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, 2014 | |
or | |
o | 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 (State or other jurisdiction of incorporation or organization) | 84-0748903 (I.R.S. Employer Identification No.) |
121 SOUTH 13TH STREET, SUITE 100 LINCOLN, NEBRASKA (Address of principal executive offices) | 68508 (Zip Code) |
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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [X] No [ ]
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X]
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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 a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer [X ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [ ]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
The aggregate market value of the registrant’s voting common stock held by non-affiliates of the registrant on June 30, 2014 (the last business day of the registrant’s most recently completed second fiscal quarter), based upon the closing sale price of the registrant’s Class A Common Stock on that date of $41.43 per share, was $1,092,770,730. For purposes of this calculation, the registrant’s directors, executive officers, and greater than 10 percent shareholders are deemed to be affiliates.
As of January 31, 2015, there were 34,663,780 and 11,486,932 shares of Class A Common Stock and Class B Common Stock, par value $0.01 per share, outstanding, respectively (excluding 11,317,364 shares of Class A Common Stock held by wholly owned subsidiaries).
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement to be filed for its 2015 Annual Meeting of Shareholders, scheduled to be held May 14, 2015, are incorporated by reference into Part III of this Form 10-K.
NELNET, INC.
FORM 10-K
TABLE OF CONTENTS
December 31, 2014
FORWARD-LOOKING AND CAUTIONARY STATEMENTS
This report contains forward-looking statements and information that are based on management's current expectations as of the date of this document. Statements that are not historical facts, including statements about the Company's plans and expectations for future financial condition, results of operations or economic performance, or that address management's plans and objectives for future operations, and statements that assume or are dependent upon future events, are forward-looking statements. The words “may,” “should,” “could,” “would,” “predict,” “potential,” “continue,” “expect,” “anticipate,” “future,” “intend,” “plan,” “believe,” “estimate,” “assume,” “forecast,” “will,” and similar expressions, as well as statements in future tense, are intended to identify forward-looking statements.
The forward-looking statements are based on assumptions and analyses made by management in light of management's experience and its perception of historical trends, current conditions, expected future developments, and other factors that management believes are appropriate under the circumstances. These statements are subject to known and unknown risks, uncertainties, assumptions, and other factors that may cause the actual results and performance to be materially different from any future results or performance expressed or implied by such forward-looking statements. These factors include, among others, the risks and uncertainties set forth in “Risk Factors” and elsewhere in this report, and include such risks and uncertainties as:
• | student loan portfolio risks such as interest rate basis and repricing risk resulting from the fact that the interest rate characteristics of the student loan assets do not match the interest rate characteristics of the funding for those assets, the risk of loss of floor income on certain student loans originated under the Federal Family Education Loan Program (the "FFEL Program" or "FFELP"), risks related to the use of derivatives to manage exposure to interest rate fluctuations, uncertainties regarding the expected benefits from recently purchased securitized and unsecuritized FFELP student loans and initiatives to purchase additional FFELP and private education loans, and risks from changes in levels of student loan prepayment or default rates; |
• | financing and liquidity risks, including risks of changes in the general interest rate environment and in the securitization and other financing markets for student loans, which may increase the costs or limit the availability of financings necessary to purchase, refinance, or continue to hold student loans; |
• | risks from changes in the educational credit and services markets resulting from changes in applicable laws, regulations, and government programs and budgets, such as the expected decline over time in FFELP loan interest income and fee-based revenues due to the discontinuation of new FFELP loan originations in 2010 and potential government initiatives or legislative proposals to consolidate existing FFELP loans to the Federal Direct Loan Program or otherwise allow FFELP loans to be refinanced with Federal Direct Loan Program loans, risks related to reduced government payments to guaranty agencies to rehabilitate defaulted FFELP loans and services in support of those activities, risks related to the Company's ability to maintain or increase volumes under the Company's loan servicing contract with the U.S. Department of Education (the "Department"), which accounted for approximately 10 percent of the Company's revenue in 2014 and for which the loan allocation metrics were modified effective September 1, 2014, and risks related to the Company's ability to comply with agreements with third-party customers for the servicing of FFELP, Federal Direct Loan Program, and private education loans; |
• | risks related to a breach of or failure in the Company's operational or information systems or infrastructure, or those of third-party vendors; |
• | uncertainties inherent in forecasting future cash flows from student loan assets and related asset-backed securitizations; and |
• | risks and uncertainties associated with litigation matters and with maintaining compliance with the extensive regulatory requirements applicable to the Company's businesses, and uncertainties inherent in the estimates and assumptions about future events that management is required to make in the preparation of the Company's consolidated financial statements. |
All forward-looking statements contained in this report are qualified by these cautionary statements and are made only as of the date of this document. Although the Company may from time to time voluntarily update or revise its prior forward-looking statements to reflect actual results or changes in the Company's expectations, the Company disclaims any commitment to do so except as required by securities laws.
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PART I.
ITEM 1. BUSINESS
Overview
Nelnet, Inc. (the “Company”) provides educational services in loan servicing, payment processing, education planning, and asset management. These products and services help students and families plan, prepare, and pay for their education and make the administrative and financial processes more efficient for schools and financial organizations. In addition, the Company earns interest income on a portfolio of federally insured student loans. Substantially all revenue from external customers is earned, and all long-lived assets are located, in the United States.
The Company was formed as a Nebraska corporation in 1978 to service federal student loans for two local banks. The Company built on this initial foundation as a servicer to become a leading originator, holder, and servicer of federal student loans, principally consisting of loans originated under the FFEL Program. A detailed description of the FFEL Program is included in Appendix A to this report.
The Health Care and Education Reconciliation Act of 2010 (the “Reconciliation Act of 2010”) eliminated new loan originations under the FFEL Program effective July 1, 2010 and requires that all new federal student loan originations be made through the Federal Direct Loan Program. This law does not alter or affect the terms and conditions of existing FFELP loans.
As a result of the Reconciliation Act of 2010, the Company no longer originates new FFELP loans. However, a significant portion of the Company's income continues to be derived from its existing FFELP student loan portfolio and other FFELP service offerings. As of December 31, 2014, the Company had a $28.0 billion student loan portfolio that will amortize over the next 25 years. Interest income on the Company's existing FFELP loan portfolio, as well as fee-based revenue from FFELP guaranty and third-party servicing, will decline over time as the Company's and the Company's third-party lender clients' FFELP loan portfolios are paid down. However, the Company believes there will be opportunities to purchase additional FFELP loan portfolios from current FFELP loan holders looking to adjust their FFELP businesses, which will generate incremental earnings and cash flow.
To reduce its reliance on interest income on student loans, the Company has expanded its educational services and products. In addition, in June 2009, the Company was awarded a contract to service federally-owned student loans for the Department. As of December 31, 2014, the Company was servicing $133.6 billion of student loans for 5.9 million borrowers on behalf of the Department.
Customers
The Company serves several different groups of customers, including:
• | Students and families |
• | Colleges and universities, specifically financial aid, business, and admissions offices |
• | Private, faith-based, and other K-12 schools |
• | Lenders and student loan servicers |
• | Government entities |
An increase in the size of the education market generally increases the demand for the Company's products and services. As shown in the chart below, total student enrollment is projected to continue to grow for many years. An increasing number of students are pursuing a higher education, often with the help of financial aid by the federal government, for whom the Company services loans. In addition, as the education market continues to grow, often with budget and funding concerns, schools at all levels have an increasing need to become more efficient, offer consistent and quality services, and recruit and retain students.
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(1) Source: Digest of Education Statistics 2013, National Center for Education Statistics, U.S. Department of Education, December 2014, NCES 2014-015
Operating Segments
The Company has three reportable operating segments with several different brands. The Company's reportable operating segments offer a broad range of services designed to simplify education planning and financing for students and families and the administrative and financial processes for schools and financial institutions. The Company's reportable operating segments include:
Student Loan and Guaranty Servicing
• | Referred to as Nelnet Diversified Solutions (“NDS”) |
• | Focuses on student loan servicing, student loan servicing-related technology solutions, and outsourcing services for lenders, guaranty agencies, and other entities |
• | Includes the brands Nelnet Loan Servicing, Firstmark Services, Nelnet Guarantor Solutions, 5280 Solutions, CampusGuard, Proxi, and U-Fi |
Tuition Payment Processing and Campus Commerce
• | Commonly known as Nelnet Business Solutions (“NBS”) |
• | Focuses on tuition payment plans, financial needs assessment services, online payment and refund processing, and school information system software |
• | Includes the brands FACTS Management and RenWeb |
Asset Generation and Management
• | Includes the acquisition and management of the Company's student loan assets |
Segment Operating Results
The Company's reportable operating segments are defined by the products and services they offer or the types of customers they serve, and they reflect the manner in which financial information is currently evaluated by management. The Company includes separate financial information about its reportable segments, including revenues, net income or loss, and total assets for each of the Company's reportable segments, for the last three fiscal years in note 14 of the notes to consolidated financial statements included in this report. In 2014, management determined that the Company's Enrollment Services business no longer met the quantitative thresholds for which separate information about an operating segment is required. For segment reporting purposes, business activities and operating segments that are not reportable are combined and included in "Corporate and Other Activities." Beginning in 2014, the operating results of Enrollment Services are included with Corporate and Other Activities. Prior period segment operating results were restated to conform to the current period presentation.
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Student Loan and Guaranty Servicing
The primary service offerings of this operating segment include:
• | Servicing federally-owned student loans for the Department |
• | Servicing FFELP loans |
• | Marketing, originating, and servicing private education loans |
• | Servicing and outsourcing services for FFELP guaranty agencies, including FFELP guaranty collection services |
• | Providing student loan servicing software and other information technology products and services |
• | Providing outsourced services including call center, processing, and marketing services |
As of December 31, 2014, the Company serviced $161.6 billion of student loans for 7.5 million borrowers. See Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Student Loan and Guaranty Servicing Operating Segment - Results of Operations - Student Loan Servicing Volumes" for additional information related to the Company's servicing volume.
Servicing federally-owned student loans for the Department
The Company is one of four private sector companies (referred to as Title IV Additional Servicers, or "TIVAS") awarded a student loan servicing contract by the Department in June 2009 to provide additional servicing capacity for loans owned by the Department, with new loan volume currently being allocated among the four servicers based on certain performance metrics established by the Department. These loans include Federal Direct Loan Program loans originated directly by the Department and FFEL Program loans purchased by the Department. Under the servicing contract, the Company earns a monthly fee from the Department for each unique borrower who has loans owned by the Department and serviced by the Company. The amount paid per each unique borrower is dependent on the status of the borrower (such as in school or in repayment). The servicing contract was originally scheduled to expire in June 2014. Effective as of June 17, 2014, the Department extended the servicing contract with the Company for an additional five years through June 16, 2019.
Effective as of September 1, 2014, the Department modified the loan allocation metrics and pricing under the loan servicing contract. The modification provided that certain amounts to be paid under the servicing contract as determined by borrower status changed effective September 1, 2014. Based on the Company’s current portfolio of borrowers, the Company does not expect the initial weighted average revenue earned per unique borrower to be significantly different under the revised pricing structure than under the pre-modification pricing structure.
In addition, the modification provided that the Department will begin allocating new loan volume among the four servicers based on the following performance metrics:
• | Two metrics will measure the satisfaction among separate customer groups, including borrowers (35 percent) and Federal Student Aid personnel who work with the servicers (5 percent). |
• | Three metrics will measure the success of keeping borrowers in an on-time repayment status and helping borrowers avoid default as reflected by the percentage of borrowers in current repayment status (30 percent), percentage of borrowers more than 90 days but less than 271 days delinquent (15 percent), and percentage of borrowers over 270 days and less than 361 days delinquent (15 percent). |
The allocation of ongoing volume will be determined twice each year based on the performance of each servicer in relation to the other servicers. Quarterly results will be compiled for each servicer. The average of the September and December quarter end results will be used to allocate volume for the period from March 1 to August 31, and the average of the March and June quarter end results will be used to allocate volume for the period from September 1 to February month end, of each year.
The Department also has contracts with 32 not-for-profit entities to service student loans that are serviced by seven prime servicers. These entities have operated under separate pricing and performance metrics, but effective as of October 1, 2014, the changes discussed above were also extended to the not-for-profit entities so that all Department servicers now operate under common pricing and performance metrics. While previously these entities have only serviced existing loans, effective January 1, 2015 they began to receive a total of 25 percent of new borrower loan volume. This will decrease new allocation volume for the Company.
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Based on the pre-modification performance metrics, the Company was ranked second out of the four Department servicers for the fifth year of the servicing contract and was allocated 26 percent of new loan volume originated by the Department during the period from August 15, 2014 to February 28, 2015. As of the filing of this report, the Department has not announced the September and December 2014 quarter end performance results based on the modified metrics.
As of December 31, 2014, the Company was servicing $133.6 billion of student loans for 5.9 million borrowers under this contract.
Incremental revenue components earned by the Company from the Department (in addition to loan servicing revenues) include:
• | Administration of the Total and Permanent Disability (TPD) Discharge program. The Company processes applications for the TPD Discharge program and is responsible for discharge, monitoring, and servicing of TPD loans. Individuals who are totally and permanently disabled may qualify for a discharge of their federal student loans, and the Company processes applications under the program and receives a fee from the Department on a per application basis, as well as a monthly servicing fee during the monitoring period. The Company is the exclusive provider of this service to the Department. |
• | Origination of consolidation loans. Beginning in 2014, the Department implemented a new process to outsource the origination of consolidation loans whereby each of the four TIVAS receives Federal Direct Loan consolidation origination volume based on borrower choice. The Department pays the Company a fee for each completed consolidation loan application it processes. The Company services the consolidation volume it originates. |
The Department is the Company's largest customer, representing approximately 10 percent of the Company's revenue in 2014.
Servicing FFELP loans
The Student Loan and Guaranty Servicing operating segment provides for the servicing of the Company's student loan portfolio and the portfolios of third parties. The loan servicing activities include loan conversion activities, application processing, borrower updates, customer service, payment processing, due diligence procedures, funds management reconciliations, and claim processing. These activities are performed internally for the Company's portfolio, in addition to generating external fee revenue when performed for third-party clients.
The Company's student loan servicing division uses proprietary systems to manage the servicing process. These systems provide for automated compliance with most of the federal student loan regulations adopted under Title IV of the Higher Education Act of 1965, as amended (the “Higher Education Act”).
The Company serviced FFELP loans on behalf of 38 third-party servicing customers as of December 31, 2014. The Company's FFELP servicing customers include national and regional banks, credit unions, and various state and non-profit secondary markets. The majority of the Company's external FFELP loan servicing activities are performed under “life of loan” contracts. Life of loan contract servicing essentially provides that as long as the loan exists, the Company shall be the sole servicer of that loan; however, the agreement may contain “deconversion” provisions where, for a fee, the lender may move the loan to another servicer.
The elimination of new FFELP loan originations in July 2010 will cause FFELP servicing revenue to decline as FFELP loan portfolios are paid down. However, the Company believes there will be opportunities to service additional FFELP loan portfolios from current FFELP participants looking to adjust their FFELP businesses.
Originating and servicing private education student loans
The Student Loan and Guaranty Servicing operating segment conducts origination and servicing activities for private education loans. Private education loans are loans to students or their families that are non-federal loans and loans not insured or guaranteed under the FFELP. These loans are used primarily to bridge the gap between the cost of higher education and the amount funded through financial aid, federal loans, or borrowers' resources. Although similar in terms of activities and functions as FFELP loan servicing (i.e., application processing, disbursement processing, payment processing, customer service, statement distribution, and reporting), private education loan servicing activities are not required to comply with provisions of the Higher Education Act and may be more customized to individual client requirements. The Company serviced private education loans on behalf of 29 third-party servicing customers as of December 31, 2014.
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Servicing and outsourcing services for FFELP guaranty agencies, including FFELP guaranty collection services
The Student Loan and Guaranty Servicing operating segment provides servicing support for guaranty agencies, which serve as intermediaries between the Department and FFELP lenders, and are responsible for paying the claims made on defaulted loans. The Department has designated approximately 30 guarantors that have been formed as either state agencies or non-profit corporations that provide FFELP guaranty services in one or more states. Approximately half of these guarantors contract externally for operational or technology services. The services provided by the Company include providing software and data center services, borrower and loan updates, default aversion services, claim processing services, and post-default collection services.
