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, 2003
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 [ ] No [X]
The aggregate market value of the Registrant's voting common stock held by
non-affiliates of the Registrant (assuming for the purposes of this calculation
only, that the Registrant's directors, executive officers and greater than 10%
shareholders are affiliates of the Registrant), based upon the closing sale
price of the Registrant's common stock on February 13, 2004 was $418,219,512.
As of February 13, 2004, there were 39,601,834 and 14,023,454 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
2004 Annual Meeting of Stockholders scheduled to be held May 27, 2004 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, changes in the terms of student
loans and the educational credit marketplace arising from the implementation of
applicable laws and regulations and from changes in these laws and regulations,
which may reduce the volume, average term and costs of yields on student loans
under the Federal Family Education Loan Program ("FFELP" or "FFEL Program") or
result in loans being originated or refinanced under non-FFELP programs or may
affect the terms upon which banks and others agree to sell FFELP loans to us. We
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 "we," "us," "our" and "the Company" refer to
Nelnet, Inc. and its subsidiaries.
PART I.
ITEM 1. BUSINESS
Overview
We are a vertically integrated education finance company, with over $11.9
billion in total assets as of December 31, 2003, making us one of the leading
education finance companies in the country. We are focused on providing quality
products and services to participants in the education finance process.
Headquartered in Lincoln, Nebraska, we originate, hold and service student
loans, principally loans originated under the FFEL Program. We, together with
our branding partners, originated and acquired approximately $4.3 billion of
student loans in 2003, which includes $1.2 billion of existing loans we
consolidated from our own loan portfolio, making us a leading originator and
acquirer of student loans. A detailed description of the FFEL Program appears in
Appendix A to this annual report on Form 10-K (the "Report").
We offer a broad range of financial services and technology-based products,
including student loan origination and lending, student loan and guarantee
servicing and a suite of software solutions. Our products are designed to
simplify the student loan process by automating financial aid delivery, loan
processing and funds disbursement. Our 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.
Our business is comprised of four primary product and service offerings:
o Asset management, including student loan originations and
acquisitions. We provide student loan sales, marketing, originations,
acquisition and portfolio management. We own a large portfolio of
student loan assets through a series of education lending
subsidiaries. As of December 31, 2003, our student loan portfolio was
$10.3 billion, consisting of over 99% of FFELP loans and less than 1%
of private loans. We generate loans owned in special purpose lending
facilities through direct origination or through acquisition of loans.
We generate the majority of our earnings from the spread between the
yield we earn on our student loan portfolio and the cost of funding
these loans. We also provide marketing and sales support and
managerial and administrative support related to our asset generation
activities, as well as those performed for our branding partners or
other lenders who sell such loans.
o Student loan servicing. We service our student loan portfolio and the
portfolios of third parties. As of December 31, 2003, we serviced or
provided complete outsourcing of servicing activities for more than
$18.7 billion in student loans, including $9.2 billion of loans in our
own portfolio. The servicing activities include loan origination
activities, application processing, borrower updates, payment
processing, claim processing and due diligence procedures. These
activities are performed internally for our own portfolio and generate
fee revenue when performed for third-party clients.
o Guarantee servicing. We provide 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, 2003, we provided servicing
support to agencies that guarantee more than $20 billion of FFELP
loans. These activities generate fee revenue in addition to expanding
our relationship with other participants in the education finance
sector.
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o Servicing software. We provide student loan servicing software
internally and to third-party student loan holders and servicers. As
of December 31, 2003, our software was used to service $46 billion in
student loans, which included $27 billion serviced by third parties
using our software. We earn software license and maintenance fees
annually from third-party clients for use of this software. We also
provide computer consulting, custom software applications and customer
service support.
In accordance with accounting principles generally accepted in the United
States, our asset management and student loan servicing offerings constitute
reportable operating segments. Our guarantee servicing and servicing software
offerings are operating segments that do not meet the quantitative thresholds,
and, therefore, are included as other segments that do not meet the reportable
segment criteria. In 2003, our asset management, student loan servicing and
other segments generated 61.8%, 27.3% and 10.9%, respectively, of our total
segment revenues (excluding intersegment revenue) and 72.7%, 23.3% and 4.0%,
respectively, of our segment net income. For additional information, see note 18
of the notes to the consolidated financial statements.
Our earnings and earnings growth are directly affected by the size of our
portfolio of student loans, the interest rate characteristics of our portfolio,
the costs associated with financing and managing our portfolio and the costs
associated with origination and acquisition of the student loans in the
portfolio. We generate the majority of our earnings from the spread between the
yield we receive on our 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 we receive a minimum
yield on our student loans, so long as certain requirements are met. We also
earn fees from student loan and guarantee servicing and licensing fees from our
servicing software. Earnings growth is primarily driven by the growth in the
student loan portfolio and growth in our fee-based product and service
offerings, coupled with cost-effective financing and expense management. In
2003, we generated net interest income of $178.6 million, total other income,
including loan servicing income, of $117.5 million and net income of $27.1
million. Our earnings in 2003 included $12.8 million of variable-rate floor
income and a mark-to-market loss on derivative instruments of $1.2 million. Our
operating expenses in 2003 included $12.8 million of amortization of intangible
assets resulting from acquisitions prior to 2003, of which $6.7 million is not
deductible for federal income tax purposes.
As of December 31, 2003, over 99% of the student loans in our portfolio were
FFELP loans, as opposed to the less than 1% of private loans in our 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
we meet certain procedures and standards specified in the Higher Education Act.
We believe we are 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. As a result, holders of FFELP loan portfolios
historically have experienced minimal losses net of the guarantee. Our net loan
losses on FFELP loans in 2003 were approximately $3.5 million, or less than
0.04% of our average FFELP loan portfolio.
Our History
We have a 26-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. It grew its third-party student loan servicing business to
approximately $9.7 billion in loans in 2000, when it was merged with Nelnet. Our
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, we decided to create a vertically integrated platform that would be
able to compete in each sector of the student loan industry. Over the past four
years we have acquired several education finance services companies, including a
student loan secondary market company. In addition, in August 2003, we acquired
a securities company that provides us with broker-dealer services in connection
with our asset-backed securitizations and in January 2004, we acquired a 50%
ownership interest in a collection firm specializing in past due debts for
higher education companies.
We executed these acquisitions to complete our effort to vertically
integrate and add geographic diversity and operational expertise to our
education finance platform. Historically, we have successfully integrated these
companies into the Nelnet platform, and they have increased our profitability as
a result. We now believe that we have all of the key components of our vertical
integration strategy. Going forward, we intend to focus principally on organic
growth while opportunistically making company and student loan portfolio
acquisitions.
Product and Service Offerings
Asset management, including student loan originations and acquisitions
Our asset management business, including student loan originations and
acquisitions, is our largest product and service offering and drives the
majority of our earnings. When we originate FFELP loans on our own behalf or
when we acquire FFELP loans from others,
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we engage one or more "eligible lenders," as defined in the Higher Education
Act, to act as our trustees to hold title to all such originated and acquired
FFELP loans. These eligible lender trustees hold the legal title to our FFELP
loans, and we hold 100% of the beneficial interests in those loans. We
originated and acquired $4.3 billion in student loans in 2003, which includes
$1.2 billion of existing loans we consolidated from our own loan portfolio. We
often originate loans using the Nelnet brand name but, in many cases, we use
well-known, geographically strategic brand names of our branding partners, such
as SunTrust Bank, Education Solutions, Inc. and Union Bank. This strategy gives
us the flexibility to market the brand with the best recognition in a given
region or at a given college or university. We originate and acquire loans
through our direct channel, branding partner channel, forward flow channel and
through spot purchases.
Through our direct channel, we originate student loans in one of our brand
names directly to students and parent borrowers. Of the $4.3 billion of student
loans we originated and acquired in 2003, $2.3 billion were loans consolidated
through our direct channel, $1.2 billion of which were existing loans we
consolidated from our own loan portfolio. We originated, including loans
originated through consolidation, 58.9% of the loans added to our student loan
portfolio in 2003. Excluding loans we consolidated from our own loan portfolio,
we originated 43.4% of the loans added to our student loan portfolio in 2003.
Student loans that we originate through our direct channel are our most
profitable student loans because they typically cost us less than loans acquired
through our other channels and they remain in our 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, we have developed an extensive loan consolidation department to
serve borrowers with loans in our portfolio as well as borrowers whose loans are
held by other lenders.
Through our branding partner channel, we acquire student loans from lenders
to whom we provide marketing and origination services established through our
various contracts with FFELP lenders. In 2003, 19.0% of our loan acquisitions
were attributable to this channel. Excluding loans we consolidated from our own
loan portfolio, 26.2% of our loan acquisitions were attributable to this channel
in 2003. We frequently act as exclusive marketing agent for some branding
partners in specified geographic areas. We ordinarily purchase 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. We
ordinarily retain 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 performed by us 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 us. 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. We are generally obligated to
purchase all of the loans originated by our branding partners under these
commitments, although our branding partners are not obligated to provide us with
a minimum amount of loans.
