UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________TO________ . COMMISSION FILE NUMBER 001-31924 NELNET, INC. (Exact name of registrant as specified in its charter) NEBRASKA 84-0748903 (State or other jurisdiction of incorporation (I.R.S. Employer or organization) Identification No.) 121 SOUTH 13TH STREET, SUITE 201 68508 LINCOLN, NEBRASKA (Zip Code) (Address of principal executive offices) (402) 458-2370 (Registrant's telephone number, including area code) 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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] As of July 31, 2005, there were 39,763,193 and 13,962,954 shares of Class A Common Stock and Class B Common Stock, par value $0.01 per share, outstanding, respectively.
NELNET, INC. FORM 10-Q INDEX JUNE 30, 2005 PART I. FINANCIAL INFORMATION Item 1. Financial Statements...........................................2 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operation..........................14 Item 3. Quantitative and Qualitative Disclosures about Market Risk....36 Item 4. Controls and Procedures.......................................40 PART II. OTHER INFORMATION Item 1. Legal Proceedings.............................................40 Item 4. Submission of Matters to a Vote of Security Holders...........41 Item 6. Exhibits......................................................41 SIGNATURES....................................................................42
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS <TABLE> <CAPTION> NELNET, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF AS OF JUNE 30, DECEMBER 31, 2005 2004 --------------- -------------- (UNAUDITED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) <S> <C> <C> ASSETS: Student loans receivable (net of allowance for loan losses of $10,689 and $7,272, respectively)............................... $ 15,661,315 13,461,814 Cash and cash equivalents: Cash and cash equivalents - not held at a related party........ 50,866 4,854 Cash and cash equivalents - held at a related party............ 40,461 35,135 -------------- ------------- Total cash and cash equivalents...................................... 91,327 39,989 Restricted cash...................................................... 837,198 732,066 Restricted investments............................................... 143,827 281,829 Restricted cash - due to customers................................... 37,757 249,070 Accrued interest receivable.......................................... 296,522 251,104 Accounts receivable, net............................................. 29,125 27,156 Goodwill............................................................. 65,839 8,522 Intangible assets, net............................................... 34,357 11,987 Furniture, equipment, and leasehold improvements, net................ 34,364 29,870 Other assets......................................................... 77,272 66,598 -------------- ------------- Total assets.................................................. $ 17,308,903 15,160,005 ============== ============== LIABILITIES: Bonds and notes payable............................................. $ 16,580,078 14,300,606 Accrued interest payable............................................ 75,162 48,578 Fair value of derivative instruments, net........................... 3,688 11,895 Other liabilities................................................... 88,548 93,681 Due to customers.................................................... 37,757 249,070 -------------- ------------- Total liabilities............................................. 16,785,233 14,703,830 -------------- ------------- SHAREHOLDERS' EQUITY: Preferred stock, $0.01 par value. Authorized 50,000,000 shares; no shares issued or outstanding............................... -- -- Common stock: Class A, $0.01 par value. Authorized 600,000,000 shares; issued and outstanding 39,763,193 shares as of June 30, 2005 and 39,687,037 shares as of December 31, 2004......................................... 398 397 Class B, $0.01 par value. Authorized 15,000,000 shares; issued and outstanding 13,962,954 shares as of June 30, 2005 and 13,983,454 shares as of December 31, 2004......................................... 140 140 Additional paid-in capital.......................................... 209,949 207,915 Retained earnings................................................... 313,378 247,064 Unearned compensation............................................... (53) (77) Accumulated other comprehensive income (loss), net of taxes......... (142) 736 -------------- ------------- Total shareholders' equity.................................... 523,670 456,175 -------------- ------------- COMMITMENTS AND CONTINGENCIES Total liabilities and shareholders' equity.................... $ 17,308,903 15,160,005 ============== ============= See accompanying notes to consolidated financial statements. </TABLE> 2
<TABLE> <CAPTION> NELNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- -------------------------- 2005 2004 2005 2004 ------------ ------------- ------------ ----------- (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) <S> <C> <C> <C> <C> INTEREST INCOME: Loan interest................................................. $ 207,144 224,399 391,469 313,126 Investment interest........................................... 8,150 3,181 15,152 6,832 ------------ ------------ ------------ ------------ Total interest income..................................... 215,294 227,580 406,621 319,958 INTEREST EXPENSE: Interest on bonds and notes payable........................... 133,277 52,352 237,802 101,395 ------------ ------------ ------------ ------------ Net interest income........................................ 82,017 175,228 168,819 218,563 Less provision (recovery) for loan losses......................... 2,124 (6,421) 4,155 (3,306) ------------ ------------ ------------ ------------ Net interest income after provision (recovery) for loan losses............................................... 79,893 181,649 164,664 221,869 ------------ ------------ ------------ ------------ OTHER INCOME (EXPENSE): Loan and guarantee servicing income........................... 34,678 22,846 71,854 48,909 Other fee-based income........................................ 9,027 1,630 12,383 3,519 Software services income...................................... 2,602 1,780 4,808 3,672 Other income.................................................. 1,524 1,285 2,924 2,728 Derivative market value adjustment and net settlements........ (57,373) 1,357 (7,169) (2,384) ------------ ------------ ------------ ------------ Total other income (expense)............................... (9,542) 28,898 84,800 56,444 ------------ ------------ ------------ ------------ OPERATING EXPENSES: Salaries and benefits......................................... 39,977 49,036 79,304 76,805 Other operating expenses: Depreciation and amortization.............................. 4,918 4,677 9,384 9,085 Trustee and other debt related fees........................ 2,121 2,851 4,449 5,465 Occupancy and communications............................... 4,344 3,135 8,576 6,217 Advertising and marketing.................................. 4,610 2,961 7,748 5,284 Professional services...................................... 4,576 2,894 10,352 7,354 Postage and distribution................................... 5,079 3,220 9,385 7,068 Other...................................................... 8,254 7,422 16,069 12,130 ------------ ------------ ------------ ------------ Total other operating expenses........................... 33,902 27,160 65,963 52,603 ------------ ------------ ------------ ------------ Total operating expenses................................. 73,879 76,196 145,267 129,408 ------------ ------------ ------------ ------------ Income (loss) before income taxes........................ (3,528) 134,351 104,197 148,905 Income tax expense (benefit)...................................... (1,755) 49,098 37,883 54,531 ------------ ------------ ------------ ------------ Net income (loss)........................................ $ (1,773) 85,253 66,314 94,374 ============ ============ ============ ============ Earnings (loss) per share, basic and diluted............. $ (0.03) 1.59 1.23 1.76 ============ ============ ============ ============ Weighted average shares outstanding, basic and diluted... 53,712,048 53,647,697 53,697,390 53,641,664 ============ ============ ============ ============ See accompanying notes to consolidated financial statements. </TABLE> 3
<TABLE> <CAPTION> NELNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS) (unaudited) PREFERRED COMMON STOCK SHARES COMMON STOCK ADDITIONAL STOCK ---------------------- PREFERRED ----------------- PAID-IN RETAINED UNEARNED SHARES CLASS A CLASS B STOCK CLASS A CLASS B CAPITAL EARNINGS COMPENSATION --------- ---------- ---------- --------- -------- -------- ---------- --------- ------------ (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> BALANCE AS OF MARCH 31, 2004........ -- 39,624,243 14,023,454 $ -- 396 140 207,359 107,006 -- Comprehensive income: Net income........... -- -- -- -- -- -- -- 85,253 -- Other comprehensive income, related to cash flow hedge, net of tax............. -- -- -- -- -- -- -- -- -- Total comprehensive income.... ------- ----------- ----------- -------- ------- ------ --------- -------- --------- BALANCE AS OF JUNE 30, 2004............ -- 39,624,243 14,023,454 $ -- 396 140 207,359 192,259 -- ======= =========== =========== ======== ======= ====== ========= ======== --------- BALANCE AS OF MARCH 31, 2005.......... -- 39,727,864 13,983,454 $ -- 397 140 209,259 315,151 (64) Comprehensive income: Net loss............ -- -- -- -- -- -- -- (1,773) -- Other comprehensive loss: Cash flow hedge, net of tax........ -- -- -- -- -- -- -- -- -- Foreign currency translation....... -- -- -- -- -- -- -- -- -- Total comprehensive loss.............. Issuance of common stock.................. -- 14,829 -- -- 1 -- 690 -- 11 Conversion of common stock.................. -- 20,500 (20,500) -- -- -- -- -- -- ------- ----------- ----------- -------- ------- ------ --------- -------- --------- BALANCE AS OF JUNE 30, 2005........... -- 39,763,193 13,962,954 $ -- 398 140 209,949 313,378 (53) ======= =========== =========== ======== ======= ====== ========= ======== ========= BALANCE AS OF DECEMBER 31, 2003...... -- 39,601,834 14,023,454 $ -- 396 140 206,831 97,885 -- Comprehensive income: Net income......... -- -- -- -- -- -- -- 94,374 -- Other comprehensive income, related to cash flow hedge, net of tax........... -- -- -- -- -- -- -- -- -- Total comprehensive income........... Issuance of common stock................. -- 22,409 -- -- -- -- 528 -- -- ------- ----------- ----------- -------- ------- ------ --------- -------- --------- BALANCE AS OF JUNE 30, 2004.......... -- 39,624,243 14,023,454 $ -- 396 140 207,359 192,259 -- ======= =========== =========== ======== ======= ====== ========= ======== ========= BALANCE AS OF DECEMBER 31, 2004...... -- 39,687,037 13,983,454 $ -- 397 140 207,915 247,064 (77) Comprehensive income: Net income......... -- -- -- -- -- -- -- 66,314 -- Other comprehensive income: Cash flow hedge, net of tax....... -- -- -- -- -- -- -- -- -- Foreign currency translation...... -- -- -- -- -- -- -- -- -- Total comprehensive income........... Issuance of common stock................. -- 55,656 -- -- 1 -- 2,034 -- 24 Conversion of common stock................. -- 20,500 (20,500) -- -- -- -- -- -- ------- ----------- ----------- --------- -------- ----- ---------- -------- --------- BALANCE AS OF JUNE 30, 2005.......... -- 39,763,193 13,962,954 $ -- 398 140 209,949 313,378 (53) ======= =========== =========== ========= ======== ===== ========== ======== ========= CONTINUED ACCUMULATED OTHER TOTAL COMPREHENSIVE SHAREHOLDERS' INCOME (LOSS) EQUITY --------------- ------------- BALANCE AS OF MARCH 31, 2004........ (264) 314,637 Comprehensive income: Net income........... -- 85,253 Other comprehensive income, related to cash flow hedge, net of tax............. 1,092 1,092 ---------- Total comprehensive income.... 86,345 ----------- ---------- BALANCE AS OF JUNE 30, 2004............ 828 400,982 ----------- ---------- BALANCE AS OF MARCH 31, 2005.......... 428 525,311 Comprehensive income: Net loss............ -- (1,773) Other comprehensive loss: Cash flow hedge, net of tax........ (335) (335) Foreign currency translation....... (235) (235) ----------- Total comprehensive loss.............. (2,343) Issuance of common stock.................. -- 702 Conversion of common stock.................. -- -- ----------- ----------- BALANCE AS OF JUNE 30, 2005........... (142) 523,670 =========== =========== BALANCE AS OF DECEMBER 31, 2003...... 237 305,489 Comprehensive income: Net income......... -- 94,374 Other comprehensive income, related to cash flow hedge, net of tax........... 591 591 ----------- Total comprehensive income........... 94,965 Issuance of common stock................. -- 528 ---------- ----------- BALANCE AS OF JUNE 30, 2004.......... 828 400,982 ========== =========== BALANCE AS OF DECEMBER 31, 2004...... 736 456,175 Comprehensive income: Net income......... -- 66,314 Other comprehensive income: Cash flow hedge, net of tax....... (440) (440) Foreign currency translation...... (438) (438) ----------- Total comprehensive income........... 65,436 Issuance of common stock................. -- 2,059 Conversion of common stock................. -- -- ---------- ----------- BALANCE AS OF JUNE 30, 2005.......... (142) 523,670 ========== =========== See accompanying notes to consolidated financial statements. </TABLE> 4
<TABLE> <CAPTION> NELNET, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) SIX MONTHS ENDED JUNE 30, ---------------------------- 2005 2004 ------------ ------------- (DOLLARS IN THOUSANDS) <S> <C> <C> Net income................................................$ 66,314 94,374 Adjustments to reconcile net income to net cash provided by operating activities, net of business acquisitions: Depreciation and amortization, including loan premiums and deferred origination costs.................................. 45,380 47,033 Derivative market value adjustment.................. (8,918) (548) Ineffectiveness of cash flow hedge.................. 12 30 Non-cash compensation expense....................... 1,567 528 Income from equity method investments............... (263) (524) Deferred income tax expense......................... 6,751 7,441 Provision (recovery) for loan losses................ 4,155 (3,306) Increase in accrued interest receivable............. (45,418) (31,461) (Increase) decrease in accounts receivable.......... (953) 3,796 Decrease in other assets............................ 1,993 7,641 Increase in accrued interest payable................ 26,584 4,509 (Decrease) increase in other liabilities............ (24,308) 72,721 ----------- ----------- Net cash provided by operating activities..... 72,896 202,234 ----------- ----------- Cash flows from investing activities, net of business acquisitions: Originations, purchases, and consolidations of student loans, including loan premiums and deferred origination costs........(2,024,666) (2,405,463) Purchases of student loans, including loan premiums, from a related party...................... (938,768) (360,633) Net proceeds from student loan principal payments... 727,449 1,137,987 Net purchases of furniture, equipment, and leasehold improvements.............................. (10,314) (8,421) Decrease (increase) in restricted cash.............. (105,132) 203,681 Purchases of restricted investments................. (434,826) (415,380) Proceeds from maturities of restricted investments.. 572,828 301,489 Purchase of equity method investments............... -- (10,110) Purchase of loan origination rights................. (260) (7,898) Business acquisitions, net of cash acquired......... (76,984) (10,829) ----------- ----------- Net cash used in investing activities........(2,290,673) (1,575,577) ----------- ----------- Cash flows from financing activities: Payments on bonds and notes payable.................(1,412,830) (953,134) Proceeds from issuance of bonds and notes payable....3,692,295 2,195,562 Payments of debt issuance costs..................... (10,880) (6,075) Proceeds from issuance of common stock.............. 492 -- ----------- ----------- Net cash provided by financing activities..... 2,269,077 1,236,353 ----------- ----------- Effect of exchange rate fluctuations on cash.............. 38 -- Net increase (decrease) in cash and cash equivalents.............................. 51,338 (136,990) Cash and cash equivalents, beginning of period............ 39,989 198,423 ----------- ----------- Cash and cash equivalents, end of period..................$ 91,327 61,433 =========== =========== Supplemental disclosures of cash flow information: Interest paid.......................................$ 205,078 90,800 =========== =========== Income taxes paid, net of refunds...................$ 35,478 1,506 =========== =========== See accompanying notes to consolidated financial statements. </TABLE> 5
NELNET, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (INFORMATION AS OF JUNE 30, 2005 AND FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2005 AND 2004 IS UNAUDITED) 1. BASIS OF FINANCIAL REPORTING The accompanying unaudited consolidated financial statements of Nelnet, Inc. and subsidiaries (the "Company") as of June 30, 2005 and for the three and six months ended June 30, 2005 and 2004 have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2004 and, in the opinion of the Company's management, the unaudited consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of results of operations for the interim periods presented. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Operating results for the three and six months ended June 30, 2005 are not necessarily indicative of the results for the year ending December 31, 2005. The unaudited consolidated financial statements should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2004. Certain amounts from 2004 have been reclassified to conform to the current period presentation. 2. STUDENT LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES Student loans receivable as of June 30, 2005 and December 31, 2004 consisted of the following: <TABLE> <CAPTION> AS OF AS OF JUNE 30, DECEMBER 31, 2005 2004 ------------ ------------ (DOLLARS IN THOUSANDS) <S> <C> <C> Federally insured loans....................................$ 15,371,984 13,208,689 Non-federally insured loans................................ 97,705 90,405 ------------- ------------ 15,469,689 13,299,094 Unamortized loan premiums and deferred origination costs... 202,315 169,992 Allowance for loan losses - federally insured loans........ (99) (117) Allowance for loan losses - non-federally insured loans.... (10,590) (7,155) ------------- ------------ $ 15,661,315 13,461,814 ============= ============ Federally insured allowance as a percentage of ending balance of federally insured loans........................ 0.00% 0.00% Non-federally insured allowance as a percentage of ending balance of non-federally insured loans............. 10.84% 7.91% Total allowance as a percentage of ending balance of total loans............................................ 0.07% 0.05% </TABLE> A portion of the Company's Federal Family Education Loan Program ("FFELP" or "FFEL Program") loan portfolio is comprised of loans financed prior to September 30, 2004 with tax-exempt obligations issued prior to October 1, 1993. Based upon provisions of the Higher Education Act of 1965, as amended (the "Higher Education Act"), and related interpretations by the U.S. Department of Education (the "Department"), the Company is entitled to receive special allowance payments on these loans equal to a 9.5% minimum rate of return. In May 2003, the Company sought confirmation from the Department regarding the treatment and recognition of special allowance payments as income based on the 9.5% minimum rate of return. Pending satisfactory resolution of this issue with the Department, the Company deferred recognition of the interest income that was generated by these loans in excess of income based upon the standard special allowance rate. In June 2004, after consideration of certain clarifying information received in connection with the guidance it had sought, including written and verbal communications with the Department, the Company concluded that the earnings process had been completed related to the special allowance payments on these loans and recognized $124.3 million of interest income. As of December 31, 2003 and March 31, 2004, the amount of deferred excess interest income on these loans was $42.9 million and $78.8 million, respectively. The allowance for loan losses represents management's estimate of probable losses on student loans. This evaluation process is subject to estimates and judgments. The Company evaluates the adequacy of the allowance for loan losses on its federally insured loan portfolio separately from its non-federally insured loan portfolio. 6