The Company's three guaranty servicing customers are Tennessee Student Assistance Corporation, College Assist, and the National Student Loan Program.
A significant portion of guaranty servicing revenue earned by the Company relates to rehabilitating defaulted FFELP loans (collection services). Recent federal budget provisions that became effective July 1, 2014 have reduced payments by the Department to guaranty agencies for assisting student loan borrowers with the rehabilitation of defaulted loans under FFELP. These provisions reduced the amount guaranty agencies retain upon successful rehabilitation from 37 percent to 16 percent of the loan balance. The Company earns revenue from rehabilitating defaulted FFELP student loans on behalf of guaranty agencies. The decrease in the retention percent earned by guaranty agencies negatively impacted the Company’s guaranty collections revenue, and also contributed to a reduction in the segment's operating margin. During the years ended December 31, 2014 and 2013, the Company recognized $41.6 million and $54.2 million, respectively, in revenue from rehabilitating defaulted FFELP loans for guaranty agencies. Of the $41.6 million of revenue recognized by the Company in 2014, $10.9 million was recognized subsequent to July 1, 2014, the effective date of the reduced payments. The Company anticipates that guaranty agencies will continue to operate with reduced levels of FFELP student loan rehabilitation activities as a result of the reduced payment framework.
Providing student loan servicing software and other information technology products and services
The Student Loan and Guaranty Servicing operating segment provides student loan servicing software, which is used internally by the Company and licensed to third-party student loan holders and servicers. These software systems have been adapted so that they can be offered as hosted servicing software solutions that can be used by third-parties to service various types of student loans, including Federal Direct Loan Program and FFEL Program loans. The Company earns a monthly fee from its remote hosting customers for each unique borrower on the Company's platform, with a minimum monthly charge for most contracts. As of December 31, 2014, 1.6 million borrowers were hosted on the Company's hosted servicing software solution platforms.
In addition, this operating segment has historically provided information technology products and services, with core areas of business in educational loan software solutions, technical consulting services, enterprise content management solutions, and outsourcing and back office support services. However, the elimination of new loan originations under the FFEL Program has reduced these service offerings over the last several years.
Providing outsourced services including call center, processing, and marketing services
The Company provides business process outsourcing specializing in contact center management. The contact center solutions and services include taking inbound calls, helping with outreach campaigns and sales, and interacting with customers through multi-channels.
Competition
The Company's scalable servicing platform allows it to provide compliant, efficient, and reliable service at a low cost, giving the Company a competitive advantage over others in the industry for all of this segment's services, which are discussed below.
Loan servicing
The principal competitor for existing and prospective FFELP and private education loan servicing business is Navient Corporation ("Navient"). Navient is the largest for-profit provider of servicing functions, as well as one of the largest service providers for private education loans. In contrast to its competitors, the Company has segmented its private education loan servicing on a distinct platform, created specifically to meet the needs of private education student loan borrowers, their families, the schools they attend, and the lenders who serve them. This ensures access to specialized teams with a dedicated focus on servicing these borrowers.
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With the elimination of new loan originations under the FFEL Program, four servicers, including the Company, were named by the Department as servicers of federally-owned loans. The three competitors for gaining future servicing volume from the Department are Great Lakes Educational Loan Services Inc. (“Great Lakes”), FedLoan Servicing (Pennsylvania Higher Education Assistance Agency (“PHEAA”)), and Navient.
In addition, the Department has contracts with 32 not-for-profit entities to service student loans that are serviced by seven prime servicers. These entities were authorized in 2012 to begin servicing loans for existing borrower accounts. While previously these entities have only serviced existing loans, effective January 1, 2015 they began to receive a total of 25 percent of new borrower loan volume. This will decrease new allocation volume for the TIVAS, including the Company. The Company currently licenses its hosted servicing software to four prime servicers that represent 13 not-for-profit organizations. PHEAA is the only other TIVAS servicer offering a hosted Federal Direct Loan Program servicing solution to the not-for-profit servicers.
Guaranty servicing
With the elimination of new loan originations under the FFEL Program, services provided to guaranty agencies will continue for agencies' existing portfolios. The Company currently anticipates continuing to serve its existing guaranty customers as their portfolios pay down, but does not expect to increase the number of its guaranty servicing customers.
Approximately 70 percent of the Company's guaranty servicing revenue comes from a single guaranty servicing client. The current term of the contract with this client expires on October 31, 2015 and is subject to renewal. Given the significant reduction in rehabilitation collection revenue resulting from changes in federal budget provisions that became effective July 1, 2014, the terms of this contract could be modified in ways that reduce the Company's amount of guaranty servicing revenue even further or the agreement could be terminated.
Software and technology
The Company is one of the leaders in the development of servicing software for private education, Federal Direct Loan Program, and FFELP student loans. Many student loan lenders utilize the Company's software either directly or indirectly. Management believes the Company's competitors in this segment are much smaller than the Company and do not have the depth of knowledge, experience, or products offered by the Company. In addition, the Company believes the investments it has made to scale its systems and to create a secure infrastructure to support the Department's servicing volume and requirements increase its competitive advantage as a long-term partner in the loan servicing market.
Tuition Payment Processing and Campus Commerce
The Company's Tuition Payment Processing and Campus Commerce operating segment provides products and services to help students and families manage the payment of education costs at all levels (K-12 and higher education). It also provides innovative education-focused technologies, services, and support solutions to help schools with the everyday challenges of collecting and processing commerce data. See Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Tuition Payment Processing and Campus Commerce Operating Segment - Results of Operations" for a discussion of the seasonality of the business in this operating segment.
K-12
According to the National Center for Education Statistics, the K-12 market consists of over 17,000 private and faith-based education institutions with over 50 students enrolled in the 2011-2012 academic year, the most current data available. In the K-12 market, the Company offers tuition management services, school information systems, as well as assistance with financial needs assessment and donor management.
The Company is the market leader, having actively managed tuition payment plans in place at over 5,200 K-12 educational institutions. Tuition management services include payment plan administration, incidental billing, accounts receivable management, and record keeping. K-12 educational institutions contract with the Company to administer deferred payment plans that allow families to make monthly payments over 6 to 12 months. The Company collects a fee from either the institution or the payer as an administration fee.
The Company's financial needs assessment service, which serves over 4,200 private, faith-based schools, helps K-12 schools evaluate and determine the amount of financial aid to disburse to the families it serves. The Company's donor services allow schools to assess and deliver strategic fundraising solutions using the latest technology.
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On June 3, 2014, the Company purchased 100 percent of the ownership interests of RenWeb. RenWeb currently provides school information systems to over 3,000 private and faith-based schools to help schools automate administrative processes such as admissions, scheduling, student billing, attendance, and grade book management. RenWeb's information systems software is sold as a subscription service to schools. The combination of RenWeb’s school administration software and the Company’s tuition management and financial needs assessment services is expected to significantly increase the value of the Company’s offerings in this area, allowing the Company to deliver a comprehensive suite of solutions to schools.
Higher Education
The higher education market consists of nearly 4,700 colleges and universities. The Company offers two principal products to the higher education market: actively managed tuition payment plans, and campus commerce technologies and payment processing.
The Company has actively managed tuition payment plans in place at approximately 620 colleges and universities. Higher education institutions contract with the Company to administer payment plans that allow the student and family to make monthly payments on either a semester or annual basis. The Company collects a fee from the student or family as an administration fee.
The Company's suite of campus commerce solutions provides services that allow for families' electronic billing and payment of campus charges. Campus commerce includes cashiering for face-to-face transactions, campus-wide commerce management, and refunds management, among other activities. The Company earns revenue for e-billing, hosting/maintenance, credit card processing fees, and e-payment transaction fees, which are powered by the Company's QuikPAY system, a secure payment processing engine.
QuikPAY, a campus commerce product, is sold as a subscription service to colleges and universities. QuikPAY processes payments through the appropriate channels in the banking or credit card networks to make deposits into the client's bank account. It can be further deployed to other departments around campus as requested (e.g., application fees, alumni giving, parking, events, etc.). Approximately 220 colleges and universities use the QuikPAY system.
Competition
The Company is the largest provider of tuition management services to the private and faith-based K-12 market in the United States. Competitors include financial institutions, tuition management providers, financial needs assessment providers, accounting firms, and a myriad of software companies.
In the higher education market, the Company targets business offices at colleges and universities. In this market, the primary competition is limited to three campus commerce and tuition payment providers, as well as solutions developed in-house by colleges and universities.
The Company's principal competitive advantages are (i) the customer service it provides to institutions, (ii) the information management tools provided with the Company's service, and (iii) the Company's ability to interface with the institution clients and their third party service providers. The Company believes its clients select products primarily based on technological superiority and feature functionality, but price and service also impact the selection process.
Asset Generation and Management
The Asset Generation and Management operating segment includes the acquisition, management, and ownership of the Company's student loan assets, which was historically the Company's largest product and service offering. As of December 31, 2014, the Company's student loan portfolio was $28.0 billion. The Company generates a substantial portion of its earnings from the spread, referred to as the Company's student loan spread, between the yield it receives on its student loan portfolio and the associated costs to finance such portfolio. See Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset Generation and Management Operating Segment - Results of Operations - Student Loan Spread Analysis,” for further details related to the student loan spread. The student loan assets are held in a series of education lending subsidiaries and associated securitization trusts designed specifically for this purpose. In addition to the student loan spread earned on its portfolio, all costs and activity associated with managing the portfolio, such as servicing of the assets and debt maintenance, are included in this segment.
Student loans consist of federally insured student loans and private education loans. Federally insured student loans were originated under the FFEL Program. The Company's portfolio of federally insured student loans is subject to minimal credit risk, as these loans are guaranteed by the Department at levels ranging from 97 percent to 100 percent. Substantially all of the Company's loan
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portfolio (99.9 percent as of December 31, 2014) is federally insured. The Company's portfolio of private education loans is subject to credit risk similar to other consumer loan assets.
The Higher Education Act regulates every aspect of the federally insured student loan program, including certain communications with borrowers, loan originations, and default aversion. Failure to service a student loan properly could jeopardize the guarantee on federal student loans. In the case of death, disability, or bankruptcy of the borrower, the guarantee covers 100 percent of the loan's principal and accrued interest.
FFELP loans are guaranteed by state agencies or non-profit companies designated as guarantors, with the Department providing reinsurance to the guarantor. Guarantors are responsible for performing certain functions necessary to ensure the program's soundness and accountability. Generally, the guarantor is responsible for ensuring that loans are serviced in compliance with the requirements of the Higher Education Act. When a borrower defaults on a FFELP loan, the Company submits a claim to the guarantor, who provides reimbursements of principal and accrued interest, subject to the applicable risk share percentage.
Origination and Acquisition
The Reconciliation Act of 2010 eliminated originations of new FFELP loans effective July 1, 2010. However, the Company believes there will be ongoing opportunities to continue to purchase FFELP loan portfolios from current FFELP participants looking to adjust their FFELP businesses. For example, from July 1, 2010 through December 31, 2014, the Company purchased a total of $17.1 billion of FFELP student loans from various third-parties, including a total of $6.1 billion during 2014. The Company's competition for the purchase of student loan portfolios and residuals includes large banks, hedge funds, and other student loan finance companies.
Interest Rate Risk Management
Because the Company generates a significant portion of its earnings from its student loan spread, the interest rate sensitivity of the Company's balance sheet is very important to its operations. The current and future interest rate environment can and will affect the Company's interest income and net income. The effects on the Company's results of operations as a result of the changing interest rate environments are further outlined in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Asset Generation and Management Operating Segment - Results of Operations - Student Loan Spread Analysis" and Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk.”
Intellectual Property
The Company owns numerous trademarks and service marks (“Marks”) to identify its various products and services. As of December 31, 2014, the Company had 46 registered Marks. The Company actively asserts its rights to these Marks when it believes infringement may exist. The Company believes its Marks have developed and continue to develop strong brand-name recognition in the industry and the consumer marketplace. Each of the Marks has, upon registration, an indefinite duration so long as the Company continues to use the Mark on or in connection with such goods or services as the Mark identifies. In order to protect the indefinite duration, the Company makes filings to continue registration of the Marks. The Company owns one patent application that has been published, but has not yet been issued, and has also actively asserted its rights thereunder in situations where the Company believes its claims may be infringed upon. The Company owns many copyright protected works, including its various computer system codes and displays, Web sites, books and other publications, and marketing materials. The Company also has trade secret rights to many of its processes and strategies and its software product designs. The Company's software products are protected by both registered and common law copyrights, as well as strict confidentiality and ownership provisions placed in license agreements, which restrict the ability to copy, distribute, or improperly disclose the software products. The Company also has adopted internal procedures designed to protect the Company's intellectual property.
The Company seeks federal and/or state protection of intellectual property when deemed appropriate, including patent, trademark/service mark, and copyright. The decision whether to seek such protection may depend on the perceived value of the intellectual property, the likelihood of securing protection, the cost of securing and maintaining that protection, and the potential for infringement. The Company's employees are trained in the fundamentals of intellectual property, intellectual property protection, and infringement issues. The Company's employees are also required to sign agreements requiring, among other things, confidentiality of trade secrets, assignment of inventions, and non-solicitation of other employees post-termination. Consultants, suppliers, and other business partners are also required to sign nondisclosure agreements to protect the Company's proprietary rights.
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Employees
As of December 31, 2014, the Company had approximately 3,100 employees. None of the Company's employees are covered by collective bargaining agreements. The Company is not involved in any material disputes with any of its employees, and the Company believes that relations with its employees are good.
Available Information
Copies of the Company's annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to such reports are available on the Company's Web site free of charge as soon as reasonably practicable after such reports are filed with or furnished to the United States Securities and Exchange Commission ("SEC"). Investors and other interested parties can access these reports and the Company's proxy statements at http://www.nelnetinvestors.com. The Company routinely posts important information for investors on its Web site.
The Company has adopted a Code of Conduct that applies to directors, officers, and employees, including the Company's principal executive officer and its principal financial and accounting officer, and has posted such Code of Conduct on its Web site. Amendments to and waivers granted with respect to the Company's Code of Conduct relating to its executive officers and directors which are required to be disclosed pursuant to applicable securities laws and stock exchange rules and regulations will also be posted on its Web site. The Company's Corporate Governance Guidelines, Audit Committee Charter, Compensation Committee Charter, Nominating and Corporate Governance Committee Charter, Risk and Finance Committee Charter, and Compliance Committee Charter are also posted on its Web site.
Information on the Company's Web site is not incorporated by reference into this report and should not be considered part of this report.
ITEM 1A. RISK FACTORS
We operate our business in a highly competitive and regulated environment. We are subject to risks including, but not limited to, market, liquidity, credit, regulatory, technology, operational, security, and other business risks such as reputation damage related to negative publicity and dependencies on key personnel, customers, vendors, and systems. This section highlights specific risks that could affect us. Although this section attempts to highlight key risk factors, other risks may emerge at any time and we cannot predict all risks or estimate the extent to which they may affect our financial performance. These risk factors should be read in conjunction with the other information included in this report.
Student Loan Portfolio
Our student loan portfolio is subject to certain risks related to interest rates, our ability to manage the risks related to interest rates, prepayment, and credit risk, each of which could reduce the expected cash flows and earnings on our portfolio.
Interest rate risk - basis and repricing risk
We are exposed to interest rate risk in the form of basis risk and repricing risk because the interest rate characteristics of our student loan assets do not always match the interest rate characteristics of the funding for those assets.
We fund the majority of our FFELP student loan assets with one-month or three-month LIBOR indexed floating rate securities. In addition, the interest rates on some of our debt are set via a “dutch auction.” Meanwhile, the interest earned on our FFELP student loan assets is indexed to one-month LIBOR and Treasury bill rates. The different interest rate characteristics of our loan assets and our liabilities funding these assets results in basis risk. We also face repricing risk due to the timing of the interest rate resets on our liabilities, which may occur as infrequently as once a quarter, in contrast to the timing of the interest rate resets on our assets, which generally occur daily. In a declining interest rate environment, this may cause our student loan spread to compress, while in a rising interest rate environment, it may cause the spread to increase.
