Nelnet, Inc. (NNI) 2008 Q2 法說會逐字稿

Good day everyone and welcome to Nelnet second quarter 2008 conference call. Today's call is being recorded and broadcast over the internet.

Now at this time for opening remarks and introductions, I'd like to turn the conference over to Mr. Phil Morgan with Investor Relations. Please go ahead, sir.

Thank you. Good afternoon and thank you everyone for joining us today. Nelnet's second quarter earnings release and financial supplement have been posted to the Investor Relations website at www.nelnetinvestors.com. On today's call, Jeff Noordhoek, President; and Terry Heimes, Chief Financial Officer, will be making formal remarks. And Mike Dunlap, Chief Executive Officer, will be joining us for the question-and-answer session.

Before we begin the formal remarks, I would like to read the Safe Harbor statement. We would like to remind you that there will be forward-looking statements made during today's call. The forward-looking statements may differ materially from actual results and are subject to certain risks and uncertainties that are detailed in the company's Form 10-K with and other filings with the SEC. The company does not intend to update any forward-looking statements made during the call. During the course of this call, we will refer to a non-GAAP financial measure which the company defines as base net income. Please refer to our second quarter 2008 supplemental earnings disclosure, which is posted on our website for the reconciliation of GAAP net income to base net income. After Jeff and Terry have concluded their formal remarks, we will open the call for questions. I would now to now turn the call over to Jeff.

Thanks, Phil. Good afternoon, everyone. Obviously we are quite pleased with our results for the second quarter. The three significant items impacting the company this quarter were liquidity, reduced operating expenses, and improved core student loan spread.

First, I will discuss liquidity. Our funding sources for new FFELP loan originations have always been corporate cash, unsecured lines of credit, participation agreements, and our ABCP warehouse line of credit. When the credit crisis started hitting in August last year and the term ABS market became disrupted, we used our financial strength to quickly supplement our capacity to fund new loan originations by increasing the size of our warehouse facility to $8.9 billion. As the ABS market continued its freefall, it became apparent that renewing the liquidity backstop for our existing warehouse facility would be very expensive.

Fortunately we had two things working in our favor. First, in early 2007 when the credit markets were strong, we negotiated a multiyear component to our warehouse facility instead of a traditional 364 day structure with terms significantly better than those offered in the market. Even though the banks and the ABCP warehouse facility worked hard to come up with acceptable terms for all parties, in the end we agreed to disagree and we decided not to renew the facility. That said, we maintained the ongoing positive relationship and mutually beneficial working relationship with these institutions, and the facility will remain outstanding through May of 2010.

Second, Congress passed Ensuring Continued Access To Student Loans Act. As a result of this legislation, the Department of Education developed a plan to purchase loans and offer short term liquidity to lenders. In the spirit of the legislation, we will utilize the government provided liquidity facility for its intended purpose of making sure that every eligible student has access to FFELP loans for the upcoming academic year. The Department of Education has been working long hours to implement the new [installation] and approximate we applaud their efforts to get the facility up and running. The funding facility is far from perfect, but we believe it will serve it intended purpose. We have filed our documents with the department, and we anticipate we will begin funding loans in the facility as early as next week. Hopefully this provides some background on why we choose to cost of funds by terming the warehouse facility versus an expensive and restrictive option of renewing it. Given the ongoing global credit crisis, we believe it is the right long term decision for the company.

The second significant item for the quarter was reduced operating expenses. We continue to aggressively manage our operating costs and have decreased them by more than $20 million or 18% compared to the second quarter of last year, and $40 million year-to-date. While we have achieved most of the run rate reductions that we set out to accomplish, we will continue to evaluate different areas of the company where we can operate more efficiently. As a company, we are laser focused on staying ahead of our competitors in a rapidly changing world.

The third significant item was improved spread, which was a welcome development in what continues to be an extremely difficult capital market environment. Terry will cover the spread in greater detail, but before I turn the call over to him, I want to discuss our continued diversification.