The allowance for the federally insured loan portfolio is based on periodic evaluations of the Company's loan portfolios considering 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 98% of the principal of and the interest on federally insured student loans, which limits the Company's loss exposure to 2% of the outstanding balance of the Company's federally insured portfolio. Effective June 1, 2004, the Company was designated as an Exceptional Performer by the Department in recognition of its exceptional level of performance in servicing FFELP loans. As a result of this designation, the Company received 100% reimbursement on all eligible FFELP default claims submitted for reimbursement during the 12-month period following the effective date of its designation. The Company was not subject to the 2% risk sharing on eligible claims submitted during this 12-month period. Only FFELP loans that are serviced by the Company, as well as loans owned by the Company and serviced by other service providers designated as Exceptional Performers by the Department, are eligible for the 100% reimbursement. In June 2005, the Company submitted its application for Exceptional Performer redesignation to the Department. The Department has 60 days to redesignate the Company as an Exceptional Performer or deny the Company's application. Until that time, the Company continues to receive the benefit of the Exceptional Performer designation. It is the opinion of the Company's management, based on information currently known, that there is no reason to believe the Company's application will be rejected. If the Department rejected the Company's application for Exceptional Performer status, the Company would have to establish a provision for loan losses related to the 2% risk sharing on those loans that the Company services internally. Based on the balance of federally insured loans outstanding as of June 30, 2005, this provision would be approximately $10.0 million. As of June 30, 2005, more than 99% of the Company's federally insured loans were serviced by providers designated as Exceptional Performers. Of this portion, the Company serviced approximately 92% and third parties serviced approximately 8%. The Company is entitled to receive the 100% reimbursement benefit as long as it and/or its service providers continue to meet the required servicing standards published by the Department. Compliance with such standards is assessed on a quarterly basis and service providers must apply for redesignation annually as discussed previously. If the Company or a third party servicer were to lose its Exceptional Performer designation, either by the Department discontinuing the program or the Company or third party servicer not meeting the required servicing standards, loans serviced by the Company or such third party would become subject to the 2% risk sharing for all claims submitted after loss of the designation. Pursuant to the terms of the Higher Education Act, the FFEL Program is periodically amended, and the Higher Education Act is generally reauthorized by Congress every five to six years in order to prevent sunset of that Act. The current provisions of the Higher Education Act are scheduled to expire on September 30, 2005. Historically, the United States Congress makes changes to the provisions of the Higher Education Act during the reauthorization process. One of the changes to the Higher Education Act that is included in the reauthorization proposal is changes to the guarantee rates and terms on FFELP loans, including proposals for a decrease in insurance and reinsurance on portfolios receiving the benefit of Exceptional Performance designation by up to 2%, from 100% to 98% of principal and accrued interest, and a decrease in insurance and reinsurance on portfolios not subject to the Exceptional Performance designation by up to 2%, from 98% to 96% of principal and accrued interest. If the insurance and reinsurance decrease during reauthorization, the Company would have to establish a provision for loan losses related to the new risk sharing amounts. This provision would be recognized by the Company upon the effective date of the new provisions of the Higher Education Act, which is estimated to be October 1, 2006. See Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Risks - Political/Regulatory Risk." In determining the adequacy of the allowance for loan losses on the non-federally insured loans, the Company considers several factors including: loans in repayment versus those in a nonpaying status, months in repayment, delinquency status, type of program, and trends in defaults in the portfolio based on Company and industry data. The Company places a non-federally insured loan on nonaccrual status and charges off the uninsured loan when the collection of principal and interest is 120 days past due. 3. RELATED PARTY TRANSACTION On February 4, 2005, the Company entered into an agreement to amend certain existing contracts with Union Bank and Trust Company ("UB&T"), an entity under common control with the Company. Under the agreement, UB&T committed to transfer to the Company substantially all of the remaining balance of UB&T's origination rights in guaranteed student loans to be originated in the future, except for student loans previously committed for sale to others. UB&T will continue to originate student loans, and such guaranteed student loans not previously committed for sale to others are to be sold by UB&T to the Company in the future. UB&T also granted to the Company exclusive rights as marketing agent for student loans on behalf of UB&T. As part of the agreement, UB&T also agreed to sell the Company a portfolio of guaranteed student loans. During the six months ended June 30, 2005, the Company completed the acquisition portion of this agreement by acquiring $630.8 million in loans from UB&T. The Company agreed to pay the outstanding principal and accrued interest with respect to the student loans purchased, together with a one-time payment to UB&T in the amount of $20.0 million. The Company allocated the consideration paid to UB&T to loan premiums except for $260,000, which was allocated to loan origination rights. 7
4. ACQUISITIONS On December 1, 2004, the Company purchased 100% of the capital stock of EDULINX Canada Corporation ("EDULINX") and its wholly owned subsidiary, Tricura Canada Inc., for $7.0 million. An additional payment of approximately $6.3 million is to be paid by the Company if EDULINX obtains an extension or renewal of a significant customer servicing contract that currently expires in February 2006. This contingency payment is due following the date on which such extension or renewal period of the servicing contract commences. The acquisition was accounted for under purchase accounting and the results of operations have been included in the consolidated financial statements from the date of acquisition. The Company is in the process of obtaining third-party valuations of certain intangible assets; thus, the allocation of the purchase price is subject to refinement. The preliminary allocation of the purchase price for EDULINX is shown below (dollars in thousands): Cash and cash equivalents........................... $ -- Accounts receivable................................. 11,273 Intangible assets................................... 5,419 Furniture, equipment, and leasehold improvements.... 5,464 Other assets........................................ 1,180 Excess cost over fair value of net assets acquired.. 1,958 Other liabilities................................... (18,247) ---------- Total purchase price $ 7,047 ========== Effective February 28, 2005, the Company purchased 100% of the capital stock of Student Marketing Group, Inc. ("SMG") and 100% of the membership interests of National Honor Roll, L.L.C. ("NHR"). The initial consideration paid by the Company was $27.0 million. SMG and NHR were entities owned under common control. SMG is a full service direct marketing agency providing a wide range of products and services to help businesses reach the middle school, high school, college bound high school, college, and young adult marketplace in a cost-effective manner. In addition, SMG provides marketing services and college bound student lists to college and university admissions offices nationwide. NHR recognizes middle and high school students for exceptional academic success by providing publication in the NATIONAL HONOR ROLL COMMEMORATIVE EDITION, scholarships, a College Admissions Notification Service, and notices to local newspapers and elected officials. In addition to the initial purchase price, additional payments are to be paid by the Company based on the operating results of SMG and NHR as defined in the purchase agreement. The contingent payments are payable in annual installments through April 2008 and in total will range from a minimum of $4.0 million to a maximum of $24.0 million. These acquisitions were accounted for under purchase accounting and the results of operations have been included in the consolidated financial statements from the effective date of the acquisitions. The Company is in the process of obtaining third-party valuations of certain intangible assets; thus, the allocation of the purchase price is subject to refinement. The preliminary allocation of the purchase price for SMG and NHR is shown below (dollars in thousands): Cash and cash equivalents..............................$ 157 Accounts receivable.................................... 1,212 Intangible assets...................................... 13,111 Furniture, equipment, and leasehold improvements....... 545 Other assets........................................... 5,355 Excess cost over fair value of net assets acquired..... 10,110 Other liabilities...................................... (3,490) ------------ Total purchase price $ 27,000 ============ Effective June 1, 2005, the Company purchased 80% of the capital stock of FACTS Management Co. and American Card Services, Inc. (collectively, "FACTS") for $56.0 million. FACTS Management Co. and American Card Services, Inc. were entities owned under common control. FACTS provides automated tuition payment solutions, online payment processing, detailed information reporting, and data integration services to educational institutions, families, and students. In addition, FACTS provides financial needs analysis for students applying for aid in private and parochial K-12 schools. Included in the FACTS purchase agreement is a "call" option that allows the Company to purchase the remaining 20% of the capital stock of FACTS at a price as determined in the agreement. The Company can exercise this option anytime after June 1, 2008. In addition, the minority shareholder has a "put" option that if exercised requires the Company to purchase the remaining 20% of the capital stock of FACTS at a price as determined in the agreement. The put option can be exercised at anytime during the period from June 1, 2007 through June 1, 2010. The acquisition of FACTS was accounted for under purchase accounting and the results of operations have been included in the consolidated financial statements from the effective date of the acquisition. 8
The Company is in the process of obtaining third-party valuations of certain intangible assets; thus, the allocation of the purchase price is subject to refinement. The preliminary allocation of the purchase price for FACTS is shown below (dollars in thousands): Cash and cash equivalents..............................$ 2,466 Restricted cash - due to customers..................... 11,034 Accounts receivable.................................... 55 Intangible assets...................................... 10,250 Furniture, equipment, and leasehold improvements....... 360 Other assets........................................... 24 Excess cost over fair value of net assets acquired..... 45,569 Due to customers....................................... (11,034) Other liabilities...................................... (2,679) Minority interests' ownership in net assets acquired... (45) ---------- Total purchase price $ 56,000 ========== Subsequent to June 30, 2005, the Company purchased 100% of the capital stock of Foresite Solutions, Inc. ("Foresite") for $750,000. Foresite develops complementary Web-based software applications that improve the administration of financial aid offices and work-study programs at colleges and universities. The Company will account for the acquisition of Foresite under purchase accounting and the results of operations will be included in the consolidated financial statements from the effective date of this acquisition, which was July 1, 2005. The following pro forma information presents the combined results of the Company as though the SMG, NHR, and FACTS acquisitions occurred as of the beginning of each reporting period. The pro forma information does not necessarily reflect the results of operations if the acquisitions had been in effect at the beginning of the period or that may be attained in the future. In addition, the pro forma information reflects the results of operations based on the Company's preliminary allocation of purchase price. <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- -------------------------- 2005 2004 2005 2004 ------------- ----------- ---------- -------------- (DOLLARS IN THOUSANDS, (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) EXCEPT SHARE DATA) <S> <C> <C> <C> <C> Net interest income...................................... $ 82,017 175,228 168,819 218,563 Other income (expense)................................... (5,223) 39,255 98,047 75,782 Net income (loss)........................................ (1,823) 85,871 67,917 96,671 Weighted average shares outstanding, basic and diluted... 53,712,048 53,647,697 53,697,390 53,641,664 Earnings (loss) per share, basic and diluted............. $ (0.03) 1.60 1.26 1.80 </TABLE> 5. INTANGIBLE ASSETS AND GOODWILL Intangible assets as of June 30, 2005 and December 31, 2004 consist of the following: <TABLE> <CAPTION> WEIGHTED AVERAGE AS OF AS OF USEFUL JUNE 30, DECEMBER 31, LIFE 2005 2004 -------------- ------------ ------------ <S> <C> <C> <C> Amortizable intangible assets: (DOLLARS IN THOUSANDS) Covenants not to compete (net of accumulated amortization of $227)... 61 months $ 10,436 -- Student lists (net of accumulated amortization of $683).............. 48 months 7,514 -- Loan origination rights (net of accumulated amortization of $826 and $395, respectively)............................................... 117 months 7,332 7,505 Customer relationships (net of accumulated amortization of $458 and $61, respectively)....................................... 84 months 5,888 3,716 Servicing system software (net of accumulated amortization of $7,120 and $6,137, respectively)..................................... 61 months 772 766 Trade name (net of accumulated amortization of $15).................. 84 months 161 -- ----------- ----------- ---------- Total - amortizable intangible assets......................... 75 months 32,103 11,987 =========== Unamortizable intangible assets - trade names........................... 2,254 -- ----------- ----------- $ 34,357 11,987 =========== =========== </TABLE> 9
The Company recorded amortization expense on its intangible assets of $1.6 million and $2.1 million for the three months ended June 30, 2005 and 2004, respectively, and $2.7 million and $4.2 million for the six months ended June 30, 2005 and 2004, respectively. The Company will continue to amortize intangible assets over their remaining useful lives and estimates it will record amortization expense as follows (dollars in thousands): 2005...................$ 3,318 2006................... 6,367 2007................... 5,860 2008................... 5,781 2009................... 4,066 2010 and thereafter... 6,711 -------- $32,103 ======== The change in the carrying amount of goodwill by segment for the six months ended June 30, 2005 was as follows (dollars in thousands): <TABLE> <CAPTION> STUDENT LOAN PAYMENT ASSET AND GUARANTEE SERVICING DIRECT MANAGEMENT MANAGEMENT SERVICING SOFTWARE MARKETING SERVICES TOTAL ----------- ----------- ----------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Balance as of January 1, 2005.............. $ 5,971 -- 2,551 -- -- 8,522 Goodwill acquired during the period...... -- -- -- 10,110 -- 10,110 ----------- ----------- ----------- ---------- ---------- ---------- Balance as of March 31, 2005............... $ 5,971 -- 2,551 10,110 -- 18,632 Goodwill acquired during the period...... -- -- -- -- 45,569 45,569 Goodwill from prior period acquisition allocated during the current period...... -- 1,958 -- -- -- 1,958 Effect of foreign currency fluctuations. -- (320) -- -- -- (320) ----------- ----------- ----------- ---------- ---------- ---------- Balance as of June 30, 2005................ $ 5,971 1,638 2,551 10,110 45,569 65,839 =========== =========== =========== ========== ========== ========== </TABLE> 6. BONDS AND NOTES PAYABLE On February 16, 2005, April 19, 2005, and July 22, 2005, the Company consummated debt offerings of student loan asset-backed notes of $1.3 billion, $2.0 billion, and $1.3 billion, respectively, with final maturity dates ranging from 2011 through 2038. The notes issued in these transactions have variable interest rates based on a spread to LIBOR. On May 25, 2005, the Company consummated a debt offering consisting of $275.0 million in aggregate principal amount of Senior Notes due June 1, 2010 (the "Notes"). The Notes are unsecured obligations of the Company. Interest on the Notes is 5.125%, payable semiannually. At the Company's option, the Notes are redeemable in whole at any time or in part from time to time at the redemption price described in its prospectus supplement. 7. NONEMPLOYEE DIRECTORS COMPENSATION PLAN The Company has a compensation plan for nonemployee directors pursuant to which nonemployee directors can elect to receive their annual retainer fees in the form of cash or Class A common stock. If a nonemployee director elects to receive Class A common stock, the number of shares of Class A common stock that are awarded is equal to the amount of the annual retainer fee otherwise payable in cash divided by 85% of the fair market value of a share of Class A common stock on the date the fee is payable. Nonemployee directors who choose to receive Class A common stock may also elect to defer receipt of the Class A common stock until termination of their service on the board of directors. On June 27, 2005, the Company issued 8,222 shares of its Class A common stock under the plan. These shares were issued to directors that for 2005 elected to receive shares and did not defer receipt of the shares. In addition, there were directors that elected to receive shares and defer receipt of the shares. Included in the Company's weighted average shares outstanding is 6,727 shares that will be issued to these directors upon their termination from the board of directors. 8. DERIVATIVE FINANCIAL INSTRUMENTS The Company accounts for derivative instruments under Statement of Financial Accounting Standards ("SFAS") No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES ("SFAS No. 133"), which requires that every derivative instrument be recorded on the balance sheet as either an asset or liability measured at its fair value. Management has structured all of the Company's derivative transactions with the intent that each is economically effective; however, the majority do not qualify for hedge accounting under SFAS No. 133. 10
By using derivative instruments, the Company is exposed to credit and market risk. When the fair value of a derivative contract is positive, this generally indicates that the counterparty owes the Company. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain in a derivative. When the fair value of a derivative contract is negative, the Company owes the counterparty and, therefore, it has no credit risk. The Company minimizes the credit (or repayment) risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company's risk committee. The Company also maintains a policy of requiring that all derivative contracts be governed by an International Swaps and Derivatives Association, Inc. Master Agreement. Market risk is the adverse effect that a change in interest rates, or implied volatility rates, has on the value of a financial instrument. The Company manages market risk associated with interest rates by establishing and monitoring limits as to the types and degree of risk that may be undertaken. The following table summarizes the notional values and fair values of the Company's outstanding derivative instruments as of June 30, 2005: <TABLE> <CAPTION> WEIGHTED AVERAGE FIXED/ FIXED/ FIXED RATE ON FLOATING BASIC FLOATING FIXED/FLOATING MATURITY SWAPS SWAPS SWAPS TOTAL SWAPS - -------------------------- ----------- --------- -------- -------- -------------- (DOLLARS IN MILLIONS) <C> <C> <C> <C> <C> <C> 2005 $ 1,187 1,000 1,010 3,197 2.20 % 2006 613 500 -- 1,113 2.99 2007 512 -- -- 512 3.42 2008 463 -- -- 463 3.76 2009 312 -- -- 312 4.01 2010 and thereafter 1,938 -- -- 1,938 4.29 ----------- -------- ------- --------- ------------ Total $ 5,025 1,500 1,010 7,535 3.48 % =========== ======== ======= ========= ============ Fair value (in thousands) $ (1,897) (971) (820) (3,688) =========== ======== ======= ========= </TABLE> The following is a summary of the amounts included in derivative market value adjustment and net settlements on the consolidated statements of operations: <TABLE> <CAPTION> THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ------------------------ ------------------------ 2005 2004 2005 2004 ----------- ----------- ----------- ----------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Change in fair value of derivative instruments $ (51,372) 3,075 8,918 548 Settlements, net (6,001) (1,718) (16,087) (2,932) ----------- ---------- ---------- --------- Derivative market value adjustment and net settlements $ (57,373) 1,357 (7,169) (2,384) =========== ========== ========== ========= </TABLE> 9. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The Company's components of accumulated other comprehensive income (loss) at each balance sheet date follow: FOREIGN ACCUMULATED CURRENCY OTHER TRANSACTION CASH FLOW COMPREHENSIVE ADJUSTMENT HEDGE INCOME (LOSS) ------------ ------------- -------------- (DOLLARS IN THOUSANDS) Balance as of December 31, 2004 $ -- 736 736 Current period activity (438) (440) (878) ----------- ----------- ------------ Balance as of June 30, 2005 $ (438) 296 (142) =========== =========== ============ 11