As of December 31, 2014, we had $27.3 billion and $0.9 billion of FFELP loans indexed to the one-month LIBOR and the three-month Treasury bill rate, respectively, both of which reset daily, and $16.5 billion of debt indexed to three-month LIBOR, which resets quarterly, and $9.9 billion of debt indexed to one-month LIBOR, which resets monthly. While these indices are all short term in nature with rate movements that are highly correlated over a longer period of time, there have been points in recent history related to the U.S. and European debt crisis that have caused volatility to be high and correlation to be reduced. There can be no assurance that the indices' historically high level of correlation will not be disrupted in the future due to capital market dislocations
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or other factors not within our control. In such circumstances, our earnings could be adversely affected, possibly to a material extent.
We have entered into basis swaps to hedge our basis and repricing risk. For these derivatives, we receive three-month LIBOR set discretely in advance and pay one-month LIBOR plus or minus a spread as defined in the agreements (the "1:3 Basis Swaps").
Interest rate risk - loss of floor income
FFELP loans originated prior to April 1, 2006 generally earn interest at the higher of the borrower rate, which is fixed over a period of time, or a floating rate based on the Special Allowance Payments ("SAP") formula set by the Department. The SAP rate is based on an applicable index plus a fixed spread that depends on loan type, origination date, and repayment status. We generally finance our student loan portfolio with variable rate debt. In low and/or certain declining interest rate environments, when the fixed borrower rate is higher than the SAP rate, these student loans earn at a fixed rate while the interest on the variable rate debt typically continues to reflect the low and/or declining interest rates. In these interest rate environments, we may earn additional spread income that we refer to as floor income.
Depending on the type of loan and when it was originated, the borrower rate is either fixed to term or is reset to an annual rate each July 1. As a result, for loans where the borrower rate is fixed to term, we may earn floor income for an extended period of time, which we refer to as fixed rate floor income, and for those loans where the borrower rate is reset annually on July 1, we may earn floor income to the next reset date, which we refer to as variable rate floor income.
For the year ended December 31, 2014, we earned $179.9 million of fixed rate floor income, net of $24.4 million of settlements paid related to derivatives used to hedge loans earning fixed rate floor income. Absent the use of derivative instruments, a rise in interest rates will reduce the amount of floor income received and this will have an impact on earnings due to interest margin compression caused by increased financing costs, until such time as the federally insured loans earn interest at a variable rate in accordance with their SAP formulas. In higher interest rate environments, where the interest rate rises above the borrower rate and fixed rate loans effectively convert to variable rate loans, the impact of the rate fluctuations is reduced.
Interest rate risk - use of derivatives
We utilize derivative instruments to manage interest rate sensitivity. Our derivative instruments are intended as economic hedges but do not qualify for hedge accounting; consequently, the change in fair value, called the “mark-to-market,” of these derivative instruments is included in our operating results. Changes or shifts in the forward yield curve can and have significantly impacted the valuation of our derivatives. Accordingly, changes or shifts in the forward yield curve will impact our financial position and results of operations.
Although we believe our derivative instruments are highly effective, developing an effective strategy for dealing with movements in interest rates is complex, and no strategy can completely insulate us from risks associated with such fluctuations. Because many of our derivatives are not balance guaranteed to a particular pool of student loans and we may not elect to fully hedge our risk on a notional and/or duration basis, we are subject to the risk of being under or over hedged, which could result in material losses. In addition, our interest rate risk management activities could expose us to substantial mark-to-market losses if interest rates move in a materially different way than was expected based on the environment when the derivatives were entered into. As a result, we cannot offer any assurance that our economic hedging activities will effectively manage our interest rate sensitivity or have the desired beneficial impact on our results of operations or financial condition.
By using derivative instruments, we are exposed to credit and market risk. We attempt to manage credit and market risks associated with interest rates by establishing and monitoring limits as to the types and degree of risk that may be undertaken and by entering into transactions with high-quality counterparties that are reviewed periodically by our risk committee. As of December 31, 2014, all of our derivative counterparties had investment grade credit ratings. We also have a policy of requiring that all derivative contracts be governed by an International Swaps and Derivatives Association, Inc. Master Agreement.
When the fair value of a derivative contract is positive (an asset on our balance sheet), this generally indicates that the counterparty owes us if the derivative was settled. If the counterparty fails to perform, credit risk with such counterparty is equal to the extent of the fair value gain in the derivative less any collateral held by us. If we were unable to collect from a counterparty, we would have a loss equal to the amount the derivative is recorded on the consolidated balance sheet. As of December 31, 2014, the fair value of our derivatives which had a positive fair value in our favor (an asset on our balance sheet) was $64.4 million. The Company held no collateral as of December 31, 2014 related to these derivatives.
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When the fair value of a derivative instrument is negative (a liability on our balance sheet), we would owe the counterparty if the derivative was settled and, therefore, have no immediate credit risk. If the negative fair value of derivatives with a counterparty exceeds a specified threshold, we may have to make a collateral deposit with the counterparty. The threshold at which we may be required to post collateral is dependent upon our unsecured credit rating. The Company believes any downgrades from its current unsecured credit ratings (Standard & Poor's: BBB- (stable outlook) and Moody's: Ba1 (stable outlook)), would not result in additional collateral requirements of a material nature. In addition, no counterparty has the right to terminate its contracts in the event of downgrades from the current ratings. However, some derivative contracts have mutual optional termination provisions that can be exercised during the years 2016 through 2023. As of December 31, 2014, the fair value of derivatives with early termination provisions was a positive $34.7 million (an asset on our balance sheet).
Interest rate movements have an impact on the amount of collateral we are required to deposit with our derivative instrument counterparties. Based on the interest rate swaps outstanding as of December 31, 2014 (for both the floor income and hybrid debt hedges), if the forward interest rate curve was one basis point lower for the remaining duration of these derivatives, we would have been required to post $0.5 million in additional collateral. In addition, if the forward basis curve between 1-month and 3-month LIBOR experienced a one basis point reduction in spread for the remaining duration of our 1:3 Basis Swaps (in which we pay 1-month LIBOR and receive 3-month LIBOR), we would have been required to post $7.1 million in additional collateral.
With our current derivative portfolio, we do not currently anticipate a near term movement in interest rates having a material impact on our liquidity or capital resources, nor expect future movements in interest rates to have a material impact on our ability to meet potential collateral deposit requirements with our counterparties. Due to the existing low interest rate environment, our exposure to downward movements in interest rates on our interest rate swaps is limited. In addition, we believe the historical high correlation between 1-month and 3-month LIBOR limits our exposure to interest rate movements on the 1:3 Basis Swaps.
However, if interest rates move materially and negatively impact the fair value of our derivative portfolio or if we enter into additional derivatives in which the fair value of such derivatives become negative, we could be required to deposit a significant amount of collateral with our derivative instrument counterparties. The collateral deposits, if significant, could negatively impact our liquidity and capital resources. As of December 31, 2014, the fair value of our derivatives which had a negative fair value (a liability on our balance sheet) was $32.8 million. The Company had no collateral deposited as of December 31, 2014 related to these derivatives.
Our outstanding cross-currency interest rate swap is a derivative entered into as a result of an asset-backed security financing. This derivative was entered into at the securitization trust level with the counterparty and does not contain credit contingent features related to our or the trust's credit ratings. As such, there are no collateral requirements and the impact of changes to foreign currency rates has no impact on the amount of collateral we would be required to deposit with the counterparty on this derivative.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) represents a comprehensive overhaul of the regulatory framework for the financial services industry within the United States. The Dodd-Frank Act provides the Commodity Futures Trading Commission (the "CFTC") with substantial authority to regulate over-the-counter derivative transactions. The CFTC issued final regulations that require derivative transactions to be executed through an exchange or central clearinghouse. As such, effective June 10, 2013, all over-the-counter derivative contracts executed by us are cleared post-execution at a regulated clearinghouse. Clearing is a process by which a third-party, the clearinghouse, steps in between the original counterparties and guarantees the performance of both, by requiring that each post substantial amounts of liquid collateral on an initial and mark-to-market basis to cover the clearinghouse's potential future exposure in the event of default. The new clearing requirements did not alter or affect the terms and conditions of our derivative instruments executed prior to June 10, 2013. The new clearing requirements require us to post substantial amounts of liquid collateral when executing new derivative instruments, which could negatively impact our liquidity and capital resources and may prevent or limit us from utilizing derivative instruments to manage interest rate sensitivity and risks. However, the new clearing requirements reduce counterparty risk associated with derivatives executed by us after June 10, 2013.
Prepayment risk
Higher rates of prepayments of student loans, including consolidations by the Department through the Federal Direct Loan Program, would reduce our interest income.
Pursuant to the Higher Education Act, borrowers may prepay loans made under the FFEL Program at any time without penalty. Prepayments may result from consolidations of student loans by the Department through the Federal Direct Loan Program or by a lending institution through a private education loan, which historically tend to occur more frequently in low interest rate
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environments; from borrower defaults, which will result in the receipt of a guaranty payment; and from voluntary full or partial prepayments; among other things.
Legislative risk exists as Congress evaluates proposals to reauthorize the Higher Education Act. If the federal government and the Department initiate additional loan forgiveness, repayment plans, or consolidation loan programs, these initiatives could further increase prepayments and reduce interest income.
The rate of prepayments of student loans may be influenced by a variety of economic, social, political, and other factors affecting borrowers, including interest rates, federal budgetary pressures, and the availability of alternative financing. Our profits could be adversely affected by higher prepayments, which reduce the balance of loans outstanding and, therefore, the amount of interest income we receive.
Credit risk
Future losses due to defaults on loans held by us, or loans sold to unaffiliated third parties which we are obligated to repurchase in the event of certain delinquencies, present credit risk which could adversely affect our earnings.
The vast majority (99.9 percent) of our student loan portfolio is federally guaranteed. The allowance for loan losses from the federally insured loan portfolio is based on periodic evaluations of our loan portfolios, considering loans in repayment versus those in nonpaying status, delinquency status, trends in defaults in the portfolio based on Company and industry data, past experience, trends in student loan claims rejected for payment by guarantors, changes to federal student loan programs, current economic conditions, and other relevant factors. The federal government currently guarantees 97 percent of the principal and interest on federally insured student loans disbursed on and after July 1, 2006 (and 98 percent for those loans disbursed on and after October 1, 1993 and prior to July 1, 2006), which limits our loss exposure on the outstanding balance of our federally insured portfolio. Student loans disbursed prior to October 1, 1993 are fully insured for both principal and interest.
Our private education loans are unsecured, with neither a government nor a private insurance guarantee. Accordingly, we bear the full risk of loss on these loans if the borrower and co-borrower, if applicable, default. In determining the adequacy of the allowance for loan losses on the private education loans, we consider several factors, including: loans in repayment versus those in a nonpaying status, delinquency status, type of program, trends in defaults in the portfolio based on Company and industry data, past experience, current economic conditions, and other relevant factors. We place a private education loan on nonaccrual status when the collection of principal and interest is 30 days past due, and charge off the loan when the collection of principal and interest is 120 days past due.
The evaluation of the allowance for loan losses is inherently subjective, as it requires material estimates that may be subject to significant changes. As of December 31, 2014, our allowance for loan losses was $48.9 million. During the year ended December 31, 2014, we recognized a provision for loan losses of $9.5 million. The provision for loan losses reflects the activity for the applicable period and provides an allowance at a level that management believes is appropriate to cover probable losses inherent in the loan portfolio. However, future defaults can be higher than anticipated due to a variety of factors, such as downturns in the economy, regulatory or operational changes, and other unforeseen future trends. General economic and employment conditions, including employment rates for recent college graduates, during the recent recession led to higher rates of student loan defaults which can have an adverse effect on our earnings, particularly with respect to private education loans. Although default rates have subsequently decreased as economic conditions have improved, they remain higher than the pre-recession levels. If actual performance is significantly worse than currently estimated, it would materially affect our estimate of the allowance for loan losses and the related provision for loan losses in our statements of income.
The Company has sold various portfolios of private education loans to third-parties. Per the terms of the servicing agreements, the Company’s servicing operations are obligated to repurchase loans subject to the sale agreements in the event such loans become 60 or 90 days delinquent. As of December 31, 2014, the balance of loans subject to these repurchase obligations was $155.3 million. As of December 31, 2014, we had a reserve related to this obligation of $11.8 million included in other liabilities on the consolidated balance sheet. The evaluation of the reserve related to these loans is inherently subjective, as it requires estimates that may be subject to changes. If actual performance is worse than estimated, it would negatively affect our results of operations.
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Liquidity and Funding
We fund student loans in FFELP warehouse facilities. The current maturities of these facilities do not match the maturity of the related funded assets. Therefore, we will need to modify and/or find alternative funding related to the student loan collateral in these facilities prior to their expiration. If we cannot find any funding alternatives, we would lose our collateral, including the student loan assets and cash advances, related to these facilities.
The majority of our portfolio of student loans is funded through asset-backed securitizations that are structured to substantially match the maturity of the funded assets, and there are minimal liquidity issues related to these facilities. We also have student loans funded in shorter term FFELP warehouse facilities. The current maturities of these facilities do not match the maturity of the related funded assets. Therefore, we will need to modify and/or find alternative funding related to the student loan collateral in these facilities prior to their expiration.
As of December 31, 2014, we maintained three FFELP warehouse facilities as described in note 4 of the notes to consolidated financial statements included in this report. These facilities have revolving financing structures supported by 364-day liquidity provisions, which expire in 2015. In the event we are unable to renew the liquidity provisions for a facility, the facility would become a term facility at a stepped-up cost, with no additional student loans being eligible for financing, and we would be required to refinance the existing loans in the facility by its final maturity date in 2016 or 2017. The FFELP warehouse facilities also contain financial covenants relating to levels of our consolidated net worth, ratio of adjusted EBITDA to corporate debt interest, and unencumbered cash. Any noncompliance with these covenants could result in a requirement for the immediate repayment of any outstanding borrowings under the facilities. As of December 31, 2014, $1.2 billion was outstanding under the warehouse facilities and $73.4 million was advanced as equity support.
If we are unable to obtain cost-effective funding alternatives for the loans in the FFELP warehouse facilities prior to the facilities' maturities, our cost of funds could increase, adversely affecting our results of operations. If we cannot find any funding alternatives, we would lose our collateral, including the student loan assets and cash advances, related to these facilities.
We are exposed to mark-to-formula collateral support risk on one of our FFELP warehouse facilities.
One of our warehouse facilities provides formula based advance rates based on market conditions, which requires equity support to be posted to the facility. As of December 31, 2014, $21.9 million was advanced as equity support under this facility. The other two warehouse facilities have static advance rates that require initial equity for loan funding, but do not require increased equity based on market movements. In the event that a significant change in the valuation of loans results in additional required equity funding support for the warehouse facilities greater than what we can provide, the warehouse facilities could be subject to an event of default resulting in termination of the facilities and an acceleration of the repayment provisions. If we cannot find any funding alternatives, we would lose our collateral, including the student loan assets and cash advances, related to these facilities. A default on the FFELP warehouse facilities would result in an event of default on our $350.0 million unsecured line of credit that would result in the outstanding balance on the line of credit becoming immediately due and payable.
We are committed to purchase private education loans from certain third-parties. We intend to initially fund these purchases using operating cash and our unsecured line of credit. If we are unable to subsequently finance these loans in private education loan warehouse facilities and/or securitization transactions, our liquidity could be adversely affected and our opportunities to purchase additional such loans could be limited.
On December 22, 2014, we entered into an agreement with Union Bank in which we will provide marketing, origination, and servicing services to Union Bank related to private education loans. We have committed to purchase, or arrange for a designee to purchase, all volume originated by Union Bank under this agreement. On February 5, 2015, we committed to purchase up to $150.0 million of private education loans originated by CommonBond, Inc., a student lending company that provides private education loans to graduate students.
We intend to use operating cash and our unsecured line of credit to initially fund these purchases of private education loans. We are currently forming a private education loan warehouse facility to be used to pool loans before financing them under more permanent securitization financing arrangements. If we are not successful in establishing specific financing facilities for private education loans, our liquidity could be adversely affected and our opportunities to purchase additional such loans could be limited.
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We are subject to economic and market fluctuations related to our investments.
We currently invest a substantial portion of our excess cash in student loan asset-backed securities and other investments that are subject to market fluctuations. The amount of these investments was $149.1 million as of December 31, 2014, including $145.0 million in student loan asset-backed securities. These securities earn a floating interest rate and carry expected returns of approximately LIBOR + 200-500 basis points to maturity. While the vast majority of these securities are backed by FFELP government guaranteed student loan collateral, most are in subordinate tranches and have a greater risk of loss with respect to the applicable student loan collateral pool. While we expect these securities to have few credit issues if held to maturity, they do have limited liquidity, and we could incur a significant loss if the investments were sold prior to maturity at an amount less than the original purchase price.