As you know, we have never operated our company based on quarterly performance, but instead remained focused on long term cash flow and value creation for our customers and shareholders. That said, typically the second quarter each year is seasonally the smallest revenue quarts in some of our fee generating businesses. Despite the seasonality, we continue to experience planned net income contribution from our fee businesses, specifically in our tuition payment plan and enrollment services business. In our tuition payment and campus commerce segment, we are adding a record number of new schools, we are growing our revenue at existing schools, and we are deploying new products. We also continue to see new wins in our enrollment services business, a perfect recent example of this is the $3.8 million contract we entered into with the Department of Defense to provide college search and selection, test preparation, job readiness, and military success programs to personnel in all branches of the military. Now I will turn the call over to Terry to dive deeper into financial analysis of the quarter.

Thanks, Jeff. As Jeff indicated we are very pleased with the results this quarter. Besides the improvement of our net interest margin and the continued reduction in our operating cost, we also benefited from continued performance of our fee base basis and some nonrecurring items that added to our bottom line.

Let me start with high level numbers. Our GAAP net income for the quarter was $0.89 per share. Our base net income from continuing operations excluding any restructuring charges was $0.54 per share for the second quarter compared to $0.31 per share for the first quarter and $0.44 per share last year. The $0.54 per share does include $0.06 related to a change in estimate and approximately $0.14 from improvements in our student loan spread, which may not benefit future periods. Excluding these nonrecurring items, our base income per share was approximately $0.34 per share for the quarter. Expanding on the student loan spread, our core spread was 107 basis points for the second quarter compared to 73 basis points in the first quarter.

The first quarter was substantially impacted by the credit market crisis and accordingly was abnormally low. While there is still substantial volatility in the credit markets, we did begin to see some stabilization in the relationship between certain rate indices. We saw a narrowing of the CP LIBOR spread, which benefited our entire portfolio. We also saw improvement in our funding cost on our short term warehouse as well as a nominal [lead] in the periodic reset of our auction rate debt. While we have employed various discrete versus average derivative products to protect our spread in the time of falling interest rates, we do not maintain 100% hedge portfolio and we benefited from the timing of the resets and leveling off of interest rates. We estimate that approximately 15 basis pines of our spread improvement was due to the anomalies in our auction rate securities and other rate reset relationships, which most likely will not continue going forward. Nevertheless, we did see significant improvement in our core spread, which we believe will carry forward into future periods.

Moving to our fee-based business, our loan and guarantee servicing segment is our largest and most stable fee-based business in terms of operations and scale. As anticipated, revenue for the second quarter and year-to-date has declined driven by the legislative changes related to guarantor of the FA agreements. Fortunately we have also started to achieve some efficiencies in terms of operating expense reductions this quarter. And more importantly, we are beginning to see opportunities for new revenue generation and expansion of revenue with existing clients. Now that business solutions continues to achieve very impressive results, though some of them will not show in our operating numbers until the last half of 2008 and into 2009.

Operating margins have compressed slightly during the second quarter compared to last year, as we have made investments in new products and technology. It is important to note that we have the market leader in this area. We are the largest provider of tuition payment plans in the nation. In the current academic year or school year, Nelnet business solutions achieved a greater than 15% growth in revenues, and based on projections of new schools and transaction volume, we will exceed that for the next academic year beginning this fall.

We see significant opportunities in the lead generation and planning areas. Revenues related to these areas of enrollment services are up more than 30% year-over-year for both the quarter and six months ended July 30th. The operating results of our enrollment services segment as a whole, however, are masked by the anticipates challenges we have experienced in our risk management business. We continue to focus on increasing margins and operating leverage and we see opportunities to generate new revenue. With that, let's open it up for questions. Operator?

(OPERATOR INSTRUCTIONS) We will go first to Matt Snowling with FBR Capital Markets.