In addition to the branding partner channel, we have established a forward
flow channel for acquiring FFELP loans from lenders to whom we provide
origination services, but provide no marketing services, or who agree to sell
loans to us under forward sale commitments. In 2003, 14.2% of our loan
acquisitions were attributable to this channel. Excluding loans we consolidated
from our own loan portfolio, 19.5% of our loan acquisitions were attributable to
this channel in 2003. 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. We are
generally obligated to purchase loans subject to forward flow commitments
shortly following full disbursement, although our forward flow lenders are not
obligated to provide us with a minimum amount of loans. We typically retain
rights to purchase serial loans. The loans subject to purchase are generally
subject to a servicing agreement with us for the life of each such loan. Such
forward flow commitments ordinarily are for terms of three to five years in
duration.
In addition, we acquire student loans through spot purchases, which
accounted for 7.9% of the student loans that we originated and acquired in 2003.
Excluding loans we consolidated from our own loan portfolio, 10.9% of our loan
acquisitions were attributable to this channel in 2003.
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As of December 31, 2003, the characteristics of our student loan portfolio,
exclusive of the unamortized cost of acquisition, were as described below.
Composition of Student Loan Portfolio
(As of December 31, 2003)
(loan balances in thousands)
Loans outstanding ............................................ $10,314,874
FFELP loans:
Stafford loans .......................................... $4,901,289
PLUS/SLS loans (a) ...................................... $249,217
Consolidation loans ..................................... $5,073,081
Private loans ................................................ $91,287
Number of borrowers .......................................... 800,520
Average outstanding principal balance per borrower ........... $12,885
Number of loans .............................................. 2,125,027
Average outstanding principal balance per loan ............... $4,854
Weighted average annual interest rate ........................ 4.50%
Weighted average remaining term (months) ..................... 180
- -------
(a) Supplemental Loans for Students, or SLS, are the predecessor to
unsubsidized Stafford loans.
Our capital markets and portfolio administration departments provide
financing options to fund our loan portfolio. As of December 31, 2003, we had a
warehousing capacity of $2.8 billion through 364-day commercial paper conduits.
These transactions provide short-term asset financing for the purchase of
student loan portfolios. The financings are constructed to offer short-term
capital and are annually renewable.
Short-term warehousing allows us to buy and manage student loans prior to
transferring them into more permanent financing arrangements. Our large
warehousing capacity allows us 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 one of our long-term securitizations. We hold
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 one of our long-term securitizations. Because transferring those loans to a
long-term securitization includes certain fixed administrative costs, we
maximize our economies of scale by executing large transactions that routinely
price in line with our largest competitor. We are a frequent issuer of
asset-backed securities and benefit from a high level of name recognition by the
asset-backed investment community.
We had approximately $9.3 billion in asset-backed securities issued and
outstanding as of December 31, 2003, including auction-rate notes whose interest
rates are reset periodically. These asset-backed securities allow us to finance
student loan assets over multiple years, thereby reducing the renewal risk
associated with warehouse vehicles.
We rely upon securitization vehicles as our most significant source of
funding for student loans on a long-term basis. The net cash flow we receive
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 may have been pledged to secure additional bond
obligations. Our 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.
Our 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 our securitizations increased, we began publicly offering
asset-backed securities under shelf registration statements, using special
purpose entities. When we deemed long-term interest rates attractive, we issued
fixed-rate debt backed by cash flows from FFELP loans with fixed-rate floors,
which effectively match the funding of our assets and liabilities. In 2002, we
began accessing the term asset-backed securities market by issuing amortizing
multi-tranche LIBOR-indexed variable-rate debt securities. We have utilized
financial guarantees from monoline insurers and senior/subordinate structures to
assist in obtaining "AAA" ratings on our senior securitized debt in addition to
cash reserves and excess spread to assist in obtaining "A" and "AA" ratings on
our subordinated debt. We intend 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 our cost of funds and
give us the most flexibility to optimize the return on our student loan assets.
We acquired UFS Securities LLC, or UFS Securities, in August 2003 in order
to enhance our access to broker-dealer services related to our debt securities
offerings. UFS Securities fits into our overall business strategy by effectively
decreasing our costs associated with accessing the asset-backed securitization
market. UFS Securities sells certain tranches of our auction rate securities in
co-broker-dealer arrangements with certain third-party broker-dealers. Since UFS
Securities has become our wholly owned subsidiary, the fees that it receives in
conjunction with sales of our securities reduce our overall costs of issuance
with respect to our auction rate securities. We intend to continue other
business activities of UFS Securities, including providing consulting services
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to financial institutions and broker-dealers, serving as a distributor of
accounts with the College Savings Plan of Nebraska and acting as an underwriter
for mutual funds. The business activities of UFS Securities do not constitute a
material part of our business.
Student Loan Servicing
We specialize in the servicing of FFELP and private student loans. Our
servicing division offers lenders across the country 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. Our student loan and guarantee servicing divisions each uses a
proprietary system to manage the servicing process. These systems provide for
automated compliance with most Higher Education Act regulations.
Our quality and experience in student loan servicing is evident in the
historical performance of our entire pool of loan assets, which enjoys a very
low initial claim rejection rate due to servicer error, which is the percent of
claims submitted by us or our servicing customers rejected by a guaranty agency
due to servicer error. In 2003, the initial claim rejection rate due to servicer
error was approximately 0.33% of all claims filed by us or our servicing
customers. The substantial majority of these initial claim rejections are cured,
meaning a payment or the borrower's promise to pay has been received. In 2003,
the aggregate of our losses and those of our servicing customers from rejected
loans and interest denials were less than $500,000, or less than 0.01% of our
average servicing portfolio.
As we expand our student loan origination and acquisition activities, we may
face increased competition with some of our servicing customers. In the past,
including in one case recently, servicing customers have terminated their
servicing relationships with us, and we could in the future lose more servicing
customers as a result. However, due to our life-of-loan servicing agreements, we
do not expect this loss and potential loss of customers to have a material
adverse effect on our results of operations for the foreseeable future.
Guarantee Servicing
We provide servicing support for guaranty agencies, which are the
organizations that serve as the intermediary between the federal government and
the lender of FFELP loans and who are responsible for paying the claims made on
defaulted loans. One of our guarantee servicing customers notified us of its
intention not to renew its servicing contract. The loss of this customer is not
expected to have a material effect on our results of operations.
Servicing Software
Our servicing software is focused on providing technology solutions to
education finance issues. Our 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. In
addition, 5280 Solutions, Inc., of which we own a 50% voting interest, provides
customized software solutions to help in the administration and management of
the student loan process.
Software Products
Our software products are designed to provide us loan origination access to
colleges and universities, while simplifying the financial aid process. We also
license our servicing software products to third-party student loan holders and
servicers. Our software products include the following:
o Nteract -- an Internet-based, open-architecture student loan
origination and disbursement management system. Nteract provides a
complete solution for processing FFELP and private student loan
certifications, initiating change transactions, and can serve as a
comprehensive loan delivery system. Nteract operates in a real-time
environment and can be accessed for online inquiry at any time 24
hours a day, seven days a week. Nteract is used with our student loan
origination, acquisition and portfolio management offering and our
student loan servicing product offering.
o Ntrust -- a centralized disbursement service. Ntrust is a
comprehensive, open-architecture solution for receiving FFELP and
private student loan funds, reports and the student loan industry's
standardized data files. Ntrust provides a single point of contact for
the college or university's entire electronic loan processing needs
and provides real-time loan disbursement adjustment processing. Ntrust
is used by our student loan origination, acquisition and portfolio
management offering and our student loan servicing product offering.
o Ngenius -- the origination engine that supports the Ntrust and Nteract
products. Used for loan origination initiatives, Ngenius is a
table-driven origination platform which provides flexibility and
scalability. The system interacts with multiple guaranty agencies and
can support an instant guarantee. Ngenius is used by our student loan
origination, acquisition and portfolio
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management offering and our student loan servicing product offering.
o Nservice -- our servicing engine for FFELP and private loans. The
Nservice system is a profile driven system, allowing for easy
implementation of most regulatory changes and rapid development of
custom loan programs. Software development is aided by the use of
high-level application development tools to speed delivery of
enhancements. The Nservice system provides for automated compliance
with most Higher Education Act regulations. Nservice also facilitates
the servicing of FFELP and private loans into a single, integrated
servicing environment, improving service to schools, borrowers and
lenders. Nservice is used by our student loan servicing product
offering, and the software is also licensed to third-party student
loan holders and servicers by our servicing software product offering.
In addition to the products described above, we offer a variety of borrower
services to assist students and parents in navigating the financial aid process.
These services include our 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.
Our 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. We capitalize
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 our 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
Statement of Financial Accounting Standards ("SFAS") No. 86, Accounting for the
Cost of Computer Software to be Sold, Leased or Otherwise Marketed.
Interest Rate Risk Management
Since we generate the majority of our earnings from the spread between the
yield we receive on our portfolio of student loans and the cost of financing
these loans, the interest rate sensitivity of our balance sheet could have a
material effect on our operations. Although the majority of our student loans
have variable-rate characteristics in interest rate environments when the
special allowance payment formula exceeds the borrower rate, some of our student
loans, primarily consolidation loans, have fixed-rate characteristics to them.
We attempt 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 our assets and varying market conditions, we do not attempt to perfectly
match the interest rate characteristics of the entire loan portfolio with the
underlying debt instruments. To date, we have financed the majority of our
student loan portfolio with variable-rate debt.
