Earnings Transcript for NNI - Q2 Fiscal Year 2009

Executives: Jeff Noordhoek - President Terry Heimes - Chief Financial Officer Phil Morgan - Managing Director of Investor Relations

Analysts: Mike Taiano - Sandler O’Neill Sameer Gokhale - KBW

Operator: Good day everyone and welcome to the Nelnet second quarter 2009 conference call. Today’s call is being recorded and broadcast live over the Internet. At this time, Mr. Phil Morgan, Nelnet’s Managing Director of Investor Relations will begin with opening remarks. Please go ahead, sir.

Phil Morgan: Thanks, Dan. Good afternoon and welcome to Nelnet’s 2009 second quarter earnings conference call. On today’s call, we have Jeff Noordhoek, President, and Terry Heimes, Chief Financial Officer. Please note that during the conference call, we may discuss predictions and expectations and may make other forward-looking statements. Actual results may differ from those discussed here based on a variety of factors. These factors are discussed in the company’s Form 10-K and other filings with the SEC. The company does not intend to update any forward-looking statements made during the call. During the course of the call, we will refer to our non-GAAP financial measure, which the company defines as base net income. A description of base net income and a reconciliation of GAAP net income to base net income are included in our second quarter 2009 supplemental earnings disclosure, which is posted on our Investor Relations website at www.nelnetinvestors.com. After Jeff and Terry have concluded their formal remarks, we will open up the call for questions. Thank you. I will now turn the call over to Jeff.

Jeff Noordhoek: Thanks, Phil, and good afternoon, everyone. We are extremely pleased with our operating results for the first half of 2009 and in the second quarter. We have exceeded our expectations. Our fee-based revenues are growing net interest margins, has increased expenses have decreased and we have virtually eliminated our liquidity risk. In the second quarter, we reported base net income of $0.60 per share compared to $0.54 in 2008. We continue our transformation to a fee-for-service processing company and as we look forward, we will continue to focus on meeting our primary objectives of growing and diversifying our fee-for-service businesses and maximizing the value of our existing loan portfolio. Making progress towards these objectives and winning a portion of the government servicing contract has made us optimistic about the remainder of 2009 and the foreseeable future. The government servicing contract allows us the opportunity to leverage our fixed costs infrastructure and further increases and diversifies our revenue. We look forward to growing this important new business line and to provide the best possible service to students in schools under the contract. We know an ongoing important topic related to our company is the president’s budget proposal to eliminate the FFEL Program. In July, the House Education committee passed the bill similar to the president’s proposal. Next week expect to education committee to debate legislation in September. We find at interesting at during this summers healthcare debate the administration has given numerous policy speeches advocating the creation of a new public healthcare system that will compete with private industry. Specifically, the competition between a public option and a private option will give consumers choice, thereby improving the whole system. Their approach in advocating competition between a government and private option in healthcare seems inconsistent with their approach of complete elimination of choice in education finance. We are hopeful that people see the parallels in the healthcare proposal and FFEL elimination proposal, as they are governed by the same committees in Congress. A broad Coalition of loan industry participants have delivered an alternative proposal that accomplishes 100% of the president’s goal of making a profit on all future loans for the Federal Government and to use that profit to increase funding for Pell Grants and other spending initiatives. One of the enhancements in the industry proposal is that it would retain the private lender infrastructure currently in place to originate loans and would perform it at a lower cost to taxpayer. We believe this proposal gives the government the same amount of projected profits, retains the key component of competition, which drives innovation and strong customer service, and retains thousands of jobs in the private student loan industry. The industry proposal also eliminates the execution risk of converting more than 4000 schools from one program to another in less than eight months. We trust Congress will carefully consider what is truly in the long term interest of students and the country by creating a better Pell program, preserving customer service and the infrastructure of private investment education, while retaining tens of thousands of jobs in America. Regardless of the outcome of the budget proposal, education at a high level remains dynamic. Enrollment and the cost of education continue to increase. Private credit is tight, and families are increasingly finding the process of planning and paying for school challenging. We have positioned our businesses to help families, schools and financial institutions navigate this increasingly complex system. As we have discussed many times, these products and services include tuition payment plans, enrollment services, electronic campus commerce and test preparation, to mention just a few. We have no doubt; the fundamentals of our business model remain strong. We have stable, well established fee-for-service businesses with recurring revenue. We generate significant cash flow from all of our businesses and our student loan portfolio. We believe we are well positioned for growth in a very dynamic market. Now I’ll turn the call over to Terry to discuss our financial results. Terry.