Operations
Risks associated with our operations, as further discussed below, include those related to our information technology systems and potential security and privacy breaches, our ability to manage performance related to regulatory requirements, and the importance of maintaining scale by retaining existing customers and attracting new business opportunities.
A failure in or breach of one of our operational or information systems or infrastructure, or those of our third-party vendors, could disrupt our businesses. These types of failures or breaches, including but not limited to cyber attacks, could result in a denial of service or misuse of confidential or proprietary information which could damage our reputation, increase costs, and jeopardize existing business contracts or result in regulatory penalties.
As a loan servicer, hosted loan servicing software provider, and payment processor for the federal government, financial institutions, and the education industry that serves millions of customers through the Internet and other distribution channels across the U.S., we depend on our ability to process, secure, record, and monitor a large number of customer transactions and confidential information on a continuous basis.
Information security risks have significantly increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to support and process customer transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. Our operations rely on the secure processing, transmission, and storage of confidential information in our computer systems and networks. Our business segments rely on our digital technologies, computer and email systems, software, and networks to conduct their operations. In addition, to access our products and services, our customers may use personal smartphones, tablet PC's, and other mobile devices that are beyond our control systems. Although we believe we have robust information security procedures and controls, our technologies, systems, networks, and our customers' devices may become the target of cyber attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss, or destruction of Company or customer confidential, proprietary, and other information, or disrupt the Company's or our customers' business operations. A cyber attack or information security breach of this nature could significantly affect our ability to retain strategic business customers, which could lead to increased costs to retain customers or result in regulatory penalties or a material loss of future revenue.
Third parties with which we do business or that facilitate our business activities, including financial intermediaries, data centers, data storage locations, collection services, distribution centers, or other vendors that provide services or security solutions for our operations, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints.
Although to date we have not experienced a material loss relating to cyber attacks or other information security breaches, there can be no assurance that we will not suffer such losses in the future or that a current threat remains undetected at this time. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats, and the size and scale of our servicing contracts, including our loan servicing contract with the Department.
As a result, cyber security and the continued development and enhancement of our training, controls, processes, and practices designed to protect and monitor our systems, computers, software, data, and networks from attack, damage, or unauthorized access remain a priority for the Company and each of our business segments. Even though we maintain technology and telecommunication, professional services, media, network security, privacy, injury, and liability insurance coverage to offset costs that may be incurred as a result of a cyber attack, information security breach, or extended system outage, this insurance coverage may not cover all costs of such incidents.
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As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities.
Additionally, we must continually and cost-effectively maintain and improve our information technology systems and infrastructure in order to successfully deliver competitive products and services to our customers. The widespread adoption of new technologies and market demands could require substantial expenditures to enhance system infrastructure and existing products and services. If we fail to enhance and scale our systems and operational infrastructure or products and services, our operating segments may lose their competitive advantage and this could adversely affect financial and operating results.
We also face the risk of business disruption if system outages occur as a result of changes in infrastructure, introduction of new software or software enhancements, relocation of infrastructure, or failure to perform required services, which could have a material impact upon our reputation and our ability to retain customers. Although we have business continuity management plans, a major physical disaster or other calamity that causes significant damage to or the loss of our information systems or business operations for a sustained period of time could adversely affect our business, cash flows, and ability to retain customers.
We must satisfy certain requirements necessary to maintain the federal guarantees of our federally insured loans, and we may incur penalties or lose our guarantees if we fail to meet these requirements.
As of December 31, 2014, we serviced $25.0 billion of FFELP loans that maintained a federal guarantee, of which $19.7 billion and $5.3 billion were owned by the Company and third-party entities, respectively.
We must meet various requirements in order to maintain the federal guarantee on our federally insured loans. The federal guarantee on our federally insured loans is conditional based on our compliance with origination, servicing, and collection policies set by the Department and guaranty agencies. Federally insured loans that are not originated, disbursed, or serviced in accordance with the Department's and guaranty agency regulations may risk partial or complete loss of the guarantee. If we experience a high rate of servicing deficiencies (including any deficiencies resulting from the conversion of loans from one servicing platform to another, errors in the loan origination process, establishment of the borrower's repayment status, and due diligence or claim filing processes), it could result in the loan guarantee being revoked or denied. In most cases we have the opportunity to cure these deficiencies by following a prescribed cure process which usually involves obtaining the borrower's reaffirmation of the debt. However, not all deficiencies can be cured.
We are allowed three years from the date of the loan rejection to cure most loan rejections. If a cure cannot be achieved during this three year period, insurance is permanently revoked, although we maintain our right to collect the loan proceeds from the borrower. In cases where we purchase loans that were serviced previously by another servicing institution and we identify a serving deficiency by the prior servicer, we may, based on the terms of the purchase agreement, have the ability to require the previous lender to repurchase the rejected loans.
A guaranty agency may also assess an interest penalty upon claim payment if the deficiency does not result in a loan rejection. These interest penalties are not subject to cure provisions and are typically related to isolated instances of due diligence deficiencies. Additionally, we may become ineligible for special allowance payment benefits from the time of the first deficiency leading to the loan rejection through the date that the loan is cured.
Failure to comply with federal and guarantor regulations may result in penalties, a loss of special allowance payment benefits, or a loss of the federal guarantee. A loss of a federal guarantee on a third party serviced loan could subject us to potential claims from our servicing customers.
Our largest fee-based customer, the Department of Education, represents approximately 10 percent of our revenue. Failure to extend the Department contract, unfavorable contract modifications, or our inability to consistently surpass competitor performance metrics, could significantly lower loan servicing revenue and hinder future servicing opportunities.
We are one of four private sector companies awarded a student loan servicing contract by the Department to provide additional servicing capacity for loans owned by the Department. Our contract with the Department expires on June 16, 2019. As of December 31, 2014, we were servicing $133.6 billion of student loans for 5.9 million borrowers under this contract. For the year ended December 31, 2014, we recognized $124.4 million in revenue from the Department, which represented approximately 10 percent of our revenue. In the event the Department servicing contract is not extended beyond the current expiration date or substantial unfavorable modifications are made to the existing Department contract, loan servicing revenue would decrease significantly.
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New loan volume is currently being allocated among the four servicers based on certain performance metrics established by the Department. The amount of future allocations of new loan volume could be negatively impacted if we are unable to consistently surpass competitor performance metrics. The Department also has contracts with not-for-profit entities to service student loans who historically received small servicing allocations from the Department. However, effective January 1, 2015, these entities began to receive 25 percent of new borrower servicing allocations from the Department. This will decrease new allocation volume for us.
Additionally, we are partially dependent on the existing Department contract to broaden servicing operations with the Department, other federal and state agencies, and commercial clients. The size and importance of this contract provides us the scale and infrastructure needed to profitably expand into new business opportunities. Failure to extend the Department contract beyond the current expiration date could significantly hinder future opportunities.
Federal budget deficits and their effect on budgetary and regulatory provisions could adversely impact future revenue.
A significant portion of guaranty servicing revenue earned by us relates to rehabilitating defaulted FFELP loans (collection services). Recent federal budget provisions that became effective July 1, 2014 have reduced payments by the Department to guaranty agencies for assisting student loan borrowers with the rehabilitation of defaulted loans under FFELP. These provisions reduced the amount guaranty agencies retain upon successful rehabilitation from 37 percent to 16 percent of the loan balance. We earn revenue from rehabilitating defaulted FFELP student loans on behalf of guaranty agencies. The decrease in the retention percent earned by guaranty agencies negatively impacted our guaranty collections revenue, and also contributed to a reduction in our operating margin. During the year ended December 31, 2014, we recognized $41.6 million in revenue from rehabilitating defaulted FFELP loans for guaranty agencies. Prior to the July 1, 2014 rate change, we recognized $30.7 million in revenue during the first two quarters of 2014 compared to $10.9 million during the last two quarters of 2014. The Company anticipates that guaranty agencies will continue to operate with reduced levels of FFELP student loan rehabilitation activities as a result of the reduced payment framework.
Approximately 70 percent of our guaranty servicing revenue comes from a single guaranty servicing client. The current term of the contract with this client expires on October 31, 2015 and is subject to renewal. Given the significant reduction in rehabilitation collection revenue resulting from changes in federal budget provisions that became effective July 1, 2014, the terms of this contract could be modified in ways that reduce our amount of guaranty servicing revenue even further or the agreement could be terminated.
In the future, the federal government could engage in prolonged debates related to the federal deficit, debt ceiling, and other budget spending issues. If U.S. lawmakers fail to reach agreement on these issues, the federal government could stop or delay payment on its obligations, including those on services we provide. We cannot predict how or what programs will be impacted by any actions that Congress or the federal government may take. Legislation to address the federal deficit and spending could include proposals that adversely affect our cash flow, revenue, and profit margins.
Our ability to continue to grow and maintain our contracts with commercial businesses and government agencies is partly dependent on our ability to maintain compliance with various laws, regulations, and industry standards applicable to those contracts.
We are subject to various laws, regulations, and industry standards related to our commercial and government contracts. In most cases, these contracts are subject to termination rights, audits, and investigations. If we are found to be in noncompliance with the contract provisions or applicable laws, regulations, or standards, or the contracted party exercises its termination or other rights for that or other reasons, our reputation could be negatively affected, and our ability to compete for new contracts or maintain existing contracts could diminish. If this were to occur, our results of operations from existing contracts and future opportunities for new contracts could be negatively affected.
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Regulatory and Legal
Federal and state laws and regulations can restrict our business, and noncompliance with these laws and regulations could result in penalties, litigation, reputation damage, and a loss of customers.
Our operating segments and customers are heavily regulated by federal and state government regulatory agencies. The laws and regulations enforced by these agencies are proposed or enacted to protect consumers and the financial industry as a whole, not necessarily the Company, our operating segments, or our shareholders. We have procedures and controls in place to monitor compliance with numerous federal and state laws and regulations. However, because these laws and regulations are complex, differ between jurisdictions, and are often subject to interpretation, or as a result of unintended errors, we may, from time to time, inadvertently violate these laws and regulations. Compliance with these laws and regulations is expensive and requires the time and attention of management. These costs divert capital and focus away from efforts intended to grow our business. If we do not successfully comply with laws, regulations, or policies, we could incur fines or penalties, lose existing or new customer contracts, or suffer damage to our reputation. Changes in these laws and regulations can significantly alter our business environment, limit business operations, and increase costs of doing business, and we cannot predict the impact such changes would have on our profitability. The use of Executive Order provisions from the Executive Branch of the Federal Government has created new regulations that have impacted us. The use of Executive Order provisions to define regulations creates additional uncertainty and risks within the education and student loan industry.
Our Student Loan and Guaranty Servicing and Asset Generation and Management operating segments are subject to the Higher Education Act and various consumer protection and privacy regulations. These operating segments take what we believe are necessary steps to evaluate, monitor, and comply with these regulations. However, the Department or other government agencies could, based on regulatory interpretation, determine we are not compliant. Failure to comply with these regulations could lead to a loss of the guarantee on our federally insured loans, increased servicing costs to cure such loans, or suspension or termination of our rights to participate as a servicer, negative publicity, or potential legal claims. Although new FFELP loan originations were eliminated effective July 1, 2010, we continue to face risks from potential legislative changes or other government initiatives with respect to existing FFELP loans. Congress is currently evaluating proposals to reauthorize the Higher Education Act. If the federal government or the Department initiate additional loan forgiveness, repayment options, or consolidation loan programs, these initiatives could further increase prepayments, reduce servicing fees, and lower interest income.
Certain provisions of the Higher Education Act that became effective July 1, 2011 have impacted our Enrollment Services operating segment in connection with services it provides to for-profit schools. To be eligible to participate in federal student aid programs, the Higher Education Act requires educational institutions, including for-profit schools, to enter into a program participation agreement with the Department. This agreement includes a number of requirements with which an institution must comply to be granted initial and continuing eligibility to participate in the federal student aid program. The related regulations impose strict liability on educational institutions for misrepresentations made by entities, like us, who contract with these institutions to provide marketing services. As a result, our school customers have demanded, and in limited circumstances we have agreed to, limited contractual indemnification provisions for our customers that cover actions by our third-party inquiry generation vendors. Significantly all inquiry generation and management revenue (which makes up approximately 76 percent of total revenue included in the Enrollment Services business) was generated from for-profit schools in 2014. The regulations discussed above may subject us to greater risk of liability and may increase our cost of compliance with these regulations or limit our ability to serve for-profit schools. In addition, the regulations could negatively impact enrollment at for-profit schools, which could adversely affect revenue. For a variety of business reasons, including the risk of liability, the Company made the decision to exit the lead generation business in 2014. We continue to provide marketing services for education institution customers.
The Dodd-Frank Act established the Consumer Financial Protection Bureau (the “CFPB”), which has broad authority to regulate a wide range of consumer financial products and services. On December 3, 2013, the CFPB issued a rule that allows the CFPB to supervise nonbank student loan servicers that handle more than one million borrowers, including the Company, thus giving the CFPB broad authority to examine, investigate, supervise, and otherwise regulate our businesses, including the authority to impose fines and require changes with respect to any practices that the CFPB finds to be unfair, deceptive, or abusive. There is significant uncertainty regarding how the CFPB's strategies and priorities will impact our businesses and our results of operations going forward. Actions by the CFPB could result in requirements to alter our services, causing them to be less attractive or effective and impair our ability to offer them profitably. In the event that the CFPB changes regulations adopted in the past by other regulators, or modifies past regulatory guidance, our compliance costs and litigation exposure could increase. Our litigation exposure could also increase if the CFPB exercises its authority to limit or ban pre-dispute arbitration clauses in contracts for consumer financial services.
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Additionally, the Dodd-Frank Act authorizes state officials to enforce regulations issued by the CFPB. Most states also have statutes that prohibit unfair and deceptive practices. To the extent states enact requirements that differ from federal standards or state officials and courts adopt interpretations of federal consumer laws that differ from those adopted by the CFPB under the Dodd-Frank Act, or states increase their examination, supervision, and enforcement activities, our ability to offer the same products and services to consumers nationwide may be limited and we may be subject to a higher risk of state enforcement actions.
We provide marketing, origination, and loan servicing services related to private education loans. Over the last couple of years, private education loans have received considerable focus from the CFPB. CFPB industry reports have included reconsideration by Congress of the federal Bankruptcy Code’s treatment of private education loans, reforms to disclosures, and guidelines that apply to payment application, borrower benefits, record retention, and other aspects of student loan servicing similar to changes previously made for the credit card and mortgage businesses. These or other regulatory changes to private education loans may adversely impact the profitability and growth of this business opportunity.
The CFPB is currently conducting its initial supervisory examination of the large nonbank student loan servicers, including the Company. If the CFPB were to determine we were not in compliance, it is possible that this could result in material adverse consequences, including, without limitation, settlements, fines, penalties, adverse regulatory actions, changes in our business practices, or other actions. However, we are unable to estimate at this time any potential financial or other impact that could result from the CFPB's examination, in the event that any adverse regulatory actions occur.
The Dodd-Frank Act also provides the Commodity Futures Trading Commission (the "CFTC") and the SEC with substantial authority to regulate over-the-counter derivative transactions, and includes provisions that require derivative transactions to be executed through an exchange or central clearinghouse. There are also new risk retention rules set to go into effect in 2016 that could affect future student loan asset-backed securities transactions by requiring issuers of asset-backed securities or persons who organize and initiate asset-backed securities transactions to retain a portion of the underlying assets' credit risk, disclosure and reporting requirements for each tranche of asset-backed securities, including new loan-level data requirements, and disclosure requirements relating to the representations, warranties, and enforcement mechanisms available to investors. Although we cannot predict the ultimate outcome of these processes and regulations, they may increase our costs and cash collateral margin requirements and affect the terms of future asset-backed securities transactions and derivatives used to manage financial risks related to interest rate and foreign currency exchange rate volatility.