In the current low interest rate environment, our FFELP loan portfolio is
yielding excess income due to the reduction in the interest rates on the
variable-rate liabilities financing student loans at a fixed borrower rate. In
higher interest rate environments, where the interest rate rises above the
borrower rate and fixed-rate loans become variable, the impact of the rate
fluctuations is substantially reduced. We have employed various derivative
instruments to help manage our interest rate risk. We periodically review
mismatched interest rate characteristics of our portfolios of student loans and
those of our underlying debt instruments in order to evaluate utilization of
interest rate swaps and other derivative instruments as part of our overall risk
management strategy. As a result of our interest rate management activities, we
believe we have reduced the volatility and effects of a rising interest rate
environment. For further information, see "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Risks -- Market and Interest
Rate Risk."
Intellectual Property
We own numerous trademarks and service marks to identify our various
products and services, both by words and logos, or by "design" marks. We have 12
pending and 15 registered marks for such products and services, and we actively
assert our rights to those marks when we believe potential infringement may be
occurring. We believe our marks and logos have developed and continue to develop
strong brand-name recognition in our industry and the consumer marketplace. Each
of these marks has, upon registration, an indefinite duration so long as we
continue to use the mark on or in connection with such goods or services as the
mark identifies. In order to protect the indefinite duration, we make filings to
continue registration of these marks. We own one patent application that has
been published with respect to a customer-loyalty program and have also actively
asserted our rights thereunder in situations
7
where we believe our claims may be infringed upon. If such patent is granted, it
will have a duration and effect of 20 years from the date of application. We own
many copyright-protected works, including our various computer system codes and
displays, Web sites, publications and marketing collateral. We also have trade
secret rights to many of our processes and strategies, and our software product
designs. Our software products are protected by both registered and common law
copyrights. We also protect our software products through strict confidentiality
and ownership provisions placed in license agreements which restrict the ability
to copy, distribute or disclose the software products. We also have adopted
internal procedures designed to preserve trade secrets with respect to our
intellectual property.
We seek 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. Our
employees are trained in the fundamentals of intellectual property, intellectual
property protection and infringement issues, and 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 our 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 February
account for 73% of our total annual Stafford and PLUS disbursements. While
applications and disbursements are seasonal, our earnings are generally not tied
to this cycle. Due to our portfolio size and the volume of our acquisitions
through our 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. Historically, consolidation loans have primarily been made prior to
or immediately after the July 1 reset in a rising or falling interest rate
environment. This trend in the disbursement of consolidation loan disbursements
has not occurred in the second half of 2003 and first quarter of 2004, as low
interest rate environments and continued solicitation activities have resulted
in a continued increase in our consolidation disbursements.
Customers
As of December 31, 2003, we provided student loan servicing either directly
or through our proprietary software to more than 1.7 million borrowers. We have
direct and indirect relationships with hundreds of colleges and universities
across the nation. As of December 31, 2003, we had servicing agreements with
approximately 280 customers and software license agreements with more than 30
licensees. Notwithstanding the depth of our customer base, our 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. Our 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 our business. We cannot assure that our forward flow
channel lenders or our branding partners will continue their relationships with
us. Loss of a strong relationship, like that with a significant branding
partner, such as Union Bank, or with schools such as University of Phoenix and
Nova Southeastern University from which we directly or indirectly acquire a
significant volume of student loans, could result in an adverse effect on our
volume derived from our branding partner channel. For example, Nova Southeastern
University, from which we purchased FFELP loans (through its relationship with
Union Bank) comprising approximately 5.6% of our total student loan channel
acquisitions in 2003, has informed us and Union Bank, the direct acquirer of the
student loans, of its intent to not renew its sale commitment starting January
2007, in order to make a request for a proposal to potential purchasers,
including Union Bank and us.
Competition
We face competition from many lenders in the highly competitive student loan
industry. Using our size, we have leveraged economies of scale to gain market
share and compete by offering a full array of FFELP and private loan products
and services. In addition, we differentiate ourselves from other lenders through
our vertical integration, technology and strong relationships with colleges and
universities.
We view SLM Corporation, the parent company of Sallie Mae, as our largest
competitor in loan origination, holding and servicing. SLM Corporation services
nearly half of all outstanding FFELP loans and is the largest holder of student
loans, with a portfolio of over $89 billion of managed and owned student loans
as of December 31, 2003. Large national and regional banks are also strong
competition, although many are involved only in origination. In different
geographic locations across the country, we run into strong competition from the
local tax-exempt student loan secondary markets. The Federal Direct Lending
("FDL") Program has also
8
reduced the origination volume available for FFEL Program participants, which in
2002 accounted for 28% of total 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, 2003, we had approximately 2,100 employees. Approximately
730 of these employees hold professional and management positions while
approximately 1,370 are in support and operational positions. None of our
employees are covered by collective bargaining agreements. We are not involved
in any material disputes with any of our employees, and we believe that
relations with our employees are good.
Available Information
We maintain a Web site at www.nelnet.net. Copies of our annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy
statement and amendments to such reports are available without charge on our Web
site as soon as reasonably practicable after such reports are filed with or
furnished to the United States Securities and Exchange Commission (the "SEC").
We have adopted a Code of Business Conduct and Ethics (the "Code of
Conduct") that applies to directors, officers and employees, including our
principal executive officers and our principal financial and accounting officer,
and have posted such Code of Conduct on our Web site. Amendments to and waivers
granted with respect to our Code of Conduct relating to our 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 our Web site.
Our Corporate Governance Guidelines, Audit Committee Charter, Compensation
Committee Charter and Nominating and Corporate Governance Committee Charter are
also posted on our Web site and, along with our 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
ITEM 2. PROPERTIES
We maintain 15 principal offices in cities across the United States. We do
not own any of our principal facilities. The following table lists the principal
facilities leased by us.
Lease
Square expiration
Location Primary Function or Segment footage date
- -------- -------------------------------------------------- -------- -------------
Albany, NY........ Charter Servicing Software 3,550 September 2004
Boise, ID......... IFA Servicing Software 9,993 August 2005
Denver, CO........ Student Loan Servicing, Executive Management, Technology 120,663 February 2008
Fredericksburg, VA Loan Consolidations 18,000 May 2007
Honolulu, HI...... Sales 611 October 2004
Indianapolis, IN.. Student Loan Servicing and Loan Generation 58,770 February 2008
Jacksonville, FL.. Student Loan Servicing and Loan Generation, 134,828 January 2007
Guarantee Servicing, Technology
Lincoln, NE....... Corporate Headquarters, Student Loan Servicing and 94,909 December 2010
Loan Generation
Scottsdale, AZ.... Capital Markets 3,129 May 2005
Portland, ME...... Loan Generation, Sales 5,211 January 2010
Tempe, AZ......... Loan Generation 3,431 March 2004
Tucson, AZ........ Loan Generation 426 June 2004
Tulsa, OK......... Loan Generation, Sales 2,500 July 2008
Warwick, RI....... Loan Generation, Sales 5,608 May 2005
Washington, DC.... Government Relations, Sales 6,852 May 2010
We believe that our respective properties are generally adequate to meet our
long-term student loan and new business goals. Our principal office is located
at 121 South 13th Street, Suite 201, Lincoln, Nebraska 68508.
9
ITEM 3. LEGAL PROCEEDINGS
We are 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 our management that the disposition or
ultimate determination of these claims, lawsuits and proceedings will not have a
material adverse effect on our business, financial position or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On November 3, 2003, a special shareholders' meeting was held in which the
Company's shareholders unanimously approved the adoption of Second Amended and
Restated Articles of Incorporation, the Directors Stock Compensation Plan and
the Employee Share Purchase Plan. 29,061,876 votes of Class A and Class B
Shareholders were voted in favor of each of the proposals and no votes were
voted against any of the proposals or withheld. There were no abstentions.
On November 17, 2003, a special shareholders' meeting was held in which the
Company's shareholders unanimously approved the adoption of the Restricted Stock
Plan. 28,171,665 votes of Class A and Class B Shareholders were voted in favor
of the proposal and no votes were voted against the proposal or withheld. There
were no abstentions.
On November 25, 2003, a special shareholders' meeting was held in which the
Company's shareholders unanimously approved the adoption of the revised
Directors Stock Compensation Plan. 26,573,475 votes of Class A and Class B
Shareholders were voted in favor of the proposal and no votes were voted against
the proposal or withheld. There were no abstentions.
PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
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 13, 2004 was approximately 166 and
six, respectively. For the partial quarter from December 11, 2003 (the initial
public offering date of our Class A Common Stock) until December 31, 2003, the
high and low sales prices for the Company's Class A Common Stock were $22.40 and
$20.86, respectively.
The Company did not pay cash dividends on either class of our 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 were to be in
default under the credit agreement or if payment of such a dividend or
distribution would result in such a default. In addition, indentures governing
the education lending subsidiaries limit the amounts of funds that can be
transferred to the Company by its subsidiaries through cash dividends. These
limitations result from the restrictions contained in trust indentures under
debt financing arrangements to which the Company's education lending
subsidiaries are parties.
For information regarding the Company's equity compensation plans, see Part
III, Item 12 of this Report.
In 2003, the Company issued unregistered securities in the transaction
described below.
On March 12, 2003, the Company issued an aggregate of 331,800 shares of
Class A Common Stock to 35 employees for $2.43 per share, or an aggregate of
$806,274. The securities issued in these transactions were issued in reliance on
an exemption from registration under Section 4(2) of the Securities Act of 1933,
as amended (the "Securities Act"), as transactions by an issuer not involving
any public offering. The recipients of the securities represented their
intentions to acquire the securities for investment only and not with a view to,
or for sale or in connection with, any distribution thereof. Appropriate legends
were affixed to the certificates representing the securities in such
transactions.
