other servicing agreements, and the termination of any
such servicing agreements could result in an adverse effect on its business.
COMPETITION
The Company faces competition from many lenders in the highly competitive
student loan industry. Using its size, the Company has leveraged economies of
scale to gain market share and compete by offering a full array of FFELP and
non-federally insured loan products and services. In addition, the Company
differentiates itself from other lenders through its vertical integration,
technology, and strong relationships with colleges and universities.
The Company views SLM Corporation, the parent company of Sallie Mae, as its
largest competitor in loan origination and holding and servicing student loans.
Large national and regional banks are also strong competition, although many are
involved only in origination. In different geographic locations across the
country, the Company faces strong competition from the local tax-exempt student
loan secondary markets. The Federal Direct Lending ("FDL") Program has also
reduced the origination volume available for FFEL Program participants. In 2003
(according to the most recent Department information available), the FDL Program
accounted for approximately 25% of total student loan volume, although this
portion of total volume has decreased from approximately 33% in 1998. In
addition, in the last few years, low interest rates have attracted many new
competitors to the student loan consolidation business.
EMPLOYEES
As of December 31, 2004, the Company had approximately 2,700 employees.
Approximately 900 of these employees hold professional and management positions
while approximately 1,800 are in support and operational positions. None of the
Company's employees are covered by collective bargaining agreements. The Company
is not involved in any material disputes with any of its employees, and the
Company believes that relations with its employees are good.
AVAILABLE INFORMATION
Copies of the Company's annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, proxy statement, and amendments to such
8
reports are available on the Company's Web site free of charge as soon as
reasonably practicable after such reports are filed with or furnished to the
United States Securities and Exchange Commission (the "SEC"). Investors and
other interested parties can access these reports at HTTP://WWW.NELNET.NET. The
SEC maintains an Internet site (HTTP://WWW.SEC.GOV) that contains periodic and
other reports such as annual, quarterly, and current reports on Forms 10-K,
10-Q, and 8-K, respectively, as well as proxy and information statements
regarding the Company and other companies that file electronically with the SEC.
The Company has adopted a Code of Business Conduct and Ethics (the "Code of
Conduct") that applies to directors, officers, and employees, including the
Company's principal executive officers and its principal financial and
accounting officer, and has posted such Code of Conduct on its Web site.
Amendments to and waivers granted with respect to the Company's Code of Conduct
relating to its executive officers and directors required to be disclosed
pursuant to the applicable securities law and stock exchange rules and
regulations will also be posted on its Web site. The Company's Corporate
Governance Guidelines, Audit Committee Charter, Compensation Committee Charter,
and Nominating and Corporate Governance Committee Charter are also posted on its
Web site and, along with its Code of Conduct, are available in print without
charge to any shareholder who requests them. Please direct all requests as
follows:
Nelnet, Inc.
121 South 13th Street, Suite 201
Lincoln, Nebraska 68508
Attention: Secretary
RISK FACTORS
If any of the following risks actually occurs, the Company's business,
financial condition, and results of operations could be materially and adversely
affected.
FAILURE TO COMPLY WITH GOVERNMENTAL REGULATIONS OR GUARANTY AGENCY RULES COULD
HARM THE COMPANY'S BUSINESS.
The Company's principal business is comprised of originating, acquiring,
holding, and servicing student loans made and guaranteed pursuant to the FFEL
Program, which was created by the Higher Education Act. The Higher Education Act
governs most significant aspects of the Company's lines of business. The Company
is also subject to rules and regulations of the agencies that act as guarantors
of the student loans, known as guaranty agencies. In addition, the Company is
subject to certain federal and state banking laws, regulations, and
examinations, as well as federal and state consumer protection laws and
regulations, including, specifically with respect to the Company's non-federally
insured loan portfolio, certain state usury laws and related regulations and the
Federal Truth in Lending Act. Also, Canadian laws and regulations govern the
Company's Canadian loan servicing operations. These laws and regulations impose
substantial requirements upon lenders and servicers involved in consumer
finance. Failure to comply with these laws and regulations could result in
liability to borrowers, the imposition of civil penalties, and potential class
action suits.
The Company's failure to comply with regulatory regimes described above may
arise from:
o breaches of the Company's internal control systems, such as a failure to
adjust manual or automated servicing functions following a change in
regulatory requirements;
o technological defects, such as a malfunction in or destruction of the
Company's computer systems; or
o fraud by the Company's employees or other persons in activities such as
borrower payment processing.
Such failure to comply, irrespective of the reason, could subject the Company
to loss of the federal guarantee on federally insured loans, costs of curing
servicing deficiencies or remedial servicing, suspension or termination of the
Company's right to participate in the FFEL Program or to participate as a
servicer, negative publicity, and potential legal claims or actions brought by
the Company's servicing customers and borrowers.
THE COMPANY MUST SATISFY CERTAIN REQUIREMENTS NECESSARY TO MAINTAIN THE FEDERAL
GUARANTEES OF ITS FEDERALLY INSURED LOANS, AND THE COMPANY MAY INCUR PENALTIES
OR LOSE ITS GUARANTEES IF IT FAILS TO MEET THESE REQUIREMENTS.
The Company must meet various requirements in order to maintain the federal
guarantee on its federally insured loans. These requirements establish servicing
requirements and procedural guidelines and specify school and borrower
eligibility criteria. The federal guarantee on the Company's federally insured
loans is conditioned on compliance with origination, servicing, and collection
standards set by the Department and guaranty agencies. Federally insured loans
that are not originated, disbursed, or serviced in accordance with the
Department's regulations risk partial or complete loss of the guarantee thereof.
If the Company experiences a high rate of servicing deficiencies or costs
associated with remedial servicing, and if the Company is unsuccessful in curing
such deficiencies, the eventual losses on the loans that are not cured could be
material.
9
A guaranty agency may reject a loan for claim payment due to a violation of
the FFEL Program due diligence servicing requirements. In addition, a guaranty
agency may reject claims under other circumstances, including, for example, if a
claim is not timely filed or adequate documentation is not maintained. Once a
loan ceases to be guaranteed, it is ineligible for federal interest subsidies
and special allowance payments. If a loan is rejected for claim payment by a
guaranty agency, the Company continues to pursue the borrower for payment and/or
institutes a process to reinstate the guarantee.
Rejections of claims as to portions of interest may be made by guaranty
agencies for certain violations of the due diligence collection and servicing
requirements, even though the remainder of a claim may be paid. Examples of
errors that cause claim rejections include isolated missed collection calls or
failures to send collection letters as required.
The Department has implemented school eligibility requirements, which include
default rate limits. In order to maintain eligibility in the FFEL Program,
schools must maintain default rates below specified levels, and both guaranty
agencies and lenders are required to ensure that loans are made only to or on
behalf of students attending schools that do not exceed the default rate limits.
If the Company fails to comply with any of the above requirements, it could
incur penalties or lose the federal guarantee on some or all of its federally
insured loans. If the Company's actual loss experience on denied guarantees were
to increase substantially in future periods the impact could be material to the
Company's operations.
FAILURE TO COMPLY WITH RESTRICTIONS ON INDUCEMENTS UNDER THE HIGHER EDUCATION
ACT COULD HARM THE COMPANY'S BUSINESS.
