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NNI > SEC Filings for NNI > Form 10-K on 28-Feb-2013All Recent SEC Filings

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Form 10-K for NELNET INC


28-Feb-2013

Annual Report


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, 2012, 2011, and 2010. All dollars are in thousands, except per share amounts, unless otherwise noted.)

The following discussion and analysis provides information that the Company's management believes is relevant to an assessment and understanding of the consolidated results of operations and financial condition of the Company. The discussion 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 also contains forward-looking statements and should also 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 is an education services company focused primarily on providing fee-based processing services and quality education-related products and services in four core areas: asset management and finance, loan servicing, payment processing, and enrollment services (education planning). 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 summary of consolidated results and financial and operational highlights is provided below.
Continued strong earnings. For the year ended December 31, 2012, the Company's net income, excluding derivative market value and foreign currency adjustments, was $207.4 million, or $4.38 per share, compared to $215.4 million, or $4.47 per share, for 2011. GAAP net income for the year ended December 31, 2012 was $178.0 million, or $3.76 per share, compared with GAAP net income for 2011, which was $204.3 million, or $4.24 per share. Derivative market value and foreign currency adjustments were an expense of $29.4 million after tax, or $0.62 per share, during 2012, compared with an expense of $11.1 million after tax, or $0.23 per share, for 2011. (a)

The decrease in net income in 2012 compared to 2011 was expected as the Company's student loan portfolio runs off due to Congress' elimination of new loan originations under the FFEL Program in 2010. The decrease was partially offset by the growth of the Company's fee-based businesses.

An increase in revenue from fee-based businesses (excluding intersegment servicing revenue) to $402.1 million, or 7.5%, for 2012 as compared to $373.9 million in 2011.

Purchased $3.9 billion (par value) of student loans from third parties during 2012, including $3.0 billion during the fourth quarter.

Repurchased 806,023 shares of Class A common stock for $22.8 million ($28.30 per share) during 2012, including 746,459 shares repurchased in the fourth quarter of 2012.

Repurchased $136.1 million of debt for a gain totaling $4.0 million during 2012, including $114.4 million of debt repurchased during the fourth quarter for a gain of $3.0 million.

Paid cash dividends totaling $1.40 per share in 2012, which includes a special fourth quarter 2012 cash dividend of $1.00 per share.

An increase in book value per share to $25.00, or 10.5%, from December 31, 2011.

Strong liquidity represented by $149.3 million of cash and investments as of December 31, 2012 and $299.3 million of net cash provided by operating activities during 2012.

(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.


The Company earns fee-based revenue through the following 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")

Enrollment Services - commonly called Nelnet Enrollment Solutions ("NES")

In addition, 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, 2012, the Company had a $24.8 billion student loan portfolio that will amortize over the next approximately 20 years. The Company actively seeks to acquire FFELP loan portfolios to leverage its servicing scale and expertise to generate incremental earnings and cash flow.

The information below provides the operating results for each reportable operating segment for the years ended December 31, 2012, 2011, and 2010 (dollars in millions).

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(a) Total 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 an expense of $51.8 million, income of $7.6 million, and income of $3.0 million for the years ended December 31, 2012, 2011, and 2010, respectively. Net income excludes changes in fair values of derivatives and foreign currency transaction adjustments, net of tax, which was an expense of $32.1 million, income of $4.7 million, and income of $1.9 million for the years ended December 31, 2012, 2011, and 2010, respectively.

(b) Computed as income before income taxes, excluding restructuring and impairment charges, divided by total revenue.

A summary of the results and financial highlights for each reportable operating segment for the year ended December 31, 2012 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

An increase in government servicing revenue due to increased volume from the Department.

An increase in guaranty collection revenue due to an increase in defaulted loan volume.

An increase in software services revenue as a result of the Company beginning to provide hosted student loan servicing to a significant customer in October 2011.

An increase in operating expenses due to incurring additional costs related to the government servicing contract and the hosted servicing software product.

Achieved the first place ranking in the most recent annual survey results related to the servicing contract with the Department, which led to a larger allocation of loan volume to the Company for the fourth year of this contract (the period from August 15, 2012 through August 14, 2013). The Company is allocated 30 percent of new loan volume originated by the Department, up from 16 percent the prior two years.

Tuition Payment Processing and Campus Commerce

An increase in revenue as a result of an increase in the number of managed tuition payment plans and campus commerce customers.

