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Nelnet Inc. (NYSE:NNI)

Q3 2008 Earnings Call

November 12, 2008 3:00 pm ET

Executives

Phil Morgan – Investor Relations

Michael S. Dunlap – Chairman of the Board, Chief Executive Officer

Jeffrey R. Noordhoek – President

Jim Krueger – Controller

Analysts

Sameer Gokhale – Keefe, Bruyette & Woods

Matt Snowling – Friedman, Billings, Ramsey Capital Markets

Moshe Orenbuch – Credit Suisse

Operator

Welcome to Nelnet's third quarter 2008 conference call. Today's call is being recorded and broadcast live over the Internet. At this time for opening remarks and introductions I would like to turn the conference over to Mr. Phil Morgan.

Phil Morgan

Good afternoon and welcome to Nelnet's 2008 third quarter earnings conference call. On today's call Jeff Noordhoek, President, and Jim Krueger, Controller, will be making formal remarks, and Mike Dunlap, Chief Executive Officer, will be joining us for the question and answer session.

Please note that during the conference call we may discuss predictions and expectations and may make other forward-looking statements. Actual results may differ from those discussed here based on a variety of factors. These factors are discussed in the company's Form 10-K 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 the call we will refer to a non-GAAP financial measure which the company defines as base net income. A description of base net income and a reconciliation of GAAP net income to base net income is included in our third quarter 2008 supplemental earnings disclosure which is posted at our investor relations website at www.nelnetinvestors.com. After Jeff and Jim have concluded their formal remarks we will open up the call for questions.

Thank you and now I'll turn the call over to Jeff.

Jeffrey Noordhoek

As Phil mentioned joining me on the call is Jim Krueger our Controller. Jim is filling in for Terry Heimes who recently had surgery for a knee injury making him unavailable to join us on the call.

One of the things we worked on over the years is developing a strong bench in our associate base. As most of you know Jim works alongside Terry in the preparation and analysis of the financial statements. In short, we are quite pleased with our results for the third quarter. While operating in an unprecedented period of market disruption, our performance this year demonstrates the strong fundamentals of our company including our diversification into fee-based businesses which have significant growth opportunities and operating margins.

On today's call we plan to discuss three items that have impacted the operating results of the company. Strong revenue generated from our fee-based businesses and better than expected student loan spread, lower operating expenses, and an update on our liquidity. Before I discuss our liquidity, Jim will address our operating results.

Jim Krueger

As Jeff indicated we reported very strong earnings for the third quarter. Our earnings performance was driven by increased revenue from our fee-based businesses, better than anticipated core student loan spread and reduced operating expenses.

Let's start by reviewing the high level financial results. Our GAAP net income for the quarter was $0.48 per share. Our base net income was $0.47 per share for the third quarter compared to $0.54 in the second quarter and $0.45 per share last year. We continue to be pleased with our revenue growth and significant operating margins from our fee-based businesses.

During the third quarter our total fee-based revenues was $76.7 million, an increase of $4.6 million from last year. Our enrollment services, tuition payment and campus commerce businesses continue to perform well. Total revenue for these businesses was $39.4 million, an increase of 27% from last year. It is important to remember these businesses are not related to the federal student loan program and therefore have little legislative risk.

Not only do we continue to focus on growing our fee-based revenues, but also in making sure we allocate appropriate corporate overhead to our various business units for improved transparency and analysis. Operating margins for our fee-based businesses for the third quarter remain healthy at 20%, and excluding the allocation of corporate overhead, the margin was 28%. We continue to focus on decreasing the operating costs related to corporate activities.

Core student loan spread remained strong at 102 basis points for the quarter compared with 107 basis points during the second quarter. The compression in spread was due to a reduction and fixed rate for income and the full impact of ABS transactions completed during the second quarter. Spread benefited in the third quarter due to the relationship between CP and LIBOR indices. We would expect the core student loan spread to remain relatively stable in the 90 to 100 basis point range in the fourth quarter and in the first quarter of 2009.

In October we did see an unprecedented diversion in the CP LIBOR spread when the world's major banks ceased lending to each other. However, because of the timing and limited duration of this event it is not expected to have a significant impact on our fourth quarter results. However, our spread could be impacted if there was a prolonged spike or divergence in the CP LIBOR indices. Operating expenses for the quarter decreased more than $15 million or 13% compared to last year, and $56 million or 16% year-to-date.

The decreases would have been greater but operating expenses for the third quarter included $2.8 million of severance and retention costs related to strategic operating decisions. There will be continued focus on operating efficiency throughout the enterprise with particular attention on information technology, operating systems and loan origination and servicing platforms.

Those are the highlights of our earnings for the quarter. I will now turn the call over to Jeff to address our liquidity.

Jeffrey Noordhoek

Our short-term liquidity is primarily affected by two items, new loan originations and the mark-to-market provision included in our $2.1 billion FFELP warehouse facility. We have originated more than $400 million of federal student loans this quarter. All new loan originations are being funded through the government's participation facility.