On August 14, 2003, in connection with the recapitalization effected
pursuant to the Company's amended and restated articles of incorporation, the
Company issued an aggregate of 45,038,488 shares of its Class A and Class B
Common Stock to the holders of its pre-recapitalization Class A Voting Common
Stock and Class B Non-Voting Common Stock. The securities issued in this
transaction were issued in reliance on the exemption from registration under
Section 3(a)(9) of the Securities Act, relating to securities exchanged by an
issuer with its existing security holders exclusively where no commission or
other remuneration is paid or given, directly or indirectly, for soliciting such
exchange.
10
Each of the sales of securities was made without the use of an underwriter
and the certificates evidencing the shares bear a restricted legend permitting
the transfer thereof only upon registration of the shares or an exemption under
the Securities Act.
On December 11, 2003, the Company issued and sold an aggregate of 8,000,000
shares of its Class A Common Stock pursuant to an effective registration
statement under the Securities Act for $21 per share, or an aggregate of
$168,000,000. On December 22, 2003, the Company issued and sold an aggregate of
586,800 shares of its Class A Common Stock pursuant to an effective registration
statement under the Securities Act for $21 per share, or an aggregate of
$12,322,800. We used a portion of the net proceeds of $167.6 million, less $4
million in stock offering costs, from these offerings as follows: $18.3 million
was used to fund the two acquisitions in the first quarter of 2004 as discussed
in "Management's Discussion and Analysis of Financial Condition and Results of
Operations--Acquisitions"; and $30.0 million was used to repay then-outstanding
revolving credit indebtedness. We intend to use the remaining net proceeds from
these offerings to fund the future acquisition as discussed in "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Acquisitions," for general corporate purposes, including capital
expenditures, working capital needs and potential other transactions
complementary to our business.
11
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated 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,
related notes, and "Management's Discussion and Analysis of Financial Condition
and Results of Operations" included in this Form 10-K.
Year ended December 31,
--------------------------------------------------------------------------------
2003 2002 2001 2000 1999
------------ ------------ ------------ ------------ ------------
(dollars in thousands, except share data)
Income Statement Data:
Net interest income .... $ 178,612 $ 190,900 $ 114,565 $ 64,853 $ 59,538
Less provision for
loan losses ........... (11,475) (5,587) (3,925) (1,370) (1,800)
------------ ------------ ------------ ------------ ------------
Net interest income
after provision for
loan losses ........... 167,137 185,313 110,640 63,483 57,738
Loan servicing and
other fee income ...... 99,294 103,899 93,172 66,015 --
Software services and
other income .......... 19,398 21,909 7,713 8,431 5,387
Derivative market
value loss ............ (1,170) (579) (2,962) -- --
Operating expenses ..... (238,370) (234,701) (195,438) (131,196) (47,417)
------------ ------------ ------------ ------------ ------------
Income before income
taxes and minority
interest .............. 46,289 75,841 13,125 6,733 15,708
Net income ............. 27,103 48,538 7,147 4,520 9,671
Earnings per share,
basic and diluted ..... $ 0.60 $ 1.08 $ 0.16 $ 0.11 $ 0.42
Weighted average
shares outstanding .... 45,501,583 44,971,290 44,331,490 41,187,230 22,863,444
Other Data:
Origination and
acquisition volume (a) $ 4,253,014 $ 2,665,786 $ 1,448,607 $ 1,027,498 $ 2,015,263
Average student loans .. $ 9,451,035 $ 8,171,898 $ 5,135,227 $ 3,388,156 $ 1,750,097
Student loans
serviced (at end of
period) ............... $ 18,773,899 $ 17,863,210 $ 16,585,295 $ 11,971,095 $ --
Ratios:
Net interest margin (b) 1.71% 2.15% 2.09% 1.76% 2.60%
Return on average
total assets .......... 0.25% 0.52% 0.12% 0.12% 0.32%
Return on average equity 19.4% 49.2% 11.7% 8.2% 99.6%
Net loan charge-offs
as a percentage of
average student loans . 0.079% 0.047% 0.042% 0.055% 0.033%
As of December 31,
-------------------------------------------------------------------
2003 2002 2001 2000 1999
----------- ----------- ----------- ----------- -----------
(dollars in thousands)
Balance Sheet Data:
Cash and cash equivalents ... $ 198,423 $ 40,155 $ 36,440 $ 23,263 $ 26,497
Student loan receivables, net 10,455,442 8,559,420 7,423,872 3,585,943 2,989,985
Total assets ................ 11,931,509 9,766,583 8,134,560 4,021,948 3,302,098
Bonds and notes payable ..... 11,366,458 9,447,682 7,926,362 3,934,130 3,265,532
Shareholders' equity ........ 305,489 109,122 63,186 54,161 15,380
- ---------------
(a) Initial loans originated and acquired through various channels, including
originations through our direct channel and acquisitions through our
branding partner channel, our forward flow channel and the secondary market.
(b) Net interest margin is computed by dividing net interest income by the sum
of average student loans and the average balance of other interest earning
assets.
12
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
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, changes in the terms of student
loans and the educational credit marketplace arising from the implementation of
applicable laws and regulations and from changes in these laws and regulations,
which may reduce the volume, average term and costs of yields on student loans
under the FFEL Program or result in loans being originated or refinanced under
non-FFELP programs or may affect the terms upon which banks and others agree to
sell FFELP loans to us. We 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.
Overview
We are a vertically integrated education finance company, with over $11.9
billion in total assets as of December 31, 2003, making us one of the leading
education finance companies in the country. We are focused on providing quality
products and services to participants in the education finance process.
Headquartered in Lincoln, Nebraska, we originate, hold and service student
loans, principally loans originated under the FFEL Program. We, together with
our branding partners, originated and acquired approximately $4.3 billion of
student loans in 2003, which includes $1.2 billion of existing loans we
consolidated from our own loan portfolio, making us a leading originator and
acquirer of student loans.
Our business is comprised of four primary product and service offerings:
o Asset management, including student loan originations and
acquisitions. We provide student loan sales, marketing, originations,
acquisition and portfolio management. We own a large portfolio of
student loan assets through a series of education lending
subsidiaries. We generate loans owned in special purpose lending
facilities through direct origination or through acquisition of loans.
We also provide marketing and sales support and managerial and
administrative support related to our asset generation activities.
o Student loan servicing. We service our student loan portfolio and the
portfolios of third parties. The servicing activities provided include
loan origination activities, application processing, borrower updates,
payment processing, claim processing and due diligence procedures.
o Guarantee servicing. We provide 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.
o Servicing software. We provide student loan servicing software
internally and to third-party student loan holders and servicers.
In accordance with accounting principles generally accepted in the United
States, our asset management and student loan servicing offerings constitute
reportable operating segments. Our guarantee servicing and servicing software
offerings are operating segments that do not meet the quantitative thresholds,
and, therefore, are included as other segments that do not meet the reportable
segment criteria. The following table shows the total segment revenue (excluding
intersegment revenue) and net income of each of our reportable segments for the
years ended December 31, 2003 and 2002. For additional information, see note 18
of the notes to the consolidated financial statements.
Year ended December 31, 2003 Year ended December 31, 2002
---------------------------------- -----------------------------------
Student Student
Asset loan Other Asset loan Other
management servicing segments management servicing segments
---------- --------- -------- ---------- --------- --------
Segment revenue 61.8% 27.3% 10.9% 63.7% 28.2% 8.1%
Segment net income 72.7% 23.3% 4.0% 94.6% 13.5% (8.1%)
13
Our student loan portfolio has grown significantly through origination and
acquisition. With the development of our fully integrated platform, we are
positioned for organic growth. We originated and acquired $4.3 billion of
student loans in 2003, which includes $1.2 billion of existing loans we
consolidated from our own loan portfolio, through various channels, including:
o our direct channel, in which we originate student loans in one of our
brand names directly to student and parent borrowers, which accounted
for 58.9% of the student loans we originated and acquired in 2003
(43.4% when excluding loans we consolidated from our own loan
portfolio);
o our branding partner channel, in which we acquire student loans from
lenders to whom we provide marketing and origination services, which
accounted for 19.0% of the student loans we originated and acquired in
2003 (26.2% when excluding loans we consolidated from our own loan
portfolio); and
o our forward flow channel, in which we acquire student loans from
lenders to whom we provide origination services, but provide no
marketing services, or who have agreed to sell loans to us under
forward sale commitments, which accounted for 14.2% of the student
loans we originated and acquired in 2003 (19.5% when excluding loans
we condolidated from our own loan portfolio).
In addition, we also acquire student loans through spot purchases, which
accounted for 7.9% of student loans that we originated and acquired in 2003
(10.9% when excluding loans we consolidated from our own loan portfolio). We
have increased our student loan portfolio by $6.8 billion over the last three
years, including $2.9 billion of loans acquired in subsidiary acquisitions.
Significant Drivers and Trends
Our earnings and earnings growth are directly affected by the size of our
portfolio of student loans, the interest rate characteristics of our portfolio,
the costs associated with financing and managing our 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 our student loan portfolio, our
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 our financing
programs and access to capital markets; and
o prepayment rates on student loans, including prepayments relating to
loan consolidations.