Good morning, guys. Can you hear me?

Yes. Hey, Matt.

This is actually Mike Park on behalf of Matt Snowling. A quick question based on operating expenses and run rate going forward, and just trying to get a sense -- I know a lot of the restructuring was focused in 1Q, and a little bit carried forward into 2Q. But can you give us a sense as to whether or not this is a good run rate or what the sustainability of the operating expense base is from Q2?

Sure, Mike. This is Terry. We have achieved most of the targeted reduction that is we had planned. I would use Q2 as a good run rate in terms of going forward with -- obviously we are going to continue to look for ways that we can identify efficiencies, but the second quarter would be a good run rate.

Okay. Great. Thanks.

We will go next to Mike Taiano with Sandler O'Neill.

Hi, thanks. A couple of questions. First, on the variable rate floor income, is that something that will go away in the third quarter after the July 1 resets, or do you expect some residual impact from that?

Mike, this is Terry. The variable rate floor will go away with the reset July 1.

Okay. And on the tax rate, I think it was down 31% and I think you said in the Q it would probably stay there for the remainder of the year. Should we use that as the run rate going forward into 2009 as well?

No, that's primarily for the rest of this year because of the operating loss we sustained in the first quarter. That's going to have the impact of a tax rate for the remainder of the year. As we move into 2009, it will probably go back to the 36% to 37% to 38% range.

Okay. Great. And then just on the spread in the quarter, the improvement, I mean where should, could you give us some sense of guidance? Because I know there's a lot of moving parts and it is highly dependent on where the credit markets end up, but should we expect further or compression going later into '08 and into early '09 despite the government facility that's in place?

Well, I mean in terms of -- as you said, there's a lot of moving parts with the spread and the various components. We anticipate that as much as 15 basis points of the spread improvement that we achieved this quarter may be nonrecurring on a go forward basis. However we did achieve some stability in the various rate indices, so that's very positive. I think also in terms of the new facility, that will be at CP plus 50. So that will provide a stable base. Anything that we issue in terms of new securitizations will depend on the issuance level, compared to the loans that we are refinancing out of our warehouse. So all of those factors could impact that going forward. I think if you start with a base of 90 to 95 basis points, given that 15 basis point nonrecurring level would be a good starting point.

Okay. Great. And then just last question on that, the $3.8 million department of defense contract that you have, over what period is that?

It is Jeff. That contract started in July and it is over a 14 month period.

14 months?

Yes.

Okay. Great. Thanks a lot.

Next to Moshe Orenbuch with Credit Suisse.

Two separate questions. First is how does -- how do you lenders decide whether the spread on the warehouse line is going to be the high or lower number -- I guess contingency, they can't use their asset, their commercial paper facilities spread wide -- ?

It is Jeff. The way that works is if they fund the assets in the commercial paper conduits as they have done always in the past, it stays at the current rate, plus stepped up 10 basis points. If they choose to take the assets out of their conduit and fund them on their balance sheets, which means they have to hold capital against those assets, then they would go up to the higher return of 128.5 basis points. So it will be an individual decision by each institution on if they want to fund it off their balance sheet at the lower spread or on their balance sheet while holding capital at the higher spread.

I guess I'm a little confused though. So you have no kind of insight as to what they're going to do? Are they able to issue the commercial paper, or?

Our insight would be that the vast majority of the banks anticipate funding them in their conduits off their balance sheets. That's why we come up with the average number we did, between 10 and 30 basis points in our announcement. Maybe one or two banks might put it on their balance sheet. We think it will be a limited amount.

Okay. Separately -- in terms of the interplay, if you will, if that is even relevant between the income which has been declining in absolute terms and expense which is have been declining -- is there a way that we could think about the two of those together? Is there going be a positive relationship from an earnings perspective between the two of them at some point? When would you think those lines would cross?