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 entered into arrangements with
various schools pursuant to which the schools become lenders of FFELP loans to
graduate students, and the Company provides funding, loan origination, and
servicing to the schools with respect to such loans. The Department challenged a
similar "school-as-lender" arrangement that SLM Corporation previously had in
place, but a federal court decision determined the arrangement fell within the
parameters of regulatory guidelines established by the Department. SLM
Corporation also has come under scrutiny as a result of recent claims that it
makes non-federally insured loans available to students of a school only if the
school, in return, promises to leave the FDL Program and market SLM
Corporation's FFELP loans to its students. The Department has stated that
non-federally insured loans are legal and permissible if offered simply as a
benefit to schools. The Company offers non-federally insured loans to student
borrowers on a regular basis but does so without requiring anything in return
from the schools that these borrowers attend. In addition, because guidance from
the Department permits de minimus gifts in connection with marketing of FFELP
loans, from time to time the Company entertains school financial aid officers at
student loan industry conferences and functions and sponsors promotional events
such as lunches and golf outings. If the Department were to change its position
on any of these matters, the Company may have to change the way it markets
non-federally insured and FFELP loans and a new marketing strategy may not be as
effective. If the Company fails to respond to the Departments change in
position, the Department could potentially impose sanctions upon the Company
that could negatively impact its business.
The Company has also entered into various agreements to acquire marketing
lists of prospective FFELP loan borrowers from sources such as college alumni
associations. The Company pays to acquire these lists and for the completed
applications for loans resulting there from. The Company believes that such
arrangements are permissible and do not violate restrictions on inducements, as
they fit within a regulatory exception recognized by the Department for
generalized marketing and advertising activities. The Department has provided
informal guidance to the Company that such arrangements are not improper
inducements, since such arrangements fall within the generalized marketing
exception. If the Department were to change its position, this could harm the
Company's reputation and marketing efforts, and, if the Company fails to adjust
its practices to such change, could potentially result in the Department
imposing sanctions on the Company. Such sanctions could negatively impact the
Company's business.
POSSIBLE CHANGES IN LEGISLATION AND REGULATIONS COULD HAVE A NEGATIVE IMPACT
UPON THE COMPANY'S BUSINESS.
Pursuant to the terms of the Higher Education Act, the FFEL Program is
periodically amended, and the Higher Education Act must be reauthorized by
Congress every five to six years in order to prevent sunset of that Act. Changes
in the Higher Education Act made in the two most recent reauthorizations have
included reductions in student loan yields paid to lenders, increased fees paid
by lenders, and a decreased level of federal guarantee. Future changes could
result in further negative impacts on the Company's business. Moreover, there
can be no assurance that the provisions of the Higher Education Act, which is
scheduled to expire on September 30, 2005, will be reauthorized. While Congress
has consistently extended the effective date of the Higher Education Act, it may
elect not to reauthorize the Department's ability to provide interest subsidies,
special allowance payments, and federal guarantees for student loans. A failure
to reauthorize such provisions of the Higher Education Act would reduce the
number of federally guaranteed student loans available for the Company to
originate or acquire in the future. With respect to EDULINX, changes in the
Canada Student Loans Program, or the CSLP, which governs the majority of the
loans serviced by EDULINX, could result in a similar negative impact on EDULINX'
business.
10
Some of the highlights of specific proposed legislation and President Bush's
fiscal year 2006 budget proposals that, if enacted, could have a material effect
on the Company's operations, in no particular order, include:
o allowing for increased borrower loan limits, which may provide
opportunities for increasing the average size of the Company's future
loan originations;
o allowing refinancing of consolidation loans, which would open
approximately 59% of the Company's portfolio to such refinancing;
o increasing origination fees paid by lenders in connection with making or
holding loans;
o allowing for variable-rate consolidation loans and extended repayment
terms of Stafford loans, which would lead to fewer loans lost through
consolidation of the Company's portfolio, but would also decrease
consolidation opportunities;
o allowing for the continuation of variable interest rates on Stafford and
PLUS loans beyond the scheduled change to fixed interest rates on July
1, 2006;
o changes to the FFEL Program guarantee rates and terms, including
proposals for a decrease in insurance on portfolios receiving the
benefit of the Exceptional Performance designation from 100% to 97% of
principal and accrued interest, and a decrease in insurance on
portfolios not subject to the Exceptional Performance designation from
98% to 95% of principal and accrued interest;
o eliminating variable-rate floor income, including prospectively and
permanently eliminating the 9.5% floor interest rate on loans refinanced
with funds from pre-1993 tax-exempt financings (the "9.5% Floor") and
eliminating rebate of excess earnings on loans where the borrower rate
is in excess of the lender rate;
o limiting and/or preventing a FFEL Program lender from making a
consolidation loan consisting of only FDL loans; and
o initiatives aimed at promoting the FDL Program to the detriment of the
FFEL Program.
In addition, Edward M. Kennedy of Massachusetts and others have been
proponents of legislation which could act to retroactively remove eligibility
for the 9.5% Floor from FFELP loans that have, prior to September 30, 2004, been
refinanced with proceeds of taxable obligations. The Company cannot predict
whether such legislation will be advanced in the future. If such retroactive
legislation were to be enacted and withstand legal challenge, it would have a
material adverse effect upon the Company's financial condition and results of
operations. Senator Kennedy called for such retroactive legislation during
congressional debate in October 2004. However, the Department has indicated that
receipt of the 9.5% Floor income is permissible under current law and previous
interpretations thereof. The Company cannot predict whether the Department will
maintain its position in the future on the permissibility of the 9.5% Floor.
The Company cannot predict whether the above legislative or budget proposals
will be enacted into law, but they may form some of the framework utilized by
Congress in negotiating the fiscal year 2006 budget resolution and
reauthorization of the Higher Education Act. In addition, the Department
oversees and implements the Higher Education Act and periodically issues
regulations and interpretations of that Act. Changes in such regulations and
interpretations could negatively impact the Company's business.
VARIATION IN THE MATURITIES, TIMING OF RATE RESET, AND VARIATION OF INDICES
OF THE COMPANY'S ASSETS AND LIABILITIES MAY POSE RISKS TO THE COMPANY.
Because the Company generates the majority of its earnings from the spread
between the yield received on its portfolio of student loans and the cost of
financing these loans, the interest rate sensitivity of the balance sheet could
have a material effect on the Company's results of operations. The majority of
the Company's student loans have variable-rate characteristics in interest rate
environments where the special allowance payment formula exceeds the borrower
rate. Some of the Company's student loans, primarily consolidation loans,
include fixed-rate components depending upon loan terms and the rate reset
provisions set by the Department. The Company has financed the majority of its
student loan portfolio with variable-rate debt. Absent utilization of derivative
instruments to match the interest rate characteristics and duration of the
assets and liabilities, fluctuations in the interest rate environment will
affect the Company's results of operations. Such fluctuations may be adverse and
may be material.
In the current low interest rate environment, the Company's federally insured
loan portfolio is yielding excess income due to variable-rate liabilities
financing student loans at a fixed borrower rate. Absent the use of derivative
instruments, a rise in interest rates will have an adverse effect on earnings
and fair values due to interest margin compression caused by increasing
financing costs, until such time as that the federally insured loans earn
interest at a variable rate in accordance with the special allowance payment
formula. In higher interest rate environments, where the interest rate rises
11
above the borrower rate and fixed-rate loans become variable, the impact of the
rate fluctuations is reduced. Loans that reset annually on each July 1st can
generate excess spread income as compared to the rate based on the special
allowance payment formula in declining interest rate environments where the
borrower rate establishes a floor on the Company's variable-rate assets. The
Company refers to this additional income as variable-rate floor income, and it
is included in loan interest income. Historically, the Company has earned
variable-rate floor income in declining interest rate environments. Since the
rates are reset annually, the Company views these earnings as temporary and not
necessarily sustainable. The Company's ability to earn variable-rate floor
income in future periods is dependent upon the interest rate environment
following the annual reset of borrower rates, and the Company cannot assure that
such environment will exist in the future.
