Elie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of valueslant.com, a site dedicated to value investing research and analysis.
Nelnet (NNI) is undergoing a transformation from one of the largest student lenders in the US to a provider of fee-based education related services. Does this transition provide an opportunity for investors to get two businesses for the price of one?
|Price as of 6/28/2011||22.00|
|52 Week Range||17.57-24.47|
|Shares Out (MMs)||48.48|
|Market Cap (MMs)||1,070|
Nelnet’s legacy business is the origination and management of federally subsidized student loans, primarily under the Federal Family Education Loan (FFEL) program. Under the FFELP, private lenders would put out capital for student loans but the federal government would subsidize certain costs and guarantee virtually the entire loan. Due to the almost non-existent credit risk, Nelnet was able to leverage their equity 30 to 40 times to generate excellent returns even as the business grew with booming higher education enrollment.
Congress put the kibosh on the gravy train in March 2010 by eliminating any new loans under the FFEL program (although the program continues for existing loans). Going forward all government subsidized student loans will be originated directly by the government under the Direct Loan program.
Nelnet anticipated the government crackdown and began to transition away from the student loan business over the past several years. A majority of their revenues (58% in 2010) now come from providing fee-based educational services. Nelnet has attempted to leverage their access to students and educational institutions to grow this new side of the business. Their offerings include:
- Student loan servicing
- Student loan processing software
- Tuition payment processing
- Enrollment recruitment
- College guidance products and services for students
NNI still holds $24 billion in student loans, making it a somewhat confusing mixture of specialty finance company and educational services provider. But Nelnet does a good job of breaking apart the two segments in their filings, and the stock might provide a compelling value for investors.
Asset Management Segment
The NNI loan portfolio is basically in run-off as no new FFELP loans can be issued and the company does not want to enter the riskier private loan space. However, NNI envisions that there might be attractive opportunities to acquire FFELP loan portfolios from companies looking to exit what is now a non-growth niche.
NNI funds their FFELP loans through issuing asset backed securities (ABS), which enables them to match the maturities of their loans and debt. They profit on the spread between their obligations on the ABS and the interest received from student borrowers. FFELP interest rates are typically set at a variable rate with a fixed rate floor. The extremely low rate environment of the past few years has been a huge boon for NNI. Their interest income is fixed at the floor for about a third of their portfolio, while their entirely variable rate interest expense has declined, thereby widening their interest spread. In the past year, the fixed rate floor provided 52 basis points of their 148 basis point spread.
The following chart from the recent NNI 10Q caught my eye:
NNI is forecasting cash flows of $1.71 billion dollars from their current loan portfolio. With a market cap of $1.07 billion and enterprise value of $1.2 billion (if we add on net debt that is recourse to the company) that seemed interesting considering they also have the fee-based segment doing over $100 million in EBITDA a year.
We have to consider several points to temper our excitement. The first is that the chart includes cash flows just from the interest spread without deducting loan servicing and administrative expenses. SG&A is about $15 million and loan servicing about 20% of the cash flow. Yet even with those expenses the cash flows still come to $1.2 billion, or the entire enterprise value of the company.
We also need to discount back to account for the timing of the cash flows. Doing that at 8% (which might be conservative given the credit security of the portfolio) still gets us a $740 million present value.
The other point is that the cash flow schedule is subject to a myriad of assumptions, most notably regarding interest rates. The company says the model was constructed using the current forward rate curve, which shows a modest but steady rise in rates. If rates were to spike in the next few years above the rate floors then the cash flows would look dramatically different. NNI has partially hedged through this year on loans for which they are receiving floor rates, but has decided for now that longer term hedges are too expensive. Interest rate risk appears to be the main risk in owning NNI given the importance of floor income to their earnings in the past two years.
(I should note that the chart does not include cash flows from the 12% of their loan portfolio that is not currently being funded through ABS. It also does not consider potential growth in the portfolio through loan purchases. NNI bought $241 million of loans in the first quarter. )
The fee-based segment is on track to do $113 million in EBITDA and $53 million in net income if we annualize Q1 numbers. But the elimination of the FFEL program will impact this segment as well. The fee-based segment derived 43% of revenues from servicing FFELP loans in the last quarter, and that will slowly run off. The volume of government issued student loans will be increasing, and NNI has been successful in securing servicing contracts for those loans. However, competition there is intense and margins are lower than on the FFELP business. The payment processing and enrollment services have been growing steadily for the past several years, and should compensate in part for the decline on the loan servicing side.
Are we getting the fee-based business for free? NNI has about $140 million in net debt (backing out the non-recourse debt and the warehouse line). Based on our estimate of the asset management cash flows we can derive an implied market valuation of the fee-based business. If we assign a $740 million enterprise value to the asset management business and assign all of the corporate level debt to the fee-based segment we get:
|Fee Business Implied Valuation|
Those are pretty cheap multiples for a set of attractive of business lines with recurring revenues and low capex requirements, but it is not quite free.
I am inclined to pass on NNI for now with the shares at $22 due to the interest rate risk and the headwinds in loan servicing. But there is much to like about NNI and it appears to be somewhat misunderstood by the market. I would just like more of a margin of safety. I will definitely revisit the stock in the mid to high