Competition for the supply channel of education financing and the student
loan industry has caused the cost of acquisition related to our student loan
assets to increase. In addition, we have seen significant increases in
consolidation loan activity and consolidation loan volume within our industry.
The increase in competition for consolidation loans has caused us to be
aggressive in our measures to protect and secure our existing portfolio through
internal consolidation efforts. We will generally recognize our cost of
acquisition over the average useful life of the assets; however, we will
generally accelerate recognition of the unamortized cost of acquisition when
loans are consolidated, even if they are consolidated on our balance sheet. The
significant increase in consolidation activity, entrants and competition within
the industry, coupled with our asset retention practices, have caused our yields
to be reduced in recent years through amortization of acquisition costs. If
these trends continue, we could continue to see our yields reduced through the
increase in consolidation loans, which have a lower yield and also result in a
further increase in amortization costs. See "-- Student Loan Portfolio--Student
Loan Spread Analysis." Although our short-term yields may be reduced, we will
have been successful in protecting our assets and stabilizing our balance sheet
for long-term growth.
Our student loan portfolio and asset growth will be significant factors in
determining future growth in our net interest income as our primary source of
income is interest earned on our student loan portfolio. If our student loan
portfolio continues to grow and our net interest margin remains relatively
stable, we expect our net interest income to increase after adjusting for any
variable-rate floor income. Interest income, and to a certain extent our net
income, is also dependent upon the relative level of interest rates. While we
expect our student loan portfolio and interest earning assets to continue to
grow, which should cause interest income and earnings growth, we do not expect
to continue to grow at historical levels. Specifically, our net income in 2003
decreased $21.4 million, or 44.2%, as compared to 2002 primarily because of the
decrease in our variable-rate floor income. Net interest income decreased by
$12.3 million, or 6.4%, in 2003 as compared to 2002. This decrease was a result
of a decrease in variable rate floor income of $37.0 million, which was offset
by an increase in interest income from the growth in our student loan portfolio
and decreased interest rates on our borrowings. Therefore, net interest income,
excluding the effects of variable-rate floor income, increased approximately
$24.7 million, or 17.5%, in 2003 as compared to 2002. This increase in net
interest income, excluding variable-rate floor income, has resulted from the
portfolio growth previously discussed. Variable-rate floor income occurs in
certain declining interest rate environments, and we cannot predict whether
these interest rate
14
environments will occur in the future. We generally do not anticipate receiving
or plan to receive variable-rate floor income.
We reported net income of $27.1 million in 2003, or $0.60 per basic and
diluted share, as compared to $48.5 million, or $1.08 per basic and diluted
share, in 2002. Net interest income includes more than $69.3 million, or 73
basis points, in yield reduction due to amortization of loan acquisition costs
or premiums in 2003, as compared to $55.1 million, or 67 basis points, in 2002.
Despite our solid loan volume growth, our unamortized cost of loan acquisitions
or premiums has been reduced from 1.9% at December 31, 2002 to 1.5% at December
31, 2003. In addition, we recorded approximately $12.8 million of variable-rate
floor income in 2003 as compared to approximately $49.8 million in 2002.
Operating expenses in 2003 included $12.8 million of amortization of intangible
assets resulting from acquisitions prior to 2003, of which $6.7 million is not
deductible for federal income tax purposes. Amortization of intangible assets
totaled $22.2 million in 2002, which included $16.2 million not deductible for
federal income tax purposes. Operating expenses in 2003 also include an
additional $5.1 million in one-time costs to terminate consulting and employment
contracts in 2003. In addition, in preparing for our initial public offering in
December 2003, we incurred a non-recurring, nondeductible, non-cash stock
compensation expense of $5.2 million for stock purchased by employees early in
2003.
Our net income also included a mark-to-market loss on derivative instruments
of $1.2 million in 2003 as compared to $0.6 million in 2002. We maintain an
overall interest rate risk management strategy that incorporates the use of
derivative instruments to minimize the economic effect of interest rate
volatility. Management has structured all of our derivative transactions with
the intent that each is economically effective. However, most of our 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 our consolidated statements of income may fluctuate from
period to period.
Acquisitions
We have positioned ourselves for growth by building a strong foundation
through mergers and acquisitions of related and unrelated entities. Although our
assets and loan portfolios increased through these transactions, a key aspect of
each transaction was its impact on our prospective organic growth and the
development of our integrated platform of services. As a result of our rapid
growth, the development of our platform and changes in operations,
period-to-period comparability of our results of operations may be difficult.
In 2000, we acquired UNIPAC Service Corporation, a related entity, and
InTuition Holdings, Inc., which added servicing and origination operations. In
2001, we acquired MELMAC, Inc., which increased our FFELP portfolio by $424
million, and GuaranTec LLP, which added guarantee servicing to our activities.
In addition, in December 2001, we acquired EFS, Inc., which increased our loan
servicing operations and added $2.5 billion to our FFELP portfolio. In 2002, we
expanded our product suite by adding loan servicing software products through
the acquisitions of Idaho Financial Associates, Inc. and Charter Account
Systems, Inc. In 2003, we acquired UFS Securities, LLC, which added
broker-dealer services to our services.
In January 2004, we acquired a 50% interest in Premiere Credit of North
America, LLC, or Premiere, a collection services company that specializes in
collection of educational debt. Premiere is based in Indianapolis, Indiana, and
employs approximately 45 persons. In March 2004, we acquired rights, for a term
of ten years, in certain assets of the Rhode Island Student Loan Authority, or
RISLA, including the right to originate student loans in RISLA's name without
competition from RISLA during such time period. RISLA also sold to us a
portfolio of FFELP loans with an aggregate outstanding balance of approximately
$175 million. We have further agreed to provide administrative services in
connection with certain of the indentures governing debt securities of RISLA for
a ten-year period. We have also entered into an agreement to acquire a FFELP
loan secondary market, which holds a FFELP loan portfolio of approximately $130
million. We expect this acquisition to close during the second quarter of 2004.
Net Interest Income
We generate the majority of our earnings from the spread between the yield
we receive on our portfolio of student loans and the cost of funding these
loans. This spread income is reported on our income statement as net interest
income. The amortization and write-offs of premiums or discounts, including
capitalized costs of origination, the consolidation loan rebate fee and yield
adjustments from borrower benefit programs, are netted against loan interest
income on our income statement. The amortization and write-offs of bond issuance
costs are included in interest expense on our income statement.
Our 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
U.S. Department of Education (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 and the
loan's repayment status. Depending on the type of student loan and when the loan
was originated, the borrower rate is either fixed to term or is reset to a
market rate each July 1. Loans that reset annually on each July 1 can generate
excess spread income as compared to the rate based on the SAP formula in certain
declining interest rate environments. We refer to this additional income as
15
variable-rate floor income and it is included in loan interest income as
described further in "-- Results of Operations" below. Historically, we have
earned excess spread, or variable-rate floor income, in declining interest rate
environments as recently as our most recent fiscal year. Since the rates are
reset annually, we view these earnings as temporary and not necessarily
sustainable. Our ability to earn variable-rate floor income in the future
periods is dependent upon the interest rate environment following the annual
reset of borrower rates, and we cannot assure that such environment will exist
in the future.
The table below sets forth the weighted average borrower interest rate and
weighted average lender interest rate for all variable-rate student loan assets
for the period indicated.
As of December 31,
-----------------------------
2003 2002 2001
---- ---- ----
Weighted average borrower
interest rate................... 3.76% 4.97% 7.02%
Weighted average lender
interest rate................... 3.49% 4.27% 6.23%
Because we generate the majority of our earnings from the spread between the
yield we receive on our portfolio of student loans and the cost of financing
these loans, the interest rate sensitivity of our balance sheet is very
important to our operations. The current and future interest rate environment
can and will affect our interest earnings, net interest income and net income.
The effects of changing interest rate environments are further outlined in "--
Risks -- Market and Interest Rate Risk" below.
On those FFELP loans with fixed to term borrower rates, primarily
consolidation loans, we earn interest at the greater of the borrower rate or a
variable rate based on the SAP formula. Since we finance the majority of our
student loan portfolio with variable-rate debt, we may earn excess spread on
these loans for an extended period of time.
On most consolidation loans, we must pay a 1.05% per year rebate fee to the
Department. Those consolidation loans which have variable interest rates based
on the SAP formula earn a yield less than that of a Stafford loan. Those
consolidation loans which have fixed interest rates less than the sum of 1.05%
and the variable rate based on the SAP formula also earn a yield less than that
of a Stafford loan. As a result, as consolidation loans matching these criteria
become a larger portion of our loan portfolio, there will be a lower yield on
our loan portfolio in the short term. However, due to the extended terms of
consolidation loans, we expect to earn the yield on these loans for a longer
duration, making them beneficial to us in the long term.