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 its entire loan portfolio with the underlying debt
instruments. This mismatch in duration and interest rate characteristics could
have a negative impact on the Company's results of operations. The Company has
employed various derivative instruments to somewhat offset this mismatch.
Changes in interest rates and the composition of the Company's student loan
portfolio and derivative instruments will impact the effect of interest rates on
the Company's earnings, and the Company cannot predict any such impact with any
level of certainty.
MARKET RISKS TO WHICH THE COMPANY IS SUBJECT MAY HAVE AN ADVERSE IMPACT UPON ITS
BUSINESS AND OPERATIONS.
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 borrower rates on federally insured loans
are generally reset by the Department each July 1st based on a formula
determined by the date of the origination of the loan, with the exception of
rates on consolidation loans which are fixed to term. The interest rate the
Company actually receives on federally insured loans is the greater of the
borrower rate and a rate determined by a formula based on a spread to either the
91-day Treasury Bill index or the 90-day commercial paper index, depending on
when the loans were originated and the current repayment status of the loans.
The Company issues asset-backed securities, both fixed- and variable-rate, to
fund its student loan assets. The variable-rate debt is generally indexed to
90-day LIBOR or set by auction. The income generated by the Company's student
loan assets is generally driven by different short-term indices than the
Company's liabilities, which creates interest rate risk. The Company has
historically borne this risk internally through the net spread on its portfolio
while continuing to monitor this interest rate risk.
The Company purchased EDULINX in December 2004. EDULINX is a Canadian
corporation that engages in servicing Canadian student loans. As a result of
this acquisition, the Company is also exposed to market risk related to
fluctuations in foreign currency exchange rates between the U.S. and Canadian
dollars. The Company has not entered into any foreign currency derivative
instruments to hedge this risk. Fluctuations in foreign currency exchange rates
may have an adverse effect on the financial position, results of operations, and
cash flows of the Company.
THE COMPANY'S DERIVATIVE INSTRUMENTS MAY NOT BE SUCCESSFUL IN MANAGING ITS
INTEREST RATE RISKS.
When the Company utilizes derivative instruments, it utilizes them to manage
interest rate sensitivity. Although the Company does not use derivative
instruments for speculative purposes, the majority of its derivative instruments
do not qualify for hedge accounting under SFAS No. 133, Accounting for
Derivatives Instruments and Hedging Activities ("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 can
significantly impact the valuation of the Company's derivatives. Accordingly,
changes or shifts to the forward yield curve will impact the financial position,
results of operations, and cash flows of the Company. The derivative instruments
used by the Company are typically in the form of interest rate swaps, basis
swaps, and interest rate caps. Interest rate swaps effectively convert
variable-rate debt obligations to a fixed-rate or fixed-rate debt obligations to
a variable-rate. Basis swaps effectively convert variable-rate debt obligations
to a variable-rate based on a different index. Interest rate caps effectively
limit the maximum interest on variable-rate debt obligations.
Developing an effective strategy for dealing with movements in interest rates
is complex, and no strategy can completely insulate the Company from risks
associated with such fluctuations. In addition, a counterparty to a derivative
instrument could default on its obligation, thereby exposing the Company to
credit risk. Further, the Company may have to repay certain costs, such as
transaction fees or brokerage costs, if the Company terminates a derivative
instrument. Finally, the Company's interest rate risk management activities
could expose the Company to substantial losses if interest rates move materially
differently from management's expectations. As a result, the Company cannot
assure that its economic hedging activities will effectively manage its interest
rate sensitivity or have the desired beneficial impact on its results of
operations or financial condition.
When the fair value of a derivative instrument is negative, the Company owes
the counterparty and, therefore, has no credit risk. However, if the value of
derivatives with a counterparty exceeds a specified threshold, the Company may
12
have to pay a collateral deposit to the counterparty. If interest rates move
materially differently from management's expectations, the Company could be
required to deposit a significant amount of collateral with its derivative
instrument counterparties. The collateral deposits, if significant, could
negatively impact the Company's capital resources. The Company manages market
risks associated with interest rates by establishing and monitoring limits as to
the types and degree of risk that may be undertaken.
THE COMPANY FACES LIQUIDITY RISKS DUE TO THE FACT THAT ITS OPERATING AND
WAREHOUSE FINANCING NEEDS ARE SUBSTANTIALLY PROVIDED BY THIRD-PARTY SOURCES.
The Company's primary funding needs are those required to finance its student
loan portfolio and satisfy its cash requirements for new student loan
originations and acquisitions, operating expenses, and technological
development. The Company's operating and warehouse financings are substantially
provided by third parties, over which it has no control. Unavailability of such
financing sources may subject the Company to the risk that it may be unable to
meet its financial commitments to creditors, branding partners, forward flow
lenders, or borrowers when due unless it finds alternative funding mechanisms.
The Company relies upon conduit warehouse loan financing vehicles to support
its funding needs on a short-term basis. There can be no assurance that the
Company will be able to maintain such warehouse financing in the future. As of
December 31, 2004, the Company had a student loan warehousing capacity of $4.3
billion, of which $2.5 billion was outstanding, through 364-day commercial paper
conduit programs. These conduit programs mature in 2005 through 2009; however,
they must be renewed annually by underlying liquidity providers and may be
terminated at any time for cause. There can be no assurance the Company will be
able to maintain such conduit facilities, find alternative funding, or increase
the commitment level of such facilities, if necessary. While the Company's
conduit facilities have historically been renewed for successive terms, there
can be no assurance that this will continue in the future. The Company's has two
general operating lines of credit that are for terms of less than one year each,
are renewable at the option of the lenders, and may be terminated at any time
for cause. In addition, the Company has a credit facility agreement with a
Canadian financial institution that is cancelable by either party upon demand.
CHARACTERISTICS UNIQUE TO ASSET-BACKED SECURITIZATION POSE RISKS TO THE
COMPANY'S CONTINUED LIQUIDITY.
The Company has historically relied upon, and expects to continue to rely
upon, asset-backed securitizations as its most significant source of funding for
student loans on a long-term basis. As of December 31, 2004 and 2003, $11.8
billion and $9.3 billion, respectively, of the Company's student loans were
funded by long-term asset-backed securitizations. 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. In addition, some of the
residual interests in these securitizations have been pledged to secure
additional bond obligations. The Company's rights to cash flow from securitized
student loans are subordinate to bondholder interests, and these loans may fail
to generate any cash flow beyond what is due to pay bondholders.
The interest rates on certain of the Company's asset-backed securities are
set and periodically reset via a "dutch auction" utilizing remarketing agents
for varying intervals ranging from seven to 91 days. Investors and potential
investors submit orders through a broker-dealer as to the principal amount of
notes they wish to buy, hold, or sell at various interest rates. The
broker-dealers submit their clients' orders to the auction agent or remarketing
agent, who determines the interest rate for the upcoming period. If there are
insufficient potential bid orders to purchase all of the notes offered for sale
or being repriced, the Company could be subject to interest costs substantially
above the anticipated and historical rates paid on these types of securities. A
failed auction or remarketing could also reduce the investor base of the
Company's other financing and debt instruments.
In addition, rising interest rates existing at the time the Company's
asset-backed securities are remarketed may cause other competing investments to
become more attractive to investors than the Company's securities, which may
decrease the Company's liquidity.