The following table shows the components of the change in accumulated other comprehensive income (loss), net of tax, related to one interest rate swap with a notional amount of $150.0 million accounted for as a cash flow hedge: <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED ------------------------ -------------------- JUNE 30, JUNE 30, 2005 2004 2005 2004 ----------- ----------- -------- ---------- (dollars in thousands) <S> <C> <C> <C> <C> Balance at beginning of perioD $ 631 (264) 736 237 Change in fair value of cash flow hedge (340) 1,088 (449) 572 Hedge ineffectiveness reclassified to earnings 5 4 9 19 ----------- ----------- -------- ---------- Total change in unrealized loss on derivative (335) 1,092 (440) 591 ----------- ----------- -------- ---------- Balance at end of period $ 296 828 296 828 =========== =========== ======== ========== </TABLE> 10. SEGMENT REPORTING The Company is a vertically integrated education finance organization that has five operating segments as defined in SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION ("SFAS No. 131"), as follows: Asset Management, Student Loan and Guarantee Servicing, Servicing Software, Direct Marketing, and Payment Management Services. The addition of Direct Marketing and Payment Management Services as operating segments is a result of the Company's acquisitions of SMG, NHR, and FACTS in 2005 (see note 4). The Asset Management and Student Loan and Guarantee Servicing operating segments meet the quantitative thresholds identified in SFAS No. 131 as reportable segments and therefore the related financial data is presented below. The Servicing Software, Direct Marketing, and Payment Management Services operating segments do not meet the quantitative thresholds and therefore their financial data is combined and shown as "other" in the presentation below. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies in the consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. SMG and NHR, which constitute the Direct Marketing segment, recognize revenue when lists or products are shipped. FACTS, which constitutes the Payment Management Services segment, recognizes revenue over the period in which it provides services to its customers. The Asset Management segment includes the acquisition, management, and ownership of the student loan assets. Revenues are primarily generated from interest income on the student loan assets. The Company generates student loan assets through direct origination or through acquisitions. The student loan assets are held in a series of education lending subsidiaries designed specifically for this purpose. The Student Loan and Guarantee Servicing segment provides for the servicing of the Company's student loan portfolios and the portfolios of third parties and servicing provided to guaranty agencies. The servicing activities include loan origination activities, application processing, borrower updates, payment processing, due diligence procedures, and claim processing. These activities are performed internally for the Company's portfolio in addition to generating fee revenue when performed for third-party clients. The guarantee servicing activities include providing systems software, hardware and telecommunications support, borrower and loan updates, default aversion tracking services, claim processing services, and post-default collection services to guaranty agencies. The Servicing Software segment provides software licenses and maintenance associated with student loan servicing software products to both the Company and third-party customers. The Direct Marketing segment provides marketing products and services and college bound student lists and recognizes middle and high school students for academic success by providing publications, scholarships, and various notifications. The Payment Management Services segment provides automated tuition payment solutions, online payment processing, detailed information reporting, and data integration services to educational institutions, families, and students. In addition, this segment provides financial needs analysis for students applying for aid in private and parochial K-12 schools. Substantially all of the Company's revenues are earned from customers in the United States except for revenue generated from servicing Canadian student loans. For the three and six months ended June 30, 2005, the Company recognized $13.0 million and $28.5 million, respectively, from Canadian student loan servicing customers. Costs excluded from segment net income before taxes primarily consist of unallocated corporate expenses, net of miscellaneous revenues. Thus, net income before taxes of the segments includes only the costs that are directly attributable to the operations of the individual segment. Intersegment revenues are charged by a segment to another segment that provides the product or service. The amount of intersegment revenue is based on comparable fees charged in the market. 12
Segment data is as follows: <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, ---------------------------------------------------------------------------------------------- 2005 2004 ----------------------------------------------- --------------------------------------------- STUDENT LOAN STUDENT LOAN ASSET AND GUARANTEE TOTAL ASSET AND GUARANTEE TOTAL MANAGEMENT SERVICING OTHER SEGMENTS MANAGEMENT SERVICING OTHER SEGMENTS ------------ ------------- -------- ---------- ----------- ----------- --------- --------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> <C> <C> <C> <C> Net interest income $ 82,546 753 108 83,407 175,054 193 1 175,248 Other income (expense) (55,015) 34,677 9,605 (10,733) 3,323 22,845 1,779 27,947 Intersegment revenues -- 26,830 883 27,713 -- 19,659 827 20,486 ------------ ------------ -------- ----------- ------------ ----------- --------- --------- Total revenue 27,531 62,260 10,596 100,387 178,377 42,697 2,607 223,681 Provision (recovery) for loan losses 2,124 -- -- 2,124 (6,421) -- -- (6,421) Depreciation and amortization 32 951 1,057 2,040 334 126 1,769 2,229 Net income (loss) before taxes $ (4,450) 19,406 4,585 19,541 160,721 12,781 (632) 172,870 ============ ============ ======== =========== =========== =========== ========= ========= SIX MONTHS ENDED JUNE 30, ---------------------------------------------------------------------------------------------- 2005 2004 ------------------------------------------------ --------------------------------------------- STUDENT LOAN STUDENT LOAN ASSET AND GUARANTEE TOTAL ASSET AND GUARANTEE TOTAL MANAGEMENT SERVICING OTHER SEGMENTS MANAGEMENT SERVICING OTHER SEGMENTS ------------- ------------- --------- ---------- ----------- ----------- --------- --------- (DOLLARS IN THOUSANDS Net interest income $ 168,616 1,431 123 170,170 217,743 454 4 218,201 Other income (expense) (2,586) 71,843 13,035 82,292 2,431 48,701 3,671 54,803 Intersegment revenues -- 52,932 2,185 55,117 -- 38,622 1,806 40,428 ------------ ------------ -------- ----------- ------------ ----------- --------- --------- Total revenue 166,030 126,206 15,343 307,579 220,174 87,777 5,481 313,432 Provision (recovery) for loan losses 4,155 -- -- 4,155 (3,306) -- -- (3,306) Depreciation and amortization 58 1,870 1,855 3,783 669 252 3,532 4,453 Net income (loss) before taxes $ 103,223 38,068 6,611 147,902 176,867 26,156 (1,195) 201,828 ============ ============ ======== =========== ============ =========== ========= ========= </TABLE> 13
AS OF AS OF JUNE 30, DECEMBER 31, 2005 2004 -------------- --------------- (DOLLARS IN THOUSANDS) Asset management $ 17,084,810 14,808,684 Student loan and guarantee servicing 157,826 334,181 Other 108,105 5,934 -------------- --------------- Total segment assets $ 17,350,741 15,148,799 ============== =============== Reconciliation of segment data to the consolidated financial statements is as follows: <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, -------------------------- ------------------------- 2005 2004 2005 2004 ------------- ------------ ----------- ----------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Total segment revenues $ 100,387 223,681 307,579 313,432 Elimination of intersegment revenues (27,713) (20,486) (55,117) (40,428) Corporate activities' revenues, net (199) 931 1,157 2,003 ------------- ----------- ----------- ----------- Total consolidated revenues $ 72,475 204,126 253,619 275,007 ============= =========== =========== =========== Total net income before taxes of segments $ 19,541 172,870 147,902 201,828 Corporate activities' expenses, net (23,069) (38,519) (43,705) (52,923) ------------- ----------- ----------- ----------- Total consolidated net income (loss) before taxes $ (3,528) 134,351 104,197 148,905 ============= =========== =========== =========== </TABLE> Net corporate revenues included in the previous table are from activities that are not related to the five identified operating segments, such as investment earnings. The net corporate expenses include expenses for marketing and other unallocated support services. The net corporate revenues and expenses are not associated with an ongoing business activity as defined by SFAS No. 131 and, therefore, have not been included within the operating segments. AS OF AS OF JUNE 30, DECEMBER 31, 2005 2004 ------------- ------------- (DOLLARS IN THOUSANDS) Total segment assets $ 17,350,741 15,148,799 Elimination of intercompany assets (75,993) (39,213) Corporate assets 34,155 50,419 ------------- ------------- Total consolidated assets $ 17,308,903 15,160,005 ============= ============= The assets held at the corporate level are not identified with any of the operating segments. Accordingly, these assets are included in the reconciliation of segment assets to total consolidated assets. These assets consist primarily of cash, investments, furniture, equipment, leasehold improvements, and other assets. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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 should be read in conjunction with the Company's consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. 14
This report contains forward-looking statements and information that are based on management's current expectations as of the date of this document. When used in this report, the words "anticipate," "believe," "estimate," "intend," and "expect" and similar expressions are intended to identify forward-looking statements. These forward-looking statements are subject to risks, uncertainties, assumptions, and other factors that may cause the actual results to be materially different from those reflected in such forward-looking statements. These factors include, among others, the risks and uncertainties set forth in "Risk Factors" and elsewhere in this Quarterly Report on Form 10-Q and changes in the terms of student loans and the educational credit marketplace arising from the implementation of, or changes in, applicable laws and regulations, which may reduce the volume, average term, and costs of yields on student loans under the FFEL Program or result in loans being originated or refinanced under non-FFEL programs or may affect the terms upon which banks and others agree to sell FFELP loans to the Company. The Company could also be affected by changes in the demand for educational financing or in financing preferences of lenders, educational institutions, students, and their families; changes in the general interest rate environment and in the securitization markets for education loans, which may increase the costs or limit the availability of financings necessary to initiate, purchase, or carry education loans; losses from loan defaults; and changes in prepayment rates and credit spreads. The reader should not place undue reliance on forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. The Company is not obligated to publicly release any revisions to forward-looking statements to reflect events after the date of this Quarterly Report on Form 10-Q or unforeseen events. Although the Company may from time to time voluntarily update its prior forward-looking statements, it disclaims any commitment to do so except as required by securities laws. OVERVIEW The Company is one of the leading education finance companies in the United States and is focused on providing quality products and services to students and schools nationwide. The Company ranks among the nation's leaders in terms of total net student loan assets with $15.7 billion as of June 30, 2005. The Company's business is comprised of five primary product and service offerings: o ASSET MANAGEMENT, INCLUDING STUDENT LOAN ORIGINATIONS AND ACQUISITIONS. The Company provides student loan marketing, originations, acquisitions, and portfolio management services. The Company owns a large portfolio of student loan assets through a series of education lending subsidiaries. The Company obtains loans through direct origination or through acquisition of loans. The Company also provides marketing, sales, managerial, and administrative support related to its asset generation activities. o STUDENT LOAN AND GUARANTEE SERVICING. The Company services its student loan portfolio and the portfolios of third parties. Servicing activities include loan origination activities, application processing, borrower updates, payment processing, due diligence procedures, and claim processing. In December 2004, the Company purchased EDULINX Canada Corporation, or EDULINX. EDULINX is a Canadian corporation that engages in servicing student loans in Canada. The following table summarizes the Company's loan servicing volumes as of June 30, 2005: COMPANY PERCENT THIRD PARTY PERCENT TOTAL ---------- --------- ---------- -------- --------- (DOLLARS IN MILLIONS) FFELP and private loans $ 14,038 62.8% $ 8,319 37.2% $ 22,357 Canadian loans (in U.S. $) -- -- 7,034 100.0 7,034 ---------- ------ ---------- ------ --------- Total $ 14,038 47.8% $ 15,353 52.2% $ 29,391 ========== ====== ========== ====== ========= The Company also provides servicing support to guaranty agencies, which includes system software, hardware and telecommunications support, borrower and loan updates, default aversion tracking services, claim processing services, and post-default collection services. o SERVICING SOFTWARE. The Company uses internally developed loan servicing software and also provides this software to third-party student loan holders and servicers. o DIRECT MARKETING. The Company provides a wide range of direct marketing products and services to help businesses reach the middle school, high school, college bound high school, college, and young adult market places in a cost-effective manner. The Company also provides marketing services and college bound student lists to college and university admissions offices nationwide. The Company also recognizes middle and high school students for exceptional academic success by providing publications and scholarships. o PAYMENT MANAGEMENT SERVICES. The Company provides automated tuition payment solutions, online payment processing, detailed information reporting, and data integration services to educational institutions, families, and students. In addition, the Company provides financial needs analysis for students applying for aid in private and parochial K-12 schools. The Company's education lending subsidiaries under the Asset Management service offering are engaged in the securitization of education finance assets. These education lending subsidiaries hold beneficial interests in eligible loans, subject to creditors with specific interests. The liabilities of the Company's education lending subsidiaries are not the obligations of the Company or any of its other subsidiaries and cannot be consolidated in the event of bankruptcy. The transfers of student loans to the eligible lender trusts do not qualify as sales under the provisions of SFAS No. 140, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, as the trusts continue to be under the effective control of the Company. Accordingly, all the financial activities and related assets and liabilities, including debt, of the securitizations are reflected in the Company's consolidated financial statements. 15
The Company's Asset Management and Student Loan and Guarantee Servicing offerings constitute reportable operating segments according to the provisions of SFAS No. 131. The Servicing Software, Direct Marketing, and Payment Management Services offerings are operating segments that do not meet the quantitative thresholds, and, therefore, are combined and included as "Other segments." The following tables show the percentage of total segment revenue (excluding intersegment revenue) and net income (loss) before taxes for each of the Company's reportable segments: <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, ---------------------------------------------------------------- 2005 2004 -------------------------------- ------------------------------- STUDENT STUDENT LOAN AND LOAN AND ASSET GUARANTEE OTHER ASSET GUARANTEE OTHER MANAGEMENT SERVICING SEGMENTS MANAEMENT SERVICING SEGMENTS -------------------- -------- --------- --------- -------- <S> <C> <C> <C> <C> <C> <C> Segment revenues........... 37.9% 48.8% 13.3% 87.8% 11.3% 0.9% Segment net income (loss) before taxes........... (22.8)% 99.3% 23.5% 93.0% 7.4% (0.4)% SIX MONTHS ENDED JUNE 30, ---------------------------------------------------------------- 2005 2004 -------------------------------- ------------------------------- STUDENT STUDENT LOAN AND LOAN AND ASSET GUARANTEE OTHER ASSET GUARANTEE OTHER MANAGEMENT SERVICING SEGMENTS MANAEMENT SERVICING SEGMENTS -------------------- -------- --------- --------- -------- Segment revenues.......... 65.8% 29.0% 5.2% 80.6% 18.0% 1.4% Segment net income (loss) before taxes......... 69.8% 25.7% 4.5% 87.6% 13.0% (0.6)% </TABLE> The Company's derivative market value adjustment and net settlements are included in the Asset Management segment. Because the majority of the Company's derivatives do not qualify for hedge accounting under SFAS No. 133, the derivative market value adjustment can cause the percent of revenue and net income (loss) before taxes to fluctuate from period to period between segments. The Company's student loan portfolio has grown significantly through originations and acquisitions. The Company originated or acquired $1.4 billion and $2.9 billion of student loans during the three and six months ended June 30, 2005, respectively, through student loan acquisition channels, including: o the direct channel, in which the Company originates student loans in one of its brand names directly to student and parent borrowers, which accounted for 40.0% and 39.3% of the student loans added to the Company's loan portfolio through a student loan channel during the three and six months ended June 30, 2005, respectively; o the branding partner channel, in which the Company acquires student loans from lenders to whom it provides marketing and origination services, which accounted for 28.3% and 37.4% of the student loans added to the Company's loan portfolio through a student loan channel during the three and six months ended June 30, 2005, respectively; and o the forward flow channel, in which the Company acquires student loans from lenders to whom it provides origination services, but provides no marketing services, or who have agreed to sell loans to the Company under forward sale commitments, which accounted for 31.5% and 22.1% of the student loans added to the Company's loan portfolio through a student loan channel during the three and six months ended June 30, 2005, respectively. In addition, the Company also acquires student loans through spot purchases, which accounted for 0.2% and 1.2% of student loans added to the Company's loan portfolio through a student loan channel during the three and six months ended June 30, 2005, respectively. SIGNIFICANT DRIVERS AND TRENDS The Company's earnings and earnings growth are directly affected by the size of its portfolio of student loans, the interest rate characteristics of its portfolio, the costs associated with financing and managing its portfolio, and the costs associated with the origination and acquisition of the student loans in the portfolio. In addition to the impact of growth of the Company's student loan portfolio, the Company's results of operations and financial condition may be materially affected by, among other things, changes in: o applicable laws and regulations that may affect the volume, terms, effective yields, or refinancing options of education loans; 16
o demand for education financing and competition within the student loan industry; o the interest rate environment, funding spreads on the Company's financing programs, and access to capital markets; and o prepayment rates on student loans, including prepayments relating to loan consolidations. The Company's net interest income, or net interest earned on its student loan portfolio, is the primary source of the Company's income and is primarily impacted by the size of the portfolio and the net yield of the assets in the portfolio. If the Company's student loan portfolio continues to grow and its net interest margin remains relatively stable, the Company expects its net interest income to increase. The Company's portfolio of FFELP loans generally earns interest at the higher of a variable rate based on the special allowance payment, or SAP, formula set by the Department and the borrower rate, which is fixed over a period of time. The SAP formula is based on an applicable index plus a fixed spread that is dependent upon when the loan was originated, the loan's repayment status, and funding sources for the loan. Based upon provisions of the Higher Education Act, and related interpretations by the Department, loans financed prior to September 30, 2004 with tax-exempt obligations issued prior to October 1, 1993 are entitled to receive special allowance payments equal to a 9.5% minimum rate of return. In May 2003, the Company sought confirmation from the Department regarding the treatment and recognition of special allowance payments as income based on the 9.5% minimum rate of return. Pending satisfactory resolution of this issue with the Department, the Company deferred recognition of the interest income that was generated by these loans in excess of income based upon the standard special allowance rate. In June 2004, after consideration of certain clarifying information received in connection with the guidance it had sought, including written and verbal communications with the Department, the Company concluded that the earnings process had been completed related to the special allowance payments on these loans and recognized $124.3 million of interest income. As of December 31, 2003 and March 31, 2004, the amount of deferred excess interest income on these loans was $42.9 million and $78.8 million, respectively. As of June 30, 2005, the Company holds $3.2 billion in loans that are receiving special allowance payments based upon the minimum 9.5% rate. The Company currently recognizes the income from the special allowance payments, referred to as the special allowance yield adjustment, on these loans as it is earned. Since the portfolio subject to the 9.5% floor is not expected to increase, interest income recognized on this portfolio will decrease as compared to historical periods. In addition, if interest rates rise, the normal yield on the portfolio of loans earning this special allowance will increase, thereby reducing the special allowance yield adjustment. The Company has entered into interest rate swaps to reduce the risk of rising interest rates on this portfolio. Interest income is also dependent upon the relative level of interest rates. The Company maintains an overall interest rate risk management strategy that incorporates the use of interest rate derivative instruments to reduce the economic effect of interest rate volatility. The Company's management has structured all of its derivative instruments with the intent that each is economically effective. However, most of the Company's derivative instruments do not qualify for hedge accounting under SFAS No. 133 and thus the change in the market value on the derivative instruments is recognized in the statement of operations each reporting period. This mark-to-market adjustment may fluctuate from period to period and adversely impact earnings. Competition for the supply channel of education financing in the student loan industry has caused the cost of acquisition (or loan premiums) related to the Company's student loan assets to increase. In addition, the Company has seen significant increases in consolidation loan activity and consolidation loan volume within the industry. The increase in competition for consolidation loans has caused the Company to be aggressive in its measures to protect and secure its existing portfolio through consolidation efforts. The Company will amortize its premiums paid on the purchase of student loans over the average useful life of the assets. When the Company's loans are consolidated, the Company may accelerate recognition of unamortized premiums if the consolidated loan is considered a new loan. The increase in premiums paid on student loans due to the increase in entrants and competition within the industry, coupled with the Company's asset retention practices through consolidation efforts, have caused the Company's yields to be reduced in recent periods due to the amortization of premiums, consolidation rebate fees, and the lower yields on consolidation loans. If the percentage of consolidation loans continues to increase as a percentage of the Company's overall loan portfolio, the Company will continue to experience reduced yields. If these trends continue, the Company could continue to see an increase in consolidation rebate fees and amortization costs and a reduction in yield. See "-- Student Loan Portfolio--Student Loan Spread Analysis." Although the Company's short-term yields may be reduced if this trend continues, the Company will have been successful in protecting its assets and stabilizing its balance sheet for long-term growth. Conversely, a reduction in consolidation of the Company's own loans or the loans of third parties could positively impact the effect of amortization on the Company's student loan yield from period to period. Also, as the Company's portfolio of consolidation loans grows both in nominal dollars and as a percentage of the total portfolio, the impact of premium amortization as a percent of student loan yield should decrease, unless the cost of acquisition of consolidation loans or underlying loans increases substantially in the future. 17