I think the, while there has been, while there would, there is some interplay, they really are focused on two different aspects. Many of the expense reductions that we targeted have achieved have been in the asset generation area, and/or in terms of infrastructure or our corporate activities area. Some of the -- on the fee generation businesses, we have the opportunity to generate significant operating leverage. We have chosen to make investments specifically in for example our Nelnet business solutions, where we made investments and you saw a decline in the operating margin this quarter from investments in technology and new products. We expect to gain significant operating leverage going forward and we have experienced very positive growth results there. We would expect to capitalize really on the growth and revenue without adding significant expense as we go forward.

The same would be true in terms of the enrollment services area. That probably has a slightly higher relationship to the growth in revenue as there is some cost of goods sold type relationship there. But we would expect as we move forward into the last half of 2008 and 2009, to get pick up from those two areas in terms of the revenue growth without adding significant expense.

The other decline that you saw in terms of our fee-based revenues really was the loan and guarantee servicing area, and that was driven by legislative changes related to how guarantors earn revenue and how we earn revenue related to that contract. And so while we were able to achieve some expense reduction to offset some of that loss in revenue as we go forward, we are well positioned to focus on growing that revenue from a base year without adding significant expense to that, because we will have the ability to again capitalize in operating leverage. So, the decline in revenues has been offset by the decline in expenses, but they were done really for different reasons and different purposes. And we should, we expect to capitalize on the operating leverage going forward.

Right. So the second part of the question was when do you think those line also actually cross when the operating leverage will actually -- ?

I think toward the last half of this year into the fourth quarter and beginning of '09.

Thank you.

(OPERATOR INSTRUCTIONS) We will go next to Sameer Gokhale with KBW.

Hi. Thank you. I had a question on growth expectations for Stafford and Plus loans. If you look at the year-over-year growth there, there is actually I think a modest decline year-over-year, and I think recently you reiterated your commitment to making loans to all students at all schools who needed the government guaranteed student loans. So at this point, given that you probably have a very good sense for what the origination volume is going to be, could you give us a hint -- some data point which suggests how your origination volume is expected to be in Q3?

It is Jeff. Our loans, our new origination loan volume is down as we expected. Now, there are a whole bunch of factors affecting new volume, and let me just list some of the things going on that affect the volume. If you go back, obviously we proactively modified our [borrow] benefits and our marketing costs in order to retain value on all new loan originations. We proactively reduced our capital market exposure in response to liquidity crisis by reducing loan origination volume. Subsequently, we successfully limited our liquidity risk on all new loan originations and obviously with our announcement, in the spirit of a new legislation, we announced we will make a loan to any student in the United States.

Let me give you more data points to think about. We have seen 124 lenders exit the loan generation market in the last six months. We have seen virtually all remaining lenders follow us on elimination of borrow benefits and we have in the last couple months seen a significant number of new lender list wins. Now take all of that, and the ultimate impact to our volume from the combination of these decisions is very difficult to predict at this time. Really it's part of the reason we eliminated earnings guidance this year. We believe that by the third quarter we should expect to have a better line of sight on what the volume is going to be. It is very difficult at this point in time in this part of the process.

So what time, when do you expect to get some information from the schools and financial offices that say okay this is the amount of loans that the students are taking out, this is what you need to disburse -- when do you find that out?

Our largest single month for disbursement is August and September -- those two months. So we believe -- by the next call we will have a real clear sight of what our volume is going to be for the year. Okay.

And then you have curtailed originations of private student loans but do you have a sense of -- given our talk recently about the lack of availability of private student loans and how it's been hurting students. In your view, are you seeing any signs that the application volume has been hurt because of the lack of availability of private student loans? What kind of color can you share there?