In addition, we are encouraged that Congress extended Ensuring Continued Access to Student Loans Act for a second academic year. In the spirit of this legislation, we are committed to making federal loans for all students attending all eligible schools through the 2009-2010 academic year. The main pressure that we are receiving on our liquidity is coming from the mark-to-market formula used to value the loans included in our FFELP warehouse facility.

This has resulted in a significant equity contribution to support the federally guaranteed loans in this facility. This mark-to-market evaluation formula is mostly driven by current spreads in the a-backed securities market. As you know, ABS spreads have continued to widen as these securities are liquidated in an unprecedented manner.

Without an active market for these securities, we believe the mark-to-market formula is broken and unreasonable. As of today, the mark-to-market formula has required us to post $375 million as equity funding support including $165 million in October. This level of equity support applies a value on the loans of approximately $0.83 on the dollar. This seems irrational given these loans are guaranteed by the federal government, are available rate assets and can be pledged by the banks to the federal reserve at a 90% advance rate.

Another example of the irrational amount of equity support to these assets is the fact there are thousands of banks in America that could own these loans on their balance sheet and earn a return on equity in excess of 25%. We have utilized our $750 million unsecured line of credit to fund the equity advances and have $51 million available for future use on this facility. In addition, as of last week we had over $100 million in cash, approximately $90 million of unencumbered private loan assets, and approximately $80 million of our own unencumbered subordinated bonds.

To reduce our exposure from the mark-to-market advance rate provisions included in our warehouse facility, we have signed a letter of agreement engaging Bank of America Securities to arrange an amendment of certain of our credit facilities, including but not limited to an amendment to place a floor on evaluation of collateral in our FFELP warehouse conduit for which Bank of America acts as administrative agent.

Bank of America Securities has commenced amendment process and together with us is seeking the approval of our lenders of a proposed amendment of such credit facilities on mutually agreeable terms. In addition, the Department of Education has announced a new funding facility for government guaranteed student loans awarded after October 1, 2003. We believe approximately $900 million of loans in our warehouse will be eligible for this program.

We are also encouraged by Secretary Paulson's remarks today in which he said "with the Federal Reserve we are exploring development, the potential liquidity facility for highly rated AAA Asset-Backed Securities. We are looking at ways to possibly use the TARP to encourage private investors to come back to this troubled market by providing them access to federal financing while protecting the taxpayer's investment. Addressing the needs of the securitization sector will help get lending going again, helping consumers and supporting the U.S. economy."

He also indicated the goal for the program has increased the supply of consumer credit including student loans. We believe this type of program would reduce ABS spreads and improve the mark-to-market valuation in our warehouse facility.

Finally, we continue to look at various alternatives to remove loans from the warehouse including other financing arrangement and/or selling loans. We are encouraged by these recent events and announcement and believe they have the potential to alleviate the liquidity pressure the company is facing related to the mark-to-market provisions in our FFELP warehouse facility.

With that I would like to now open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Sameer Gokhale – KBW.

Sameer Gokhale – Keefe, Bruyette & Woods

I guess my first question is it would be helpful to get a sense for what kind of discussions you've been having with B of A or the other lenders in your warehouse facility. Clearly you've pointed out the low credit risk associated with these loans and it doesn't seem rational for these loans to be valued at $0.83 on the dollar. Have you put it point blank to the lender saying you've gotten TARP funding from the federal government? If you're not going to lend against these loans what other loans are you going to lend against. It would be helpful to get a sense for how those discussions are going and what pushback you might be getting from your warehouse lenders.

Jeffrey Noordhoek

Sure, it's Jeff. We have engaged Bank of America and we have addressed all the issues around what we believe is the irrationality on the mark. I would tell you that in general almost all the banks agree that it is irrational in the given market. So, we are in the process of negotiating with them as a whole to alleviate that. We'll give you a further update as we go through the process but right now we're right in the middle of it.

Sameer Gokhale – Keefe, Bruyette & Woods

The other question I had was Moody's recently downgraded your debt because of concerns over liquidity. Now, if and when the DOE's plan to fund older loans is finalized and that would free up say one-third of the cash and equity trapped in your warehouse for the support you are providing, would that result in an upgrade of your debt or how will the rating agencies perceive that? Have you had those discussions with them?

Jeffrey Noordhoek

Well, to start obviously we disagree with the Moody's ratings action. That said, you are correct with the government program. There would be a significant reduction in the warehouse line and a significant freeing of capital, and so we are and will be continuing to make those same arguments to the rating agencies. I can't tell you how it's going to turn out but we obviously believe strongly in those arguments that you just laid out.

Sameer Gokhale – Keefe, Bruyette & Woods

I just had one last question, which was on a different topic. Looking at your lender partner originations I think they were up year-over-year. And if I recall correctly there was some timing issue between Q2 and Q3, but it would seem, at least when we are hearing that other banks are less interested in making FFELP loans, so should we be expecting to see the lender partner originations decrease over time or how should we think about that?