A compression in margin due to an increase in amortization of intangible assets and continued investment in new products and services to meet customer needs and expand product and service offerings.

Enrollment Services

Continued decrease in inquiry generation and inquiry management (agency) revenue due to the effects from 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.

Recorded a charge of $2.8 million related to the impairment of student list costs.

Asset Generation and Management

The acquisition of $3.9 billion (par value) of FFELP student loans during 2012.

The loss of $936.4 million of FFELP student loans during 2012 as a result of the Department's special direct consolidation loan initiative, the student loan borrower application period for which expired June 30, 2012.

Continued recognition of significant fixed rate floor income due to historically low interest rates.

Liquidity and Capital Resources

As of December 31, 2012, the Company had $149.3 million of cash and investments.

For the year ended December 31, 2012, the Company generated $299.3 million in net cash provided by operating activities.

Forecasted future undiscounted cash flows from the Company's FFELP student loan portfolio remain strong and are estimated to be approximately $1.97 billion as of December 31, 2012.

On February 17, 2012, the Company entered into a new $250.0 million unsecured line of credit that has a maturity date of February 17, 2016. As of December 31, 2012, $195.0 million was available for borrowing under this line of credit.

The Company will continue to use its strong liquidity position to capitalize on market opportunities, including FFELP student loan acquisitions; strategic acquisitions and investments, including ongoing investments in its core business areas of asset management and finance, loan servicing, payment processing, and enrollment services (education planning); and capital management initiatives, including stock repurchases, debt repurchases, and dividend distributions.


Income Taxes

The Company's effective tax rate was 35.0 percent for the year ended December 31, 2012, compared to 36.5 percent in 2011. During 2012, state tax laws were enacted that reduced the Company's income tax expense by $3.4 million. The Company currently expects the effective tax rate in 2013 will be 36.0 percent to 38.0 percent.

CONSOLIDATED RESULTS OF OPERATIONS

The components of the Company's consolidated financial statements are summarized 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 four distinct operating segments. The Company's operating segments include:

Student Loan and Guaranty Servicing

Tuition Payment Processing and Campus Commerce

Enrollment Services

Asset Generation and Management

See Item 1, "Business - Overview" for further discussion on the components of each segment. In addition, the operating results of each of the Company's reportable operating segments, including a reconciliation of the segment operating results to the consolidated results of operations, are included in note 14 of the notes to the 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 segment basis. As further discussed in the notes to the consolidated financial statements, in 2012 the Company changed its operating segment income measurement from "base net income" to GAAP net income. Prior period segment operating results have been restated to conform to the current period presentation.

Consolidated Net Interest Income after Provision for Loan Losses (net of

settlements on derivatives)
                                                                    December 31, 2012 vs. 2011      December 31, 2011 vs. 2010
                                   Year ended December 31,              Increase(Decrease)              Increase(Decrease)
                                2012         2011        2010           $                %              $                %
Interest income:
Loan interest                $ 609,237     589,686     598,675       19,551           3.3  %         (8,989 )        (1.5 )%
Investment interest              4,616       3,168       5,256        1,448          45.7            (2,088 )       (39.7 )
Total interest income          613,853     592,854     603,931       20,999           3.5           (11,077 )        (1.8 )
Interest expense:
Interest on bonds and notes
payable                        268,566     228,289     232,860       40,277          17.6            (4,571 )        (2.0 )
Net interest income            345,287     364,565     371,071      (19,278 )        (5.3 )          (6,506 )        (1.8 )
Provision for loan losses       21,500      21,250      22,700          250           1.2            (1,450 )        (6.4 )
Net interest income after
provision for loan losses      323,787     343,315     348,371      (19,528 )        (5.7 )          (5,056 )        (1.5 )
Derivative settlements, net
(a)                            (14,022 )    (7,840 )   (14,264 )     (6,182 )       (78.9 )           6,424         (45.0 )
Net interest income after
provision for loan losses
(net of settlements on
derivatives)                 $ 309,765     335,475     334,107      (25,710 )        (7.7 )%          1,368           0.4  %

(a) The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. Management has structured the majority of the Company's derivative transactions with the intent that each is economically effective; however, the Company's derivative instruments do not qualify for hedge accounting. Derivative settlements for each applicable period should be evaluated with the Company's net interest income.