FUTURE LOSSES DUE TO DEFAULTS ON LOANS HELD BY THE COMPANY PRESENT CREDIT RISK
WHICH COULD ADVERSELY AFFECT THE COMPANY'S EARNINGS.
As of December 31, 2004, more than 99% of the Company's student loan
portfolio was comprised of federally insured loans. These loans benefit from a
federal guarantee of between 98% and 100% of their principal balance and accrued
interest.
13
In June 2004, the Company was designated as an Exceptional Performer by the
Department in recognition of its exceptional level of performance in servicing
FFEL Program loans. As a result of this designation, the Company is not subject
to the 2% risk sharing loss for eligible claims submitted during a 12-month
period. The Company is entitled to receive this benefit as long as it and/or its
other service providers designated as Exceptional Performers continue to meet
the required servicing standards published by the Department. Compliance with
such standards is assessed on a quarterly basis. The Company bears full risk of
losses experienced with respect to the unguaranteed portion of its federally
insured loans (those loans not serviced by a service provider designated as an
Exceptional Performer). If the Company or a third party service provider were to
lose its Exceptional Performance designation, either by the Department
discontinuing the program or the Company or third party not meeting the required
servicing standards, loans serviced by the Company or third-party would become
subject to the 2% risk sharing loss for all claims submitted after any loss of
the Exceptional Performance designation. If the Department discontinued the
program, the Company would have to establish a provision for loan losses related
to the 2% risk sharing. Based on the balance of federally insured loans
outstanding as of December 31, 2004, this provision would be approximately $9.0
million. In addition, President Bush's fiscal year 2006 budget proposals provide
for a decrease in insurance (i) under the Exceptional Performer designation from
100% to 97% and (ii) on portfolios not subject to the Exceptional Performer
designation from 98% to 95% of principal and accrued interest. The Company
cannot predict whether the budget proposals will be enacted into law, but they
may form some of the framework for Congress as it negotiates the fiscal year
2006 budget resolution.
Losses on the Company's non-federally insured loans are borne by the Company,
with the exception of certain privately insured loans. Privately insured loans
constitute a minority of the Company's non-federally insured loan portfolio. The
loan loss pattern on the Company's non-federally insured loan portfolio is not
as developed as that on its federally insured loan portfolio. As of December 31,
2004, the aggregate principal balance of non-federally insured loans comprised
less than 1% of the Company's entire student loan portfolio; however, it is
expected to increase to between 3% and 5% over the next three to five years.
There can be no assurance that this percentage will not further increase over
the long term. The performance of student loans in the portfolio is affected by
the economy, and a prolonged economic downturn may have an adverse effect on the
credit performance of these loans.
While the Company has provided allowances estimated to cover losses that may
be experienced in both its federally insured and non-federally insured loan
portfolios, there can be no assurance that such allowances will be sufficient to
cover actual losses in the future.
THE COMPANY COULD EXPERIENCE CASH FLOW PROBLEMS IF A GUARANTY AGENCY DEFAULTS ON
ITS GUARANTEE OBLIGATION.
A deterioration in the financial status of a guaranty agency and its ability
to honor guarantee claims on defaulted student loans could result in a failure
of that guaranty agency to make its guarantee payments in a timely manner, if at
all. The financial condition of a guaranty agency can be adversely affected if
it submits a large number of reimbursement claims to the Department, which
results in a reduction of the amount of reimbursement that the Department is
obligated to pay the guaranty agency. The Department may also require a guaranty
agency to return its reserve funds to the Department upon a finding that the
reserves are unnecessary for the guaranty agency to pay its FFEL Program
expenses or to serve the best interests of the FFEL Program.
If the Department has determined that a guaranty agency is unable to meet its
guarantee obligations, the loan holder may submit claims directly to the
Department, and the Department is required to pay the full guarantee claim.
However, the Department's obligation to pay guarantee claims directly in this
fashion is contingent upon the Department making the determination that a
guaranty agency is unable to meet its guarantee obligations. The Department may
not ever make this determination with respect to a guaranty agency and, even if
the Department does make this determination, payment of the guarantee claims may
not be made in a timely manner, which could result in the Company experiencing
cash shortfalls.
FAILURE OF COUNTERPARTIES TO PERFORM UNDER CREDIT ENHANCEMENT AGREEMENTS COULD
HARM THE COMPANY'S BUSINESS.
In connection with the Company's securitizations, the Company periodically
utilizes credit enhancements or other support agreements such as letters of
credit, bond insurance, and interest rate swap agreements. The Company utilizes
these credit enhancement agreements in order to improve the marketability of
certain of its asset-backed securities when such enhancements will lower the
overall costs with respect to these securities. The Company cannot assure
performance of the counterparties to these various agreements, and failure of
such counterparties to perform their obligations under these agreements could
impair the viability of the underlying debt or securitization structures, which
in turn could adversely impact the Company's results of operations and financial
condition.
COMPETITION CREATED BY THE FDL PROGRAM AND FROM OTHER LENDERS AND SERVICERS MAY
ADVERSELY IMPACT THE COMPANY'S BUSINESS.
14
Under the FDL Program, the Department makes loans directly to student
borrowers through the educational institutions they attend. The volume of
student loans made under the FFEL Program and available for the Company to
originate or acquire may be reduced to the extent loans are made to students
under the FDL Program. In addition, if the FDL Program expands, to the extent
the volume of loans serviced by the Company is reduced, the Company may
experience reduced economies of scale, which could adversely affect earnings.
Loan volume reductions could further reduce amounts received by the guaranty
agencies available to pay claims on defaulted student loans.
In the FFEL Program market, the Company faces significant competition from
SLM Corporation, the parent company of Sallie Mae. SLM Corporation services
nearly half of all outstanding federally insured loans and is the largest holder
of student loans. The Company also faces intense competition from other existing
lenders and servicers. As the Company expands its student loan origination and
acquisition activities, that expansion may result in increased competition with
some of its servicing customers. This has in the past resulted in servicing
customers terminating their contractual relationships with the Company, and the
Company could in the future lose more servicing customers as a result. As the
Company seeks to further expand its business, the Company will face numerous
other competitors, many of which will be well established in the markets the
Company seeks to penetrate. Some of the Company's competitors are much larger
than the Company, have better name recognition, and have greater financial and
other resources. In addition, several competitors have large market
capitalizations or cash reserves and are better positioned to acquire companies
or portfolios in order to gain market share. Furthermore, many of the
institutions with which the Company competes have significantly more equity
relative to their asset bases. Consequently, such competitors may have more
flexibility to address the risks inherent in the student loan business. Finally,
some of the Company's competitors are tax-exempt organizations that do not pay
federal or state income taxes and which generally receive floor income on
certain tax-exempt obligations on a greater percentage of their student loan
portfolio because they have financed a greater percentage of their student loans
with tax-exempt obligations issued prior to October 1, 1993. These factors could
give the Company's competitors a strategic advantage.
HIGHER RATES OF PREPAYMENTS OF STUDENT LOANS COULD REDUCE THE COMPANY'S PROFITS.