Terry Heimes: Thanks, Jeff. As Jeff mentioned, we had a very strong second quarter from a financial perspective. Our base net income excluding certain restructuring and liquidity related charges was $0.60 per share or nearly $30 million compared to $0.54 per share a year ago. For the six months ended June 30, our base net income excluding restructuring activities was more than $60 million compared to $42 million a year ago. As a reminder, base net income excludes the mark-to-market adjustment on our derivative portfolio, amortization of intangible assets and the economic benefit received from variable-rate floor income. Base net income is a measure used by management to evaluate the company’s performance. GAAP net income for the second quarter was $0.16 per share. The primary differences between GAAP and base net income this quarter was a $34 million mark-to-market adjustment our derivative products. The financial highlights related to our second quarter can be summarized with three basic operating metrics. One continued growth and diversification of our revenue through our fee-based businesses. Two, improvement in our core student loans, and three, continued reduction in our operating expenses. First, as it relates to revenue diversification, for the second quarter, our total fee-based revenues were up $10 million, or 15% compared to last year and revenues from tuition payment plans, campus commerce and lead generation product lines grew more than 23% more over $6 million when compared to last year. I know we’ve said this before, but we are excite and energized by our fee-based businesses because they have solid growth potential provide recurring positive cash flow and most importantly are the cornerstone to our diversification strategy. Second, related to our portfolio performance, our core student loan spread improved during the second quarter to 109 basis points. Two significant factors were in play here. First, CP/LIBOR spreads narrowed substantially, which improved the spread on our variable rate assets and second, we continued to earn fixed rate floor income on a larger pool of assets due to the unprecedented low interest rate environment. For the quarter, CP/LIBOR averaged about 45 basis points. Through the third quarter, it’s averaged between 17 basis points and 20 basis points, so we will likely experience additional improvement in the core student loan spread in the third quarter as well and finally, as it relates to operating expenses, on the surface, total operating expenses were flat to last year. However, excluding restructuring charges and direct cost of certain lead generation activities, our run rate expenses were down over $7 million or 9% compared to the same period a year ago and down nearly 12% year-to-date. I would also like to touch base briefly on our improved liquidity. During the quarter, we funded over $1 billion in the government-backed Straight-A Funding vehicle, leaving us with just over $400 million remaining in our FFELP warehouse facility. We are pleased to announce that we have structured a new $500 million revolving warehouse facility that will provide funding through July 2012, virtually eliminating the short to mid-term liquidity needs related to these assets. We were also able to repurchase an additional $35 million of our unsecured notes due in 2010 during the second quarter, generating a gain of just over $4 million. Combined with the successful tender for an additional $103 million that we completed in July, we have roughly $102 million outstanding in these notes due in May of 2010. So when we recap the quarter from a financial perspective, I would focus on the following. One, our base net income $0.60 per share or roughly $30 million in the midst of an extremely challenging economic conditions, we are excited to report such positive operating results during a time when many companies are experiencing operating losses. Two, we continue to grow and diversify our fee-based revenues. The government servicing contract will supplement our growth and continue diversification, but we will likely not see significant bottom line impact until 2010 or beyond as we get clarity on volume. Three, our portfolio continues to serve as a valuable annuity stream. The improvement in CP/LIBOR combined with the low interest rate environment increased our core student loan spread to 109 basis points this quarter. Four, we continue to manage our operating costs with expenses down 9% compared to prior year and nearly 12% year-to-date. Five, we have virtually eliminated our liquidity risk related to our student loan assets and have begun to systematically reduce our operating debt. We are very pleased with our performance and believe we are well positioned for the future, no matter what happens when the legislative for clears. At this time, we’d be happy to take your questions.

Operator: (Operator Instructions) Your first question comes from Mike Taiano - Sandler O’Neill.

Mike Taiano - Sandler O’Neill: I guess first question on the put to the department the $1.7 billion that you expect. Do you have a sense whether that will be done in the third quarter, meaning September, or whether it could fall into the fourth quarter and then I have a couple follow ups.

Terry Heimes: It probably will occur in both the third and the fourth quarter reality. We’ll have some in the third quarter and some will likely go into the fourth as we have the option to delay it a little bit.

Mike Taiano - Sandler O’Neill: Okay and then I had a question. Hypothetically, if the Miller bill does end up going through as currently constituted, are there do you guys taken another loot at your expense based for potentially further cost reductions, particularly on the loan origination side and maybe, I don’t know if you can give us some quantification as to, how big that is as a percentage of your expenses?

Jeff Noordhoek: The short answer is yes, obviously if we’re not originating loans, then the expense associated with originating those assets today would go away.

Terry Heimes: We have, we have already, Mike, substantially reduced some of our operating expenses directly related to the loan origination. We would not anticipate those going away, though, until after, the next year. At this point in time, I would not offer an estimate as to the size of those numbers.