ACQUISITIONS The Company has positioned itself for growth by building a strong foundation through acquisitions. Although the Company's assets, loan portfolios, and fee-based revenues increase through such transactions, a key aspect of each transaction is its impact on the Company's prospective organic growth and the development of its integrated platform of services. As a result of these acquisitions and the Company's rapid organic growth, the period-to-period comparability of the Company's results of operations may be difficult. A summary of 2004 and 2005 acquisitions follows: In January 2004, the Company acquired 50% of the membership interests in Premiere Credit of North America, LLC ("Premiere"), a collection services company that specializes in collection of educational debt. This investment is being accounted for under the equity method of accounting. In March 2004, the Company acquired rights, title, and interest in certain assets of the Rhode Island Student Loan Authority ("RISLA"), including the right to originate student loans in RISLA's name without competition from RISLA for a period of ten years. The Company further agreed to provide administrative services in connection with certain of the indentures governing debt securities of RISLA for a ten-year period. In April 2004, the Company purchased SLAAA Acquisition Corp. ("SLAAA"), a student loan secondary market. This acquisition was accounted for under purchase accounting and the results of operations have been included in the consolidated financial statements from the date of acquisition. Also in April 2004, the Company purchased 50% of the stock of infiNET Integrated Solutions, Inc. ("infiNET"), an ecommerce services provider for colleges, universities, and healthcare organizations. infiNET provides customer-focused electronic transactions, information sharing, and account and bill presentment. This investment is being accounted for under the equity method of accounting. In December 2004, the Company purchased 100% of the stock of EDULINX. EDULINX is a Canadian corporation that engages in the servicing of student loans in Canada. This acquisition was accounted for under purchase accounting and the results of operations have been included in the consolidated financial statements from the date of acquisition. Effective February 28, 2005, the Company acquired 100% of the capital stock of SMG, a full service direct marketing agency, and 100% of the membership interests of NHR, a company which provides publications and scholarships for middle and high school students achieving exceptional academic success. This acquisition was accounted for under purchase accounting and the results of operations have been included in the consolidated financial statements from the date of acquisition. Effective June 1, 2005, the Company purchased 80% of the capital stock of FACTS. FACTS provides automated tuition payment solutions, online payment processing, detailed information reporting, and data integration services to educational institutions, families, and students. In addition, FACTS provides financial needs analysis for students applying for aid in private and parochial K-12 schools. This acquisition was accounted for under purchase accounting and the results of operations have been included in the consolidated financial statements from the date of acquisition. Effective July 1, 2005, the Company purchased 100% of the capital stock of Foresite, a company which develops complementary Web-based software applications that improve the administration of financial aid offices and work-study programs at colleges and universities. NET INTEREST INCOME The Company generates the majority 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. This spread income is reported on the Company's statement of operations as net interest income. The amortization of loan premiums, including capitalized costs of origination, the consolidation loan rebate fee, and yield adjustments from borrower benefit programs, are netted against loan interest income on the Company's statement of operations. The amortization of debt issuance costs is included in interest expense on the Company's statement of operations. The Company's portfolio of FFELP loans generally earns interest at the higher of a variable rate based on the special allowance payment, or SAP, formula set by the Department and the borrower rate, which is fixed over a period of time. The SAP formula is based on an applicable index plus a fixed spread that is dependent upon when the loan was originated, the loan's repayment status, and funding sources for the loan. Depending on the type of student loan and when the loan was originated, the borrower rate is either fixed to term or is reset to a market rate each July 1. The larger the reduction in rates subsequent to the annual July 1 borrower interest rate reset, the greater the Company's opportunity to earn variable-rate floor income. In declining interest rate environments, the Company can earn significant amounts of such income. Conversely, as the decline in rates abates, or in environments where interest rates are rising, the Company's opportunity to earn variable-rate floor income can be reduced, in some cases substantially. Since the borrower rates are reset annually, the Company views earnings on variable-rate floor income as temporary and not necessarily sustainable. The Company's ability to earn variable-rate floor income in future periods is dependent upon the interest rate environment following the annual reset of borrower rates, and the Company cannot assure the nature of such environment in the future. The Company recorded no variable-rate floor income during the three and six months ended June 30, 2005 and three months ended June 30, 2004 and approximately $348,000 during the six months ended June 30, 2004. 18
On those FFELP loans with fixed-term borrower rates, primarily consolidation loans, the Company earns interest at the greater of the borrower rate or a variable rate based on the SAP formula. Since the Company finances the majority of its student loan portfolio with variable-rate debt, the Company may earn excess spread on these loans for an extended period of time. On most consolidation loans, the Company must pay a 1.05% per year rebate fee to the Department. Those consolidation loans that have variable interest rates based on the SAP formula earn an annual yield less than that of a Stafford loan. Those consolidation loans that have fixed interest rates less than the sum of 1.05% and the variable rate based on the SAP formula also earn an annual yield less than that of a Stafford loan. As a result, as consolidation loans matching these criteria become a larger portion of the Company's loan portfolio, there will be a lower yield on the Company's loan portfolio in the short term. However, due to the extended terms of consolidation loans, the Company expects to earn the yield on these loans for a longer duration, making them beneficial to the Company in the long term. Because the Company generates the majority 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 earnings, net interest income, and net income. The effects of changing interest rate environments are further outlined in Item 3, "Quantitative and Qualitative Disclosures about Market Risk - -- Interest Rate Risk." Investment interest income, which is a component of net interest income, includes income from unrestricted interest-earning deposits and funds in the Company's special purpose entities which are utilized for its asset-backed securitizations. PROVISION FOR LOAN LOSSES The allowance for loan losses is estimated and established through a provision charged to expense. Losses are charged against the allowance when management believes the collectibility of the loan principal is unlikely. Recovery of amounts previously charged off is credited to the allowance for loan losses. The allowance for federally insured and non-federally insured loans is maintained at a level management believes is adequate to provide for estimated probable credit losses inherent in the loan portfolio. This evaluation is inherently subjective because it requires estimates that may be susceptible to significant changes. The Company analyzes the allowance separately for its federally insured loans and its non-federally insured loans. The allowance for the federally insured loan portfolio is based on periodic evaluations of the Company's loan portfolios considering 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 98% of the principal of and the interest on federally insured student loans, which limits the Company's loss exposure to 2% of the outstanding balance of the Company's federally insured portfolio. Effective June 1, 2004, the Company was designated as an Exceptional Performer by the Department in recognition of its exceptional level of performance in servicing FFELP loans. As a result of this designation, the Company received 100% reimbursement on all eligible FFELP default claims submitted for reimbursement during the 12-month period following the effective date of the designation. The Company was not subject to the 2% risk sharing loss for eligible claims submitted during this 12-month period. Only FFELP loans that are serviced by the Company, as well as loans owned by the Company and serviced by other service providers designated as Exceptional Performers by the Department, qualify for the 100% reimbursement. In June 2005, the Company submitted its application for Exceptional Performer redesignation to the Department. The Department has 60 days to redesignate the Company as an Exceptional Performer or deny the Company's application. Until that time, the Company continues to receive the benefit of the Exceptional Performer designation. It is the opinion of the Company's management, based on information currently known, that there is no reason to believe the Company's application will be rejected. As of June 30, 2005, more than 99% of the Company's federally insured loans were serviced by providers designated as Exceptional Performers. Of this portion, the Company serviced approximately 92% and third parties serviced approximately 8%. The Company is entitled to receive the 100% reimbursement benefit as long as it and/or its service providers continue to meet the required servicing standards published by the Department. Compliance with such standards is assessed on a quarterly basis and service providers must apply for redesignation annually as discussed previously. If the Company or a third party servicer were to lose its Exceptional Performer designation, either by the Department discontinuing the program or the Company or third party servicer not meeting the required servicing standards, loans serviced by the Company or such third party would become subject to the 2% risk sharing for all claims submitted after loss of the designation. 19
Pursuant to the terms of the Higher Education Act, the FFEL Program is periodically amended, and the Higher Education Act is generally reauthorized by Congress every five to six years in order to prevent sunset of that Act. The current provisions of the Higher Education Act are scheduled to expire on September 30, 2005. Historically, the United States Congress makes changes to the provisions of the Higher Education Act during the reauthorization process. One of the changes to the Higher Education Act that is included in the reauthorization proposal is changes to the guarantee rates and terms on FFELP loans, including proposals for a decrease in insurance and reinsurance on portfolios receiving the benefit of Exceptional Performance designation by up to 2%, from 100% to 98% of principal and accrued interest, and a decrease in insurance and reinsurance on portfolios not subject to the Exceptional Performance designation by up to 2%, from 98% to 96% of principal and accrued interest. If the insurance and reinsurance decrease during reauthorization, the Company would have to establish a provision for loan losses related to the new risk sharing amounts. This provision would be recognized by the Company upon the effective date of the new provisions of the Higher Education Act, which is estimated to be October 1, 2006. See "- Risks - Political/Regulatory Risk." In determining the adequacy of the allowance for loan losses on the non-federally insured loans, the Company considers several factors including: loans in repayment versus those in a nonpaying status, months in repayment, delinquency status, type of program, and trends in defaults in the portfolio based on Company and industry data. The Company charges off the uninsured loan when the collection of principal and interest is 120 days past due. OTHER INCOME The Company also earns fees and generates income from other sources, including principally loan and guarantee servicing income, fee-based revenue from direct marketing and payment management activities, and licensing fees on its software products. Loan servicing fees are determined according to individual agreements with customers and are calculated based on the dollar value or number of loans serviced for each customer. Guarantee servicing fees are calculated based on the number of loans serviced or amounts collected. Fee-based income is determined by the volume of sales of lists and student publications. Fee-based income also includes annual fees for providing payment management services to schools and/or students. Software services income is determined from individual agreements with customers and includes license and maintenance fees associated with student loan software products. Other income also includes the derivative market value adjustment and net settlements from the Company's derivative instruments as further discussed in Item 3, "Quantitative and Qualitative Disclosures About Market Risk -- Interest Rate Risk." OPERATING EXPENSES Operating expenses includes indirect costs incurred to generate and 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, costs incurred to provide direct marketing, payment management, and software services to third parties, and other general and administrative expenses. Operating expenses also includes the depreciation and amortization of capital assets and intangible assets. The Company does not believe inflation has a significant effect on its operations. 20
RESULTS OF OPERATIONS <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, 2005 COMPARED TO THE THREE MONTHS ENDED JUNE 30, 2004 THREE MONTHS ENDED JUNE 30 CHANGE ----------------------- --------------------- 2005 2004 DOLLARS PERCENT ---------- ----------- --------- ---------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> INTEREST INCOME: Loan interest, excluding variable-rate floor income $ 223,691 $ 239,436 $(15,745) (6.6)% Amortization of loan premiums and deferred origination costs (16,547) (15,037) (1,510) 10.0 Investment interest 8,150 3,181 4,969 156.2 ---------- ----------- --------- --------- Total interest income 215,294 227,580 (12,286) (5.4) INTEREST EXPENSE: Interest on bonds and notes payable 133,277 52,352 80,925 154.6 ---------- ----------- --------- --------- Net interest income 82,017 175,228 (93,211) (53.2) Less provision (recovery) for loan losses 2,124 (6,421) 8,545 133.1 ---------- ----------- --------- --------- Net interest income after provision (recovery for loan losses 79,893 181,649 (101,756) (56.0) ---------- ----------- --------- --------- OTHER INCOME (EXPENSE): Loan and guarantee servicing income 34,678 22,846 11,832 51.8 Other fee-based income 9,027 1,630 7,397 453.8 Software services income 2,602 1,780 822 46.2 Other income 1,524 1,285 239 18.6 Derivative market value adjustment (51,372) 3,075 (54,447) (1,770.6) Derivative settlements, net (6,001) (1,718) (4,283) (249.3) ---------- ----------- --------- --------- Total other income (expense) (9,542) 28,898 (38,440) (133.0) ---------- ----------- --------- --------- OPERATING EXPENSES: Salaries and benefits 39,977 49,036 (9,059) (18.5) Other operating expenses: Depreciation and amortization, excluding amortization of intangible assets 3,359 2,598 761 29.3 Amortization of intangible assets 1,559 2,079 (520) (25.0) Trustee and other debt related fees 2,121 2,851 (730) (25.6) Occupancy and communications 4,344 3,135 1,209 38.6 Advertising and marketing 4,610 2,961 1,649 55.7 Professional services 4,576 2,894 1,682 58.1 Postage and distribution 5,079 3,220 1,859 57.7 Other 8,254 7,422 832 11.2 ---------- ----------- --------- --------- Total other operating expenses 33,902 27,160 6,742 24.8 ---------- ----------- --------- --------- Total operating expenses 73,879 76,196 (2,317) (3.0) ---------- ----------- --------- --------- Income (loss) before income taxes (3,528) 134,351 (137,879) (102.6) Income tax expense (benefit) (1,755) 49,098 (50,853) (103.6) ---------- ----------- --------- --------- Net income (loss) $ (1,773) $ 85,253 $(87,026) (102.1)% ========== =========== ========= ========= </TABLE> NET INTEREST INCOME. Total loan interest decreased as a result of a decrease in the special allowance yield adjustment, changes in the pricing characteristics of the Company's student loan assets, and an increase in consolidation rebate fees. These decreases were offset by increases in loan interest resulting from the growth of the student loan portfolio and changes in the interest rate environment. Overall, the decrease in the student loan yield to 6.64% in 2005 from 9.06% in 2004 resulted in a decrease in loan interest income of approximately $68.3 million. The decrease in the student loan yield was caused by a decrease in the special allowance yield adjustment and an increase in the number of lower yielding consolidation loans held by the Company. The special allowance yield adjustment, which reflects the special allowance payments on loans financed prior to September 30, 2004 with tax-exempt obligations issued prior to October 1, 1993, earning at a 9.5% minimum rate of return, decreased $98.4 million to approximately $25.9 million for the three months ended June 30, 2005 from approximately $124.3 million for the three months ended June 30, 2004. The 2004 special yield adjustment included approximately $78.8 million that was previously deferred. This decrease is due to the decrease in the portfolio of loans earning the 9.5% minimum rate of return. In addition, the normal yield on this portfolio has increased due to the rising interest rate environment. When excluding the special allowance yield adjustment, the student loan yield increased to 5.93% in 2005 from 4.65% in 2004 as a result of the rising interest rate environment. Consolidation loan activity resulted in higher consolidation rebate fees and decreased loan interest by $7.4 million. The decrease in loan interest income as a result of the lower overall student loan yield and increased consolidation rebate fees was offset by increased loan interest as a result of the growth in the Company's portfolio of student loans. The average student loan portfolio increased $3.6 billion, or 32.3%, during the three months ended June 30, 2005 compared to the same period in 2004, which resulted in an increase of loan interest income by approximately $60.5 million. Interest expense on bonds and notes payable increased as a result of the increase in average variable-rate debt, the issuance of unsecured fixed-rate debt in May 2005, and the change in the interest rate environment. These increases were offset by a reduction in the average secured fixed-rate bonds and notes outstanding. Overall, the student loan cost of funds (excluding net settlements on derivatives) increased to 3.36% in 2005 from 1.69% in 2004. Average variable-rate debt increased $3.6 billion, which resulted in an increase of interest expense of approximately $28.1 million. In addition, the increase in interest 21