Additionally, the Dodd-Frank Act added provisions commonly referred to as the “Volcker Rule” to U.S. federal banking laws which generally prohibit various covered banking entities from engaging in proprietary trading of financial instruments and limit such entities’ investments in, and relationships with, hedge funds and private equity funds. On December 10, 2013, five U.S. federal regulatory agencies issued final regulations to implement the Volcker Rule. Banking entities subject to the Volcker Rule are currently required to fully conform their activities and investments to the final regulations regarding proprietary trading restrictions by July 21, 2015, and the final regulations regarding investments in and relationships with covered funds by July 21, 2016. As discussed below under “Principal Shareholder and Related Party Transactions,” we have certain relationships with Farmers & Merchants Investment Inc. (“F&M”), which controls Union Bank and Trust Company (“Union Bank”). F&M and Union Bank are banking entities subject to the Volcker Rule. Although we currently believe that the Volcker Rule and the final implementing regulations will not have a material effect on our activities, the Volcker Rule and the final implementing regulations are very complex, and many aspects of their ultimate interpretation, scope, and implementation remain uncertain.
In July 2012, the Federal Communications Commission ("FCC") amended the rules under the Telephone Consumer Protection Act ("TCPA") and promulgated additional amendments that became effective October 2013. Under the TCPA, plaintiffs may seek actual monetary loss or damages of $500 per violation, whichever is greater, and courts may treble the damage award for willful or knowing violations. In addition, TCPA lawsuits have asserted putative class action claims. Given the large number of communications we have with borrowers and other consumers, a determination that we have violated the TCPA or other communication-based statutes could expose us to significant damage awards that could, individually or in the aggregate, materially harm our business.
As a result of the Reconciliation Act of 2010, interest income on our existing FFELP loan portfolio, as well as revenue from guaranty and third-party FFELP servicing and FFELP loan servicing software licensing and consulting fees, will decline over time as our and our third-party lender clients' FFELP loan portfolios are paid down.
The Reconciliation Act of 2010 prohibits new loan originations under the FFEL Program and requires that all new federal loan originations be made through the Federal Direct Loan Program. The law did not alter or affect the terms and conditions of existing FFELP loans.
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During the years ended December 31, 2014, 2013, and 2012, we recognized approximately $430 million, $406 million, and $344 million, respectively, of net interest income on our FFELP loan portfolio, approximately $80 million, $106 million, and $96 million, respectively, in guaranty and third-party FFELP servicing revenue, and approximately $5 million, $7 million, and $6 million, respectively, in FFELP loan servicing software licensing and consulting fees related to the FFEL Program. These amounts will decline over time as our and our third-party lender clients' FFELP loan portfolios are paid down.
If the Company is unable to grow or develop new revenue streams, the Company's consolidated revenue and operating margin will decrease as a result of the decline in FFELP loan volume outstanding.
Industry changes and competitive pressures may harm revenue and profit margins.
We face aggressive price competition for our products and services and, as a result, we may have to lower our product and service prices to stay competitive, while at the same time, expand market share and maintain profit margins. Even if we are able to maintain or increase market share for a product or service, revenue or profit margins could decline because the product or service is in a maturing market or market conditions have changed due to economic, political, or regulatory pressures.
Exposure related to certain tax issues could decrease our net income.
Federal and state income tax laws and regulations are often complex and require interpretation. The nexus standards and the sourcing of receipts from intangible personal property and services have been the subject of state audits and litigation with state taxing authorities and tax policy debates by various state legislatures. As the U.S. Congress and U.S. Supreme Court have not provided clear guidance in this regard, conflicting state laws and court decisions create significant uncertainty and expense for taxpayers conducting interstate commerce. Changes in income tax regulations could negatively impact our results of operations. If states enact legislation, alter apportionment methodologies, or aggressively apply the income tax nexus standards, we may become subject to additional state taxes.
From time to time, we engage in transactions in which the tax consequences may be subject to uncertainty. Examples of such transactions include asset and business acquisitions and dispositions, financing transactions, apportionment, nexus standards, and income recognition. Significant judgment is required in assessing and estimating the tax consequences of these transactions. We prepare and file tax returns based on the interpretation of tax laws and regulations. In the normal course of business, our tax returns are subject to examination by various taxing authorities. Such examinations may result in future tax and interest assessments by these taxing authorities. In accordance with authoritative accounting guidance, we establish reserves for tax contingencies related to deductions and credits that we may be unable to sustain. Differences between the reserves for tax contingencies and the amounts ultimately owed are recorded in the period they become known. Adjustments to our reserves could have a material effect on our financial statements.
In addition to corporate tax matters, as both a lender and servicer of student loans, we are required to report student loan interest received and cancellation of indebtedness to individuals and the Internal Revenue Service on an annual basis. These informational forms assist individuals in complying with their federal and state income tax obligations. The statutory and regulatory guidance regarding the calculations, recipients, and timing are complex and we know that interpretation of these rules vary across the industry. The complexity and volume associated with these informational forms creates a risk of error which could result in penalties or damage to our reputation.
The costs and effects of litigation, investigations, or similar matters, or adverse facts and developments related thereto, could materially affect our financial position, results of operations, and cash flows.
We may be involved from time to time in a variety of lawsuits, investigations, or similar matters arising out of our business operations. Our insurance may not cover all claims that may be asserted against us, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation. If the ultimate judgments or settlements in any litigation or investigation significantly exceed our insurance coverage, they could have a material adverse effect on our financial position, results of operations, and cash flows for any particular period.
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Principal Shareholder and Related Party Transactions
Our Executive Chairman beneficially owns 67.3 percent of the voting rights of our shareholders and effectively has control over all matters at our Company.
Michael S. Dunlap, our Executive Chairman and a principal shareholder, beneficially owns 67.3 percent of the voting rights of our shareholders. Accordingly, each member of the Board of Directors and each member of management has been elected or effectively appointed by Mr. Dunlap and can be removed by Mr. Dunlap. As a result, Mr. Dunlap, as Executive Chairman and controlling shareholder, has control over all matters at our Company and has the ability to take actions that benefit him, but may not benefit other minority shareholders, and may otherwise exercise his control in a manner with which other minority shareholders may not agree or which they may not consider to be in their best interests.
Our contractual arrangements and transactions with Union Bank, which is under common control with us, present conflicts of interest and pose risks to our shareholders that the terms may not be as favorable to us as we could receive from unrelated third parties.
Union Bank is controlled by F&M, which owns 81.4 percent of Union Bank's common stock and 15.4 percent of Union Bank's non-voting non-convertible preferred stock. Mr. Dunlap, a significant shareholder, as well as Executive Chairman, and a member of our Board of Directors, along with his spouse and children, owns or controls a total of 24.1 percent of the stock of F&M, and Mr. Dunlap's sister, Angela L. Muhleisen, along with her husband and children, owns or controls 47.5 percent of F&M stock. Mr. Dunlap serves as a Director and Chairman of F&M. Ms. Muhleisen serves as Director and President of F&M and as a Director, Chairperson, President, and Chief Executive Officer of Union Bank. Union Bank is deemed to have beneficial ownership of a significant number of shares of Nelnet because it serves in a capacity of trustee or account manager for various trusts and accounts holding shares of Nelnet, and may share voting and/or investment power with respect to such shares. As of December 31, 2014, Union Bank was deemed to beneficially own 16.5 percent of the voting rights of our common stock. As of December 31, 2014, Mr. Dunlap and Ms. Muhleisen beneficially owned 67.3 percent and 21.2 percent, respectively, of the voting rights of our outstanding common stock.
We have entered into certain contractual arrangements with Union Bank, including loan purchases and sales, loan servicing, loan participations, banking services, 529 Plan administration services, lease arrangements, and various other investment and advisory services. The net aggregate impact on our consolidated statements of income for the years ended December 31, 2014, 2013, and 2012 related to the transactions with Union Bank was income (before income taxes) of $17.1 million, $16.6 million, and $11.9 million, respectively. See note 20 of the notes to consolidated financial statements included in this report for additional information related to the transactions between us and Union Bank.
Transactions between Union Bank and us are generally based on available market information for comparable assets, products, and services and are extensively negotiated. In addition, all related party transactions between Union Bank and us are approved by both the Union Bank Board of Directors and our Board of Directors. Furthermore, Union Bank is subject to regulatory oversight and review by the FDIC, the Federal Reserve, and the State of Nebraska Department of Banking and Finance. The FDIC and the State of Nebraska Department of Banking and Finance regularly review Union Bank's transactions with affiliates. The regulatory standard applied to the bank falls under Regulation W, which places restrictions on certain “covered” transactions with affiliates.
We intend to maintain our relationship with Union Bank, which our management believes provides certain benefits to us. Those benefits include Union Bank's knowledge of and experience in the FFELP industry, its willingness to provide services, and at times liquidity and capital resources, on an expedient basis, and the proximity of Union Bank to our corporate headquarters located in Lincoln, Nebraska.
The majority of the transactions and arrangements with Union Bank are not offered to unrelated third parties or subject to competitive bids. Accordingly, these transactions and arrangements not only present conflicts of interest, but also pose the risk to our shareholders that the terms of such transactions and arrangements may not be as favorable to us as we could receive from unrelated third parties. Moreover, we may have and/or may enter into contracts and business transactions with related parties that benefit Mr. Dunlap and his sister, as well as other related parties, that may not benefit us and/or our minority shareholders.
ITEM 1B. UNRESOLVED STAFF COMMENTS
The Company has no unresolved comments from the staff of the Securities and Exchange Commission regarding its periodic or current reports under the Securities Exchange Act of 1934.
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ITEM 2. PROPERTIES
The following table lists the principal facilities for office space owned or leased by the Company as of December 31, 2014. The Company owns the building in Lincoln, Nebraska where its principal office is located. The building is subject to a lien securing the outstanding mortgage debt on the property.
Location | Primary function or segment | Approximate square feet | Lease expiration date | |||||
Lincoln, NE | Corporate Headquarters, Student Loan and Guaranty Servicing, Tuition Payment Processing and Campus Commerce | 187,000 | (a) | – | ||||
Highlands Ranch, CO | Student Loan and Guaranty Servicing | 67,000 | March 2017 | |||||
Lincoln, NE | Student Loan and Guaranty Servicing, Asset Generation and Management | 51,000 | November 2023 and March 2024 | |||||
Aurora, CO | Student Loan and Guaranty Servicing | 43,000 | September 2019 | |||||
Omaha, NE (b) | Student Loan and Guaranty Servicing, Tuition Payment Processing and Campus Commerce | 34,000 | December 2020 and December 2025 | |||||
Lincoln, NE | Student Loan and Guaranty Servicing, Asset Generation and Management | 20,000 | December 2015 and August 2016 | |||||
Paramus, NJ (c) | Enrollment Services | 18,000 | March 2015 | |||||
Burleson, TX | Tuition Payment Processing and Campus Commerce | 17,000 | October 2021 | |||||
(a) | Excludes a total of approximately 27,000 square feet of owned office space that the Company leases to third parties. |
(b) | On December 30, 2014, the Company amended its lease agreement in Omaha, Nebraska, which will result in an increase in total square footage from approximately 34,000 square feet to approximately 53,000 square feet effective in May 2015. |
(c) | On December 19, 2014, the Company entered into a new lease agreement for approximately 8,000 square feet of office space in Paramus, New Jersey, which takes effect in March 2015 and expires in May 2018. As a result, the Company will terminate its current lease in Paramus as disclosed in the schedule above. |
The Company leases other office facilities located throughout the United States. These properties are leased on terms and for durations that are reflective of commercial standards in the communities where these properties are located. The Company believes that its respective properties are generally adequate to meet its long term business goals. The Company's principal office is located at 121 South 13th Street, Suite 100, Lincoln, Nebraska 68508.
ITEM 3. LEGAL PROCEEDINGS
The information required by this Item is incorporated herein by reference to the information set forth under "Legal Proceedings and Regulatory Matters - Legal Proceedings" in note 16 of the notes to consolidated financial statements included in this report.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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PART II.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company's Class A common stock is listed and traded on the New York Stock Exchange under the symbol “NNI,” while its Class B common stock is not publicly traded. As of January 31, 2015, there were 34,663,780 and 11,486,932 shares of Class A common stock and Class B common stock outstanding, respectively. The number of holders of record of the Company's Class A common stock and Class B common stock as of January 31, 2015 was 1,002 and 27, respectively. The record holders of the Class B common stock are Michael S. Dunlap and Stephen F. Butterfield, an entity controlled by them, various members of their families, and various estate planning trusts established by them. Because many shares of the Company's Class A common stock are held by brokers and other institutions on behalf of shareholders, the Company is unable to estimate the total number of beneficial owners represented by these record holders. The following table sets forth the high and low intraday sales prices for the Company's Class A common stock for each full quarterly period in 2014 and 2013.
2014 | 2013 | ||||||||||||||||||||||||||||||
1st Quarter | 2nd Quarter | 3rd Quarter | 4th Quarter | 1st Quarter | 2nd Quarter | 3rd Quarter | 4th Quarter | ||||||||||||||||||||||||
High | $ | 44.30 | $ | 44.20 | $ | 45.91 | $ | 48.52 | $ | 35.55 | $ | 39.98 | $ | 41.74 | $ | 45.49 | |||||||||||||||
Low | 34.86 | 38.42 | 40.16 | 42.42 | 28.85 | 31.56 | 36.06 | 38.00 | |||||||||||||||||||||||
Dividends on the Company's Class A and Class B common stock were paid as follows during the years ended December 31, 2014 and 2013.
2014 | 2013 | ||||||||||||||||||||||||||||||
Record date | 2/28/14 | 5/30/14 | 9/1/14 | 12/1/14 | 3/1/13 | 5/31/13 | 8/30/13 | 12/2/13 | |||||||||||||||||||||||
Payment date | 3/14/14 | 6/13/14 | 9/15/14 | 12/15/14 | 3/15/13 | 6/14/13 | 9/13/13 | 12/16/13 | |||||||||||||||||||||||
Dividend amount per share | $ | 0.10 | $ | 0.10 | $ | 0.10 | $ | 0.10 | $ | 0.10 | $ | 0.10 | $ | 0.10 | $ | 0.10 | |||||||||||||||
The Company currently plans to continue making regular quarterly dividend payments, subject to future earnings, capital requirements, financial condition, and other factors. In addition, the payment of dividends is subject to the terms of the Company's outstanding junior subordinated hybrid securities, which generally provide that if the Company defers interest payments on those securities it cannot pay dividends on its capital stock.
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Performance Graph
The following graph compares the change in the cumulative total shareholder return on the Company's Class A common stock to that of the cumulative return of the S&P 500 Index and the S&P Financials Index. The graph assumes that the value of an investment in the Company's Class A common stock and each index was $100 on December 31, 2009 and that all dividends, if applicable, were reinvested. The performance shown in the graph represents past performance and should not be considered an indication of future performance.
Company/Index | 12/31/2009 | 12/31/2010 | 12/31/2011 | 12/31/2012 | 12/31/2013 | 12/31/2014 | |||||||||||||||||
Nelnet, Inc. | $ | 100.00 | $ | 142.15 | $ | 149.45 | $ | 192.12 | $ | 274.63 | $ | 304.85 | |||||||||||
S&P 500 | 100.00 | 115.06 | 117.49 | 136.30 | 180.44 | 205.14 | |||||||||||||||||
S&P Financials | 100.00 | 112.13 | 93.00 | 119.79 | 162.48 | 187.17 | |||||||||||||||||
The preceding information under the caption “Performance Graph” shall be deemed to be “furnished” but not “filed” with the Securities and Exchange Commission.
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Stock Repurchases
The following table summarizes the repurchases of Class A common stock during the fourth quarter of 2014 by the Company or any “affiliated purchaser” of the Company, as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934.
Period | Total number of shares purchased (a) | Average price paid per share | Total number of shares purchased as part of publicly announced plans or programs (b) | Maximum number of shares that may yet be purchased under the plans or programs (b) | |||||||||
October 1 - October 31, 2014 | 22,821 | $ | 42.92 | 22,101 | 3,550,364 | ||||||||
November 1 - November 30, 2014 | 359 | 47.29 | — | 3,550,364 | |||||||||
December 1 - December 31, 2014 | 31,213 | 44.18 | 29,398 | 3,520,966 | |||||||||
Total | 54,393 | $ | 43.67 | 51,499 | |||||||||
(a) | The total number of shares includes: (i) shares repurchased pursuant to the stock repurchase program discussed in footnote (b) below; and (ii) shares owned and tendered by employees to satisfy tax withholding obligations upon the vesting of restricted shares. Shares of Class A common stock tendered by employees to satisfy tax withholding obligations included 720 shares, 359 shares, and 1,815 shares in October, November, and December, respectively. Unless otherwise indicated, shares owned and tendered by employees to satisfy tax withholding obligations were purchased at the closing price of the Company’s shares on the date of vesting. |
(b) | On May 9, 2012, the Company announced that its Board of Directors had authorized a stock repurchase program to repurchase up to a total of five million shares of the Company's Class A common stock during the three-year period ending May 24, 2015. Certain share repurchases included in the table above were made pursuant to a trading plan adopted by the Company in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934. |
Equity Compensation Plans
For information regarding the securities authorized for issuance under the Company's equity compensation plans, see Part III, Item 12 of this report.