Pursuant to the Higher Education Act, borrowers may prepay loans made under
the FFEL Program at any time. Prepayments may result from consolidating student
loans, which tends to occur more frequently in low interest rate environments,
from borrower defaults, which will result in the receipt of a guarantee payment,
and from voluntary full or partial prepayments, among other things. High
prepayment rates will have the most impact on the Company's asset-backed
securitization transactions priced in relation to LIBOR. As of December 31,
2004, the Company had six transactions outstanding totaling approximately $5.8
billion that had experienced cumulative prepayment rates ranging from 19.3% to
22.7% as compared to four transactions outstanding totaling approximately $3.2
billion that had experienced cumulative prepayment rates ranging from 19.4% to
22.4% as of December 31, 2003. The rate of prepayments of student loans may be
influenced by a variety of economic, social, and other factors affecting
borrowers, including interest rates and the availability of alternative
financing. The Company's profits could be adversely affected by higher
prepayments, which would reduce the amount of interest the Company received and
expose the Company to reinvestment risk.
INCREASES IN CONSOLIDATION LOAN ACTIVITY BY THE COMPANY AND ITS COMPETITORS
PRESENT A RISK TO THE COMPANY'S LOAN PORTFOLIO AND PROFITABILITY.
The Company's portfolio of federally insured loans is subject to refinancing
through the use of consolidation loans, which are expressly permitted by the
Higher Education Act. Consolidation loan activity may result in three
detrimental effects. First, when the Company consolidates loans in its
portfolio, the new consolidation loans have a lower yield than the loans being
refinanced due to the statutorily mandated consolidation loan rebate fee of
1.05% per year. Although consolidation loans generally feature higher average
balances, longer average lives, and slightly higher special allowance payments,
such attributes may not be sufficient to counterbalance the cost of the rebate
fees. Second, and more significantly, the Company may lose student loans in its
portfolio that are consolidated away by competing lenders. Increased
consolidations of student loans by the Company's competitors may result in a
negative return on loans, when considering the origination costs or acquisition
premiums paid with respect to these loans. Additionally, consolidation of loans
away by competing lenders can result in a decrease of the Company's servicing
portfolio, thereby decreasing fee-based servicing income. Third, increased
consolidations of the Company's own student loans create cash flow risk because
the Company incurs upfront consolidation costs, which are in addition to the
origination or acquisition costs incurred in connection with the underlying
student loans, while extending the repayment schedule of the consolidated loans.
The Company's student loan origination and lending activities could be
significantly impacted by the reauthorization of the Higher Education Act
relative to the single holder rule. For example, if the single holder rule,
which generally restricts a competitor from consolidating loans away from a
holder that owns all of a student's loans, were abolished, a substantial portion
of the Company's non-consolidated portfolio would be at risk of being
consolidated away by a competitor. On the other hand, abolition of the rule
would also open up a portion of the rest of the market and provide the Company
with the potential to gain market share. Other potential changes to the Higher
Education Act relating to consolidation loans that could adversely impact the
Company include allowing refinancing of consolidation loans, which would open
approximately 59% of the Company's portfolio to such refinancing, and increasing
origination fees paid by lenders in connection with making consolidation loans.
15
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. Volumes of
originations are greater at some schools than others, and the Company's ability
to remain an active lender at a particular school with concentrated volumes is
subject to a variety of risks, including the fact that each school has the
option to remove the Company from its "preferred lender" list or to add other
lenders to its "preferred lender" list, the risk that a school may enter the FDL
Program, or the risk that a school may begin making student loans itself. The
Company acquires student loans through forward flow commitments with other
student loan lenders, but each of these commitments has a finite term. There can
be no assurance that these lenders will renew or extend their existing forward
flow commitments on terms that are favorable to the Company, if at all,
following their expiration.
In addition, as of December 31, 2004, third parties owned approximately 58%
of the loans the Company serviced. To the extent that third-party servicing
clients reduce the volume of student loans that the Company processes on their
behalf, the Company's income would be reduced, and, to the extent the related
costs could not be reduced correspondingly, net income could be materially
adversely affected. Such volume reductions occur for a variety of reasons,
including if third-party servicing clients commence or increase internal
servicing activities, shift volume to another service provider, perhaps because
such other service provider does not compete with the client in student loan
originations and acquisitions, or exit the FFEL Program completely.
SPECIAL ALLOWANCE PAYMENTS ON STUDENT LOANS ORIGINATED OR ACQUIRED WITH THE
PROCEEDS OF CERTAIN TAX-EXEMPT OBLIGATIONS MAY LIMIT THE INTEREST RATE ON
CERTAIN STUDENT LOANS TO THE COMPANY'S DETRIMENT.
Student loans originated or acquired with the proceeds of tax-exempt
obligations issued prior to October 1, 1993, as well as student loans acquired
with the sale proceeds of those student loans, receive only a portion of the
special allowance payment which they would otherwise be entitled to receive, but
those made prior to October 30, 2004 are guaranteed a minimum rate of return of
9.5% per year, less the applicable interest rate for the student loan.
As of December 31, 2004, approximately $3.0 billion of the Company's student
loan portfolio was comprised of loans that were previously financed with the
proceeds of tax-exempt obligations issued prior to October 1, 1993. Based upon
provisions of the Higher Education Act and related interpretations by the
Department, the Company believes that, for each of these student loans, the
Company will receive partial special allowance payments, subject to the 9.5%
Floor. However, the Department may change its regulations or its interpretations
of existing regulations, or the Higher Education Act may be amended, to
eliminate this special allowance payment treatment. In this event, the Company
would receive regular special allowance payments, but with no minimum rate of
return.
In the current low interest rate environment, the Company generally receives
partial special allowance payments and the 9.5% Floor with respect to its
eligible student loans originated or acquired with qualifying tax-exempt
proceeds. In a higher interest rate environment, however, the regular special
allowance payments on loans not originated or acquired with qualifying
tax-exempt proceeds may exceed the total subsidy to holders of eligible loans
originated or acquired with qualifying tax-exempt proceeds. Thus, in a higher
interest rate environment, these loans could have an adverse effect upon the
Company's earnings.
FAILURES IN THE COMPANY'S INFORMATION TECHNOLOGY SYSTEM COULD MATERIALLY DISRUPT
ITS BUSINESS.
The Company's servicing and operating processes are highly dependent upon its
information technology system infrastructure, and the Company faces the risk of
business disruption if failures in its information systems occur, which could
have a material impact upon its business and operations. The Company depends
heavily on its own computer-based data processing systems in servicing both its
own student loans and those of third-party servicing customers. If servicing
errors do occur, they may result in a loss of the federal guarantee on the
federally insured loans serviced or in a failure to collect amounts due on the
student loans that the Company serviced. In addition, although the Company
regularly backs up its data and maintains detailed disaster recovery plans, the
Company does not maintain fully redundant information systems. A major physical
disaster or other calamity that causes significant damage to information systems
could adversely affect the Company's business. Additionally, loss of information
systems for a sustained period of time could have a negative impact on the
Company's performance and ultimately on cash flow in the event the Company were
unable to process borrower payments.
TRANSACTIONS WITH AFFILIATES AND POTENTIAL CONFLICTS OF INTEREST OF CERTAIN OF
THE COMPANY'S OFFICERS AND DIRECTORS, INCLUDING ONE OF ITS CO-CHIEF EXECUTIVE
OFFICERS, POSE RISKS TO THE COMPANY'S SHAREHOLDERS.
16
The Company has entered into certain contractual arrangements with entities
controlled by Michael S. Dunlap, the Company's Chairman and Co-Chief Executive
Officer and a principal shareholder, and members of his family and, to a lesser
extent, with entities in which other directors and members of management hold
equity interests or board or management positions. Such arrangements constitute
a significant portion of the Company's business and include, among other things:
o performance of servicing duties;
o sales of student loans by such affiliates to the Company; and
o sales of student loan origination rights by such affiliates to the
Company.