rates, specifically LIBOR and auction rates, increased the Company's average cost of funds on variable-rate debt which increased interest expense approximately $55.1 million. The Company also issued $275 million of unsecured debt in May 2005 which increased interest expense by $1.5 million. The increase in interest expense was reduced as average fixed-rate bonds and notes decreased by $257.9 million, which decreased the Company's overall interest expense by approximately $3.8 million. Net interest income, excluding the effects of the special allowance yield adjustment and variable-rate floor income, increased approximately $5.2 million, or 10.2%, to approximately $56.1 million from approximately $50.9 million. PROVISION FOR LOAN LOSSES. The provision for loan losses for federally insured student loans increased $8.9 million from a recovery of $8.8 million in 2004 to an expense of $124,000 in 2005 as a result of the Company's Exceptional Performer designation in June 2004. The provision for loan losses for non-federally insured loans decreased $340,000 from $2.3 million in 2004 to $2.0 in 2005 million because of the expected performance of the non-federally insured loan portfolio. OTHER INCOME. Loan and guarantee servicing income increased due to the acquisition of EDULINX in December 2004. EDULINX recognized $13.0 million of servicing income during the three months ended June 30, 2005. This increase was offset by the reduction in the average dollar amount of loans serviced for third parties in the Company's U.S. servicing operations from $9.1 billion for the three months ended June 30, 2004 to $8.6 billion for the three months ended June 30, 2005. Total average U.S. third-party loan servicing volume decreased $563.9 million, or 6.2%, which resulted in a decrease in loan servicing income of approximately $0.3 million. The decrease in the Company's U.S. servicing volume is due to loan pay downs being greater than loan additions within the third-party customer portfolios. In addition, guarantee servicing income decreased $1.1 million due to a customer that did not renew its servicing contract in 2004. Other fee-based income increased approximately $7.1 million due to the acquisitions of SMG and NHR in February 2005 and FACTS in June 2005. Software services income increased due to additional system maintenance and enhancement work performed for third-party customers. The Company utilizes derivative instruments to provide economic hedges to protect against the impact of adverse changes in interest rates. During the three months ended June 30, 2005, the derivative market value adjustment net losses were $51.4 million and net settlements representing realized costs were $6.0 million as compared to derivative market adjustment net gains of $3.1 million and net settlements representing realized costs of $1.7 million for the comparable period in 2004. These increases, in addition to the changes in interest rates and fluctuations in the forward yield curve, is the result of the Company entering into $3.7 billion in notional amount of derivatives in July 2004. See Item 3, "Quantitative and Qualitative Disclosures about Market Risk -- Interest Rate Risk." OPERATING EXPENSES. Salaries and benefits increased $8.4 million due to the acquisitions of EDULINX, SMG, NHR, and FACTS. This increase is offset by the Company recognizing approximately $17.7 million less in incentive plan compensation in 2005 compared to 2004 due to a change in terms of the Company's incentive plan for 2005. Depreciation and amortization, excluding amortization of intangible assets, increased $0.6 million as a result of the acquisition of EDULINX. The decrease in the amortization of intangible assets is due to certain intangible assets becoming fully amortized in 2004, offset by the amortization of acquired intangible assets related to recent acquisitions. The decrease in trustee and other debt related fees relates to the improved efficiencies in the Company's debt transactions. Advertising and marketing expenses increased approximately $1.2 million due to the acquisitions of EDULINX, SMG, NHR, and FACTS and $0.3 million due to expansion of the Company's marketing efforts, especially in the consolidations area. Occupancy and communications and professional services expenses increased due to the acquisition of EDULINX. Postage and distribution expense increased $0.8 million due to the acquisitions of EDULINX, NHR, and FACTS and $1.0 million due to the Company's direct marketing efforts, especially in the consolidations area. Other expenses increased $1.6 million due to recent acquisitions described above, which was offset by a decrease in charitable contributions expense. INCOME TAX EXPENSE. Income tax expense decreased due to the decrease in income before income taxes. The Company's effective tax rate was 49.7% and 36.5% during the three months ended June 30, 2005 and 2004, respectively. The effective tax rate in the second quarter 2005 was magnified due to the Company's loss before income taxes in the quarter. 22
<TABLE> <CAPTION> SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2004 SIX MONTHS ENDED JUNE 30, CHANGE ------------------------ -------------------- 2005 2004 DOLLARS PERCENT ---------- ------------ --------- --------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> INTEREST INCOME: Loan interest, excluding variable-rate floor income $ 423,798 $ 347,632 $ 76,166 21.9 % Variable-rate floor income -- 348 (348) (100.0) Amortization of loan premiums and deferred orgination costs (32,329) (34,854) 2,525 7.2 Investment interest 15,152 6,832 8,320 121.8 ---------- ----------- --------- -------- Total interest income 406,621 319,958 86,663 27.1 INTEREST EXPENSE: Interest on bonds and notes payable 237,802 101,395 136,407 134.5 ---------- ----------- --------- -------- Net interest income 168,819 218,563 (49,744) (22.8) Less provision (recovery) for loan losses 4,155 (3,306) 7,461 225.7 ---------- ----------- --------- -------- Net interest income after provision (recovery) for loan losses 164,664 221,869 (57,205) (25.8) ---------- ----------- --------- -------- OTHER INCOME: Loan and guarantee servicing income 71,854 48,909 22,945 46.9 Other fee-based income 12,383 3,519 8,864 251.9 Software services income 4,808 3,672 1,136 30.9 Other income 2,924 2,728 196 7.2 Derivative market value adjustment 8,918 548 8,370 1,527.4 Derivative settlements, net (16,087) (2,932) (13,155) (448.7) ---------- ----------- --------- --------- Total other income 84,800 56,444 28,356 50.2 ---------- ----------- --------- --------- OPERATING EXPENSES: Salaries and benefits 79,304 76,805 2,499 3.3 Other operating expenses: Depreciation and amortization, excluding amortization of intangible assets 6,652 4,928 1,724 35.0 Amortization of intangible assets 2,732 4,157 (1,425) (34.3) Trustee and other debt related fees 4,449 5,465 (1,016) (18.6) Occupancy and communications 8,576 6,217 2,359 37.9 Advertising and marketing 7,748 5,284 2,464 46.6 Professional services 10,352 7,354 2,998 40.8 Postage and distribution 9,385 7,068 2,317 32.8 Other 16,069 12,130 3,939 32.5 ---------- ----------- --------- --------- Total other operating expenses 65,963 52,603 13,360 25.4 ---------- ----------- --------- --------- Total operating expenses 145,267 129,408 15,859 12.3 ---------- ----------- --------- --------- Income before income taxes 104,197 148,905 (44,708) (30.0) Income tax expense 37,883 54,531 (16,648) (30.5) ---------- ----------- --------- --------- Net income $ 66,314 $ 94,374 $(28,060) (29.7)% ========== =========== ========= ========= </TABLE> NET INTEREST INCOME. Total loan interest decreased as a result of a decrease in the special allowance yield adjustment, changes in the pricing characteristics of the Company's student loan assets, and an increase in consolidation rebate fees. These decreases were offset by increases in loan interest resulting from the growth of the student loan portfolio and changes in the interest rate environment. Overall, the decrease in the student loan yield to 6.60% in 2005 from 6.96% in 2004 resulted in a decrease in loan interest income of approximately $23.4 million. The decrease in the student loan yield was caused by a decrease in the special allowance yield adjustment and an increase in the number of lower yielding consolidation loans held by the Company. The special allowance yield adjustment, which reflects the special allowance payments on loans financed prior to September 30, 2004 with tax-exempt obligations issued prior to October 1, 1993, earning at a 9.5% minimum rate of return, decreased $68.6 million to approximately $55.7 million for the six months ended June 30, 2005 from approximately $124.3 million for the six months ended June 30, 2004. The 2004 special yield adjustment included approximately $42.9 million that was previously deferred. This decrease is due to the decrease in the portfolio of loans earning the 9.5% minimum rate of return. In addition, the normal yield on this portfolio has increased due to the rising interest rate environment. When excluding the special allowance yield adjustment, the student loan yield increased to 5.81% in 2005 from 4.67% in 2004 as a result of the rising interest rate environment. Consolidation loan activity resulted in higher consolidation rebate fees and decreased loan interest by $14.7 million. The decrease in loan interest income as a result of the lower overall student loan yield and increased consolidation rebate fees was offset by increased loan interest as a result of the growth in the Company's portfolio of student loans. The average student loan portfolio increased $3.5 billion, or 31.9%, during the six months ended June 30, 2005 compared to the same period in 2004, which resulted in an increase of loan interest income by approximately $114.4 million. Interest expense on bonds and notes payable increased as a result of the increase in average variable-rate debt, the issuance of unsecured fixed-rate debt in May 2005, and the change in the interest rate environment. These increases were offset by a reduction in the average secured fixed-rate bonds and notes outstanding. Overall, the student loan cost of funds (excluding net settlements on derivatives) increased to 3.13% in 2005 from 1.69% in 2004. Average variable-rate debt increased $3.4 billion, which resulted in an increase of interest expense by approximately $50.1 million. In addition, the increase in interest rates, specifically LIBOR and auction rates, increased the Company's average cost of funds on variable-rate debt which increased interest expense approximately $91.7 million. The Company also issued $275 million of unsecured debt in May 2005 which increased interest expense by $1.5 million. The increase in interest expense was reduced as average fixed-rate debt decreased by $234.1 million, which decreased the Company's overall interest expense by approximately $6.9 million. 23
Net interest income, excluding the effects of the special allowance yield adjustment and variable-rate floor income, increased approximately $19.2 million, or 20.5%, to approximately $113.2 million from approximately $93.9 million. PROVISION FOR LOAN LOSSES. The provision for loan losses for federally insured student loans increased $7.5 million from a recovery of $7.3 million in 2004 to an expense of $205,000 in 2005 as a result of the Company's Exceptional Performer designation in June 2004. OTHER INCOME. Loan and guarantee servicing income increased due to the acquisition of EDULINX in December 2004. EDULINX recognized $28.5 million of servicing income during the six months ended June 30, 2005. This increase was offset by the reduction in the average dollar amount of loans serviced for third parties in the Company's U.S. servicing operations from $9.2 billion for the six months ended June 30, 2004 to $8.8 billion for the six months ended June 30, 2005. Total average U.S. third-party loan servicing volume decreased $394.1 million, or 4.3%, which resulted in a decrease in loan servicing income of approximately $3.0 million. The decrease in the Company's U.S. servicing volume is due to loan pay downs being greater than loan additions within the third-party customer portfolios. In addition, guarantee servicing income decreased $2.7 million due to a customer that did not renew its servicing contract in 2004. Other fee-based income increased $8.3 million due to the acquisitions of SMG and NHR in February 2005 and FACTS in June 2005. Software services income increased due to additional system maintenance and enhancement work performed for third-party customers. The Company utilizes derivative instruments to provide economic hedges to protect against the impact of adverse changes in interest rates. During the six months ended June 30, 2005, the derivative market value adjustment net gains were $8.9 million and net settlements representing realized costs were $16.1 million as compared to derivative market adjustment net gains of $0.5 million and net settlements representing realized costs of $2.9 million for the comparable period in 2004. These increases, in addition to the changes in interest rates and fluctuations in the forward yield curve, is the result of the Company entering into $3.7 billion in notional amount of derivatives in July 2004. See Item 3, "Quantitative and Qualitative Disclosures about Market Risk -- Interest Rate Risk." OPERATING EXPENSES. Salaries and benefits increased $15.9 million due to the acquisitions of EDULINX, SMG, NHR, and FACTS. This increase is offset by the Company recognizing approximately $14.8 million less in incentive plan compensation in 2005 compared to 2004 due to a change in terms of the Company's incentive plan for 2005. Depreciation and amortization, excluding amortization of intangible assets, increased $1.3 million as a result of the acquisitions of EDULINX, SMG, and FACTS. The decrease in the amortization of intangible assets is due to certain intangible assets becoming fully amortized in 2004, offset by the amortization of acquired intangible assets related to recent acquisitions. The decrease in trustee and other debt related fees relates to the improved efficiencies in the Company's debt transactions. Advertising and marketing expenses increased approximately $1.5 million due to the acquisitions of EDULINX, SMG, NHR, and FACTS and $0.7 million due to expansion of the Company's marketing efforts, especially in the consolidations area. Occupancy and communications and professional services expenses increased due to the acquisitions of EDULINX, SMG, NHR and FACTS. Postage and distribution expense increased $1.5 million due to the acquisitions of EDULINX, NHR, and FACTS and $1.0 million due to the Company's direct marketing efforts, especially in the consolidations area. Other expenses increased $2.8 million due to recent acquisitions described above and other miscellanious expenses incurred as a result of growth of the Company, which was offset by a decrease in charitable contributions expense. INCOME TAX EXPENSE. Income tax expense decreased due to the decrease in income before income taxes. The Company's effective tax rate was 36.4% and 36.6% during the six months ended June 30, 2005 and 2004, respectively. 24
FINANCIAL CONDITION <TABLE> <CAPTION> AS OF JUNE 30, 2005 COMPARED TO DECEMBER 31, 2004 CHANGE AS OF AS OF ---------------------- JUNE 30, DECECEMBER 31, 2005 2004 DOLLARS PERCENT ------------- -------------- --------- --------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Student loans receivable, net $ 15,661,315 $ 13,461,814 $ 2,199,501 16.3 % Cash, cash equivalents, and restricted cash and investments 1,110,109 1,302,954 (192,845) (14.8) Other assets 537,479 395,237 142,242 36.0 ------------- --------------- ------------- ------ Total assets $ 17,308,903 $ 15,160,005 $ 2,148,898 14.2 % ============= =============== ============= ====== LIABILITIES: Bonds and notes payable $ 16,580,078 $ 14,300,606 $ 2,279,472 15.9 % Fair value of derivative instruments, net 3,688 11,895 (8,207) (69.0) Other liabilities 201,467 391,329 (189,862) (48.5) ------------- --------------- ------------- ------ Total liabilities 16,785,233 14,703,830 2,081,403 14.2 Shareholders' equity 523,670 456,175 67,495 14.8 ------------- --------------- ------------- ------ Total liabilities and shareholders' equity $ 17,308,903 $ 15,160,005 $ 2,148,898 14.2 % ============= =============== ============= ====== </TABLE> Total assets increased primarily due to an increase in student loans receivable. The Company originated and acquired $2.9 billion of student loans during the six months ended June 30, 2005, offset by repayments of approximately $0.7 billion. Cash, cash equivalents, and restricted cash and investments decreased primarily because of a $211.3 million decrease in restricted cash due to loan program customers, which reflects timing of disbursements on loans and reduced lockbox volume. Other assets increased primarily due the acquisitions of SMG, NHR, and FACTS since December 2004. In addition, accrued interest receivable is included in other assets and increased as a result of the increase in student loans receivable. Total liabilities increased primarily because of an increase in bonds and notes payable, resulting from additional borrowings to fund growth in student loans. Fair value of derivative instruments, net decreased as a result of a decrease in the fair value of the Company's derivative instruments. Other liabilities includes restricted cash amounts due to loan program customers that decreased $211.3 million as a result of timing of disbursements on loans and reduced lockbox volume. This is offset by increases due to the acquisitions of SMG, NHR, and FACTS and an increase in accrued interest on bonds and notes payable as a result of changes in the interest rate environment and additional borrowings. Shareholders' equity increased primarily as a result of net income of $66.3 million during the six months ended June 30, 2005. LIQUIDITY AND CAPITAL RESOURCES The Company utilizes operating cash flow, operating lines of credit, and secured financing transactions to fund operations and student loan acquisitions. In addition, on April 13, 2005, the Company filed a universal shelf registration statement with the Securities and Exchange Commission ("SEC") which was declared effective on May 12, 2005. This facility allows the Company to sell up to $750 million of securities that may consist of common stock, preferred stock, unsecured debt securities, warrants, stock purchase contracts, and stock purchase units. The terms of any securities are established at the time of the offering. On May 25, 2005, the Company consummated a debt offering under this universal shelf consisting of $275.0 million in aggregate principal amount of Senior Notes due June 1, 2010 (the "Notes"). The Notes are unsecured obligations of the Company. Interest on the Notes is 5.125%, payable semiannually. At the Company's option, the Notes are redeemable in whole at any time or in part from time to time at the redemption price described in its prospectus supplement. Operating activities provided net cash of $72.9 million during the six months ended June 30, 2005, a decrease of $129.3 million from the net cash provided by operating activities of $202.2 million during the comparable period in 2004. Operating cash flows consist of net income adjusted for various non-cash items such as the provision for loan losses, depreciation and amortization, deferred income taxes, the derivative market value adjustment, non-cash compensation expense, and income from equity method investments. These non-cash items resulted in a decrease in cash provided by operating activities of $2.0 million during the six months ended June 30, 2005 as compared to the comparable period in 2004. As of June 30, 2005, the Company had a $35.0 million operating line of credit and a $50.0 million commercial paper commitment under two separate facilities from a group of six large regional and national financial institutions, both of which expire in September 2005. The Company uses these facilities primarily for general operating purposes and had no borrowings under these facilities as of June 30, 2005. The Company had $85.0 million available to borrow under these operating lines as of June 30, 2005. The Company believes these facilities, the issuance of $275.0 million of unsecured debt under its universal shelf in May 2005, and the remaining capacity on the universal shelf indicate a favorable trend in its available capital resources. 25
The Company's secured financing instruments include short-term student loan warehouse programs, variable-rate tax-exempt bonds, fixed-rate tax-exempt bonds, fixed-rate bonds, and various asset-backed securities. Of the $16.6 billion of debt outstanding as of June 30, 2005, $13.9 billion was issued under securitization transactions. On February 16, 2005, April 19, 2005, and July 22, 2005, the Company completed asset-backed securities transactions totaling $1.3 billion, $2.0 billion, and $1.3 billion, respectively. Depending on market conditions, the Company anticipates continuing to access the asset-backed securities market in 2005 and subsequent years. Securities issued in the securitization transactions are generally priced based upon a spread to LIBOR or set under an auction procedure. The interest rate on student loans being financed is generally set based upon a spread to commercial paper or U.S. Treasury bills. The Company's warehouse facilities allow for expansion of liquidity and capacity for student loan growth and should provide adequate liquidity to fund the Company's student loan operations for the foreseeable future. As of June 30, 2005, the Company had a loan warehousing capacity of $4.4 billion, of which $2.4 billion was outstanding, through 364-day commercial paper conduit programs. The Company had $2.0 billion in warehouse capacity available under its warehouse facilities as of June 30, 2005. These conduit programs mature in 2006 through 2009; however, they must be renewed annually by underlying liquidity providers. Historically, the Company has been able to renew its commercial paper conduit programs, including the underlying liquidity agreements, and therefore the Company does not believe the renewal of these contracts present a significant risk to its liquidity. The Company is limited in the amounts of funds that can be transferred from its subsidiaries through intercompany loans, advances, or cash dividends. These limitations result from the restrictions contained in trust indentures under debt financing arrangements to which the Company's education lending subsidiaries are parties. The Company does not believe these limitations will significantly affect its operating cash needs. The amounts of cash and investments restricted in the respective reserve accounts of the education lending subsidiaries are shown on the balance sheets as restricted cash and investments. The following table summarizes the Company's bonds and notes outstanding as of June 30, 2005: <TABLE> <CAPTION> INTEREST RATE RANGE ON CARRYING AMOUNT TOTAL AMOUNT FINAL MATURITY ---------- ------------ -------------- -------------------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Variable rate bonds and notes (a): Bonds and notes based on indices $ 9,983,808 60.2 % 1.84% - 4.17% 11/25/09 - 01/25/41 Bonds and notes based on auction 3,334,220 20.1 2.30% - 3.45% 11/01/09 - 07/01/43 ------------- -------- Total variable rate bonds and notes 13,318,028 80.3 Commerical paper and other 2,362,465 14.2 2.85% - 3.24% 05/12/06 - 09/02/09 Fixed-rate bonds and notes (a) 609,585 3.7 5.20% - 6.68% 12/01/05 - 05/01/29 Unsecured fixed rate debt 275,000 1.7 5.13% 06/01/10 Other borrowings 15,000 0.1 6.00% 11/01/05 ------------- -------- Total $16,580,078 100.0 % ============= ======== </TABLE> - ----------- (a) Issued in securitization transactions. The Company is committed under noncancelable operating leases for certain office and warehouse space and equipment. The Company's contractual obligations as of June 30, 2005 were as follows: <TABLE> <CAPTION> LESS THAN MORE THAN TOTAL 1 YEAR 1 TO 3 YEARS 3 TO 5 YEARS 5 YEARS ------------- ------------ ------------- ------------ -------------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> <C> Bonds and notes payable $16,580,078 $1,919,917 $ 199,366 $1,143,689 $ 13,317,106 Operating lease obligations 19,582 6,187 9,430 3,484 481 Other 3,438 3,438 -- -- -- ------------- ------------ ------------ ------------ -------------- Total $16,603,098 $1,929,542 $ 208,796 $1,147,173 $ 13,317,587 ============= ============ ============ ============ ============== </TABLE> 26