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ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial and other operating information of the Company. The selected financial data in the table is derived from the consolidated financial statements of the Company. The following selected financial data should be read in conjunction with the consolidated financial statements, the related notes, and “Management's Discussion and Analysis of Financial Condition and Results of Operations” included in this report.
Year ended December 31, | |||||||||||||||
2014 | 2013 | 2012 | 2011 | 2010 | |||||||||||
(Dollars in thousands, except share data) | |||||||||||||||
Operating Data: | |||||||||||||||
Net interest income | $ | 436,563 | 413,875 | 345,287 | 364,565 | 371,071 | |||||||||
Loan and guaranty servicing revenue | 240,414 | 243,428 | 209,748 | 175,657 | 158,584 | ||||||||||
Tuition payment processing, school information, and campus commerce revenue | 98,156 | 80,682 | 74,410 | 67,797 | 59,824 | ||||||||||
Enrollment services revenue | 82,883 | 98,078 | 117,925 | 130,470 | 139,897 | ||||||||||
Other income | 54,002 | 46,298 | 39,476 | 29,513 | 31,310 | ||||||||||
Gain on sale of loans and debt repurchases, net | 3,651 | 11,699 | 4,139 | 8,340 | 78,631 | ||||||||||
Net income attributable to Nelnet, Inc. | 307,610 | 302,672 | 177,997 | 204,335 | 189,034 | ||||||||||
Earnings per common share attributable to Nelnet, Inc. shareholders - basic and diluted: | 6.62 | 6.50 | 3.76 | 4.24 | 3.82 | ||||||||||
Dividends per common share | 0.40 | 0.40 | 1.40 | 0.37 | 0.70 | ||||||||||
Other Data: | |||||||||||||||
Fixed rate floor income, net of derivative settlements | $ | 179,870 | 148,431 | 145,345 | 144,454 | 132,243 | |||||||||
Core student loan spread | 1.48 | % | 1.54 | % | 1.44 | % | 1.52 | % | 1.48 | % | |||||
Origination and acquisition of student loans (par value) | $ | 6,099,249 | 4,058,997 | 3,885,138 | 2,841,334 | 4,202,164 | |||||||||
Student loans serviced (at end of period) | 161,642,254 | 138,208,897 | 97,492,053 | 76,119,717 | 61,477,651 | ||||||||||
As of December 31, | |||||||||||||||
2014 | 2013 | 2012 | 2011 | 2010 | |||||||||||
Balance Sheet Data: | (Dollars in thousands, except share data) | ||||||||||||||
Cash and cash equivalents | $ | 130,481 | 63,267 | 66,031 | 42,570 | 283,801 | |||||||||
Student loans receivables, net | 28,005,195 | 25,907,589 | 24,830,621 | 24,297,876 | 24,033,001 | ||||||||||
Goodwill and intangible assets, net | 168,782 | 123,250 | 126,511 | 145,492 | 155,830 | ||||||||||
Total assets | 30,098,143 | 27,770,849 | 26,607,895 | 25,852,217 | 25,893,892 | ||||||||||
Bonds and notes payable | 28,027,350 | 25,955,289 | 25,098,835 | 24,434,540 | 24,672,472 | ||||||||||
Nelnet, Inc. shareholders' equity | 1,725,448 | 1,443,662 | 1,165,208 | 1,066,205 | 906,633 | ||||||||||
Tangible Nelnet, Inc. shareholders' equity (a) | 1,556,666 | 1,320,412 | 1,038,697 | 920,713 | 750,803 | ||||||||||
Book value per common share | 37.31 | 31.13 | 25.00 | 22.62 | 18.75 | ||||||||||
Tangible book value per common share (a) | 33.66 | 28.47 | 22.28 | 19.53 | 15.53 | ||||||||||
Ratios: | |||||||||||||||
Shareholders' equity to total assets | 5.73 | % | 5.20 | % | 4.38 | % | 4.12 | % | 3.50 | % | |||||
(a) | Tangible Nelnet, Inc. shareholders' equity, a non-GAAP measure, equals "Nelnet, Inc. shareholders' equity" less "goodwill" and "intangible assets, net." Management believes presenting tangible equity and tangible book value per common share are useful measures of evaluating the strength of the Company's capital position. These measures may be calculated differently by other companies. |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Management’s Discussion and Analysis of Financial Condition and Results of Operations is for the years ended December 31, 2014, 2013, and 2012. All dollars are in thousands, except share data, unless otherwise noted.)
The following discussion and analysis provides information that the Company’s management believes is relevant to an assessment and understanding of the consolidated results of operations and financial condition of the Company. The discussion and analysis should be read in conjunction with the Company’s consolidated financial statements and related notes included in this report. This discussion and analysis contains forward-looking statements and should be read in conjunction with the disclosures and information contained in "Forward-Looking and Cautionary Statements" and Item 1A "Risk Factors" included in this report.
OVERVIEW
The Company provides educational services in loan servicing, payment processing, education planning, and asset management. These products and services help students and families plan, prepare, and pay for their education and make the administrative and financial processes more efficient for schools and financial organizations. In addition, the Company earns interest income on a portfolio of federally insured student loans.
A reconciliation of the Company's GAAP net income to net income, excluding derivative market value and foreign currency adjustments, is provided below.
Year ended December 31, | |||||||||
2014 | 2013 | 2012 | |||||||
GAAP net income attributable to Nelnet, Inc. | $ | 307,610 | 302,672 | 177,997 | |||||
Derivative market value and foreign currency adjustments, net of tax | (23,376 | ) | (30,128 | ) | 29,384 | ||||
Net income, excluding derivative market value and foreign currency adjustments (a) | $ | 284,234 | 272,544 | 207,381 | |||||
Earnings per share: | |||||||||
GAAP net income attributable to Nelnet, Inc. | $ | 6.62 | 6.50 | 3.76 | |||||
Derivative market value and foreign currency adjustments, net of tax | (0.50 | ) | (0.65 | ) | 0.62 | ||||
Net income, excluding derivative market value and foreign currency adjustments (a) | $ | 6.12 | 5.85 | 4.38 | |||||
(a) | The Company provides non-GAAP information that reflects specific items management believes to be important in the evaluation of its financial position and performance. "Derivative market value and foreign currency adjustments" include (i) the unrealized gains and losses that are caused by changes in fair values of derivatives which do not qualify for "hedge treatment" under GAAP; and (ii) the foreign currency transaction gains or losses caused by the re-measurement of the Company's Euro-denominated bonds to U.S. dollars. The Company believes these point-in-time estimates of asset and liability values related to these financial instruments that are subject to interest and currency rate fluctuations affect the period-to-period comparability of the results of operations. Accordingly, the Company provides operating results excluding these items for comparability purposes. |
Recent Developments
The Company intends to continue to use its strong liquidity position to capitalize on market opportunities, including FFELP and private education loan acquisitions and strategic acquisitions and investments.
FFELP loans - On January 29, 2015, the Company acquired $582.8 million of FFELP whole loans, which were funded in the Company’s FFELP warehouse facilities and participation agreement with Union Bank.
Private education loans - On December 22, 2014, the Company entered into an agreement with Union Bank in which the Company will provide marketing, origination, and loan servicing services to Union Bank related to private education loans. The Company has committed to purchase, or arrange for a designee to purchase, all volume originated by Union Bank under this agreement.
On February 5, 2015, the Company made a minority equity investment in CommonBond, Inc. (“CommonBond”), a student lending company that provides private education loans to graduate students. In addition, the Company has committed to purchase up to $150.0 million of private education loans originated by CommonBond.
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On February 19, 2015, the Company acquired $65.0 million of private education loans at par value from non-affiliated third-parties. The loans acquired were subject to certain repurchase obligations by the Company’s servicing business.
The Company intends to use operating cash and its unsecured line of credit to initially fund these purchases of private education loans. The Company is currently forming a private education loan warehouse facility to be used to pool loans before financing them under more permanent securitization financing arrangements.
Operating Results
The Company earns net interest income on its FFELP student loan portfolio in its Asset Generation and Management ("AGM") operating segment. This segment is expected to generate a stable net interest margin and significant amounts of cash as the FFELP portfolio amortizes. As of December 31, 2014, the Company had a $28.0 billion student loan portfolio that will amortize over the next 25 years. The Company actively seeks to acquire FFELP loan portfolios to leverage its servicing scale and expertise to generate incremental earnings and cash flow.
In addition, the Company earns fee-based revenue through the following reportable operating segments:
• | Student Loan and Guaranty Servicing ("LGS") - referred to as Nelnet Diversified Solutions ("NDS") |
• | Tuition Payment Processing and Campus Commerce ("TPP&CC") - referred to as Nelnet Business Solutions ("NBS") |
The increase in earnings in 2014 compared to 2013 was due to an increase in net interest income earned from the Company's student loan portfolio. This increase was partially offset by the expected decrease in net income from the Company's Student Loan and Guaranty Servicing operating segment.
The information below provides the operating results for each reportable operating segment for the years ended December 31, 2014, 2013, and 2012 (dollars in millions).
(a) | Revenue includes intersegment revenue of $55.1 million, $56.7 million, and $65.4 million for the years ended December 31, 2014, 2013, and 2012, respectively, earned by LGS as a result of servicing loans for AGM. |
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(b) | Revenue includes "net interest income after provision for loan losses" and "total other income" from the Company's segment statements of income, excluding the impact from changes in fair values of derivatives and foreign currency transaction adjustments, which was income of $42.9 million and $35.3 million for the years ended December 31, 2014 and 2013, respectively, and an expense of $51.8 million for the year ended December 31, 2012. Net income excludes changes in fair values of derivatives and foreign currency transaction adjustments, net of tax, which was income of $26.6 million and $21.9 million for the years ended December 31, 2014 and 2013, respectively, and an expense of $32.1 million for the year ended December 31, 2012. |
(c) | Computed as income before income taxes divided by total revenue. |
A summary of the results and financial highlights for each reportable operating segment and a summary of the Company's liquidity and capital resources follows. See "Results of Operations" for each reportable operating segment and "Liquidity and Capital Resources" under this Item 7 for additional detail.
Student Loan and Guaranty Servicing
• | As of December 31, 2014, the Company was servicing $161.6 billion in FFELP, private, and government owned student loans, as compared with $138.2 billion and $97.5 billion of loans as of December 31, 2013 and 2012, respectively. The year over year increase was due to an increase in government servicing volume. |
• | Revenue decreased in 2014 compared to 2013 due to decreases in rehabilitation collection revenue, traditional FFELP and guaranty servicing revenue, and software services revenue, which were partially offset by growth in servicing volume under the Company's contract with the Department. The increase in revenue in 2013 compared to 2012 was due primarily to the growth in servicing volume under the Department contract and an increase in rehabilitation collection revenue, which were partially offset by decreases in traditional FFELP and guaranty servicing revenue and software services revenue. |
• | Operating margin decreased in 2014 compared to 2013 as a result of the implementation of federal budget reductions for guaranty agencies' revenue. In addition, as the volume of loans serviced under the Department servicing contract continues to grow and loans serviced under the legacy commercial programs continue to run off, the Company expects operating margins to tighten accordingly. Operating margin increased in 2013 compared to 2012 as a result of the investments made and certain costs incurred by the Company in 2012 to improve performance metrics under the Department servicing contract and to implement and comply with the Department's special direct consolidation loan initiative. In addition, intangible assets for this segment were fully amortized in 2012. |
Tuition Payment Processing and Campus Commerce
• | Revenue increased in 2014 and 2013, compared to 2013 and 2012, respectively, due to increases in the number of managed tuition payment plans, campus commerce customer transaction volume, and new school customers. In addition, the Company purchased RenWeb on June 3, 2014, which increased revenue in 2014. |
• | Before tax operating margin excluding amortization of intangibles was 27.6%, 30.7%, and 28.7% for 2014, 2013, and 2012, respectively. The decrease in margin in 2014 compared to 2013 was primarily due to a change in the mix of products and services provided as a result of the acquisition of RenWeb. The increase in margin in 2013 compared to 2012 was the result of efficiencies gained in the operations of the business during 2013. In addition, certain investments were made by the Company during 2012 in new products and services to meet customer needs and expand product and service offerings. |
Asset Generation and Management
• | The Company acquired $6.1 billion of FFELP student loans during 2014, compared to $4.1 billion in 2013 and $3.9 billion in 2012. The average loan portfolio balance for 2014, 2013, and 2012 was $28.0 billion, $25.0 billion, and $23.7 billion, respectively. |
• | Core student loan spread decreased to 1.48% for 2014, compared to 1.54% for 2013. This decrease was due to recent acquisitions of consolidation loans, which have lower margins, but longer terms. |
• | Due to historically low interest rates, the Company continues to earn significant fixed rate floor income. During 2014, 2013, and 2012, the Company earned $179.9 million, $148.4 million, and $145.3 million, respectively, of fixed rate floor income (net of $24.4 million, $31.0 million, and $19.3 million of derivative settlements, respectively, used to hedge such loans). |
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Corporate and Other Activities
• | In 2014, management determined that the Company's Enrollment Services business no longer met the quantitative thresholds for which separate information about an operating segment is required. For segment reporting purposes, business activities and operating segments that are not reportable are combined and included in "Corporate and Other Activities." Beginning in 2014, the operating results of Enrollment Services are included with Corporate and Other Activities. Prior period segment operating results were restated to conform to the current period presentation. Revenue for Enrollment Services was $82.9 million, $98.1 million, and $117.9 million in 2014, 2013, and 2012, respectively. Net income (loss) for the Enrollment Services business was ($0.2 million), $0.6 million, and ($3.7 million) in 2014, 2013, and 2012, respectively. Revenues from these services have been affected by the ongoing regulatory uncertainty regarding recruiting and marketing to potential students in the for-profit college industry, which has caused schools to decrease spending on marketing efforts. |
• | Whitetail Rock Capital Management, LLC, the Company's SEC-registered investment advisory subsidiary, recognized revenue of $17.5 million, $17.4 million, and $9.3 million for 2014, 2013, and 2012, respectively. These amounts include performance fees earned from the sale of managed securities or managed securities being called prior to the full contractual maturity. |
Liquidity and Capital Resources
• | As of December 31, 2014, the Company had cash and investments of $279.6 million. |
• | For the year ended December 31, 2014, the Company generated $357.4 million in net cash provided by operating activities. |
• | Forecasted undiscounted future cash flows from the Company's FFELP student loan portfolio financed in asset-backed securitization transactions are estimated to be approximately $2.29 billion as of December 31, 2014. |
• | As of December 31, 2014, no amounts were outstanding on the Company's unsecured line of credit and $350.0 million was available for future use. The unsecured line of credit has a maturity date of June 30, 2019. |
• | During 2014, the Company repurchased a total of 381,689 shares of Class A common stock for $15.7 million ($41.17 per share). |
• | During 2014, the Company repurchased a total of $54.0 million (par value) of its own asset-backed and unsecured debt securities for a gain totaling $6.6 million. |
• | During 2014, the Company paid cash dividends of $18.5 million. |
• | The Company intends to use its strong liquidity position to capitalize on market opportunities, including FFELP and private education loan acquisitions; strategic acquisitions and investments in loan financing, loan servicing, and payment processing; and capital management initiatives, including stock repurchases, debt repurchases, and dividend distributions. |
CONSOLIDATED RESULTS OF OPERATIONS
An analysis of the Company's operating results for the years ended December 31, 2014, 2013, and 2012 is provided below.
The Company’s operating results are primarily driven by the performance of its existing portfolio and the revenues generated by its fee-based businesses and the costs to provide such services. The performance of the Company’s portfolio is driven by net interest income (which includes financing costs) and losses related to credit quality of the assets, along with the cost to administer and service the assets and related debt.