Jeffrey Noordhoek

We see our primary originations in the future coming through our own channel. We have seen decreases in the lender partner's channel. That said, we saw some timing differences where we accelerated some purchases in the last quarter and that's how we see it in a go forward basis.

Operator

Your next call comes from Matt Snowling – FBR Capital Markets.

Matt Snowling – Friedman, Billings, Ramsey Capital Markets

Just maybe a follow-up on the last question; with the announcement of the TARP in the new conduit shouldn't that return the market to a more rational pricing level in terms of the mark-to-markets?

Jeffrey Noordhoek

The short answer is we absolutely believe it should. We have to wait to see that happen in the market but we believe it should.

Matt Snowling – Friedman, Billings, Ramsey Capital Markets

I know it's a little irrational out there but if they're buying loans through the conduit at somewhere around par one would believe that would return the market almost immediately, right?

Jeffrey Noordhoek

We will wait and see but we are very hopeful.

Matt Snowling – Friedman, Billings, Ramsey Capital Markets

Can you give us any specifics in terms of the announced conduit in terms of will they be buying loans at par or, probably more importantly, do you have any sense as to what level that conduit could issue commercial paper at?

Jeffrey Noordhoek

Generally, let me give you an update on where that is. So, the government has announced that it'll provide liquidity support to the conduit. It has essentially delegated the creation of that conduit over to the student loan industry, which is great news because obviously ourselves and our competitors are highly motivated to get that up and running and in place in a workable manner. So, we expect something near a 100% or par advanced rate. We don't know what the exact number is; they haven't released it yet, but we expect something close to par.

Matt Snowling – Friedman, Billings, Ramsey Capital Markets

Will there be a fee paid to the government to sponsor the conduit?

Jeffrey Noordhoek

We have not seen any details on that yet, if there is going to be a fee.

Operator

Your next call comes from Moshe Orenbuch – Credit Suisse.

Moshe Orenbuch – Credit Suisse

Jeff, I'm just wondering if you could look out a little while, think about what's the prospect post these government programs. How does the FFELP program look whenever the government decides to end this or do you think that they kind of sustain this over the intermediate term beyond the 2009 year?

Jeffrey Noordhoek

It's a great question. Let me tell you how we see it which is right now we've got funding for new loan originations to the '09-'10 season that's been passed through Congress and has been approved by the Department of Education on what they're going to do. That handles all new loan originations.

We also have this funding facility that's coming up in place to handle all the Stafford and PLUS loans that had been originated since 2003 that are trapped out there. So that's great news in creating liquidity. So, ultimately what does that mean? What we believe is those two programs operating makes sense in today's environment in the sense that the FFELP industry is providing $50 billion plus annually of new loans to the student market and so it's highly needed.

I would also tell you as it relates to all of this that throughout time in the FFELP program, so over the last 30 plus years, the industry has always had a government backstop in place in case the capital market's disrupted. Up until recent times that backstop was Sallie Mae which was a GSC; that GSC then funded [borrowers] from the financing bank to fund the rest of the industry if there was a disruption and that had happened. Every time there's always a backstop.

This is the first capital market disruption, or large capital market disruption we've seen since the GSC status went away. So, once again the government just had to step in to provide liquidity like it always has in this market since the beginning of the FFELP program. So, again to summarize, we expect the two programs to compete from everything we’re hearing on a go forward basis.

Moshe Orenbuch – Credit Suisse

Just to follow up on that, the interesting thing about that observation is that when that was happening Sallie Mae was funding cheaply and even more recently you and Sallie Mae were funding cheaply and so you were cost competitive with the direct program. As you kind of look out two years from now it will be harder to make that statement I guess, right?

Mike Dunlap

The other thing you need to take a look at is how much debt does the government want to put on their balance sheet and if there's a way to have a public private/partnership to keep some of that debt off the federal balance sheet, we think this is a great program that can do that. If you look at the number of loans that are being originated over the next 10 years it could be a trillion dollars of guaranteed student loans and if there's a way for that to not show up on the government's balance sheet we think that’s another real valuable argument. More so now than ever given all the other things that are going on to add to the federal deficit.

Operator

Gentleman, with no further questions in the queue I'd like to turn things back to Mr. Noordhoek for any additional or closing comments.

Jeffrey Noordhoek

In closing, it's important to remember the fundamentals of our business remain strong. Approximately 90% of our portfolio was financed to term for the life of the loan at rates which will create a significant and viable cash flow stream for the company of $1.4 billion. We have capital and liquidity for new loan originations through the government participation and 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 $56 million for the first nine months of the year.

We have developed a broad diversified offering of fee-based businesses with significant growth opportunities in operating margins and we have a strong capital base with which to create long-term value for our shareholders. We are encouraged by recent events and announcements that can improve our liquidity concerns relating to the mark-to-market provisions including our FFELP warehouse facility. Thank you all very much for your participation in the call this afternoon.

Operator

That does conclude today's' conference call.

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