The Company has commitments with its branding partners and forward flow lenders which obligate the Company to purchase loans originated under specific criteria, although the branding partners and forward flow lenders are not obligated to provide the Company with a minimum amount of loans. Branding partners are those entities from whom the Company acquires student loans and provides marketing and origination services. Forward flow lenders are those entities from whom the Company acquires student loans and provides origination services. These commitments generally run for periods ranging from one to five years and are generally renewable. As of June 30, 2005, the Company was committed to extend credit or was obligated to purchase $130.4 million of student loans at current market rates at the respective sellers' requests under or pursuant to the terms of various agreements. On December 1, 2004, the Company purchased EDULINX in a business combination for $7.0 million. An additional payment of approximately $6.3 million is to be paid by the Company if EDULINX obtains an extension or renewal of a significant customer servicing contract that currently expires in February 2006. This contingency payment is due following the date on which such extension or renewal period of the servicing contract commences. Effective February 28, 2005, the Company purchased 100% of the capital stock of SMG and 100% of the membership interests of NHR. The initial consideration paid by the Company was $27.0 million. In addition to the initial purchase price, additional payments are to be paid by the Company based on the operating results of SMG and NHR as defined in the purchase agreement. The contingent payments are payable in annual installments through April 2008 and in total will range from a minimum of $4.0 million to a maximum of $24.0 million. STUDENT LOAN PORTFOLIO The table below describes the components of the Company's loan portfolio: <TABLE> <CAPTION> AS OF JUNE 30, 2005 AS OF DECEMBER 31, 2004 -------------------------- -------------------------- DOLLARS PERCENT DOLLARS PERCENT -------------- ---------- -------------- ---------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Federally insured: Stafford $ 5,815,389 37.1 % $ 5,047,487 37.5 % PLUS/SLS 325,158 2.1 252,910 1.9 Consolidation 9,231,437 59.0 7,908,292 58.7 Non-federally insured 97,705 0.6 90,405 0.7 -------------- ---------- -------------- ---------- Total 15,469,689 98.8 13,299,094 98.8 Unamortized loan premiums and deferred origination costs 202,315 1.3 169,992 1.3 Allowance for loan losses: Allowance - federally insured (99) (0.0) (117) (0.0) Allowance - non-federally insured (10,590) (0.1) (7,155) (0.1) -------------- ---------- -------------- ---------- Net $ 15,661,315 100.0 % $ 13,461,814 100.0 % ============== ========== ============== ========== </TABLE> ACTIVITY IN THE ALLOWANCE FOR LOAN LOSSES The provision for loan losses represents the periodic expense of maintaining an allowance sufficient to absorb losses, net of recoveries, inherent in the portfolio of student loans. An analysis of the Company's allowance for loan losses is presented in the following table: <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, ------------------------------- ----------------------------- 2005 2004 2005 2004 -------------- -------------- ------------- ------------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Balance at beginning of period $ 8,852 $ 16,623 $ 7,272 $ 16,026 Provision (recovery) for loan losses: Federally insured loans 124 (8,761) 205 (7,316) Non-federally insured loans 2,000 2,340 3,950 4,010 -------------- -------------- ------------- ------------- Total provision (recovery) for loan losses 2,124 (6,421) 4,155 (3,306) Charge-offs: Federally insured loans (124) (719) (223) (1,704) Non-federally insured loans (375) (1,476) (878) (3,105) -------------- -------------- ------------- ------------- Total charge-offs (499) (2,195) (1,101) (4,809) Recoveries, non-federally insured loans 212 115 363 211 -------------- -------------- ------------- ------------- Net charge-offs (287) (2,080) (738) (4,598) -------------- -------------- ------------- ------------- Balance at end of period $ 10,689 $ 8,122 $ 10,689 $ 8,122 ============== ============== ============= ============= Allocation of the allowance for loan losses: Federally insured loans $ 99 $ 735 $ 99 $ 735 Non-federally insured loans 10,590 7,387 10,590 7,387 -------------- -------------- ------------- ------------- Total allowance for loan losses $ 10,689 $ 8,122 $ 10,689 $ 8,122 ============== ============== ============= ============= Net loan charge-offs as a percentage of average student loans 0.008 % 0.074 % 0.010 % 0.085 % Total allowance as a percentage of average student loans 0.072 % 0.072 % 0.075 % 0.075 % Total allowance as a percentage of ending balance of student loans 0.069 % 0.067 % 0.069 % 0.067 % Non-federally insured allowance as a percentage of the ending balance of non-federally insured loans 10.839 % 7.822 % 10.839 % 7.822 % Average student loans $ 14,927,290 $ 11,284,876 $ 14,334,826 $ 10,869,351 Ending balance of student loans $ 15,469,689 $ 12,033,329 $ 15,469,689 $ 12,033,329 Ending balance of non-federally insured loans $ 97,705 $ 94,439 $ 97,705 $ 94,439 </TABLE> 27
Delinquencies have the potential to adversely impact the Company's earnings through increased servicing and collection costs and account charge-offs. The table below shows the student loan delinquency amounts: <TABLE> <CAPTION> AS OF JUNE 30, 2005 AS OF DECEMBER 31, 2004 ------------------------ ------------------------- DOLLARS PERCENT DOLLARS PERCENT -------------- ------- --------------- ------- (dollars in thousands) <S> <C> <C> <C> <C> Federally Insured Loans: Loans in-school/grace/deferment(1) $ 4,689,906 $ 3,584,260 Loans in forebearance(2) 1,707,940 1,654,158 Loans in repayment status: Loans current 8,039,657 89.6 % 7,142,808 89.6 % Loans delinquent 31-60 days(3) 346,665 3.9 338,434 4.3 Loans delinquent 61-90 days(3) 191,480 2.1 154,477 1.9 Loans delinquent 91 days or greater(4) 396,336 4.4 334,552 4.2 ------------- ------- -------------- ------- Total loans in repayment 8,974,138 100.0 % 7,970,271 100.0 % ------------- ======= -------------- ======= Total federally insured loans $15,371,984 $13,208,689 ============= ============== NON-FEDERALLY INSURED LOANS: Loans in-school/grace/deferment(1) $ 28,180 $ 23,106 Loans in forebearance(2) 2,757 2,110 Loans in repayment status: Loans current 61,592 92.2 % 58,606 89.9 % Loans delinquent 31-60 days(3) 2,019 3.0 2,559 3.9 Loans delinquent 61-90 days(3) 1,310 2.0 1,495 2.3 Loans delinquent 91 days or greater(4) 1,847 2.8 2,529 3.9 ------------- ------- -------------- ------- Total loans in repayment 66,768 100.0 % 65,189 100.0 % ------------- ======= -------------- ======= Total non-federally insured loans $ 97,705 $ 90,405 ============= ============== </TABLE> - ---------- (1) Loans for borrowers who still may be attending school or engaging in other permitted educational activities and are not yet required to make payments on the loans, E.G., residency periods for medical students or a grace period for bar exam preparation for law students. (2) Loans for borrowers who have temporarily ceased making full payments due to hardship or other factors, according to a schedule approved by the servicer consistent with the established loan program servicing procedures and policies. (3) The period of delinquency is based on the number of days scheduled payments are contractually past due and relate to repayment loans, that is, receivables not charged off, and not in school, grace, deferment, or forbearance. (4) Loans delinquent 91 days or greater include loans in claim status, which are loans which have gone into default and have been submitted to the guaranty agency for FFELP loans, or the insurer for non-federally insured loans, to process the claim for payment. ORIGINATION AND ACQUISITION The Company's student loan portfolio increases through various channels, including originations through the direct channel and acquisitions through the branding partner channel, the forward flow channel, and spot purchases. The Company's portfolio also increases with the addition of portfolios acquired through business acquisitions. One of the Company's primary objectives is to focus on originations through the direct channel and acquisitions through the branding partner channel. The Company has extensive and growing relationships with many large financial and educational institutions that are active in the education finance industry. Loss of a relationship with an institution from which the Company directly or indirectly acquires a significant volume of student loans could result in an adverse effect on the volume derived from its various channels. 28
The table below sets forth the activity of loans originated or acquired through each of the Company's channels: <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, ------------------------------ ----------------------------- 2005 2004 2005 2004 --------------- -------------- -------------- ------------- (DOLLARS IN THOUSANDS) (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Beginning balance $ 14,357,207 $ 11,065,865 $ 13,299,094 $ 10,314,874 Direct channel: Consolidation loan originations 781,580 505,353 1,526,670 1,311,918 Less consolidation of existing portfolio (377,300) (224,900) (714,400) (593,300) ------------- ------------ ------------- ------------- Net consolidation loan originations 404,280 280,453 812,270 718,618 Stafford/PLUS loan originations 172,599 27,385 327,622 120,312 Branding partner channel 409,013 360,704 1,082,854 715,207 Forward flow channel 453,950 362,888 641,113 448,092 Other channels 2,497 109,787 34,185 130,783 ------------- ------------ ------------- ------------- Total channel acquisitions 1,442,339 1,141,217 2,898,044 2,133,012 Loans acquired in business acquisition -- 136,138 -- 136,138 Repayments, claims, capitalized interest, and other (329,857) (309,891) (727,449) (550,695) ------------- ------------ ------------- ------------- Ending balance $ 15,469,689 $12,033,329 $ 15,469,689 $ 12,033,329 ============= ============ ============= ============= </TABLE> STUDENT LOAN SPREAD ANALYSIS Maintenance of the spread on assets is a key factor in maintaining and growing the Company's income. The following table analyzes the student loan spread on the Company's portfolio of student loans and represents the spread on assets earned in conjunction with the liabilities used to fund the assets: <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, ------------------------------ ---------------------------- 2005 2004 2005 2004 -------------- ------------- ------------ ------------- <S> <C> <C> <C> <C> Student loan yield 6.64 % 9.06 % 6.60 % 6.96 % Consolidation rebate fees (0.63) (0.57) (0.64) (0.56) Premium and deferred origination costs amortization (0.44) (0.53) (0.45) (0.64) -------------- ------------- ------------ ------------- Student loan net yield 5.57 7.96 5.51 5.76 Student loan cost of funds (a) (3.52) (1.76) (3.35) (1.74) -------------- ------------- ------------ ------------- Student loan spread 2.05 6.20 2.16 4.02 Variable-rate floor income -- -- -- (0.01) Special allowance yield adjustment, net of settlements on derivatives (b) (0.55) (4.41) (0.58) (2.29) -------------- ------------- ------------ ------------- Core Student loan spread 1.50 % 1.79 % 1.58 % 1.72 % ============== ============= ============ ============= Average balance of student loans (in thousands) $ 14,927,290 $ 11,284,876 $14,334,826 $ 10,869,351 Average balance of debt outstanding (in thousands) 15,746,521 12,418,733 15,214,821 12,026,697 </TABLE> ---------- (a) The student loan cost of funds includes the effects of the net settlement costs on the Company's derivative instruments. (b) The special allowance yield adjustment of $25.9 million and $124.3 million for the three months ended June 30, 2005 and June 30, 2004, respectively, and $55.7 million and $124.3 million for the six months ended June 30, 2005 and June 30, 2004, respectively, represents the impact on net spread had loans earned at statutorily defined rates under a taxable financing. This special allowance yield adjustment has been reduced by net settlements on derivative instruments that were used to hedge this loan portfolio earning the excess yield, which was $5.5 million for the three months ended June 30, 2005 and $14.3 million for the six months ended June 30, 2005. There were no derivative instruments used to hedge the loan portfolio earning the excess yield for the three and six months ended June 30, 2004. The compression of the Company's core student loan spread during 2005 has been was due to the following items: o an increase in lower yielding consolidation loans; o an increase in in-school loans, which have a lower yield than loans in repayment; o rising interest rates which compressed the margins on the Company's fixed rate loans that were not hedged; and o interest rate spreads in the bond market which widened during the second quarter of 2005, resulting in increased funding costs on the Company's auction rate notes. 29
RISKS If any of the following risks actually occurs, the Company's business, financial condition, and results of operations could be materially and adversely affected. See also the risk factors under the heading "Risk Factors" in Part I, Item I, "Business" in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. POLITICAL/REGULATORY RISK Pursuant to the terms of the Higher Education Act, the FFEL Program is periodically amended, and the Higher Education Act is generally reauthorized by Congress every five to six years in order to prevent sunset of that Act. Changes in the Higher Education Act made in the two most recent reauthorizations have included reductions in the student loan yields paid to lenders, increases in fees paid by lenders, and a decreased level of federal guarantee. Future changes could result in further negative impacts on the Company's business. Moreover, there can be no assurance that the provisions of the Higher Education Act, which is scheduled to expire on September 30, 2005, will be reauthorized. While Congress has consistently extended the effective date of the Higher Education Act, it may elect not to reauthorize the Department's ability to provide interest subsidies, special allowance payments, and federal guarantees for student loans. Such a failure to reauthorize would reduce the number of federally insured student loans available for the Company to originate and/or acquire in the future. Legislatively, the House Committee on Education and the Workforce recently conducted the mark-up of its reauthorization legislation and reported that bill out of the committee on July 22, 2005. The relevant items to the Company stemming from that mark-up are: o providing graduates a choice of a fixed or variable rate on consolidation loans; o changes to the FFEL Program insurance and reinsurance rates, including proposals for a decrease in insurance on portfolios receiving the benefit of the Exceptional Performer designation by up to 2%, from 100% to 98% of principal and accrued interest, and a decrease in insurance on portfolios not subject to the Exceptional Performer designation by up to 2%, from 98% to 96% of principal and accrued interest; o eliminating variable-rate floor income, including prospectively and permanently eliminating the 9.5% floor interest rate on loans refinanced with funds from pre-1993 tax-exempt financings and eliminating rebate of excess earnings on loans where the borrower rate is in excess of the lender rate; o eliminating the ability to "recycle" loans in order to earn the minimum 9.5% floor interest rate; o repealing the single-holder rule on consolidation loans; o increased loan limits; and o continued variable interest rates on all loan types. The Company cannot predict whether any of the above legislative or budget proposals will be enacted into law, but they may form some of the framework utilized by Congress in negotiating the fiscal year 2006 budget resolution and the reauthorization of the Higher Education Act. In addition, the Department oversees and implements the Higher Education Act and periodically issues regulations and interpretations of that Act. Changes in such regulations and interpretations could negatively impact the Company's business. With respect to EDULINX, changes in the Canada Student Loans Program, or the CSLP, which governs the majority of the loans serviced by EDULINX, could result in a similar negative impact on EDULINX' business. A portion of the Company's FFEL Program loan portfolio is comprised of loans financed prior to September 30, 2004 with tax-exempt obligations issued prior to October 1, 1993. Based upon provisions of the Higher Education Act, and related interpretations by the Department, the Company is entitled to receive special allowance payments on these loans equal to a 9.5% minimum rate of return ("the 9.5% Floor"). As of June 30, 2005, the Company had $3.2 billion of FFELP loans that were receiving special allowance payments based upon the 9.5% Floor. 30
In May 2003, the Company sought confirmation from the Department regarding whether it was allowed to receive the special allowance payments based on the 9.5% Floor on loans being acquired with funds obtained from the proceeds of tax-exempt obligations issued prior to October 1, 1993 and then subsequently refinanced with proceeds of taxable obligations without retiring the tax-exempt obligations. Pending satisfactory resolution of this issue, the Company deferred recognition of that portion of the 9.5% Floor income generated by these loans which exceeded statutorily defined special allowance rates under a taxable financing. In June 2004, after consideration of certain clarifying information received in connection with the guidance it had sought and based on written and verbal communications with the Department, management concluded that the earnings process had been completed and recognized the previously deferred income of $124.3 million on this portfolio. The Company is currently recognizing the 9.5% Floor income on these loans as it is earned. In October 2004, Congress passed and President Bush signed into law the Taxpayer-Teacher Protection Act of 2004 (the "October 2004 Act"), which prospectively suspended eligibility for the 9.5% Floor on any loans refinanced with proceeds of taxable obligations between September 30, 2004 and January 1, 2006. The loans in the Company's student loan portfolio that have been refinanced with proceeds of taxable obligations and are receiving special allowance payments under the 9.5% Floor were all refinanced with proceeds of taxable obligations before September 30, 2004. In April 2004, the Company ceased adding to its portfolio of loans receiving special allowance payments subject to the 9.5% Floor, and thus the provisions of the October 2004 Act do not have an effect upon the eligibility of such loans to receive the 9.5% Floor. On May 24, 2005, the Office of Inspector General of the Department ("OIG") publicly released a Final Audit Report on Special Allowance Payments to New Mexico Educational Assistance Foundation for Loans Funded by Tax-Exempt Obligations (the "NMEAF Audit Report"). In the NMEAF Audit Report, the OIG indicated it had determined that the New Mexico Educational Assistance Foundation ("NMEAF"), an entity unrelated to the Company, received what the OIG deemed to be improper special allowance payments under the 9.5% Floor calculation for loans that were transferred as security for new debt obligations ("refunded bonds") after the prior tax-exempt obligation was retired. The OIG recommended that the Chief Operating Officer for Federal Student Aid of the Department calculate and require repayment by NMEAF of the special allowance payments described in the NMEAF Audit Report. However, as discussed below, the Department has subsequently determined that NMEAF complied with applicable laws, regulations, and Department guidance with respect to such special allowance payments. In June 2005, the Company was contacted by the OIG to schedule an audit of the portion of its student loan portfolio receiving 9.5% Floor special allowance payments. The Company is fully cooperating with the OIG in connection with this audit. The Company also understands that the Department, as part of a nationwide project, is separately conducting a review of lenders related to student loans financed with the proceeds of tax-exempt bonds that are eligible for the 9.5% Floor. On June 30, 2005, the Company provided information to the Department that it requested as part of this project. On July 8, 2005, the Secretary of the Department announced that the Department had completed its review of the NMEAF Audit Report and determined that NMEAF complied with applicable laws, regulations, and Department guidance with respect to NMEAF's receipt of 9.5% Floor special allowance payments discussed in the NMEAF Audit Report and effectively indicated it disagreed with the OIG's conclusions. Although retroactive changes to the Higher Education Act are extremely uncommon, if Congress were to enact legislation that applied retroactively to remove FFELP loans that have been refinanced with proceeds of taxable obligations from eligibility for the 9.5% Floor, and if such legislation were to withstand legal challenge, it could have a material adverse effect upon the Company's financial condition and results of operations. Of the $3.2 billion in loans held by the Company as of June 30, 2005 that are receiving 9.5% Floor payments, approximately $2.9 billion in loans were financed prior to September 30, 2004 with proceeds of tax-exempt obligations issued prior to October 1, 1993 and then subsequently refinanced with the proceeds of taxable obligations. The guidance issued by the Department has indicated that receipt of the 9.5% Floor income on loans such as those held by the Company is permissible under current law and previous interpretations thereof. However, the Company cannot predict whether the Department will maintain its position in the future on the permissibility of the 9.5% Floor. Costs, if any, associated with an adverse outcome of an OIG audit or resolution of findings or recommendations arising out of an OIG audit and/or a potential Department review or legislation which would retroactively remove eligibility for the 9.5% Floor could adversely affect the Company's financial condition and results of operations. However, it is the opinion of the Company's management, based on information currently known, that any adverse outcome or resolution of findings or recommendations arising out of an OIG audit and/or a potential Department review or legislation which would retroactively remove eligibility for the 9.5% Floor would not have a material adverse effect on the Company's operations. 31