These arrangements may present potential conflicts of interest.
Many of these arrangements are with Union Bank, in which Michael S. Dunlap
owns an indirect interest and of which he serves as non-executive chairman.
Union Bank is a significant source of student loans to the Company and a
significant servicing customer.
In 2004 and 2003, approximately 9.5% and 10.4%, respectively, of the
principal amount of the Company's student loan channel acquisitions were
acquired from Union Bank, a portion of which loans were originated by Union Bank
and a portion of which were originated by third parties. The Company believes
that the acquisitions were made on terms similar to those made from unrelated
entities. The Company intends to maintain its relationship with Union Bank,
which provides substantial benefits to the Company, although there can be no
assurance that all transactions engaged with Union Bank are, or in the future
will be, on terms that are no less favorable than what could be obtained from an
unrelated third party.
MATERIAL PROBLEMS AFFECTING UNION BANK COULD HAVE A MATERIAL ADVERSE EFFECT ON
THE COMPANY.
The ability of Union Bank to continue to do business with the Company will
depend on the development of Union Bank's own business, financial condition, and
results of operations, which will be affected by competitive and other factors
beyond the Company's control or knowledge. Because Union Bank is a privately
held company, an investor in the Company's securities might have little advance
warning of problems affecting Union Bank, even though these problems could have
a material adverse effect on the Company.
IMPOSITION OF PERSONAL HOLDING COMPANY TAX WOULD DECREASE THE COMPANY'S NET
income.
A corporation is considered to be a "personal holding company" under the U.S.
Internal Revenue Code of 1986, as amended (the "Code"), if (1) at least 60% of
its adjusted ordinary gross income is "personal holding company income"
(generally, passive income) and (2) at any time during the last half of the
taxable year more than half, by value, of its stock is owned by five or fewer
individuals, as determined under attribution rules of the Code. If both of these
tests are met, a personal holding company is subject to an additional tax on its
undistributed personal holding company income, currently at a 15% rate. Five or
fewer individuals hold more than half the value of the Company's stock. In June
2003, the Company submitted a request for a private letter ruling from the
Internal Revenue Service seeking a determination that its federally guaranteed
student loans qualify as assets of a "lending or finance business," as defined
in the Code. Such a determination would have enabled the Company to establish
that a company holding such loans does not constitute a personal holding
company. Based on its historical practice of not issuing private letter rulings
concerning matters that it considers to be primarily factual, the Internal
Revenue Service has indicated that it will not issue the requested ruling,
taking no position on the merits of the legal issue. So long as more than half
of the Company's value continues to be held by five or fewer individuals, if it
were to be determined that some portion of its federally guaranteed student
loans does not qualify as assets of a "lending or finance business," as defined
in the Code, the Company could become subject to personal holding company tax on
its undistributed personal holding company income. The Company continues to
believe that neither Nelnet, Inc. nor any of its subsidiaries is a personal
holding company. However, even if Nelnet, Inc. or one of its subsidiaries was
determined to be a personal holding company, the Company believes that by
utilizing intercompany distributions, it can eliminate or substantially
eliminate its exposure to personal holding company taxes, although it cannot
assure that this will be the case.
"DO NOT CALL" REGISTRIES LIMIT THE COMPANY'S ABILITY TO MARKET ITS PRODUCTS AND
SERVICES.
The Company's direct marketing operations are or may become subject to
various federal and state "do not call" laws and requirements. In January 2003,
the Federal Trade Commission amended its rules to provide for a national "do not
call" registry. Under these new federal regulations, which are currently being
challenged in court, consumers may have their phone numbers added to the
national "do not call" registry. Generally, the Company is prohibited from
calling anyone on that registry. In September 2003, telemarketers first obtained
access to the registry and since that time have been required to compare their
call lists against the national "do not call" registry at least once every 90
days. The Company is also required to pay a fee to access the registry on a
quarterly basis. Enforcement of the Federal "do not call" provisions began in
the fall of 2003, and the rule provides for fines of up to $11,000 per violation
and other possible penalties. This and similar state laws may restrict the
Company's ability to effectively market its products and services to new
customers. Furthermore, compliance with this rule may prove difficult, and the
Company may incur penalties for improperly conducting its marketing activities.
17
THE COMPANY'S INABILITY TO MAINTAIN ITS RELATIONSHIPS WITH SIGNIFICANT BRANDING
PARTNERS AND/OR CUSTOMERS COULD HAVE AN ADVERSE IMPACT ON ITS BUSINESS.
The Company's inability to maintain strong relationships with significant
schools, branding partners, servicing customers, guaranty agencies, and software
licensees could result in loss of:
o loan origination volume with borrowers attending certain schools;
o loan origination volume generated by some of the Company's branding
partners;
o loan and guarantee servicing volume generated by some of the Company's
loan servicing customers and guaranty agencies; and
o software licensing volume generated by some of the Company's licensees.
The Company cannot assure that its forward flow channel lenders or its
branding partners will continue their relationships with the Company. Loss of a
strong relationship, like that with a significant branding partner such as Union
Bank, or with schools from which a significant volume of student loans is
directly or indirectly acquired, could result in an adverse effect on the
Company's business.
The business of servicing Canadian student loans by EDULINX is limited to a
small group of servicing customers and the agreement with the largest of such
customers is currently scheduled to expire in February 2006. EDULINX cannot
guarantee that it will obtain a renewal of this largest servicing agreement or
that it will maintain its other servicing agreements, and the termination of any
such servicing agreements could result in an adverse effect on its business.
THE COMPANY CANNOT PREDICT WITH CERTAINTY THE OUTCOME OF THE SEC INFORMAL
INVESTIGATION.
Following the Company's disclosures related to recognition of 9.5% Floor
income, Senator Edward M. Kennedy, by letter to the Secretary of Education dated
August 26, 2004, requested information as to whether the Department had approved
of the Company's receipt of the 9.5% Floor income and, if not, why the
Department had not sought to recover claimed subsidies under the 9.5% Floor. By
letter dated September 10, 2004, the Company furnished to the Department certain
background information concerning the growth of the 9.5% Floor loans in its
portfolio, which information had been requested by the Department. Senator
Kennedy, in a second letter to the SEC dated September 21, 2004, requested that
the SEC investigate the Company's activities related to the 9.5% Floor. More
specifically, Senator Kennedy raised concerns about the Company's disclosures in
connection with its decision to recognize the previously deferred income, and
trading of Company securities by Company executives following such disclosures.
On September 27, 2004, the Company voluntarily contacted the SEC to request a
meeting with the SEC Staff. The Company's request was granted, and
representatives of the Company met with representatives of the SEC Staff on
October 12, 2004. Company representatives offered to provide to the SEC
information that the SEC Staff wished to have relating to the issues raised in
Senator Kennedy's letter. By letter dated October 14, 2004, the SEC Staff
requested that, in connection with an informal investigation, the Company
provide certain identified information. The Company has furnished to the SEC
Staff the information it has requested and is fully cooperating with the SEC
Staff in its informal investigation. The Company continues to believe that the
concerns expressed to the SEC by Senator Kennedy are entirely unfounded, but it
is not appropriate or feasible to determine or predict the ultimate outcome of
the SEC's informal investigation. The Company's costs related to the SEC's
informal investigation are being expensed as incurred. Additional costs, if any,
associated with an adverse outcome or resolution of that matter, in a manner
that is currently indeterminate and inherently unpredictable, could adversely
affect the Company's financial condition and results of operations. Although it
is possible that an adverse outcome in certain circumstances could have a
material adverse effect, based on information currently known by the Company's
management, in its opinion, the outcome of such pending informal investigation
is not likely to have such an effect.