Net interest income after provision for loan losses, net of settlements on derivatives, includes the following items:

                                                                     December 31, 2012 vs. 2011      December 31, 2011 vs. 2010
                                   Year ended December 31,               Increase(Decrease)              Increase(Decrease)
                                2012         2011        2010           $                 %              $                %
Variable net interest
income, net of settlements
on derivatives (a)           $ 192,021     219,363     242,127      (27,342 )        (12.5 )%        (22,764 )        (9.4 )%
Fixed rate floor income, net
of settlements on
derivatives (b)                145,345     144,454     132,243          891            0.6            12,211           9.2
Investment interest (c)          4,616       3,168       5,256        1,448           45.7            (2,088 )       (39.7 )
Non-portfolio related
derivative settlements          (2,232 )      (611 )      (928 )     (1,621 )       (265.3 )             317          34.2
Corporate debt interest
expense (d)                     (8,485 )    (9,649 )   (21,891 )      1,164           12.1            12,242          55.9
Provision for loan losses
(e)                            (21,500 )   (21,250 )   (22,700 )       (250 )         (1.2 )           1,450           6.4
Net interest income after
provision for loan losses
(net of settlements on
derivatives)                 $ 309,765     335,475     334,107      (25,710 )         (7.7 )%          1,368           0.4  %

(a) The Company generates a significant portion of its earnings from the spread, referred to as its student loan spread, between the yield the Company receives on its student loan portfolio and the cost of funding these loans. 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 important to its operations. The current and future interest rate environment can and will affect the Company's net interest income. The effects of changing interest rate environments are further outlined in Item 7A, "Quantitative and Qualitative Disclosures about Market Risk - Interest Rate Risk."

Variable student loan spread is also impacted by the amortization/accretion of loan premiums and discounts, including capitalized costs of origination, the 1.05% per year consolidation loan rebate fee paid to the Department, and yield adjustments from borrower benefit programs. See "Asset Generation and Management Operating Segment - Results of Operations" in this Item 7 below for additional information.

(b) The Company has a portfolio of student loans that are earning interest at a fixed borrower rate which exceeds the statutorily defined variable lender rate, generating fixed rate floor income. See Item 7A, "Quantitative and Qualitative Disclosures about Market Risk - Interest Rate Risk" for additional information.

(c) Investment interest income includes income from unrestricted interest-earning deposits and investments and funds in the Company's special purpose entities which are utilized for its asset-backed securitizations. Investment interest increased in 2012 compared to 2011 due to an increase in the average investment balance, and decreased in 2011 compared to 2010 due to lower interest rates and a decrease in average cash held.

(d) Corporate debt interest expense includes interest expense incurred on the Company's 5.125% Senior Notes, which matured in 2010 (the "Senior Notes"), Junior Subordinated Hybrid Securities, and its unsecured and secured lines of credit. The decrease in corporate debt interest expense is due to the Company using cash generated by operations and proceeds from securitization transactions to pay down corporate debt. The average outstanding corporate debt during 2010, 2011, and 2012 was approximately $881.8 million, $249.5 million, and $183.5 million, respectively.

(e) The provision for loan losses represents the periodic expense of maintaining an allowance sufficient to absorb losses inherent in the Company's portfolio of loans. See "Asset Generation and Management Operating Segment - Summary and Comparison of Operating Results" in this Item 7 below for additional information.


Consolidated Other Income

The Company also earns fees and generates revenue from other sources as
summarized below.
                                                                     December 31, 2012 vs. 2011       December 31, 2011 vs. 2010
                                   Year ended December 31,               Increase(Decrease)               Increase(Decrease)
                                2012         2011        2010            $                %               $                %
Loan and guaranty servicing
revenue (a)                  $ 209,748     175,657     158,584       34,091           19.4  %         17,073           10.8  %
Tuition payment processing
and campus commerce revenue
(b)                             74,410      67,797      59,824        6,613            9.8             7,973           13.3
Enrollment services revenue
(c)                            117,925     130,470     139,897      (12,545 )         (9.6 )          (9,427 )         (6.7 )
Other income (d)                39,476      29,513      31,310        9,963           33.8            (1,797 )         (5.7 )
Gain on sale of loans and
debt repurchases (e)             4,139       8,340      78,631       (4,201 )        (50.4 )         (70,291 )        (89.4 )
Derivative market value and
foreign currency adjustments
(f)                            (47,394 )   (17,807 )     3,587      (29,587 )       (166.2 )         (21,394 )       (596.4 )
Derivative settlements, net
(g)                            (14,022 )    (7,840 )   (14,264 )     (6,182 )        (78.9 )           6,424           45.0

Total other income $ 384,282 386,130 457,569 (1,848 ) (0.5 )% (71,439 ) (15.6 )%

(a) Student loan and guaranty servicing revenue consists of revenue generated by the Student Loan and Guaranty Servicing operating segment. See "Student Loan and Guaranty Servicing Operating Segment - Results of Operations" in this Item 7 below for additional information.