LIQUIDITY RISK The Company's primary funding needs are those required to finance its student loan portfolio and satisfy its cash requirements for new student loan originations and acquisitions, operating expenses, and technological development. The Company's operating and warehouse financings are substantially provided by third parties, over which it has no control. Unavailability of such financing sources may subject the Company to the risk that it may be unable to meet its financial commitments to creditors, branding partners, forward flow lenders, or borrowers when due unless it finds alternative funding mechanisms. The Company relies upon conduit warehouse loan financing vehicles to support its funding needs on a short-term basis. There can be no assurance that the Company will be able to maintain such warehouse financing in the future. As of June 30, 2005, the Company had a student loan warehousing capacity of $4.4 billion, of which $2.4 billion was outstanding, through 364-day commercial paper conduit programs. These conduit programs mature in 2006 through 2009; however, they must be renewed annually by underlying liquidity providers and may be terminated at any time for cause. There can be no assurance the Company will be able to maintain such conduit facilities, find alternative funding, or increase the commitment level of such facilities, if necessary. While the Company's conduit facilities have historically been renewed for successive terms, there can be no assurance that this will continue in the future. The Company has two general operating lines of credit that are for terms of less than one year each, are renewable at the option of the lenders, and may be terminated at any time for cause. In addition, the Company has a credit facility agreement with a Canadian financial institution that is cancelable by either party upon notice. The Company has historically relied upon, and expects to continue to rely upon, asset-backed securitizations as its most significant source of funding for student loans on a long-term basis. As of June 30, 2005, $13.9 billion of the Company's student loans were funded by long-term asset-backed securitizations. The net cash flow the Company receives from the securitized student loans generally represents the excess amounts, if any, generated by the underlying student loans over the amounts required to be paid to the bondholders, after deducting servicing fees and any other expenses relating to the securitizations. In addition, some of the residual interests in these securitizations have been pledged to secure additional bond obligations. The Company's rights to cash flow from securitized student loans are subordinate to bondholder interests, and these loans may fail to generate any cash flow beyond what is due to pay bondholders. The interest rates on certain of the Company's asset-backed securities are set and periodically reset via a "dutch auction" utilizing remarketing agents for varying intervals ranging from seven to 91 days. Investors and potential investors submit orders through a broker-dealer as to the principal amount of notes they wish to buy, hold, or sell at various interest rates. The broker-dealers submit their clients' orders to the auction agent or remarketing agent, who determines the interest rate for the upcoming period. If there are insufficient potential bid orders to purchase all of the notes offered for sale or being repriced, the Company could be subject to interest costs substantially above the anticipated and historical rates paid on these types of securities. A failed auction or remarketing could also reduce the investor base of the Company's other financing and debt instruments. In addition, rising interest rates existing at the time the Company's asset-backed securities are remarketed may cause other competing investments to become more attractive to investors than the Company's securities, which may decrease the Company's liquidity. CREDIT RISK As of June 30, 2005, 99% of the Company's student loan portfolio was comprised of federally insured loans. These loans currently benefit from a federal guarantee of between 98% and 100% of their principal balance and accrued interest. Effective June 1, 2004, the Company was designated as an Exceptional Performer by the Department in recognition of its exceptional level of performance in servicing FFELP loans. As a result of this designation, the Company was not subject to the 2% risk sharing on eligible claims submitted during a 12-month period. The Company is entitled to receive this benefit as long as it and/or those of its service providers that are designated as Exceptional Performers continue to meet the required servicing standards published by the Department. Compliance with such standards is assessed on a quarterly basis. In addition, service providers must submit their application for redesignation as an Exceptional Performer with the Department on an annual basis. In June 2005, the Company submitted its application for Exceptional Performer redesignation to the Department. The Department has 60 days to redesignate or deny the Company's application. Until that time, the Company continues to receive the benefit of the Exceptional Performer designation. It is the opinion of the Company's management, based on information currently known, that there is no reason to believe the Company's application will be rejected. The Company bears full risk of losses experienced with respect to the unguaranteed portion of its federally insured loans (those loans not serviced by a service provider designated as an Exceptional Performer). If the Company or a third party service provider were to lose its Exceptional Performer designation, either by the Department discontinuing the program or the Company or third party not meeting the required servicing standards, loans serviced by the Company or third-party would become subject to the 2% risk sharing loss for all claims submitted after any loss of the Exceptional Performer designation. If the Department discontinued the program, the Company would have to establish a provision for loan losses related to the 2% risk sharing. Based on the balance of federally insured loans outstanding as of June 30, 2005, this provision would be approximately $10.6 million. In addition, one of the proposed changes to the Higher Education Act is a decrease in insurance and reinsurance (i) under the Exceptional Performer designation from 100% to 98% and (ii) on portfolios not subject to the Exceptional Performer designation from 98% to 96%, each of principal and accrued interest. If the insurance and reinsurance decrease during reauthorization, the Company would have to establish a provision for loan losses related to the new risk sharing amounts. This provision would be recognized by the Company upon the effective date of the new provisions of the Higher Education Act, which is estimated to be October 1, 2006. 32
Losses on the Company's non-federally insured loans are borne by the Company, with the exception of certain privately insured loans. Privately insured loans constitute a minority of the Company's non-federally insured loan portfolio. The loan loss pattern on the Company's non-federally insured loan portfolio is not as developed as that on its federally insured loan portfolio. As of June 30, 2005, the aggregate principal balance of non-federally insured loans comprised 1% of the Company's entire student loan portfolio; however, it is expected to increase to between 3% and 5% over the next three to five years. There can be no assurance that this percentage will not increase further over the long term. The performance of student loans in the portfolio is affected by the economy, and a prolonged economic downturn may have an adverse effect on the credit performance of these loans. While the Company has provided allowances estimated to cover losses that may be experienced in both its federally insured and non-federally insured loan portfolios, there can be no assurance that such allowances will be sufficient to cover actual losses in the future. OPERATIONAL RISK Operational risk can result from regulatory compliance errors, technology failures, breaches of internal control systems, and the risk of fraud or unauthorized transactions. Operational risk includes failure to comply with regulatory requirements of the Higher Education Act, rules and regulations of the agencies that act as guarantors on the student loans, and federal and state consumer protection laws and regulations on the Company's non-federally insured loans. In addition, Canadian laws and regulations govern the Company's Canadian loan servicing operations. Such failure to comply, irrespective of the reason, could subject the Company to loss of the federal guarantee on FFELP loans, costs of curing servicing deficiencies or remedial servicing, suspension or termination of the Company's right to participate in the FFEL program or to participate as a servicer, negative publicity, and potential legal claims or actions brought by the Company's servicing customers and borrowers. The Company has the ability to cure servicing deficiencies and the Company's historical losses in this area have been minimal. However, the Company's loan servicing and guarantee servicing activities are highly dependent on its information systems, and the Company faces the risk of business disruption should there be extended failures of its systems. The Company has well-developed and tested business recovery plans to mitigate this risk. The Company also manages operational risk through its risk management and internal control processes covering its product and service offerings. These internal control processes are documented and tested regularly. RISK RELATED TO CONSOLIDATION LOANS The Company's portfolio of federally insured loans is subject to refinancing through the use of consolidation loans, which are expressly permitted by the Higher Education Act. Consolidation loan activity may result in three detrimental effects. First, when the Company consolidates loans in its portfolio, the new consolidation loans have a lower yield than the loans being refinanced due to the statutorily mandated consolidation loan rebate fee of 1.05% per year. Although consolidation loans generally feature higher average balances, longer average lives, and slightly higher special allowance payments, such attributes may not be sufficient to counterbalance the cost of the rebate fees. Second, and more significantly, the Company may lose student loans in its portfolio that are consolidated away by competing lenders. Increased consolidations of student loans by the Company's competitors may result in a negative return on loans, when considering the origination costs or acquisition premiums paid with respect to these loans. Additionally, consolidation of loans away by competing lenders can result in a decrease of the Company's servicing portfolio, thereby decreasing fee-based servicing income. Third, increased consolidations of the Company's own student loans create cash flow risk because the Company incurs upfront consolidation costs, which are in addition to the origination or acquisition costs incurred in connection with the underlying student loans, while extending the repayment schedule of the consolidated loans. The Company's student loan origination and lending activities could be significantly impacted by the reauthorization of the Higher Education Act relative to the single holder rule. For example, if the single holder rule, which generally restricts a competitor from consolidating loans away from a holder that owns all of a borrower's loans, were abolished, a substantial portion of the Company's non-consolidated portfolio would be at risk of being consolidated away by a competitor. On the other hand, abolition of the rule would also open up a portion of the rest of the market and provide the Company with the potential to gain market share. Other potential changes to the Higher Education Act relating to consolidation loans that could adversely impact the Company include allowing refinancing of consolidation loans, which would open approximately 59% of the Company's portfolio to such refinancing, and increasing origination fees paid by lenders in connection with making consolidation loans. 33
COMPETITIVE RISKS Under the FDL Program, the Department makes loans directly to student borrowers through the educational institutions they attend. The volume of student loans made under the FFEL Program and available for the Company to originate or acquire may be reduced to the extent loans are made to students under the FDL Program. In addition, if the FDL Program expands, to the extent the volume of loans serviced by the Company is reduced, the Company may experience reduced economies of scale, which could adversely affect earnings. Loan volume reductions could further reduce amounts received by the guaranty agencies available to pay claims on defaulted student loans. In the FFEL Program market, the Company faces significant competition from SLM Corporation, the parent company of Sallie Mae. SLM Corporation services nearly half of all outstanding federally insured loans and is the largest holder of student loans. The Company also faces competition from other existing lenders and servicers. As the Company expands its student loan origination and acquisition activities, that expansion may result in increased competition with some of its servicing customers. This has in the past occasionally resulted in servicing customers terminating their contractual relationships with the Company, and the Company could in the future lose more servicing customers as a result. As the Company seeks to further expand its business, the Company will face numerous other competitors, many of which will be well established in the markets the Company seeks to penetrate. Some of the Company's competitors are much larger than the Company, have better name recognition, and have greater financial and other resources. In addition, several competitors have large market capitalizations or cash reserves and are better positioned to acquire companies or portfolios in order to gain market share. Furthermore, many of the institutions with which the Company competes have significantly more equity relative to their asset bases. Consequently, such competitors may have more flexibility to address the risks inherent in the student loan business. Finally, some of the Company's competitors are tax-exempt organizations that do not pay federal or state income taxes and which generally receive floor income on certain tax-exempt obligations on a greater percentage of their student loan portfolio than the Company because they have financed a greater percentage of their student loans with tax-exempt obligations issued prior to October 1, 1993. These factors could give the Company's competitors a strategic advantage. The Company's student loan originations generally are limited to students attending eligible educational institutions in the United States. Volumes of originations are greater at some schools than others, and the Company's ability to remain an active lender at a particular school with concentrated volumes is subject to a variety of risks, including the fact that each school has the option to remove the Company from its "preferred lender" list or to add other lenders to its "preferred lender" list, the risk that a school may enter the FDL Program, or the risk that a school may begin making student loans itself. The Company acquires student loans through forward flow commitments with other student loan lenders, but each of these commitments has a finite term. There can be no assurance that these lenders will renew or extend their existing forward flow commitments on terms that are favorable to the Company, if at all, following their expiration. In addition, as of June 30, 2005, third parties owned approximately 52% of the loans the Company serviced. To the extent that third-party servicing clients reduce the volume of student loans that the Company processes on their behalf, the Company's income would be reduced, and, to the extent the related costs could not be reduced correspondingly, net income could be materially adversely affected. Such volume reductions occur for a variety of reasons, including if third-party servicing clients commence or increase internal servicing activities, shift volume to another service provider, perhaps because such other service provider does not compete with the client in student loan originations and acquisitions, or exit the FFEL Program completely. The Company's inability to maintain strong relationships with significant schools, branding partners, servicing customers, guaranty agencies, and software licensees could result in loss of: o loan origination volume with borrowers attending certain schools; o loan origination volume generated by some of the Company's branding partners; o loan and guarantee servicing volume generated by some of the Company's loan servicing customers and guaranty agencies; and o software licensing volume generated by some of the Company's licensees. The Company cannot assure that its forward flow channel lenders or its branding partners will continue their relationships with the Company. Loss of a strong relationship with a significant branding partner or with schools, from which a significant volume of student loans is directly or indirectly acquired, could result in an adverse effect on the Company's business. 34
The business of servicing Canadian student loans by EDULINX is limited to a small group of servicing customers and the agreement with the largest of such customers is currently scheduled to expire in February 2006. EDULINX cannot guarantee that it will obtain a renewal of the servicing agreement with this largest customer or that it will maintain its other servicing agreements and the termination of any such servicing agreements could result in an adverse effect on its business. PREPAYMENT RISK Pursuant to the Higher Education Act, borrowers may voluntarily prepay loans made under the FFEL Program at any time in full or in part. Prepayments may also result from consolidating student loans, which tends to occur more frequently in low interest rate environments, and from borrower defaults, which will result in the receipt of a guarantee payment. The rate of prepayments of student loans may be influenced by a variety of economic, social, and other factors affecting borrowers, including interest rates and the availability of alternative financing. The Company's profits could be adversely affected by higher prepayments, which would reduce the amount of interest the Company receives and expose the Company to reinvestment risk. CRITICAL ACCOUNTING POLICIES This Management's Discussion and Analysis of Financial Condition and Results of Operations discusses the unaudited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of income and expenses during the reporting periods. The Company bases its estimates and judgments on historical experience and on various other factors that the Company believes are reasonable under the circumstances. Actual results may differ from these estimates under varying assumptions or conditions. Note 2 of the consolidated financial statements, which are included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004, includes a summary of the significant accounting policies and methods used in the preparation of the consolidated financial statements. On an on-going basis, management evaluates its estimates and judgments, particularly as they relate to accounting policies that management believes are most "critical" -- that is, they are most important to the portrayal of the Company's financial condition and results of operations and they require management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management has determined the only critical accounting policy is determining the level of the allowance for loan losses. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses represents management's estimate of probable losses on student loans. This evaluation process is subject to numerous estimates and judgments. The Company evaluates the adequacy of the allowance for loan losses on its federally insured loan portfolio separately from its non-federally insured loan portfolio. The allowance for the federally insured loan portfolio is based on periodic evaluations of the Company's loan portfolios considering 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 guarantees 98% of principal and interest of federally insured student loans, which limits the Company's loss exposure to 2% of the outstanding balance of the Company's federally insured portfolio. Effective June 1, 2004, the Company was designated as an Exceptional Performer by the Department in recognition of its exceptional level of performance in servicing FFELP loans. As a result of this designation, the Company received 100% reimbursement on all eligible FFELP default claims submitted for reimbursement during the 12-month period following the effective date of its designation. The Company was not subject to the 2% risk sharing on eligible claims submitted during this 12-month period. Only FFELP loans that are serviced by the Company, as well as loans owned by the Company and serviced by other service providers designated as Exceptional Performers by the Department, are eligible for the 100% reimbursement. In June 2005, the Company submitted its application for Exceptional Performer redesignation to the Department. The Department has 60 days to redesignate the Company as an Exceptional Performer or deny the Company's application. Until that time, the Company continues to receive the benefit of the Exceptional Performer designation. It is the opinion of the Company's management, based on information currently known, that there is no reason to believe the Company's application should be rejected. As of June 30, 2005, more than 99% of the Company's federally insured loans were serviced by providers designated as Exceptional Performers. Of this portion, the Company serviced approximately 92% and third parties serviced approximately 8%. The Company is entitled to receive the 100% reimbursement benefit as long as it and/or its service providers continue to meet the required servicing standards published by the Department. Compliance with such standards is assessed on a quarterly basis and service providers must apply for redesignation annually as discussed previously. 35