A portion of our FFELP loan portfolio, with an outstanding balance of $2.6
billion as of December 31, 2003, is comprised of loans which were previously
financed with tax-exempt obligations issued prior to October 1, 1993. Based upon
provisions of the Higher Education Act and related interpretations by the
Department, we believe that we may be entitled to receive special allowance
payments on these loans providing us with a 9.5% minimum rate of return. To
date, we have not recognized interest income generated by these loans based on
the 9.5% minimum rate of return. We have asked the Department to confirm that we
are allowed to recognize the income based on the 9.5% minimum rate of return. We
have deferred recognition of this excess interest income pending satisfactory
resolution of this issue. As of December 31, 2003, the amount of excess interest
income deferred totaled approximately $42.9 million which is included in other
liabilities on our consolidated balance sheet. Since we did not refinance loans
with the aforementioned tax-exempt obligations until 2003, all of this deferred
income was recorded this year. Legislation has been proposed to eliminate
variable rate floor income as well as the 9.5% floor interest rate on loans
financed with funds from pre-1993 tax-exempt financings. The enactment of this
legislation might prospectively eliminate floor income on pre-1993 tax-exempt
financings and allow us to recognize our deferred excess interest income.
Conversely, we cannot be assured that any such legislation, if enacted, will
only prospectively eliminate this floor income. At this time, we cannot predict
how any such potential legislation will affect our operations in the future.
In declining interest rate environments, we can earn significant amounts of
variable-rate floor income. The more drastic the reduction in rates subsequent
to the July 1 annual borrower interest rate reset date, the greater our
opportunity to earn such income. Conversely, as the decline in rates abates, or
in environments where interest rates are rising, our opportunity to earn
variable-rate floor income can be reduced, in some cases substantially. Although
we have been in a historically low interest rate environment, interest rates on
which our assets are indexed have been rising since the second quarter of 2003.
As interest rates increase, we incur greater financing costs on our
variable-rate financings. An increase in our financing costs, in turn, decreases
the spread between the rate of our FFELP loans (which reset annually) and the
rate of our financings, ultimately causing a decrease in variable-rate floor
income.
Investment interest income includes income from unrestricted
interest-earning deposits and funds in our special purpose entities for our
asset-backed securitizations.
16
Provision for Loan Losses
We maintain an allowance for loan losses associated with our student loan
portfolio at a level that is based on the performance characteristics of the
underlying loans. We analyze the allowance separately for our FFELP loans and
our private loans.
The loan loss allowance attributable to FFELP loans consists of two
components: a risk sharing reserve and a reserve for rejected guaranty agency
claim losses, caused mainly by servicing defects. The risk sharing reserve is an
estimate based on the amount of loans subject to the 2% risk sharing and on the
historical experience of losses. The rejected claim loss reserve is based on the
historical trend of ultimate losses on loans initially rejected for
reimbursement by guaranty agencies. FFELP loans are guaranteed as to both
principal and interest and, therefore, continue to accrue interest until the
time they are paid by the guaranty agency. Once a FFELP loan is rejected for
claim payment, our policy is to continue to pursue recovery of principal and
interest, whether by curing the reject or collecting from the borrower. We
attempt to cure the rejected claims through our collection efforts. As of
December 31, 2003, we had an allowance for loan losses on FFELP loans of $10.8
million.
In determining the private loan loss allowance, we divide the portfolio into
various categories, such as the type of program, loan status and months into
repayment. We then estimate defaults based on the borrowers' credit profiles,
net of estimated recoveries. We place a private loan on non-accrual status and
charge off the loan when the collection of principal and interest is 120 days
past due. We utilize this data to estimate the amount of losses in the
portfolio, net of subsequent collections, that are probable of occurrence. As of
December 31, 2003, we had an allowance for loan losses on private loans of $5.2
million.
The evaluation of the provision for loan losses is inherently subjective, as
it requires material estimates that may be subject to significant changes. The
provision for loan losses reflects the activity for the applicable period and
provides an allowance at a level which our management believes is adequate to
cover probable losses inherent in the loan portfolio.
The Higher Education Act authorizes the Department to recognize lenders and
lender servicers (as agent for the eligible lender) for an exceptional level of
performance in servicing FFELP loans. A lender or lender servicer designated for
exceptional performance can receive 100 percent reimbursement on all claims
submitted for insurance provided that the lender or lender servicer meets and
maintains all requirements for achieving its designation. On December 29, 2003,
we applied for Exceptional Performance status as a student loan servicer for the
FFEL Program. Our original application was denied by the Department based on two
issues. We believe we have provided sufficient information related to one of the
issues to consider it resolved. The other issue relates to a complaint submitted
to the Department by a former employee in connection with our procedures in
processing certain FFELP loan borrower forbearances. In March 2004, the
Department provided us with a summary of that complaint and also forwarded the
complaint on to the Office of the Inspector General, or OIG. As we understand,
this former employee's complaint alleges that we incorrectly processed certain
forbearances during a limited time period and with respect to a limited number
of borrower accounts. Our management has reviewed the procedures in connection
with this activity and concluded that such procedures did not violate FFELP loan
servicing regulations. We are cooperating with the Department to resolve this
issue. We promptly advised our independent auditors, KPMG LLP, of the issues.
There can be no assurance that the OIG will review the former employee's
complaint without conducting an investigation, or that the outcome of any
investigation will be favorable. If an OIG investigation were to occur, we do
not expect any adverse finding, nor do we believe that this issue will result in
a material adverse financial impact on us even if an investigation were to
result in an adverse finding. A delayed resolution of this matter may delay our
ability to resubmit an application with the Department to become a lender
servicer designated for exceptional performance, and an unfavorable resolution
of this matter may result in an inability to resubmit that application. If we
are able to resubmit our application, we cannot be assured that we will receive
or maintain the designation as exceptional performer. Should we receive and
maintain designation as an exceptional performer under the Higher Education Act,
our cost related to losses on defaulted FFELP loans, specifically the 2% risk
share component that is not guaranteed, could be substantially reduced and would
differ significantly from historical losses and trends.
Other Income
We also earn fees and generate income from other sources, including
principally loan servicing, guarantee servicing and licensing fees on our
software products. Loan servicing fees are determined according to individual
agreements with customers and are calculated based on the dollar value or number
of loans or accounts serviced for each customer. Guarantee servicing fees are
earned as a result of our providing system software, hardware and
telecommunication support, borrower and loan updates, default aversion tracking
services, claim processing services and post-default collection services to
guaranty agencies. Guarantee servicing fees are calculated based on the number
of loans serviced or amounts collected. Software services income includes
software license and maintenance fees associated with student loan software
products as well as certain loan marketing fees. Other income also includes the
derivative market value adjustment as further discussed in "-- Risks -- Market
and Interest Rate Risk" below.
In addition, we earn fee income on some of our securitization transactions
through UFS Securities, our wholly owned broker-dealer, which effectively
decreases our costs associated with accessing this market. UFS Securities sells
certain tranches of our auction rate securities in a co-broker dealer
arrangement with certain third-party broker-dealers. UFS Securities is paid the
same amount
17
of fees as the third-party broker-dealers for selling the auction rate
securities. Since UFS Securities, which was acquired in August 2003, is our
wholly owned subsidiary, these sales and the fees received for the sales by our
wholly owned subsidiary will have the effect of reducing our overall costs on
the sales of our auction rate securities.
As we expand our student loan origination and acquisition activities, we may
face increased competition with some of our servicing customers. In the past,
including one case in 2003, servicing customers have terminated their servicing
relationships with us. Furthermore, we could in the future lose more servicing
customers as a result of such increased competition. However, the vast majority
of our servicing agreements provide for life-of-loan servicing of the existing
loans, and, as such, we do not expect this loss or the potential future loss of
customers to have a material adverse effect on our results of operations for the
foreseeable future.
One of our guarantee servicing customers recently notified us of its
intention not to renew its servicing contract. The loss of this customer is not
expected to have a material effect on our results of operations due to the
relative portion of our earnings attributable to guarantee servicing revenue and
the size of the individual customer.
The income and revenues provided through our servicing software operations
have increased in recent years with the acquisitions of Idaho Financial
Associates, Inc. and Charter Account Systems, Inc. in January 2002 and May 2002,
respectively. This increase was offset by a decrease in other income. To the
extent that our servicing software license and maintenance revenues continue to
increase, we believe that such increase will primarily come from our existing
customer base.
Operating Expenses
Operating expenses include costs incurred to manage and administer our
student loan portfolio and our financing transactions, costs incurred to
generate and acquire student loans and general and administrative expenses,
which include corporate overhead. Operating expenses also include amortization
of intangible assets related to acquisitions. We do not believe inflation has a
significant effect on our operations.
Results of Operations
Year ended December 31, 2003 compared to year ended December 31, 2002
Net interest income. Loan interest income decreased by $45.0 million, or
11.1%, in 2003 as compared to 2002. This decrease was a result of changes in the
interest rate environment and in the pricing characteristics of our student loan
assets, although such decrease was partially offset by an increase in the size
of our student loan portfolio. Lower interest rates in 2003 caused a decrease in
the average net yield on our student loan portfolio to 3.82% from 4.96% in 2002.
Variable-rate floor income decreased approximately $37.0 million to
approximately $12.8 million in 2003 from approximately $49.8 million in 2002,
due to the timing and relative change in interest rates during the periods.
Essentially, prevailing interest rates declined drastically subsequent to the
July 1, 2002 annual borrower interest rate reset date compared to their less
substantial decline following the reset of rates on July 1, 2003. Consequently,
we realized significantly less variable-rate floor income during 2003 than we
did in 2002. The weighted average interest rate on our student loan portfolio
decreased in 2003 due to lower interest rates, together with the increase in the
number of lower yielding consolidation loans. The lower weighted average loan
interest rate resulted in a reduction in loan interest income of approximately
$41.5 million. Consolidation loan activity also increased the amortization and
write-offs of acquisition costs and increased the consolidation rebate fee,
reducing loan interest income an additional approximately $29.9 million in 2003.