(b) Tuition payment processing and campus commerce revenue consists of revenue generated by the Company's Tuition Payment Processing and Campus Commerce operating segment. See "Tuition Payment Processing and Campus Commerce - Results of Operations" in this Item 7 below for additional information.

(c) Enrollment services revenue consists of revenue generated by the Company's Enrollment Services operating segment. See "Enrollment Services Operating Segment - Results of Operations" in this Item 7 below for additional information.

(d) The following table summarizes the components of "other income."

                                                       Year ended December 31,
                                                2012             2011            2010
Borrower late fee income (1)               $      13,876          12,647          12,390
Investment advisory fees (2)                       8,727           5,062               -
Investments - realized and unrealized
gains/(losses), net                                7,511           3,183           1,103
529 Plan administration fees                       1,741           2,275           5,744
Other                                              7,621           6,346          12,073
Other income                               $      39,476          29,513          31,310

(1) Borrower late fee income is earned by the education lending subsidiaries (in the Asset Generation and Management operating segment) and is recognized when payments are collected from the borrower.

(2) During 2011, the Company began to provide 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, 2012 and December 31, 2011, the outstanding balance of investments subject to these arrangements was $669.3 million and $394.2 million, respectively.


(e) The Company periodically engages in selling loans and repurchasing its debt. Depending on market conditions, the Company generally realizes gains on such transactions. "Gain on sale of loans and debt repurchases" includes the following:

                           Year ended December 31, 2012              Year ended December 31, 2011            Year ended December 31, 2010
                                          Purchase                 Notional      Purchase                                  Purchase
                     Notional amount       price        Gain        amount        price       Gain     Notional amount      price        Gain
Gains on debt
repurchases:
Junior Subordinated
Hybrid Securities   $      1,465            1,140         325        62,558       55,651     6,907        34,995            30,073      4,922
Asset-backed
securities               134,667          130,969       3,698        12,254       12,199        55       690,750           650,789     39,961
                    $    136,132          132,109       4,023        74,812       67,850     6,962       725,745           680,862     44,883
Gain on sale of
loans                                                     116                                1,378                                     33,748
Gain on sale of
loans and debt
repurchases                                           $ 4,139                                8,340                                     78,631

(f) The change in "derivative market value and foreign currency adjustments" is the result of the change in the fair value of the Company's derivative portfolio and transaction gains/losses resulting from the re-measurement of the Company's Euro-denominated bonds to U.S. dollars. These changes are summarized below. Valuations of derivative instruments vary based upon many factors, including changes in interest rates, credit risk, foreign currency fluctuations, and other market factors. As a result, net gains and losses on derivatives and hedging activities may vary significantly from period to period.

                                                       Year ended December 31,
                                                 2012            2011           2010
Change in fair value of derivatives - income
(expense)                                    $   (27,833 )      (50,513 )      (77,134 )
Foreign currency transaction adjustment -
income (expense)                                 (19,561 )       32,706         80,721
Derivative market value and foreign currency
adjustments - income (expense)               $   (47,394 )      (17,807 )        3,587

(g) As discussed in footnote (a) to the "Consolidated Net Interest Income after Provision for Loan Losses (net of settlements on derivatives)" table above, derivative settlements should be evaluated with the Company's net interest income.

Consolidated Operating Expenses

Operating expenses includes indirect costs incurred to acquire student loans; costs incurred to manage and administer the Company's student loan portfolio and its financing transactions; costs incurred to service the Company's student loan portfolio and the portfolios of third parties; collection costs related to rehabilitation revenue; the cost to provide enrollment services; costs incurred to provide tuition payment processing and campus commerce products and services to third parties; the depreciation and amortization of capital assets and intangible assets; investments in products, services, and technology to meet customer needs and support continued revenue growth; and other general and administrative expenses. Operating expenses also includes impairment charges related to the impairment of goodwill and certain intangible assets. Operating expenses in 2010 includes employee termination benefits and lease termination costs related to restructuring activities and a litigation settlement charge.


As shown below, operating expenses, excluding direct costs to provide enrollment . . .

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