Mike Taiano - Sandler O’Neill: Then just final question, just looking at the loans repayments during the quarter, looked like there was a pretty sharp decline from the previous few quarters down to $385 million, looks like it was running closer to $600 million in the prior quarters. Anything specific driving that are you seeing slower repayments by students more broadly?

Terry Heimes: Yes, that’s accurate. We’re seeing a slowdown in prepayments and, people are not repaying their loans as faster or paying them off in total.

Jeff Noordhoek: They’re by extending the life of our portfolio.

Mike Taiano - Sandler O’Neill: So would you kind of look at that as sort of a continuing trend over the next 12 months to 18 months?

Terry Heimes: At this point we would yes.

Operator: Your final question comes from Sameer Gokhale - KBW.

Sameer Gokhale - KBW: Thanks. Just a question, again, about the [Inaudible]and I think you’d mentioned that your option, you could potentially sell some loans in Q4. What would you take into account and kind of say, okay, let’s wait and hold off until Q4 in selling these loans as opposed to exercising the fottage fall in Q3, or what I’m missing there?

Terry Heimes: Some of it is just scheduling in order to make sure that we can get everything done in a efficient manner. We may break the puts into sections so that we can better manage the administration behind it.

Sameer Gokhale - KBW: Then in your guarantor servicing business in the quarter, I think you had given the explanation in your supplemental Q that you effectively sold some loans on behalf of the guarantee agencies and retained some fees, which were included in that line item. Could you share with us what price those loans were sold at and who they were sold to?

Terry Heimes: Not at this point. Those are loans that were sold on behalf of the guarantee agency. They’re really flow through the collection revenue there. So we don’t have that information at this point in time that we can share with you.

Sameer Gokhale - KBW: Then I was trying to figure out why you wouldn’t consider buying those loans yourself of that, because the credit somewhat hard to come by or was there some other decision that went into play here as far as why you decided not to purchase the loans yourself, you actually opted to engineer the sale of those assets?

Terry Heimes: Historically, there are relationships that the guarantee agencies have with purchasers and for the past while, we’ve been focused on liquidity related to our existing portfolio and that’s where we concentrated our efforts. So it’s a combination of both of those things.

Sameer Gokhale - KBW: Then Terry, in your commentary if I heard correctly, you’d said that you expect maybe there to be some earnings contribution from the servicing, the government servicing contract in ‘10, if I heard you correctly, is that right?

Terry Heimes: That’s correct.

Sameer Gokhale - KBW: Did you also say that you expect that to become a material part of earnings in ‘10 or maybe you didn’t qualify it? I just wanted to double check.

Terry Heimes: No, we didn’t qualify that. It’s just that as we gear up and start the servicing activities in the third quarter, we really won’t experience any meaningful revenue contribution or bottom line contribution until 2010 and we need clarity on volume to determine what that will be.

Sameer Gokhale - KBW: As you look at that business, and I know there are a lot of variables here, but as you do your planning for that part of the business and you look at various scenarios, when you say meaningful contribution, I mean are you talking about 10% of earnings coming from that business, by say ‘10 or ‘11 or is that much further out, like we’re talking about five, six years out? How do you think about the magnitude of the earnings contribution from that business overtime?

Terry Heimes: Well, we haven’t offered the scope of the contribution until we get better clarity on volume. The contract as a reminder is a five year contract with five year extensions. So it will take a while to build to the maximum value associated with that contract.

Sameer Gokhale - KBW: Then just my last question, I want to just clarify this or get a better understanding again. On the variable rate floor income this quarter, did you include $7 million of economic benefit and was that number $9 million last quarter?

Terry Heimes: Yes, we did in terms of the current quarter. From a standpoint of reminder Sameer, when we look at base net income, it’s how management views it and the impact of the economic benefit of variable rate floor income. As a reminder, as we look going forward, the rates reset in July 1, so we won’t see that variable rate flooring come in Q3 or Q4 anyway.

Sameer Gokhale - KBW: Okay and this was an amount that I think you used to exclude from your base income going back before October 1 of ‘08, is that correct? Because you used to calculate base net income a different way back then and I think that excluded this variable rate floor income, which you are now including. Is that correct?

Terry Heimes: We actually disclosed it both ways and the reason is because we want to make sure we share how we look at the business and provide as much information as we can. So we actually disclose both numbers in our financial statements and again, as a reminder, it goes away after July of this year.

Operator: With no further questions in the queue, I’d like to turn the conference back to Mr. Jeff Noordhoek for any additional or closing remarks.

Jeff Noordhoek: I want to reemphasize that our business model has and will continue to deliver great operating results. We have stable, well established fee generating businesses with recurring revenue. Our company generates significant cash flow from operations and our loan portfolio. We are well positioned for growth in a very dynamic education market. I want to thank you for your participation in the call and we’d have a great day. Thank you.

Operator: That does conclude today’s presentation. We thank you for your participation.