ITEM 2. PROPERTIES
The following table lists the principal facilities leased by the Company. The
Company does not own any of its principal facilities.
Approximate Lease
square expiration
Location Primary Function or Segment feet date
-------- --------------------------- ---- ----
Jacksonville, FL.. Student Loan and Guarantee Servicing, Loan 135,000 October 2013
Generation, Technology
Denver, CO........ Student Loan Servicing, Loan Generation, Technology 124,000 February 2008
Mississauga, Ontario Student Loan Servicing 114,000 August 2009
Lincoln, NE....... Corporate Headquarters, Student Loan Servicing, 95,000 December 2010
Loan Generation
Indianapolis, IN.. Student Loan Servicing, Loan Generation 59,000 February 2008
The Company leases other facilities located throughout the United States.
These properties are leased on terms and for durations that are reflective of
commercial standards in the communities where these properties are located. The
Company believes that its respective properties are generally adequate to meet
its long-term business goals. The Company's principal office is located at 121
South 13th Street, Suite 201, Lincoln, Nebraska 68508.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject to various claims, lawsuits, and proceedings that
arise in the normal course of business. These matters principally consist of
claims by borrowers disputing the manner in which their loans have been
processed. 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.
In addition to such legal proceedings that arise in the ordinary course of
business, the Company has furnished to the SEC Staff information the SEC
requested pursuant to an informal investigation and the Company is fully
cooperating with the SEC on such informal investigation. For further
information, see Part II, Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Overview -- Recent
Developments."
18
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of fiscal 2004.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS,
AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company's Class A Common Stock is listed and traded on the New York Stock
Exchange under the symbol "NNI," while its Class B Common Stock is not publicly
traded. The number of holders of record of the Company's Class A Common Stock
and Class B Common Stock as of February 15, 2005 was approximately 206 and
seven, respectively. Because many shares of the Company's Class A Common stock
are held by brokers and other institutions on behalf of shareholders, the
Company is unable to estimate the total number of beneficial owners represented
by these record holders.
The following table sets forth the high and low sales prices for the
Company's Class A Common Stock for each full quarterly period in 2004 and for
the partial quarter from December 11, 2003 (the initial public offering date of
the Company's Class A Common Stock) until December 31, 2003. The price paid per
share by the initial purchasers in the Company's initial public offering on
December 11, 2003 was $21.00.
2003 2004
------------ -------------------------------------------------
4th Quarter (a) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
------------ ----------- ----------- ----------- ----------
High $ 22.40 $ 25.68 $ 25.83 $ 24.70 $ 27.00
Low 20.86 22.00 16.80 16.76 19.20
----------
(a) Stock prices are for the partial quarter from December 11, 2003 (the
initial public offering date of the Company's Class A Common Stock)
through December 31, 2003
The Company did not pay cash dividends on either class of its Common Stock
for the two most recent fiscal years and does not intend to pay dividends in the
foreseeable future. The Company intends to retain its earnings to finance
operations and future growth, and any decision to pay cash dividends will be
made by the Company's board of directors based on factors such as the Company's
results of operations and working capital requirements. The credit agreement
with the Company's general credit providers restricts payment of dividends or
other distributions to shareholders in the event the Company is in default under
the credit agreement or if payment of such a dividend or distribution would
result in such a default. In addition, trust indentures governing debt issued by
the education lending subsidiaries generally limit the amounts of funds that can
be transferred to the Company by its subsidiaries through cash dividends.
For information regarding the Company's equity compensation plans, see Part
III, Item 12 of this Report.
19
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial and other operating
information of the Company. The selected financial data in the table is derived
from the consolidated financial statements of the Company. The data should be
read in conjunction with the consolidated financial statements, the related
notes, and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" included in this Report.
Year ended December 31,
-------------------------------------------------------------
2004 2003 2002 2001 2000
----------- ----------- ----------- ----------- ----------
(dollars in thousands, except share data)
Income Statement Data:
Net interest income.......... $ 398,166 $ 171,722 $ 185,029 $ 115,120 $ 64,853
Less provision (recovery) for
loan losses.................. (529) 11,475 5,587 3,925 1,370
----------- ---------- ---------- ---------- ----------
Net interest income after
provision (recovery)
for loan losses............ 398,695 160,247 179,442 111,195 63,483
Loan servicing and other fee
income..................... 98,661 102,959 105,160 93,172 66,015
Software services and other
income..................... 25,868 19,017 22,781 7,713 8,431
Derivative market value
adjustment and
net settlements............ (46,058) (2,784) (579) (3,517) --
Operating expenses........... (242,751) (233,150) (230,963) (195,438) (131,196)
----------- ----------- ----------- ----------- -----------
Income before income taxes
and minority interest...... 234,415 46,289 75,841 13,125 6,733
Net income................... 149,179 27,103 48,538 7,147 4,520
Earnings per share, basic
and diluted................ $ 2.78 $ 0.60 $ 1.08 $ 0.16 $ 0.11
Weighted average shares
outstanding................ 53,648,605 45,501,583 44,971,290 44,331,490 41,187,230
Other Data:
Origination and acquisition
volume (a)................. $ 4,079,491 $ 3,093,014 $ 1,983,403 $ 1,448,607 $ 1,027,498
Average student loans........ $11,809,663 $ 9,316,354 $ 8,171,898 $ 5,135,227 $ 3,388,156
Student loans serviced (at
end of period)............. $28,288,622 $18,773,899 $17,863,210 $16,585,295 $11,971,095
Ratios:
Core student loan spread..... 1.66% 1.78% 1.65% 1.66% 2.26%
Return on average total
assets..................... 1.11% 0.25% 0.52% 0.12% 0.12%
Return on average equity..... 39.7% 19.4% 49.2% 11.7% 8.2%
Net loan charge-offs as a
percentage of average
student loans.............. 0.070% 0.080% 0.047% 0.042% 0.055%
As of December 31,
-------------------------------------------------------------
2004 2003 2002 2001 2000
-------- --------- --------- -------- ---------
(dollars in thousands)
Balance Sheet Data:
Cash and cash equivalents.... $ 39,989 $ 198,423 $ 40,155 $ 36,440 $ 23,263
Student loans receivables, net 13,461,814 10,455,442 8,559,420 7,423,872 3,585,943
Total assets................. 15,160,005 11,932,186 9,766,583 8,134,560 4,021,948
Bonds and notes payable...... 14,300,606 11,366,458 9,447,682 7,926,362 3,934,130
Shareholders' equity......... 456,175 305,489 109,122 63,186 54,161
- ------------
(a) Initial loans originated or acquired through various channels, including
originations through the direct channel and acquisitions through the
branding partner channel, the forward flow channel, and the secondary market
(spot purchases).
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company is one of the leading education finance companies in the United
States and is focused on providing quality student loan products and services to
students and schools nationwide. The Company ranks among the nation's leaders in
terms of total net student loan assets with $13.5 billion as of December 31,
2004.
The Company's business is comprised of three primary product and service
offerings:
o ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS.
The Company provides student loan marketing, originations, acquisition,
and portfolio management. The Company owns a large portfolio of student
loan assets through a series of education lending subsidiaries. The
Company obtains loans through direct origination or through acquisition of
loans. The Company also provides marketing, sales, managerial, and
administrative support related to its asset generation activities.
o STUDENT LOAN AND GUARANTEE SERVICING. The Company services its student
loan portfolio and the portfolios of third parties. Servicing activities
include loan origination activities, application processing, borrower
updates, payment processing, due diligence procedures, and claim
processing. The Company also provides servicing support to guaranty
agencies, which includes system software, hardware and telecommunication
support, borrower and loan updates, default aversion tracking services,
claim processing services, and post-default collection services.