Pursuant to the terms of the Higher Education Act, the FFEL Program is periodically amended, and the Higher Education Act is generally reauthorized by Congress every five to six years in order to prevent sunset of that Act. The current provisions of the Higher Education Act are scheduled to expire on September 30, 2005. Historically, the United States Congress makes changes to the provisions of the Higher Education Act during the reauthorization process. One of the changes to the Higher Education Act that is included in the reauthorization proposal is changes to the guarantee rates and terms on FFELP loans, including proposals for a decrease in insurance and reinsurance on portfolios receiving the benefit of Exceptional Performance designation by up to 2%, from 100% to 98% of principal and accrued interest, and a decrease in insurance and reinsurance on portfolios not subject to the Exceptional Performance designation by up to 2%, from 98% to 96% of principal and accrued interest. If the insurance and reinsurance decrease during reauthorization, the Company would have to establish a provision for loan losses related to the new risk sharing amounts. This provision would be recognized by the Company upon the effective date of the new provisions of the Higher Education Act, which is estimated to be October 1, 2006. See "- Risks - Political/Regulatory Risk." In determining the adequacy of the allowance for loan losses on the non-federally insured loans, the Company considers several factors including: loans in repayment versus those in a nonpaying status, months in repayment, delinquency status, type of program, and trends in defaults in the portfolio based on Company and industry data. The Company charges off the uninsured loan when the collection of principal and interest is 120 days past due. The allowance for federally insured and non-federally insured loans is maintained at a level management believes is adequate to provide for estimated probable credit losses inherent in the loan portfolio. This evaluation is inherently subjective because it requires estimates that may be susceptible to significant changes. RECENT ACCOUNTING PRONOUNCEMENTS In June 2005, the Financial Accounting Standards Board ("FASB") issued SFAS No. 154, REPORTING ACCOUNTING CHANGES AND ERROR CORRECTIONS ("SFAS No. 154"). SFAS No. 154 requires retrospective application for voluntary changes in accounting principle unless it is impracticable to do so. SFAS No. 154's retrospective application requirement replaces Accounting Principles Board Opinion 20's requirement to recognize most voluntary changes in accounting principle by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. If the cumulative effect of the change in accounting principle can be determined, but it is impracticable to determine the specific effects of an accounting change on one or more prior periods presented, the change in accounting policy will have to be applied to balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable, with a corresponding adjustment made to the opening balance of retained earnings or other components of equity (e.g., accumulated other comprehensive income) for that period. If it is impracticable to determine the cumulative effect of applying a change in accounting principle, the new accounting principle is to be applied prospectively from the earliest date practicable. If retrospective application for all prior periods is impracticable, the method used to report the change and the reason that retrospective application is impracticable are to be disclosed. The requirements of SFAS No. 154 are effective for accounting changes made in fiscal years beginning after December 15, 2005. As of the filing of this report, management believes that SFAS No. 154 will not have a significant effect on the financial position, results of operations, and cash flows of the Company. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISK The Company's primary market risk exposure arises from fluctuations in its borrowing and lending rates, the spread between which could impact the Company due to shifts in market interest rates. Because the Company generates the majority of its earnings from its student loan spread, the interest sensitivity of the balance sheet is a key profitability driver. The majority of student loans have variable-rate characteristics in certain interest rate environments. Some of the student loans include fixed-rate components depending upon the rate reset provisions, or, in the case of consolidation loans, are fixed at the weighted average interest rate of the underlying loans at the time of consolidation. The following table sets forth the Company's loan assets and debt instruments by rate characteristics: <TABLE> <CAPTION> AS OF JUNE 30, 2005 AS OF DECEMBER 31, 2004 -------------------------- -------------------------- DOLLARS PERCENT DOLLARS PERCENT -------------- --------- --------------- -------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Fixed-rate loan assets............$ 5,151,206 33.3 % $ 5,559,748 41.8 % Variable-rate loan assets......... 10,318,483 66.7 7,739,346 58.2 -------------- --------- --------------- -------- Total..........................$ 15,469,689 100.0 % $ 13,299,094 100.0 % ============== ========= =============== ======== Fixed-rate debt instruments.......$ 899,585 5.4 % $ 712,641 5.0 % Variable-rate debt instruments.... 15,680,493 94.6 13,587,965 95.0 -------------- --------- --------------- -------- Total..........................$ 16,580,078 100.0 % $ 14,300,606 100.0 % ============== ========= =============== ======== </TABLE> 36
The following table shows the Company's student loan assets currently earning at a fixed-rate as of June 30, 2005: BORROWER/ ESTIMATED LENDER VARIABLE CURRENT FIXED INTEREST WEIGHTED CONVERSION BALANCE OF RATE RANGE AVERAGE YIELD RATE (a) FIXED RATE ASSETS -------------- -------------- ----------- ------------------- (DOLLARS IN THOUSANDS) 6.0 - 6.5% 6.21% 3.57% $ 301,896 6.5 - 7.0 6.71 4.07 358,384 7.0 - 8.0 7.51 4.87 319,006 > 8.0 8.55 5.91 958,382 9.5 floor yield 9.50 6.86 3,213,538 ------------------ $ 5,151,206 ================== - ---------- (a) The estimated variable conversion rate is the estimated short-term interest rate at which loans would convert to variable rate. Historically, the Company has followed a policy of funding the majority of its student loan portfolio with variable-rate debt. In a low interest rate environment, the FFELP loan portfolio yields excess income primarily due to the reduction in interest rates on the variable-rate liabilities that fund student loans at a fixed borrower rate and also due to consolidation loans earning interest at a fixed rate to the borrower. Therefore, absent utilizing derivative instruments, in a low interest rate environment, a rise in interest rates will have an adverse effect on earnings. In higher interest rate environments, where the interest rate rises above the borrower rate and the fixed-rate loans become variable rate and are effectively matched with variable-rate debt, the impact of rate fluctuations is substantially reduced. The Company attempts to match the interest rate characteristics of pools of loan assets with debt instruments of substantially similar characteristics, particularly in rising interest rate environments. Due to the variability in duration of the Company's assets and varying market conditions, the Company does not attempt to perfectly match the interest rate characteristics of the entire loan portfolio with the underlying debt instruments. The Company has adopted a policy of periodically reviewing the relationship between the interest rate characteristics of its assets and liabilities and the Company's outlook as to current and future market conditions. Based on those factors, the Company will periodically use derivative instruments as part of its overall risk management strategy to manage risk arising from its fixed-rate and variable-rate financial instruments. The following table summarizes the notional values and fair values of the Company's outstanding derivative instruments as of June 30, 2005: <TABLE> <CAPTION> NOTIONAL AMOUNTS BY PRODUCT TYPE -------------------------------------------------- WEIGHTED AVERAGE FIXED FIXED/ FLOATING/ RATE ON FLOATING BASIS FIXED FIXED/FLOATING MATURITY SWAPS (a) SWAPS (b) SWAPS (c) TOTAL SWAPS - ----------------------------- ------------ -------- ------------- ---------- --------------- (DOLLARS IN MILLIONS) <C> <C> <C> <C> <C> <C> 2005 $ 1,187 $ 1,000 $ 1,010 $ 3,197 2.20 % 2006 613 500 -- 1,113 2.99 2007 512 -- -- 512 3.42 2008 463 -- -- 463 3.76 2009 312 -- -- 312 4.01 2010 and thereafter 1,938 -- -- 1,938 4.29 ----------- ---------- ------------ ---------- ------------ Total $ 5,025 $ 1,500 $ 1,010 $ 7,535 3.48 =========== ========== ============ ========== ============ Fair value (d) (in thousands) $ (1,897) $ (971) $ (820) $ (3,688) =========== ========== ============ ========== </TABLE> - ---------- (a) A fixed/floating swap is an interest rate swap in which the Company agrees to pay a fixed rate in exchange for a floating rate. The interest rate swap converts a portion of the Company's variable-rate debt (equal to the notional amount of the swap) to a fixed rate for a period of time, fixing the relative spread between a portion of the Company's student loan assets and the converted fixed-rate liability. 37
(b) A basis swap is an interest rate swap agreement in which the Company agrees to pay a floating rate in exchange for another floating rate, based upon different market indices. The Company has employed basis swaps to limit its sensitivity to dramatic fluctuations in the underlying indices used to price a portion of its variable-rate assets and variable-rate debt. (c) A floating/fixed swap is an interest rate swap in which the Company agrees to pay a floating rate in exchange for a fixed rate. The interest rate swap converts a portion of the Company's fixed-rate debt (equal to the notional amount of the swap) to a floating rate for a period of time. (d) Fair value is determined from market quotes from independent security brokers. Fair value indicates an estimated amount the Company would receive (pay) if the contracts were cancelled or transferred to other parties. The Company accounts for its derivative instruments in accordance with SFAS No. 133. SFAS No. 133 requires that changes in the fair value of derivative instruments be recognized currently in earnings unless specific hedge accounting criteria as specified by SFAS No. 133 are met. Management has structured all of the Company's derivative transactions with the intent that each is economically effective. However, the majority of the Company's derivative instruments do not qualify for hedge accounting under SFAS No. 133; consequently, the change in fair value of these derivative instruments is included in the Company's operating results. Changes or shifts in the forward yield curve can significantly impact the valuation of the Company's derivatives. Accordingly, changes or shifts to the forward yield curve will impact the financial position, results of operations, and cash flows of the Company. As of June 30, 2005, the Company accounted for one interest rate swap with a notional amount of $150 million as a cash flow hedge in accordance with SFAS No. 133. Gains and losses on the effective portion of this qualifying hedge are accumulated in other comprehensive income and reclassified to current period earnings over the period in which the stated hedged transactions impact earnings. Ineffectiveness is recorded to earnings through interest expense. The following is a summary of the amounts included in derivative market value adjustment and net settlements on the consolidated statements of operations related to those derivative instruments that do not qualify for hedge accounting: <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, -------------------------- ------------------------- 2005 2004 2005 2004 ------------ ------------ ----------- ----------- (DOLLARS IN THOUSANDS) <S> <C> <C> <C> <C> Change in fair value of derivative instruments... $ (51,372) $ 3,075 $ 8,918 $ 548 Settlements, net................................. (6,001) (1,718) (16,087) (2,932) ------------ ------------ ----------- ----------- Derivative market value adjustment and net settlements $ (57,373) $ 1,357 $ (7,169) $ (2,384) ============ ============ =========== =========== </TABLE> The increase in the derivative market value adjustment and net settlements during the three and six months ended June 30, 2005, in addition to the changes in interest rates and fluctuations in the forward yield curve, is the result of the Company entering into $3.7 billion in notional amount of derivatives in July 2004. 38
The following tables summarize the effect on the Company's earnings, based upon a sensitivity analysis performed by the Company assuming a hypothetical increase and decrease in interest rates of 100 basis points and an increase in interest rates of 200 basis points while funding spreads remain constant. The effect on earnings was performed on the Company's variable-rate assets and liabilities. The analysis includes the effects of the derivative instruments in existence during the periods presented. As a result of the Company's interest rate management activities, the Company expects the change in pre-tax net income resulting from 100 basis point and 200 basis point increases in interest rates will not result in a proportional decrease in net income. <TABLE> <CAPTION> THREE MONTHS ENDED JUNE 30, 2005 ----------------------------------------------------------------------------- CHANGE FROM DECREASE OF CHANGE FROM INCREASE OF CHANGE FROM INCREASE OF 100 BASIS POINTS 100 BASIS POINTS 200 BASIS POINTS ------------------------ ----------------------- ------------------------ Dollar Percent Dollar Percent Dollar Percent ----------- ----------- ----------- ---------- ------------ ---------- (dollars in thousands, except share data) <S> <C> <C> <C> <C> <C> <C> Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements..$ 10,789 305.8 % $ (9,745) (276.2)% $ (17,495) (495.9)% Impact of derivative settlements.............. (10,394) (294.6) 10,394 294.6 20,787 589.2 ----------- ----------- ----------- ---------- ------------ ---------- Increase in net income before taxes...........$ 395 11.2 % $ 649 18.4 % $ 3,292 93.3 % =========== =========== =========== ========== ============ ========== Increase in basic and diluted earning per share........................ $ - $ 0.01 $ 0.04 =========== =========== ============ THREE MONTHS ENDED JUNE 30, 2004 ----------------------------------------------------------------------------- CHANGE FROM DECREASE OF CHANGE FROM INCREASE OF CHANGE FROM INCREASE OF 100 BASIS POINTS 100 BASIS POINTS 200 BASIS POINTS ------------------------ ----------------------- ------------------------ Dollar Percent Dollar Percent Dollar Percent ----------- ----------- ----------- ---------- ------------ ---------- (dollars in thousands, except share data) Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements...$ 22,235 16.5 % $ (4,461) (3.3)% $ (8,034) (6.0)% Impact of derivative settlements.............. (18,804) (14.0) 15,706 11.7 32,962 24.5 ----------- ----------- ----------- ---------- ------------ ---------- Increase in net income before taxes..........$ 3,431 2.5 % $ 11,245 8.4 % $ 24,928 18.5 % =========== =========== =========== ========== ============ ========== Increase in basic and diluted earning per share.........................$ 0.04 $ 0.13 $ 0.29 =========== =========== ============ SIX MONTHS ENDED JUNE 30, 2005 ----------------------------------------------------------------------------- CHANGE FROM DECREASE OF CHANGE FROM INCREASE OF CHANGE FROM INCREASE OF 100 BASIS POINTS 100 BASIS POINTS 200 BASIS POINTS ------------------------ ----------------------- ------------------------ Dollar Percent Dollar Percent Dollar Percent ----------- ----------- ----------- ---------- ------------ ---------- (dollars in thousands, except share data) Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements...$ 20,616 19.8 % $ (18,765) (18.0)% $ (33,135) (31.8)% Impact of derivative settlements.............. (20,294) (19.5) 20,294 19.5 40,587 39.0 ----------- ----------- ----------- ---------- ------------ ---------- Increase in net income before taxes...........$ 322 0.3 % $ 1,529 1.5 % $ 7,452 7.2 % =========== =========== =========== ========== ============ ========== Increase in basic and diluted earning per share........................ $ - $ 0.02 $ 0.09 =========== =========== ============ SIX MONTHS ENDED JUNE 30, 2004 ----------------------------------------------------------------------------- CHANGE FROM DECREASE OF CHANGE FROM INCREASE OF CHANGE FROM INCREASE OF 100 BASIS POINTS 100 BASIS POINTS 200 BASIS POINTS ------------------------ ----------------------- ------------------------ Dollar Percent Dollar Percent Dollar Percent ----------- ----------- ----------- ---------- ------------ ---------- (dollars in thousands, except share data) Effect on earnings: Increase (decrease) in pre-tax net income before impact of derivative settlements...$ 44,101 29.6 % $ (7,468) (5.0)% $ (12,714) (8.5)% Impact of derivative settlements.............. (35,871) (24.1) 28,892 19.4 61,274 41.1 ----------- ----------- ----------- ---------- ------------ ---------- Increase in net income before taxes...........$ 8,230 5.5 % $ 21,424 14.4 % $ 48,560 32.6 % =========== =========== =========== ========== ============ ========== Increase in basic and diluted earning per share.........................$ 0.10 $ 0.25 $ 0.56 =========== =========== ============ </TABLE> 39
Developing an effective strategy for dealing with movements in interest rates is complex, and no strategy can completely insulate the Company from risks associated with such fluctuations. In addition, a counterparty to a derivative instrument could default on its obligation, thereby exposing the Company to credit risk. When the fair value of a derivative instrument is negative, the Company owes the counterparty and, therefore, has no credit risk. However, if the value of derivatives with a counterparty exceeds a specified threshold, the Company may have to pay a collateral deposit to the counterparty. If interest rates move materially differently from management's expectations, the Company could be required to deposit a significant amount of collateral with its derivative instrument counterparties. The collateral deposits, if significant, could negatively impact the Company's capital resources. The Company manages market risks associated with interest rates by establishing and monitoring limits as to the types and degree of risk that may be undertaken. Further, the Company may have to repay certain costs, such as transaction fees or brokerage costs, if the Company terminates a derivative instrument. Finally, the Company's interest rate risk management activities could expose the Company to substantial losses if interest rates move materially differently from management's expectations. As a result, the Company cannot assure that its economic hedging activities will effectively manage its interest rate sensitivity or have the desired beneficial impact on its results of operations or financial condition. FOREIGN CURRENCY EXCHANGE RISK The Company purchased EDULINX in December 2004. EDULINX is a Canadian corporation that engages in servicing Canadian student loans. As a result of this acquisition, the Company is exposed to market risk related to fluctuations in foreign currency exchange rates between the U.S. and Canadian dollars. The Company has not entered into any foreign currency derivative instruments to hedge this risk. However, the Company does not believe fluctuations in foreign currency exchange rates will have a significant effect on the financial position, results of operations, or cash flows of the Company. ITEM 4. CONTROLS AND PROCEDURES DISCLOSURE CONTROLS AND PROCEDURES Under supervision and with the participation of certain members of the Company's management, including the co-chief executive officers and the chief financial officer, the Company completed an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures (as defined in SEC Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, the Company's co-chief executive officers and chief financial officer believe that the disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q with respect to timely communication to them and other members of management responsible for preparing periodic reports and material information required to be disclosed in this Quarterly Report on Form 10-Q as it relates to the Company and its consolidated subsidiaries. The effectiveness of the Company's or any system of disclosure controls and procedures is subject to certain limitations, including the exercise of judgment in designing, implementing, and evaluating the controls and procedures, the assumptions used in identifying the likelihood of future events, and the inability to eliminate misconduct completely. As a result, there can be no assurance that the Company's disclosure controls and procedures will prevent all errors or fraud or ensure that all material information will be made known to appropriate management in a timely fashion. By their nature, the Company's or any system of disclosure controls and procedures can provide only reasonable assurance regarding management's control objectives. CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING There was no change in the Company's internal control over financial reporting during the Company's last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is subject to various claims, lawsuits, and proceedings that arise in the normal course of business. These matters principally consist of claims by borrowers disputing the manner in which their loans have been processed and disputes with other business entities. On the basis of present information, anticipated insurance coverage, and advice received from counsel, it is the opinion of the Company's management that the disposition or ultimate determination of these claims, lawsuits, and proceedings will not have a material adverse effect on the Company's business, financial position, or results of operations. 40
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Company's annual meeting of shareholders held on May 26, 2005, the following proposals were approved by the margins indicated: 1. To elect nine directors to serve on the Company's Board of Directors for one-year terms or until their successors are elected and qualified. NUMBER OF SHARES --------------------------------- VOTES FOR VOTES WITHHELD --------------- ---------------- James P. Abel............. 170,633,329 2,297,092 Don R. Bouc............... 171,064,732 1,865,689 Stephen F. Butterfield.... 171,064,997 1,865,424 Michael S. Dunlap......... 171,064,597 1,865,824 Thomas E. Henning......... 171,664,940 1,265,481 Arturo R. Moreno.......... 167,597,865 5,332,556 Brian J. O'Connor......... 171,665,840 1,264,581 Michael D. Reardon........ 171,665,120 1,265,301 James H. Van Horn......... 170,903,321 2,027,100 2. To ratify the appointment of KPMG LLP as independent auditors for 2005. NUMBER OF SHARES ------------------------------------------------ VOTES FOR VOTES AGAINST ABSTAIN --------------- ------------------ ------------ 172,242,002 163,820 524,599 ITEM 6. EXHIBITS 4.1 Indenture of Trust dated as of July 1, 2005, between Nelnet Student Loan Trust 2005-3 and Zions First National Bank, as trustee and as eligible lender trustee, filed as Exhibit 4.1 to Nelnet Student Loan Trust 2005-3's Current Report on Form 8-K filed on August 1, 2005 and incorporated herein by reference. 31.1* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Co-Chief Executive Officer Michael S. Dunlap. 31.2* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Co-Chief Executive Officer Stephen F. Butterfield. 31.3* Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Chief Financial Officer Terry J. Heimes. 32.** Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. - ---------- * Filed herewith ** Furnished herewith 41
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NELNET, INC. Date: August 9, 2005 By: /s/ Michael S. Dunlap ------------------------------------ Name: Michael S. Dunlap Title: Chairman and Co-Chief Executive Officer By: /s/ Stephen F. Butterfield --------------------------------------------- Name: Stephen F. Butterfield Title: Vice-Chairman and Co-Chief Executive Officer By: /s/ Terry J. Heimes -------------------------------------------- Name: Terry J. Heimes Title: Chief Financial Officer