The reduction in loan interest income resulting from the decline in interest
rates and reduction in variable-rate floor income was partially offset by an
increase in our portfolio of student loans. The average student loan portfolio
increased by $1.3 billion, or 15.7%, in 2003 as compared to 2002, which
increased loan interest income by approximately $63.1 million in 2003 as
compared to 2002.
Investment interest income decreased $5.6 million, or 26.8%, in 2003 as
compared to 2002. This decrease was due to the termination of a joint venture
with a large financial institution in the second quarter of 2003.
Interest expense on bonds and notes payable decreased $38.3 million, or
16.3%, in 2003 as compared to 2002. This decrease occurred despite an increase
in average total debt of approximately $1.6 billion, specifically an increase in
average variable-rate debt of $1.8 billion, which increased interest expense by
approximately $22.0 million. The reduction in interest rates, specifically LIBOR
and auction rates, decreased our average cost of funds to 1.86% in 2003 from
2.59% in 2002. As a result, interest expense decreased approximately $43.0
million in 2003 as compared to 2002. We reduced average fixed-rate debt by
$212.0 million in 2003, which decreased our overall interest expense by
approximately $12.5 million as compared to 2002. Interest expense on bonds and
notes payable during 2003 includes additional amortization and write-offs of
bond issuance costs of $2.6 million incurred as a result of refinancing certain
debt transactions compared to $5.3 million in 2002.
As a result of the foregoing, net interest income decreased by $12.3
million, or 6.4%, in 2003 as compared to 2002. Our net interest margin decreased
to 1.71% in 2003 from 2.15% in 2002. Net interest income, excluding the effects
of variable-rate floor
18
income of $12.8 million in 2003 and $49.8 million in 2002, increased
approximately $24.7 million, or 17.5%, to approximately $165.8 million in 2003
from approximately $141.1 million in 2002.
Provision for loan losses. The provision for loan losses for FFELP and
private loans increased $5.9 million, or 105.4%, in 2003 as compared to 2002.
The provision for loan losses for FFELP loans increased $1.1 million in 2003
compared to 2002 due to the increase in the size of our FFELP loan portfolio.
The provision for loan losses for private loans increased $4.8 million in 2003
compared to 2002. This increase was due to a provision of $4.3 million for an
identified pool of private loans based on aging, delinquency and performance of
such identified pool. This pool of private loans was limited to borrowers
attending a single school, and, in early 2002, we ceased making private loans to
borrowers attending that school. The remaining increase of $0.5 million was due
to the increase in size of our private loan portfolio. Our net loan charge-offs
as a percentage of average student loans increased to 0.079% in 2003 from 0.047%
in 2002. This increase is directly attributable to the identified pool of
private loans as a result of the continued aging of this portfolio. The Company
periodically re-evaluates the requirements of its provision for loan losses, and
future additions to the provision for our student loans and the identified pool
of private loans may be necessary.
Other income. Total other income decreased $7.7 million, or 6.2%, in 2003 as
compared to 2002. Loan servicing and other fee income decreased $4.6 million, or
4.4%, software services and other income decreased $2.5 million, or 11.5%, and
derivative market value adjustment loss increased $0.6 million, or 102.1%, in
2003 as compared to 2002.
Loan servicing and other fee income decreased due to the reduction in the
number and dollar amount of loans we serviced for third parties. Total
third-party loan servicing volume decreased $1.1 billion, or 10.1%, in 2003 as
compared to 2002. This resulted in a decrease in loan servicing income of $9.4
million in 2003 as compared to 2002. This decrease in income was offset by an
increase of $4.8 million of guarantee servicing income in 2003 due to higher
guarantee volumes.
The decrease in software services and other income was due to additional
income earned of $5.7 million in 2002 on a marketing contract that was
terminated in the fourth quarter of 2002. This decrease was offset by an
increase of $3.4 million due to the acquisitions of Charter Accounts Systems,
Inc. in May 2002 and Idaho Financial Associates in January 2002 and an increase
in other income of $1.3 million due to the acquisition of UFS Securities in
August 2003. In addition, late fee income on borrower payments increased $1.0
million in 2003. In 2002, we recognized marketing income of $2.3 million as a
broker on a loan sale.
The derivative market value adjustment loss increased as we increased our
use of derivative instruments in 2003 to provide economic hedges to protect
against the impact of adverse changes in interest rates. The derivative market
value adjustment loss of $0.6 million in 2002 was due to the interest rate swap
in the notional amount of $500 million entered into in 2001 that expired in the
second quarter of 2002. See "-- Risks -- Market and Interest Rate Risk."
Operating expenses. Total operating expenses increased $3.7 million, or
1.6%, in 2003 as compared to 2002. Salaries and benefits increased $17.4
million, or 16.3%, and total other expenses decreased $13.7 million, or 10.7%,
in 2003 as compared to 2002.
Salaries and benefits increased as a non-cash stock compensation expense of
$5.2 million was recognized in the third quarter of 2003 equal to the difference
between the product of the estimated initial public offering price and the
number of shares issued in March 2003 and the total price paid by the employees.
In addition, salary expense increased $5.1 million in 2003 as compared to 2002
associated with the termination of consulting and employment agreements, of
which $1.8 million was incurred in the fourth quarter of 2003. The remaining
increase of $7.1 million is due to the increased personnel from the acquisitions
previously described and expansion of our marketing efforts.
The net decrease in total other expenses can be attributed to a decrease in
depreciation and amortization expense of $9.3 million, or 28.7%, due to the
decrease in the amortization of intangible assets of $9.5 million as certain
intangible assets were fully amortized in 2002. Trustee and other debt-related
fees increased $2.7 million, or 16.5%, in 2003 as compared to 2002 as a result
of a $1.6 billion increase in average total debt outstanding. Advertising and
marketing expenses decreased $1.3 million, or 11.6%, in 2003 as compared to 2002
due to a $2.4 million expense incurred on a large marketing contract that was
terminated in December 2002. The decrease was offset by an increase in marketing
activities related to consolidation mailings in 2003. Consulting fees and
support services to related parties decreased $9.3 million, or 72.5%, in 2003 as
compared to 2002 as a result of a $1.4 million decrease in consulting fees due
to the termination of a large consulting agreement in December 2002. The
remaining decrease was due to the conversion related fees paid in 2002 for the
systems conversion that occurred in November 2002. Postage and distribution
expenses increased $2.1 million, or 19.3%, in 2003 as compared to 2002 due to an
increase in mass mailings to promote origination of Stafford and consolidation
loans.
Income tax expense. Income tax expense decreased $8.4 million, or 30.3%, in
2003 compared to 2002, due to the decrease in income before income taxes. Our
effective tax rate was 41.7% in 2003 as compared to 36.5% in 2002. The increase
in the effective rate principally was a result of the non-cash stock
compensation expense recognized in 2003 for financial statement purposes that
was not deductible for tax purposes.
19
Net income. Net income decreased to $27.1 million in 2003 from $48.5 million
in 2002, for the reasons discussed above.
Year ended December 31, 2002 compared to year ended December 31, 2001
Net interest income. Loan interest income increased by $86.7 million, or
27.2%, in 2002 as compared to 2001. This increase was the result of changes in
the interest rate environment, in the pricing characteristics of our student
loan assets, and in the size of our student loan portfolio. Lower interest rates
in 2002 caused a decrease in the average net yield on our student loan portfolio
to 4.96% in 2002 from 6.20% in 2001. Variable-rate floor income increased
approximately $19.9 million to approximately $49.8 million in 2002 from
approximately $29.9 million in 2001, due to the timing and relative change in
interest rates during the periods. The weighted average interest rate on our
student loan portfolio decreased in 2002 due to the lower interest rates,
together with the increase in the number of lower yielding consolidation loans.
The lower weighted average loan interest rate resulted in a reduction in loan
interest income of approximately $65.2 million. Consolidation loan activity also
increased the amortization and write-offs of acquisition costs, reducing loan
interest income an additional approximately $40.4 million in 2002. The reduction
in loan interest income resulting from the decline in interest rates and the
reduction in variable-rate floor income was partially offset by an increase in
our portfolio of student loans. The average student loan portfolio increased by
approximately $3.0 billion, or 59.1%, in 2002 as compared to 2001, which
increased loan interest income by $192.1 million in 2002 as compared to 2001,
including the increase related to variable-rate floor income.
Investment interest income increased $4.0 million, or 23.6%, in 2002 as
compared to 2001, due to an approximately $360.1 million increase in average
investment and interest-earning deposits during 2002.
Interest expense on bonds and notes payable increased $14.3 million, or
6.5%, in 2002 as compared to 2001. Average variable-rate debt increased $4.1
billion, which resulted in an increase in interest expense of $85.9 million. The
reduction in short-term interest rates, specifically LIBOR, decreased our
average cost of funds to 2.59% in 2002 from 3.95% in 2001. As a result, interest
expense decreased approximately $83.1 million in 2002 as compared to 2001. We
increased average fixed-rate debt by $199.9 million during 2002, which increased
our overall interest expense by approximately $12.0 million as compared to 2001.
In 2002, we first accessed the term securitization market. While the interest
expense associated with term securitizations is less than that associated with
our other debt instruments, the incremental benefit in 2002 was negligible.