The Company operates as distinct reportable operating segments as described previously. For a reconciliation of the reportable segment operating results to the consolidated results of operations, see note 14 of the notes to consolidated financial statements included in this report. Since the Company monitors and assesses its operations and results based on these segments, the discussion following the consolidated results of operations is presented on a reportable segment basis.
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Year ended December 31, | |||||||||||
2014 | 2013 | 2012 | Additional information | ||||||||
Loan interest | $ | 703,007 | 638,142 | 609,237 | Increase in 2014 from 2013 was due to an increase in the average student loan portfolio balance, gross fixed rate floor income, and student loan discount accretion (net), partially offset by an increase in consolidation rebate fees. Increase in 2013 from 2012 was due to an increase in the average student loan balance and student loan discount accretion (net), partially offset by an increase in consolidation rebate fees and a slight decrease in gross variable student loan yield. | ||||||
Investment interest | 6,793 | 6,668 | 4,616 | Includes income from unrestricted interest-earning deposits and investments and funds in asset-backed securitizations. | |||||||
Total interest income | 709,800 | 644,810 | 613,853 | ||||||||
Interest expense | 273,237 | 230,935 | 268,566 | The increase in 2014 compared to 2013 was due to an increase in average debt outstanding and an increase in the Company's cost of funds. The decrease in 2013 compared to 2012 was due to a decrease in student loan cost of funds, partially offset by an increase in average debt outstanding. | |||||||
Net interest income | 436,563 | 413,875 | 345,287 | See table below for additional analysis. | |||||||
Less provision for loan losses | 9,500 | 18,500 | 21,500 | Represents the periodic expense of maintaining an allowance appropriate to absorb losses inherent in the portfolio of student loans. See AGM operating segment - results of operations. | |||||||
Net interest income after provision for loan losses | 427,063 | 395,375 | 323,787 | ||||||||
Other income (expense): | |||||||||||
LGS revenue | 240,414 | 243,428 | 209,748 | See LGS operating segment - results of operations. | |||||||
TPP&CC revenue | 98,156 | 80,682 | 74,410 | See TPP&CC operating segment - results of operations. | |||||||
Enrollment services revenue | 82,883 | 98,078 | 117,925 | See table below for additional analysis. | |||||||
Other income | 54,002 | 46,298 | 39,476 | See table below for the components of "other income." | |||||||
Gain on sale of loans and debt repurchases, net | 3,651 | 11,699 | 4,139 | Gain was primarily from the repurchase of the Company's own asset-backed and unsecured debt securities. In 2014, gains from debt repurchases were partially offset by losses on the sale of loans. | |||||||
Derivative settlements, net | (21,843 | ) | (29,636 | ) | (14,022 | ) | The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. Derivative settlements for each applicable period should be evaluated with the Company's net interest income. See table below for additional analysis. | ||||
Derivative market value and foreign currency adjustments, net | 37,703 | 48,593 | (47,394 | ) | Includes (i) the unrealized gains and losses that are caused by changes in fair values of derivatives which do not qualify for "hedge treatment" under GAAP; and (ii) the foreign currency transaction gains or losses caused by the re-measurement of the Company's Euro-denominated bonds to U.S. dollars. | ||||||
Total other income | 494,966 | 499,142 | 384,282 | ||||||||
Operating expenses: | |||||||||||
Salaries and benefits | 228,079 | 196,169 | 192,826 | Increases due to additional personnel to support increased LGS servicing volume and TPP&CC revenue, as well as increased headcount as a result of a TPP&CC acquisition during 2014, partially offset by expense reductions related to enrollment services activities. | |||||||
Cost to provide enrollment services | 53,307 | 64,961 | 78,375 | See table below for additional analysis. | |||||||
Depreciation and amortization | 21,134 | 18,311 | 33,625 | Amortization expense for 2014, 2013, and 2012 was $6.5 million, $3.3 million, and $19.0 million, respectively. Increase in 2014 compared to 2013 was due to additional expense from the amortization of intangible assets as a result of an acquisition in the TPP&CC operating segment. Decrease in 2013 was due to certain intangible assets becoming fully amortized in 2012. | |||||||
Other | 149,990 | 149,542 | 128,738 | Increase was due to an increase in (i) third party loan servicing fees incurred by AGM as volume at third parties has grown with recent loan purchases, (ii) costs incurred by LGS to support increased servicing volume; and (iii) additional costs in 2014 due to an acquisition in the TPP&CC operating segment in 2014. During 2014, increases in expense were partially offset by a decrease in guaranty collection costs incurred related to rehabilitating defaulted FFELP loans on behalf of guaranty agencies. | |||||||
Total operating expenses | 452,510 | 428,983 | 433,564 | ||||||||
Income before income taxes | 469,519 | 465,534 | 274,505 | ||||||||
Income tax expense | 160,238 | 161,193 | 96,077 | Effective tax rate: 2014 - 34.25%, 2013 - 34.75%, 2012 - 35.00%. During 2014, income tax expense was reduced by $5.9 million due to a tax capital loss resulting from certain asset sales. During 2013, income tax expense was reduced by $5.3 million due to the resolution of certain tax positions. During 2012, state income tax laws were enacted that reduced the Company's income tax expense by $4.6 million. The Company expects its effective tax rate to range between 36% and 38% in future periods. | |||||||
Net income | 309,281 | 304,341 | 178,428 | ||||||||
Net income attributable to noncontrolling interest | 1,671 | 1,669 | 431 | ||||||||
Net income attributable to Nelnet, Inc. | $ | 307,610 | 302,672 | 177,997 | |||||||
Additional information: | |||||||||||
Net income attributable to Nelnet, Inc. | $ | 307,610 | 302,672 | 177,997 | The Company provides non-GAAP information that reflects specific items management believes to be important in the evaluation of its operating results. The Company believes the point-in-time estimates of asset and liability values related to its derivatives and Euro-denominated bonds that are subject to interest and currency rate fluctuations affect the period-to-period comparability of the results of operations. These items are excluded here for comparability purposes. | ||||||
Derivative market value and foreign currency adjustments | (37,703 | ) | (48,593 | ) | 47,394 | ||||||
Tax effect | 14,327 | 18,465 | (18,010 | ) | |||||||
Net income attributable to Nelnet, Inc., excluding derivative market value and foreign currency adjustments | $ | 284,234 | 272,544 | 207,381 | |||||||
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The following table summarizes the components of "net interest income" and "derivative settlements, net."
Year ended December 31, | |||||||||||
2014 | 2013 | 2012 | Additional information | ||||||||
Variable student loan interest margin, net of settlements on derivatives | $ | 234,814 | 235,480 | 192,021 | Represents the yield the Company receives on its student loan portfolio less the cost of funding these loans. Variable student loan spread is also impacted by the amortization/accretion of loan premiums and discounts, the 1.05% per year consolidation loan rebate fee paid to the Department, and yield adjustments from borrower benefit programs. See AGM operating segment - results of operations. | ||||||
Fixed rate floor income, net of settlements on derivatives | 179,870 | 148,431 | 145,345 | The Company has a portfolio of student loans that are earning interest at a fixed borrower rate which exceeds the statutorily defined variable lender rates, generating fixed rate floor income. See Item 7A, "Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk" for additional information. | |||||||
Investment interest | 6,793 | 6,668 | 4,616 | ||||||||
Non-portfolio related derivative settlements | (1,026 | ) | (1,671 | ) | (2,232 | ) | |||||
Corporate debt interest expense | (5,731 | ) | (4,669 | ) | (8,485 | ) | Includes interest expense on the Junior Subordinated Hybrid Securities and unsecured and secured lines of credit. | ||||
Net interest income (net of settlements on derivatives) | $ | 414,720 | 384,239 | 331,265 | |||||||
The following tables summarize the components of "Enrollment services revenue" and "cost to provide enrollment services."
Inquiry management (marketing) (a) | Inquiry management (software) | Inquiry generation (a) | Digital marketing | Content solutions | Total | |||||||||||||
Year ended December 31, 2014 | ||||||||||||||||||
Enrollment services revenue | $ | 51,998 | 3,640 | 7,311 | 4,488 | 15,446 | 82,883 | |||||||||||
Cost to provide enrollment services | 45,892 | — | 4,093 | 379 | 2,943 | 53,307 | ||||||||||||
Gross profit | $ | 6,106 | 3,640 | 3,218 | 4,109 | 12,503 | 29,576 | |||||||||||
Gross profit % | 11.7% | 44.0% | ||||||||||||||||
Year ended December 31, 2013 | ||||||||||||||||||
Enrollment services revenue | $ | 59,852 | 3,985 | 14,285 | 4,399 | 15,557 | 98,078 | |||||||||||
Cost to provide enrollment services | 52,919 | — | 9,108 | 318 | 2,616 | 64,961 | ||||||||||||
Gross profit | $ | 6,933 | 3,985 | 5,177 | 4,081 | 12,941 | 33,117 | |||||||||||
Gross profit % | 11.6% | 36.2% | ||||||||||||||||
Year ended December 31, 2012 | ||||||||||||||||||
Enrollment services revenue | $ | 72,930 | 3,620 | 17,650 | 4,850 | 18,875 | 117,925 | |||||||||||
Cost to provide enrollment services | 64,705 | — | 10,717 | 268 | 2,685 | 78,375 | ||||||||||||
Gross profit | $ | 8,225 | 3,620 | 6,933 | 4,582 | 16,190 | 39,550 | |||||||||||
Gross profit % | 11.3% | 39.3% | ||||||||||||||||
(a) | Inquiry management (marketing) revenue decreased $7.9 million (13.1%) and $13.1 million (17.9%) in 2014 and 2013, respectively, compared to 2013 and 2012, respectively. Inquiry generation revenue decreased $7.0 million (48.8%) and $3.4 million (19.1%) in 2014 and 2013, respectively, compared to 2013 and 2012, respectively. Revenues from these services have been affected by the ongoing regulatory uncertainty regarding recruiting and marketing to potential students in the for-profit college industry, which has caused schools to decrease spending on marketing efforts. Additionally, clients are shifting marketing budgets to more efficient or lower cost channels, which has caused a reduction in volume. Effective August 29, 2014 the Company stopped providing inquiry generation services. |
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The following table summarizes the components of "other income."
Year ended December 31, | |||||||||
2014 | 2013 | 2012 | |||||||
Borrower late fee income | $ | 14,760 | 12,686 | 13,876 | |||||
Investment advisory fees (a) | 17,530 | 17,422 | 9,347 | ||||||
Realized and unrealized gains/(losses) on investments, net | 7,052 | 6,094 | 6,914 | ||||||
Reduction of repurchase obligation (b) | 4,235 | — | — | ||||||
Other | 10,425 | 10,096 | 9,339 | ||||||
Other income | $ | 54,002 | 46,298 | 39,476 | |||||
(a) | The Company provides investment advisory services under various arrangements and earns annual fees of 25 basis points on the outstanding balance of investments and up to 50 percent of the gains from the sale of securities for which it provides advisory services. As of December 31, 2014, the outstanding balance of investments subject to these arrangements was $841.3 million. |
(b) | During 2014, the Company recognized income related to the modification of certain servicing agreements in which the Company's loan repurchase obligation was reduced. |
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STUDENT LOAN AND GUARANTY SERVICING OPERATING SEGMENT – RESULTS OF OPERATIONS
Student Loan Servicing Volumes (dollars in millions)
Company owned | $22,650 | $21,237 | $20,820 | $20,629 | $20,715 | $21,397 | $21,192 | $21,110 | $20,511 | $19,742 | ||||||||||||||||||||
% of total | 29.8% | 21.8% | 18.5% | 17.7% | 15.3% | 15.5% | 14.3% | 14.1% | 12.9% | 12.2% | ||||||||||||||||||||
Number of servicing borrowers: | ||||||||||||||||||||||||||||||
Government servicing | 3,036,534 | 3,892,929 | 4,261,637 | 4,396,341 | 5,145,901 | 5,305,498 | 5,438,933 | 5,465,395 | 5,824,743 | 5,915,449 | ||||||||||||||||||||
FFELP servicing | 1,799,484 | 1,626,146 | 1,586,312 | 1,529,203 | 1,507,452 | 1,462,122 | 1,426,435 | 1,390,541 | 1,404,619 | 1,397,295 | ||||||||||||||||||||
Private servicing | 164,554 | 173,948 | 170,224 | 173,588 | 178,935 | 195,580 | 191,606 | 186,863 | 200,095 | 202,529 | ||||||||||||||||||||
Total: | 5,000,572 | 5,693,023 | 6,018,173 | 6,099,132 | 6,832,288 | 6,963,200 | 7,056,974 | 7,042,799 | 7,429,457 | 7,515,273 | ||||||||||||||||||||
Number of remote hosted borrowers | 9,566,296 | 6,912,204 | 5,001,695 | 3,218,896 | 1,986,886 | 1,915,203 | 1,796,287 | 1,735,594 | 1,677,547 | 1,611,654 | ||||||||||||||||||||
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Summary and Comparison of Operating Results
Year ended December 31, | |||||||||||
2014 | 2013 | 2012 | Additional information | ||||||||
Net interest income | $ | 30 | 40 | 53 | |||||||
Loan and guaranty servicing revenue | 240,414 | 243,428 | 209,748 | See table below for additional analysis. | |||||||
Intersegment servicing revenue | 55,139 | 56,744 | 65,376 | Represents revenue earned by the LGS operating segment as a result of servicing loans for the AGM operating segment. Year over year decrease was due to portfolio run-off. | |||||||
Total other income | 295,553 | 300,172 | 275,124 | ||||||||
Salaries and benefits | 138,584 | 119,092 | 115,126 | Increase due to additional personnel to support the increase in volume under the government servicing contract. | |||||||
Depreciation and amortization | 10,742 | 11,419 | 18,415 | Intangible assets were fully amortized during 2012. Amortization expense for 2012 was $8.7 million. | |||||||
Other expenses | 70,211 | 79,116 | 70,505 | Collection costs associated with FFELP guaranty collection revenue was $24.3 million, $32.0 million, and $28.0 million in 2014, 2013, and 2012, respectively. Excluding collection costs, other expenses were $45.9 million, $47.1 million, and $42.5 million in 2014, 2013, and 2012, respectively. The increase in 2013 compared to 2012 was due to additional servicing volume. The decrease in 2014 compared to 2013 was due to cost saving initiatives. | |||||||
Intersegment expenses, net | 4,208 | 4,359 | 5,280 | ||||||||
Total operating expenses | 223,745 | 213,986 | 209,326 | ||||||||
Income before income taxes and corporate overhead allocation | 71,838 | 86,226 | 65,851 | ||||||||
Corporate overhead allocation | (9,029 | ) | (6,150 | ) | (5,904 | ) | |||||
Income before income taxes | 62,809 | 80,076 | 59,947 | ||||||||
Income tax expense | (23,867 | ) | (30,430 | ) | (22,780 | ) | |||||
Net income | $ | 38,942 | 49,646 | 37,167 | |||||||
Before tax operating margin | 21.2 | % | 26.7 | % | 21.8 | % | The increase in operating margin in 2013 compared to 2012 was the result of the investments made and certain costs incurred by the Company in 2012 to improve performance metrics under the Department servicing contract and to implement and comply with the Department's special direct consolidation loan initiative. In addition, intangible assets for this segment were fully amortized in 2012. This segment experienced a reduction in operating margin in 2014 compared to 2013 as a result of the implementation of previously announced federal budget reductions for guaranty agencies' revenue. In addition, as the volume of loans serviced under the Department servicing contract continues to grow and loans serviced under the legacy commercial programs continue to run off, the Company expects operating margins to tighten accordingly. | ||||
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Loan and guaranty servicing revenue
Year ended December 31, | |||||||||||
2014 | 2013 | 2012 | Additional information | ||||||||
Government servicing | $ | 124,378 | 97,351 | 69,493 | Increase due to an increase in the number of borrowers serviced under the government servicing contract. | ||||||
FFELP servicing | 13,334 | 20,420 | 24,255 | Decrease will continue as third-party customers' FFELP portfolios run off. | |||||||
Private servicing | 10,497 | 9,485 | 9,201 | Increase due to an increase in the number of borrowers serviced for third-party customers. | |||||||
FFELP guaranty servicing | 11,284 | 12,251 | 13,183 | Decrease will continue as FFELP portfolios run off and guaranty volume decreases. | |||||||
FFELP guaranty collection | 55,369 | 73,628 | 58,926 | The Company earns revenue from rehabilitating defaulted FFELP loans on behalf of guaranty agencies. Over time, this FFELP-related revenue source will decrease as FFELP portfolios continue to run off. Also, recent federal budget provisions that became effective July 1, 2014 have reduced payments by the Department to guaranty agencies for assisting student loan borrowers with the rehabilitation of defaulted loans under FFELP. Rehabilitation collection revenue was $41.6 million, $54.2 million, and $43.8 million in 2014, 2013, and 2012, respectively. This revenue was negatively impacted in 2014 as a result of these federal budget provisions. Rehabilitation collection revenue for the period from July 1, 2014, when the reduced payment framework became effective, to December 31, 2014 was $10.9 million. The Company anticipates this revenue will continue to be negatively impacted as a result of these federal budget provisions. | |||||||
Software services | 22,349 | 28,609 | 33,512 | In October 2011, the Company began providing hosted student loan servicing to a significant customer. The contract with this customer expired in December 2013. The number of remote hosted borrowers and related revenue decreased from this customer throughout 2013 as this customer's loan volume was transferred to other servicers. Revenue earned from this customer in 2013 and 2012 was $6.2 million and $14.7 million, respectively. Excluding revenue from this customer, software services revenue increased in 2013 compared to 2012 due to an increase in the number of borrowers from other remote hosted customers. | |||||||
Other | 3,203 | 1,684 | 1,178 | Increase due to additional contact center outsourcing activities. | |||||||
Loan and guaranty servicing revenue | $ | 240,414 | 243,428 | 209,748 | |||||||
37
TUITION PAYMENT PROCESSING AND CAMPUS COMMERCE OPERATING SEGMENT – RESULTS OF OPERATIONS
This segment of the Company’s business is subject to seasonal fluctuations which correspond, or are related to, the traditional school year. Tuition management revenue is recognized over the course of the academic term, but the peak operational activities take place in summer and early fall. Higher amounts of revenue are typically recognized during the first quarter due to fees related to grant and aid applications. The Company’s operating expenses do not follow the seasonality of the revenues. This is primarily due to generally fixed year-round personnel costs and seasonal marketing costs. Based on the timing of revenue recognition and when expenses are incurred, revenue and pre-tax operating margin are higher in the first quarter as compared to the remainder of the year.