Well, as it relates to our FFELP loan originations, we don't believe that private loan originations are affecting -- since we [renew] this process volume on FFELP loan origination because they're decoupled in the market pretty much today. I don't see a real impact there. That said, we do believe that there is a large disruption in the private loan market that has not fully come to the forefront of the press. There is an article this week in the Wall Street Journal about that. But we believe that there is a vacuum of private loans that are not there, and that students are going to be struggling to try to replace them coming up in the month of August and September as they realize they can't get private loan financing due to the credit crisis.

Okay. So it doesn't really sound overall from a FFELP perspective that volumes have been hurt, just because some students have saying we can't get private loans so we're not going to go to school at all. That doesn't seem to be happening based on what you are saying.

We don't believe that's happening, and from our perspective also we have partnered with other entities to upstream private loan applications who are making private loans.

Okay. Lastly, can you give us a break down of some spreads on consolidation loans versus your Stafford loans versus PLUS loans? And clearly your consolidation loan portfolio is running off -- it's just helpful from a modeling standpoint if you get those pieces.

Sure. We can try to take some of this offline, but basically in the primary difference in spread on consolidation loans will be driven by the top line. Consolidation loan is 159 basis points over the commercial paper. The Stafford and PLUS loans are going to be between 234 and 264 basis points over the commercial paper. For the most part if they're in a securitization transaction they're going to be on a blended cost of funds. If you look on a new loan or post 10/1, the new Stafford loans and PLUS loans that we originate for the most part are going to be in school loans that are going to be at 119 basis points over commercial paper. If we fund those in the government warehouse facility, that is at CP plus 50. So that will generate a spread of roughly 69 basis points. We are not generating any new consolidation loans, so that is relatively a moot point. But those would be the spread components that are driving each one of those asset pieces.

Okay. That's helpful. Those are the general terms in which we were thinking about it, but I was hoping with we can get a little more specific there, but maybe we can follow up offline. Okay. Thank you very much.

Next to [Shane Wilson with QBT Financial].

Just wondering if you can give some general commentary on how you see the securitization market, both how it evolved during the quarter and how it is now. It seemed like at some point it was getting better and now it is getting worse. Can you give some thoughts on that?

Sure. It has been pretty volatile, you're right. You are right, it did start to improve in May and June as we saw significant improvements in the market then. Then in July and August, which are typically slow months anyway, it really reversed back to the direction really significantly. So, right now, this being the slowest month and typically the worst month of the market, we do see it widening and we do hope that the ball comes start to tighten back up again. But the bottom line is right now, it's very volatile. That's why as we access the market, we think we are in a great position to fund loans whenever we are ready, so we can go out with the transaction any point in time. We're keyed up and ready to go. We're going to time the markets. We think it's a good time and fund the securitization market as it improves. Thanks.

Next to Brian Rohman with Robeco Investment.

Thanks for taking my question. Everybody seems to know this company better than me, but I will give it a try. Sameer's question about loan growth begs a question that Sallie Mae touched on in their conference call. I think you guys have gone there as well. My sense is that the student lending season has been delayed. How delayed is it?

Interesting question. I think that you are right in the sense that with all of the new legislation came out with changes, there was a lot of repackaging of students throughout the end of the summer.

What do you mean by repackaging?

When you are a student and you go to college, you get a financial aid package that states what your grants are.

A package sent, as opposed to my son.

With the increase in loan limits and last-minute legislation it was changing, and all of these lenders that were signed up that are now exiting, there has been a big shuffling of the deck. So that's what I mean by repacking. There has been a lot of last minute shuffling of the decks related to where loans are going go and who's going to fund them.

So schools are actually probably experiencing some delay in their cash flow here as well, I would think?

That's what we expect.

Yes. [So they'll be crying] soon. So use a baseball apology, the lending season, it is -- you are still going to get a nine inning game in, but there has been a rain delay?

I guess you could use that analogy. We will see if that's true or not in the coming weeks and month.

Okay. Couple more questions, you provisioned at almost first six months this year, and almost twice the rate of last year? Can you talk about what's going on there?