20
o SERVICING SOFTWARE. The Company uses internally developed student loan
servicing software and also provides this software to third-party student
loan holders and servicers.
The Company's education lending subsidiaries under the Asset Management
service offering are engaged in the securitization of education finance assets.
These education lending subsidiaries hold beneficial interests in eligible
loans, subject to creditors with specific interests. The liabilities of the
Company's education lending subsidiaries are not the obligations of the Company
or any of its other subsidiaries and cannot be consolidated in the event of
bankruptcy. The transfers of student loans to the eligible lender trusts do not
qualify for sales under the provisions of SFAS No. 140, Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities, as the
trusts continue to be under the effective control of the Company. Accordingly,
all the financial activities and related assets and liabilities, including debt,
of the securitizations are reflected in the Company's consolidated financial
statements.
The Company's primary product and service offerings constitute reportable
segments per the provisions of SFAS No. 131. The following table shows the
percent of total segment revenue (excluding intersegment revenue) and net income
(loss) before taxes for each of the Company's segments:
Years ended December 31,
---------------------------------------------------------------
2004 2003
------------------------------ -------------------------------
Student Student
loan and loan and
Asset guarantee Servicing Asset guarantee Servicing
management servicing software management servicing software
---------- --------- --------- ---------- ---------- --------
Segment revenue.............. 76.5% 21.8% 1.7% 60.8% 36.2% 3.0%
Segment net income (loss)
before taxes................. 81.1% 19.7% ( 0.8)% 62.2% 41.9% (4.1)%
The Company's derivative market value adjustment and net settlements are
included in the Asset Management segment. Because the majority of the Company's
derivatives do not qualify for hedge accounting under SFAS No. 133, the
derivative market value adjustment can cause the percent of revenue and net
income (loss) before taxes to fluctuate from period to period between segments.
The Company's student loan portfolio has grown significantly through
originations and acquisitions. The Company originated or acquired $4.1 billion
of student loans in 2004 through student loan channel acquisitions, including:
o the direct channel, in which the Company originates student loans in one
of its brand names directly to student and parent borrowers, which
accounted for 50.5% of the student loans added to the Company's loan
portfolio through a student loan channel in 2004;
o the branding partner channel, in which the Company acquires student loans
from lenders to whom it provides marketing and origination services, which
accounted for 24.3% of the student loans added to the Company's loan
portfolio through a student loan channel in 2004; and
o the forward flow channel, in which the Company acquires student loans from
lenders to whom it provides origination services, but provides no
marketing services, or who have agreed to sell loans to the Company under
forward sale commitments, which accounted for 19.1% of the student loans
added to the Company's loan portfolio through a student loan channel in
2004.
In addition, the Company also acquires student loans through spot purchases,
which accounted for 6.1% of student loans added to the Company's loan portfolio
through a student loan channel in 2004.
Not included in the previous student loan channel acquisition data is the
addition of $136.1 million of student loans acquired through a business
combination in April 2004.
21
SIGNIFICANT DRIVERS AND TRENDS
The Company's earnings and earnings growth are directly affected by the size
of its portfolio of student loans, the interest rate characteristics of its
portfolio, the costs associated with financing and managing its portfolio, and
the costs associated with the origination and acquisition of the student loans
in the portfolio. See "-- Student Loan Portfolio." In addition to the impact of
growth of the Company's student loan portfolio, the Company's results of
operations and financial condition may be materially affected by, among other
things, changes in:
o applicable laws and regulations that may affect the volume, terms,
effective yields, or refinancing options of education loans;
o demand for education financing and competition within the student loan
industry;
o the interest rate environment, funding spreads on the Company's financing
programs, and access to capital markets; and
o prepayment rates on student loans, including prepayments relating to loan
consolidations.
The Company's net interest income, or net interest earned on its student loan
portfolio, is the primary source of income and is primarily impacted by the size
of the portfolio and the net yield of the assets in the portfolio. If the
Company's student loan portfolio continues to grow and its net interest margin
remains relatively stable, the Company expects its net interest income to
increase. The Company's portfolio of FFELP loans generally earns interest at the
higher of a variable rate based on the special allowance payment, or SAP,
formula set by the Department and the borrower rate, which is fixed over a
period of time. The SAP formula is based on an applicable index plus a fixed
spread that is dependent upon when the loan was originated, the loan's repayment
status, and funding sources for the loan. Based upon provisions of the Higher
Education Act and related interpretations by the Department, loans financed
prior to September 30, 2004 with tax-exempt obligations issued prior to October
1, 1993 are entitled to receive special allowance payments equal to a 9.5%
minimum rate of return. In May 2003, the Company sought confirmation from the
Department regarding the treatment and recognition of special allowance payments
on a portion of its portfolio that had been previously financed with tax-exempt
obligations. While pending satisfactory resolution of this issue with the
Department, the Company deferred recognition of the interest income that was
generated by these loans in excess of income based upon the standard special
allowance rate. In June 2004, after consideration of certain clarifying
information received in connection with the guidance it had sought, including
written and verbal communications with the Department, the Company concluded
that the earnings process had been completed related to the special allowance
payments on these loans and recognized $124.3 million of interest income. As of
December 31, 2003, the amount of deferred excess interest income on these loans
was $42.9 million. The Company currently recognizes the income from the special
allowance payments, referred to as the special allowance yield adjustment, on
these loans as it is earned and would expect its net interest income to increase
over historical periods accordingly; however, since the portfolio subject to the
9.5% floor is not expected to increase, amounts recognized will decrease as
compared to the current period. In addition, if interest rates rise, the normal
yield on the portfolio of loans earning this special allowance will increase,
thereby reducing the special allowance yield adjustment. The Company entered
into $3.7 billion in notional amount of interest rate swaps in July 2004 to
reduce the risk of rising interest rates on this portfolio.
Net interest income increased by $226.4 million, or 131.9%, in 2004 as
compared to 2003. Net interest income, excluding the effects of variable-rate
floor income and the special allowance yield adjustment, increased approximately
$35.4 million, or 22.3%, in 2004 as compared to 2003, due primarily to portfolio
growth. Net student loans receivable increased by $3.0 billion, or 28.8%, to
$13.5 billion as of December 31, 2004 as compared to $10.5 billion as of
December 31, 2003.
Interest income is also dependent upon the relative level of interest rates.
The Company maintains an overall interest rate risk management strategy that
incorporates the use of interest rate derivative instruments to reduce the
economic effect of interest rate volatility. The Company's management has
structured all of its derivative instruments with the intent that each is
economically effective. However, most of the Company's derivative instruments do
not qualify for hedge accounting under SFAS No. 133 and thus may adversely
impact earnings. In addition, the mark-to-market adjustment recorded through
earnings in the Company's consolidated statements of income may fluctuate from
period to period. See Item 7A, "Quantitative and Qualitative Disclosures about
Market Risk -- Interest Rate Risk."
Competition for the supply channel of education financing in the student loan
industry has caused the cost of acquisition (or premiums) related to the
Company's student loan assets to increase. In addition, the Company has seen
significant increases in consolidation loan activity and consolidation loan
volume within the industry. The increase in competition for consolidation loans
has caused the Company to be aggressive in its measures to protect and secure
the Company