While we expect that we will continue to access the term securitization markets,
we cannot predict whether the benefits of our accessing those markets will be
material to our results of operations in future periods.
As a result of the foregoing, net interest income increased by $76.3
million, or 66.6%, in 2002 as compared to 2001. Our net interest margin
increased to 2.15% in 2002 from 2.09% in 2001. Net interest income, excluding
the effects of variable-rate floor income of $49.8 million in 2002 and $29.9
million in 2001, increased $56.4 million, or 66.6%, to $141.1 million in 2002
from $84.7 million in 2001.
Provision for loan losses. The provision for loan losses for FFELP and
private loans increased $1.7 million, or 43.3%, in 2002 as compared to 2001. The
provision for loan losses for FFELP loans decreased $100,000, or 3.0%, in 2002
as compared to 2001. The provision for loan losses for private loans increased
$1.8 million, or 242.9%, in 2002 as compared to 2001. This increase was due to a
provision of approximately $1.6 million for an identified pool of private loans
based on aging, delinquency and performance of such identified pool. This pool
of private loans was limited to loans to borrowers attending a single school,
and, in early 2002, we ceased making private loans to borrowers attending that
school. The remaining combined increase of $100,000, or 2.5%, was due to the
increase in size of our FFELP and private loan portfolios.
Other income. Total other income increased $27.3 million, or 27.9%, in 2002
as compared to 2001. Loan servicing and other fee income increased $10.7
million, or 11.5%, software services and other income increased $14.2 million,
or 184.1%, and derivative market value adjustment loss decreased $2.4 million,
or 80.5%, in 2002 as compared to 2001.
Loan servicing and other fee income increased due to growth in the loan
servicing portfolio of $817.5 million in 2002 and the acquisition of EFS, Inc.,
which increased the servicing portfolio by an additional $1.0 billion in 2002.
The change in the loan servicing volume resulted in an increase in loan
servicing income of $1.3 million. In addition, we acquired GuaranTec, LLP in
June 2001 resulting in an increase of $8.7 million in guarantee servicing income
in 2002 as compared to 2001.
Software services and other income increased due to the acquisitions of
Charter Account Systems, Inc. in May 2002 and Idaho Financial Associates, Inc.
in January 2002. These acquisitions resulted in an increase in income of
approximately $6.2 million in 2002 compared to 2001. Additional income of $6.6
million was earned on a marketing contract in 2002 that was not in existence in
2001. Other income also included an increase in administrative services income
of $1.2 million in 2002 as compared to 2001 from the support services provided
to FirstMark Services, LLC, which was not in existence in 2001.
The derivative market value adjustment loss decreased as the interest rate
swap entered into in 2001 expired in June 2002.
20
Operating expenses. Total operating expenses increased $39.3 million, or
20.1%, in 2002 as compared to 2001. Salaries and benefits increased $29.5
million, or 38.1%, and total other expenses increased $11.3 million, or 10.1%,
in 2002 as compared to 2001. The increase in salaries and benefits is due to the
following: the acquisition of EFS, Inc. in December 2001, which increased
salaries and benefits by $11.2 million, the acquisition of Idaho Financial
Associates, Inc. in January 2002, which increased salaries and benefits by $7.9
million and the acquisition of Charter Account Systems, Inc. in May 2002, which
increased salaries and benefits by $1.0 million. The remaining increase in
salaries and benefits is due to an increase in support services personnel and
the rising cost of employee benefits.
The net increase in total other expenses can be attributed to an increase in
depreciation and amortization of $3.9 million, or 13.5%, in 2002 as compared to
2001, which includes an increase in the amortization of intangible assets of
$3.4 million due to acquisitions of EFS, Inc., Idaho Financial Associates, Inc.
and Charter Account Systems, Inc. in December 2001, January 2002 and May 2002,
respectively. The remaining increase in depreciation and amortization was a
result of increased depreciation and amortization of furniture, equipment and
leasehold improvements in 2002 as compared to 2001, due to the acquisitions
previously described. Trustee and other debt related fees increased $3.8
million, or 29.5%, in 2002 as compared to 2001, as a result of the $4.3 billion
increase in average total debt outstanding. Occupancy and communications expense
increased $3.9 million, or 52.6%, in 2002 as compared to 2001 due to the
acquisitions previously described. Advertising and marketing expenses increased
$1.4 million, or 13.7%, in 2002 as compared to 2001 due to an increase in
consolidation loan origination activities. Professional services increased $5.9
million, or 175.3%, in 2002 as compared to 2001 as a result of
technology-related consulting in 2002 that did not exist in 2001. Consulting
fees and support services to related parties decreased $16.6 million, or 56.4%,
in 2002 as compared to 2001. This decrease can be attributed to a $9.7 million
decrease due to the termination of the support services contract for InTuition
Holdings, Inc. and GuaranTec, LLP in December 2001, a $4.8 million decrease in
contracted technology services obtained from 5280 Solutions, Inc. related to the
consolidation of our servicing platform in December 2001 and a $2.1 million
decrease as a result of a reduction in consulting fees for services provided by
related parties. Other expenses increased $4.0 million, or 21.5%, due to the
acquisitions previously described.
Income tax expense. Income tax expense increased to $27.7 million in 2002 as
compared to $5.4 million in 2001 due to the increase in income before income
taxes in 2002. Our effective tax rate was 36.5% in 2002 as compared to 41.0% in
2001. The 2002 effective tax rate was lower than the 2001 rate because other net
items, not deductible for tax purposes, contributed positively to our effective
tax rate in 2002 whereas they contributed negatively in 2001.
Net income. Net income increased to $48.5 million in 2002 from $7.1 million
in 2001, for the reasons discussed above.
Financial Condition
At December 31, 2003 compared to December 31, 2002
Total assets increased $2.1 billion, or 22.2%, from $9.8 billion at December
31, 2002 to $11.9 billion at December 31, 2003. This was due to an increase in
student loans receivable of $1.9 billion, or 22.2%, from $8.6 billion at
December 31, 2002 to $10.5 billion at December 31, 2003. This increase was a
result of net growth in consolidation loans of $2.0 billion in 2003. In
addition, cash and cash equivalents increased $158.3 million, or 394.1%, from
$40.2 million at December 31, 2002 to $198.4 million at December 31, 2003. The
increase is a result of the proceeds received from the public stock offering in
December 2003.
Total liabilities increased $2.0 billion, or 20.4%, from $9.7 billion at
December 31, 2002 to $11.6 billion at December 31, 2003. The growth in
liabilities was a result of an increase in bonds and notes payable of $2.0
billion, or 20.3%, from $9.4 billion at December 31, 2002 to $11.4 billion at
December 31, 2003. The increase in bonds and notes payable resulted from
additional borrowings to fund our growth in student loans in 2003.
Shareholders' equity increased $196.4 million, or 180.0%, from $109.1
million at December 31, 2002 to $305.5 million at December 31, 2003 as a result
of net income of $27.1 million in 2003 and the net proceeds from our public
stock offering of $167.7 million, less $4 million in stock offering costs. In
addition, shareholders' equity also increased as a result of a non-cash stock
compensation expense of $5.2 million in 2003.
Liquidity and Capital Resources
We completed an initial public offering of our Class A Common Stock issuing
8,000,000 shares on December 11, 2003. The underwriters exercised their rights
related to the over-allotment of shares, resulting in an issuance of an
additional 586,800 Class A Common Shares on December 22, 2003. The completion of
our initial public stock offering raised net proceeds of $167.7 million, less $4
million of stock offering costs.
21
We generally finance our operations through operating cash flow, borrowings
under credit facilities and secured financing transactions. We also utilize
secured and unsecured operating lines of credit and financing agreements to fund
operations and student loan acquisitions. Operating activities provided net cash
of $153.0 million in 2003, an increase of approximately $18.8 million from the
net cash provided by operating activities of $134.2 million in 2002 due to
efficiencies and decreases in our operating expenses with the integration of our
acquisitions. Operating cash flows are driven by net income adjusted for various
non-cash items such as the provision for loan losses, depreciation and
amortization and the non-cash stock compensation expense in 2003.
We have a $35.0 million operating line of credit and a $35.0 million
commercial paper conduit under two separate facilities from a group of six large
regional and national financial institutions. We had $12.7 million borrowed
under the commercial paper conduit at December 31, 2003 and subsequently paid
these borrowings off in the first quarter of 2004. The cost of funds associated
with our operating lines of credit is higher than that of the secured financing
transactions used to fund our student loan portfolio. Our operating lines of
credit are generally priced at a spread over LIBOR ranging from 60 to 225 basis
points. We believe our operating lines and credit facilities and the growth in
our cash flow from operating activities and the initial public stock offering
indicates a favorable trend in our available capital resources. As a result of
the proceeds received from the initial public offering, a $30 million operating
line of credit with a national financial institution was not renewed in February
2004 and we chose not to pursue execution of a commitment we had for a $30
million operating line of credit in late 2003.
In the fourth quarter of 2003, we expanded one of our existing short-term
student loan warehousing facilities, which resulted in an increase in the
aggregate of all short-term student loan warehousing facilities from $1.05
billion to $1.8 billion. This increased warehouse facility will allow for
expansion of our liquidity and capacity for student loan growth. We believe that
the expansion of our warehousing capacity and continued access to the
asset-backed securities market will provide adequate liquidity to fund our
student loan operations for the foreseeable future. At December 31, 2003, we had
a loan wa