Sure. The biggest reason for that change is you may or may not be aware that last year in accordance with legislation prior to October 1st, there was a provision that allowed for exceptional performer designation, which limited our exposure on risk sharing to 1% and that went away with the new legislation October 1. So therefore, we have to provide for the full amount of the risk share, because we don't qualify for exceptional performer. And that risk sharing is really between 2% and 3%, about the exception of performer designation. That's why we had to increase our allowances because of the elimination of the exceptional performer designation that was in the prior legislation.

How do you feel about your provisioning right now? Do you think that year-to-date $11 million to $12 million is adequate and is it coming in? Since obviously this is new ground for you guys. So, is your experience coming in higher or lower than expected?

It is not necessarily new ground for us, because we have been in the business for a long period of time. We happen to qualify as an exceptional performer because of the quality of our servicing. We feel obviously we analyze our exposure every period and we feel good about the quality of our loan portfolio. If you look at our loan portfolio, 99% is government guaranteed. There is a risk share component to that. Less than 1% is in our private loans. We have experienced an improving delinquency rate in our private loans. We have experienced a very low loss rate in our private loans. So we are very pleased with the quality of our portfolio and believe we are adequately provisioned.

Couple, two more questions. One gentleman earlier asked about the ABS markets, and obviously you have got the government funding program in place right now. Looking over the quarter, the second quarter, how much would ABS spreads have to come down to be competitive with the current government program?

The current government program?

The one passed in early May.

Yeah, it funds loans that were generated after May 1st of this year and the cost of funds for that is the CP rate plus 50 basis points.

Right. So, how much does -- because that's CP and ABS is priced off of other stuff, how much do you think would ABS have to come down?

The ABS market is priced off of LIBOR. As we talked about earlier, it is fairly volatile at this point in time. So, any day it could be different.

Okay. Toughest question for last. And try and avoid answering it by saying I don't know or I don't want to go there. Eventually when we get to September of '09, we are either looking at a cliff where the business just falls off and you put the business back to the government because they haven't come up with a new program, or as investors we are watching over the next 12 to 14 months as they renegotiate some sort of loan package and program with private lenders that has some sort of longer shelf life to it than 15 months. What do you think happens when we get to September of '09?

It is a really good question. We have liquidity to make loans as talked about for the upcoming '08 to '09 lending season. Remember there are over 7.5 million students and growing, which require about $80 billion of new loan financing each year. So yes it is possible that the ABS market takes a prolonged period to recover. If this occurs, and the temporary government fix that is in place is not extended for the next year to the 7.5 million students, then we will need to re-evaluate our business position at that time. We are in the business to make a proper return based on the risk profile of our investments. Every decision we make at that point in time will be based on that criteria.

The other piece to add to that is we do have an existing portfolio of $26 billion. It is generating significant cash flow well into the future, and we have diversified so over half of the revenues come from our fee-based business and we have been able to cut our expenses and maintain our service quality. So, when we get to September of '09, we will be looking at questions involving one portion of our business rather than our business as a whole.

Thank you for your time.

There appear to be no further questions at this time. I'd like to turn things back over to Jeff for additional or closing comments.

Thank you. We are encouraged by our second quarter results and outlook for the future. Consider the following -- despite the turbulent capital markets, we maintained our ability to access securitization markets. Approximately 90% of our portfolio is financed to term for the life of the loan at rates which will create significant and viable cash flow streams in excess of $1.4 billion. We have capital and liquidity for new loan originations through the government participation in [PUT] programs and see opportunities for growth in the loan generation area. We have maintained the value of our service and delivery platforms while reducing our operating costs in excess of $40 million for the first six months of the year. We have developed a broad diversified offering of fee-based businesses with significant growth opportunities and operating margins, and we have a strong capital base with which to create long term value for our shareholders. Thank you for taking the time to participate in our call. Have a great day.

That does conclude today's conference call. Thank you for your participation. You may disconnect at this time.