The Company purchased RenWeb on June 3, 2014. The results of RenWeb's operations are reported in the Company's consolidated financial statements from the date of acquisition. RenWeb's revenue from the date of acquisition through December 31, 2014 was $8.8 million.
Summary and Comparison of Operating Results
Year ended December 31, | |||||||||||
2014 | 2013 | 2012 | Additional information | ||||||||
Net interest income | $ | 6 | — | 8 | |||||||
Tuition payment processing, school information, and campus commerce revenue | 98,156 | 80,682 | 74,410 | In addition to the acquisition of RenWeb referred to above, the remaining increase was due to an increase in the number of managed tuition payment plans, campus commerce customer transaction volume, and new school customers. | |||||||
Other income | 1,268 | — | — | ||||||||
Total other income | 99,424 | 80,682 | 74,410 | ||||||||
Salaries and benefits | 48,453 | 37,575 | 34,314 | In addition to the acquisition of RenWeb referred to above, the remaining increase was due to additional personnel to support the increase in payment plans and continued system maintenance and enhancements. | |||||||
Depreciation and amortization | 8,169 | 4,518 | 7,240 | Amortization of intangible assets for 2014, 2013, and 2012 was $6.5 million, $3.3 million, and $6.3 million, respectively. Certain intangible assets were fully amortized at the end of 2012. As a result of the acquisition of RenWeb, the Company recorded $37.2 million of intangible assets that increased amortization expense in 2014. | |||||||
Other expenses | 13,006 | 9,147 | 10,439 | Implementation of electronic communications and processes resulted in reductions of paper forms, postage, and freight which decreased expenses in 2013 compared to 2012. In addition, certain investments were made by the Company during 2012 in new products and services to meet customer needs and expand product and service offerings. The increase in expenses in 2014 compared to 2013 was the result of the acquisition of RenWeb referred to above and additional expenses incurred to support the increase in payment plans and continued system maintenance and enhancements. | |||||||
Intersegment expenses, net | 5,864 | 5,989 | 5,383 | ||||||||
Total operating expenses | 75,492 | 57,229 | 57,376 | ||||||||
Income before income taxes and corporate overhead allocation | 23,938 | 23,453 | 17,042 | ||||||||
Corporate overhead allocation | (3,010 | ) | (1,957 | ) | (1,968 | ) | |||||
Income before income taxes | 20,928 | 21,496 | 15,074 | ||||||||
Income tax expense | (7,952 | ) | (8,168 | ) | (5,728 | ) | |||||
Net income | $ | 12,976 | 13,328 | 9,346 | |||||||
Before tax operating margin | 21.0 | % | 26.6 | % | 20.3 | % | Excluding the amortization of intangibles, before tax operating margin was 27.6%, 30.7%, and 28.7% for 2014, 2013, and 2012, respectively. The decrease in margin in 2014 compared to 2013 was primarily due to a change in the mix of products and services provided as a result of the acquisition of RenWeb referred to above. | ||||
38
ASSET GENERATION AND MANAGEMENT OPERATING SEGMENT – RESULTS OF OPERATIONS
Student Loan Portfolio
As of December 31, 2014, the Company had a $28.0 billion student loan portfolio that will amortize over the next 25 years. For a summary of the Company's student loan portfolio as of December 31, 2014 and 2013, see note 3 of the notes to consolidated financial statements included in this report.
Loan Activity
The following table sets forth the activity of loans:
Year ended December 31, | |||||||||
2014 | 2013 | 2012 | |||||||
Beginning balance | $ | 26,121,306 | 24,995,880 | 24,359,625 | |||||
Loan acquisitions | 6,099,249 | 4,058,997 | 3,885,138 | ||||||
Repayments, claims, capitalized interest, participations, and other | (2,745,341 | ) | (2,375,806 | ) | (1,807,144 | ) | |||
Consolidation loans lost to external parties | (990,960 | ) | (514,108 | ) | (1,331,163 | ) | |||
Loans sold | (260,346 | ) | (43,657 | ) | (110,576 | ) | |||
Ending balance | $ | 28,223,908 | 26,121,306 | 24,995,880 | |||||
Allowance for Loan Losses, Loan Repurchase Obligation, and Loan Delinquencies
The Company maintains an allowance appropriate to absorb losses, net of recoveries, inherent in the portfolio of student loans, which results in periodic expense provisions for loan losses. In addition, the Company’s servicing operations are obligated to repurchase certain private education loans sold in the event such loans become 60 or 90 days delinquent. Further, delinquencies have the potential to adversely impact the Company’s earnings through increased servicing and collection costs and account charge-offs.
For a summary of the activity in the allowance for loan losses and accrual related to the Company's loan repurchase obligation for 2014, 2013, and 2012, and a summary of the Company's federally insured student loan delinquency amounts as of December 31, 2014, 2013, and 2012, see note 3 of the notes to consolidated financial statements included in this report.
The Company's provision for loan losses and charge-offs of federally insured loans decreased in 2014 compared to 2013 and 2013 compared to 2012. The Company’s primary driver for loan growth has been acquiring student loan portfolios. The Company records loans acquired net of any credit exposure through a credit discount, separate from the allowance for loan losses. This credit discount is non-accretable to interest income. The Company continues to evaluate credit losses associated with purchased loans based on current information and changes in expectations to determine the need for any additional allowance for loan losses. The recent purchases of large loan portfolios have resulted in an increase in the non-accretable discount balance, but no additional allowance for loan losses associated with these recent loan portfolios has been necessary. In addition, as the Company’s overall student loan portfolio continues to season with the length of time that loans are in active repayment, credit performance continues to improve.
39
Student Loan Spread Analysis
The following table analyzes the student loan spread on the Company’s portfolio of student loans, which represents the spread between the yield earned on student loan assets and the costs of the liabilities and derivative instruments used to fund the assets.
Year ended December 31, | |||||||||
2014 | 2013 | 2012 | |||||||
Variable student loan yield, gross | 2.55 | % | 2.58 | % | 2.63 | % | |||
Consolidation rebate fees | (0.82 | ) | (0.77 | ) | (0.75 | ) | |||
Discount accretion, net of premium and deferred origination costs amortization | 0.05 | 0.03 | — | ||||||
Variable student loan yield, net | 1.78 | 1.84 | 1.88 | ||||||
Student loan cost of funds - interest expense | (0.95 | ) | (0.91 | ) | (1.09 | ) | |||
Student loan cost of funds - derivative settlements | 0.01 | 0.01 | 0.03 | ||||||
Variable student loan spread | 0.84 | 0.94 | 0.82 | ||||||
Fixed rate floor income, net of settlements on derivatives | 0.64 | 0.60 | 0.62 | ||||||
Core student loan spread | 1.48 | % | 1.54 | % | 1.44 | % | |||
Average balance of student loans | $ | 28,036,577 | 24,960,521 | 23,694,388 | |||||
Average balance of debt outstanding | 28,116,989 | 24,954,546 | 23,932,304 | ||||||
A trend analysis of the Company's core and variable student loan spreads is summarized below.
(a) | The interest earned on a large portion of the Company's FFELP student loan assets is indexed to the one-month LIBOR rate. The Company funds the majority of its assets with three-month LIBOR indexed floating rate securities. The relationship between the indices in which the Company earns interest on its loans and funds such loans has a significant impact on student loan spread. This table (the right axis) shows the difference between the Company's liability base rate and the one-month LIBOR rate by quarter. |
Variable student loan spread decreased in 2014 as compared to 2013 as a result of recent acquisitions of consolidation loans, which have lower margins but longer terms. Variable student loan spread increased in 2013 as compared to 2012 as a result of the tightening of the Asset/Liability Base Rate spread reflected in the previous table.
40
The primary difference between variable student loan spread and core student loan spread is fixed rate floor income. A summary of fixed rate floor income and its contribution to core student loan spread follows:
Year ended December 31, | |||||||||
2014 | 2013 | 2012 | |||||||
Fixed rate floor income, gross | $ | 204,250 | 179,453 | 164,615 | |||||
Derivative settlements (a) | (24,380 | ) | (31,022 | ) | (19,270 | ) | |||
Fixed rate floor income, net | $ | 179,870 | 148,431 | 145,345 | |||||
Fixed rate floor income contribution to spread, net | 0.64 | % | 0.60 | % | 0.62 | % | |||
(a) | Includes settlement payments on derivatives used to hedge student loans earning fixed rate floor income. |
The high levels of fixed rate floor income earned during 2014, 2013, and 2012 are due to historically low interest rates. Gross fixed rate floor income increased in 2014 due to recent purchases of loans earning fixed rate floor income. If interest rates remain low, the Company anticipates continuing to earn significant fixed rate floor income in future periods. See Item 7A, “Quantitative and Qualitative Disclosures about Market Risk - Interest Rate Risk,” which provides additional detail on the Company’s portfolio earning fixed rate floor income and the derivatives used by the Company to hedge these loans.
41
Summary and Comparison of Operating Results
Year ended December 31, | |||||||||||
2014 | 2013 | 2012 | Additional information | ||||||||
Net interest income after provision for loan losses | $ | 424,140 | 390,571 | 324,906 | See table below for additional analysis. | ||||||
Other income | 21,532 | 15,223 | 18,219 | The primary component of other income is borrower late fees, which were $14.8 million, $12.7 million, and $13.9 million in 2014, 2013, and 2012, respectively. In 2014, $4.2 million in income was recognized related to the modification of certain servicing agreements in which the Company's loan repurchase obligation was reduced. Also included in "other income" are net realized and unrealized gains /losses on investments, which were net income of $0.3 million, $0.2 million, and $1.7 million in 2014, 2013, and 2012, respectively. | |||||||
(Loss) gain on sale of loans and debt repurchases, net | (1,357 | ) | 11,004 | 3,814 | Gains were primarily from the Company repurchasing its own asset-backed debt securities. Due to improvements in the capital markets, the opportunities for the Company to repurchase debt at less than par are becoming more limited. In 2014, the Company recognized a loss from the sale of loans, which was partially offset by gains from debt repurchases. | ||||||
Derivative market value and foreign currency adjustments, net | 42,935 | 35,256 | (51,809 | ) | Includes (i) the unrealized gains and losses that are caused by changes in fair values of derivatives which do not qualify for "hedge treatment" under GAAP; and (ii) the foreign currency transaction gains or losses caused by the re-measurement of the Company's Euro-denominated bonds to U.S. dollars. | ||||||
Derivative settlements, net | (20,818 | ) | (27,966 | ) | (11,792 | ) | The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. Derivative settlements for each applicable period should be evaluated with the Company’s net interest income as reflected in the table below. | ||||
Total other income | 42,292 | 33,517 | (41,568 | ) | |||||||
Salaries and benefits | 2,316 | 2,292 | 2,252 | ||||||||
Other expenses | 33,611 | 30,945 | 16,435 | Increase due to higher third party servicing fees related to a significant amount of recent loan purchases being serviced at third parties. | |||||||
Intersegment expenses, net | 55,808 | 57,572 | 66,215 | Amount includes fees paid to the LGS operating segment for the servicing of the Company's student loan portfolio. Such amounts have decreased as the AGM portfolio serviced by LGS has run off. | |||||||
Total operating expenses | 91,735 | 90,809 | 84,902 | ||||||||
Income before income taxes and corporate overhead allocation | 374,697 | 333,279 | 198,436 | ||||||||
Corporate overhead allocation | (5,017 | ) | (3,896 | ) | (5,306 | ) | |||||
Income before income taxes | 369,680 | 329,383 | 193,130 | ||||||||
Income tax expense | (140,477 | ) | (125,165 | ) | (73,387 | ) | |||||
Net income | $ | 229,203 | 204,218 | 119,743 | |||||||
Additional information: | |||||||||||
Net income | $ | 229,203 | 204,218 | 119,743 | The Company provides non-GAAP information that reflects specific items management believes to be important in the evaluation of its operating results. The Company believes the point-in-time estimates of asset and liability values related to its derivatives and Euro-denominated bonds that are subject to interest and currency rate fluctuations affect the period-to-period comparability of the results of operations. These items are excluded here for comparability purposes. | ||||||
Derivative market value and foreign currency adjustments, net | (42,935 | ) | (35,256 | ) | 51,809 | ||||||
Tax effect | 16,315 | 13,397 | (19,687 | ) | |||||||
Net income, excluding derivative market value and foreign currency adjustments | $ | 202,583 | 182,359 | 151,865 | |||||||
42
The following table summarizes the components of "net interest income after provision for loan losses" and "derivative settlements, net."
Year ended December 31, | |||||||||||
2014 | 2013 | 2012 | Additional Information | ||||||||
Variable interest income, net of settlements on derivatives | $ | 718,274 | 645,739 | 630,267 | Increase due to an increase in the average student loan portfolio, partially offset by a decrease in the gross yield earned on student loans, net of settlements on derivatives. | ||||||
Consolidation rebate fees | (230,956 | ) | (192,061 | ) | (178,211 | ) | Increase due to an increase in the average consolidation loan balance. | ||||
Discount accretion, net of premium and deferred origination costs amortization | 15,002 | 8,067 | 47 | Increase due to the Company's purchases of loans at a net discount over the last several years. | |||||||
Interest on bonds and notes payable | (267,506 | ) | (226,265 | ) | (260,082 | ) | Increase in 2014 compared to 2013 was due to an increase in cost of funds and an increase in average debt outstanding. Decrease in 2013 compared to 2012 was due to a decrease in cost of funds, partially offset by an increase in average debt outstanding. | ||||
Variable student loan interest margin, net of settlements on derivatives | 234,814 | 235,480 | 192,021 | ||||||||
Fixed rate floor income, net of settlements on derivatives | 179,870 | 148,431 | 145,345 | The high levels of fixed rate floor income earned were due to historically low interest rates. Fixed rate floor income has increased year over year due to recent purchases of loans earning fixed rate floor income. | |||||||
Investment interest | 374 | 461 | 955 | ||||||||
Intercompany interest | (2,236 | ) | (3,267 | ) | (3,707 | ) | |||||