DBRS Assigns Senior Unsecured Rating of BBB (low) to Nelnet, Inc., Trend Stable

DBRS, Inc. (DBRS) has today assigned a Senior Unsecured Debt rating of BBB (low) to Nelnet, Inc. (Nelnet or the Company). The trend on the rating is Stable.

The ratings reflect Nelnet’s strong franchise in the education-related services market and the progress achieved by the Company in executing its strategic transformation to a fee-based business model from a lending-oriented model. Moreover, the ratings consider Nelnet’s low-risk balance sheet, high-quality earnings, and strengthening capital base. The ratings also consider the additional work to be done to expand the fee-related businesses, in particular the non-student loan servicing businesses, to offset the moderation in interest income over the long-term as the Federal Family Education Loan Program (FFELP) loan portfolio runs down. Moreover, the ratings factor in the presence of customer concentration risk as revenues from the Department of Education (ED) servicing contract become a larger contributor to overall revenue generation and the Company’s reliance on secured forms of funding.

The Stable trend reflects DBRS’s expectations that over the medium-term Nelnet will continue to be consistently profitable, supported by a well-balanced mix of revenues. This expectation is despite DBRS’s anticipation of a lower overall quantum of revenues and earnings as the loan portfolio runs-off. The Stable trend also reflects DBRS’s expectation that the Company will continue to have access to the capital markets at reasonable costs and that leverage will be maintained within tolerance levels. Over the near-term, upward ratings movement is unlikely. However, over the medium-term, further diversification of fee-based revenues, especially those not related to the ED contract, could have positive rating implications. Continued strengthening of the franchise in businesses outside of loan servicing, as well as additional improvement in capitalization as measured by tangible common equity-to-tangible assets (TCE ratio) would be viewed favorably. Conversely, any sustained material reduction in the volume of loans serviced under the ED contract or a notable increase in corporate leverage could result in the ratings being lowered. Further, pressure on fee-based earnings as the result of competition or poor execution could potentially result in negative ratings implications.

Nelnet’s strong education-related services franchise benefits from its position as the second largest servicer of student loans and the second largest holder of FFELP loans. With the passage of the Health Care and Education Reconciliation Act (the Act) in 2010, which eliminated the FFELP program, Nelnet has undertaken a strategic shift in its business to be more focused on fee-generating businesses. As part of this focus, Nelnet is one of four companies to be awarded a contract to service Federal Direct Loans for the ED. Further, Nelnet has grown both organically and through acquisitions to provide products and services to families of students, and to secondary and higher education institutions, including tuition payment processing and campus commerce. Demonstrating the progress in this transformation, fee-based revenues have grown by 23% since 2009 to $478.9 million for full year 2013, or 53% of total revenues.

The servicing contract for the ED does introduce a degree of customer concentration risk, with 10.7% of total revenues in 2013 generated by the ED contract. DBRS sees this risk mitigated by the recent announcement that the ED has extended Nelnet’s contract through June 2019 and that Nelnet was ranked as the number one servicer by the ED last year. Also, given Nelnet’s scale and the high barriers to entry, DBRS sees competition for this contract limited to the four current participants. Lastly, DBRS notes that the credit strength of the ED is backed by the federal government.

DBRS views Nelnet’s earnings generation ability as predictable, supported by a high-quality, well-balanced mix of revenues, and a well-managed cost base. Moreover, Nelnet generates income before provisions and taxes that is more than sufficient to absorb the level of credit losses produced by the FFELP portfolio, as well as other unexpected losses. Over the longer-term, as the FFELP portfolio slowly winds down, DBRS expects the quantum of revenues and earnings will decline while becoming more fee-oriented. Nevertheless, DBRS sees the lower quantum of revenue and earnings as supportive of the current rating level given the stable, predictable nature of the fee-based revenue streams. Moreover, the overall business will be less capital intensive, resulting in returns that are expected to be appropriate for the rating.

Overall, the Company has a low credit risk profile with the vast majority of the loan portfolio covered by federal guarantees on the FFELP student loan portfolio. Specifically, 99.7% of the Company’s $25.8 billion of student loans at March 31, 2014 was guaranteed to an at least 97% of principal and interest by the ED. Given its sizable servicing operations, operational risk is a notable risk component for Nelnet, but one that DBRS’s views as well-managed by the Company.

DBRS sees liquidity as appropriately managed for the business profile with sufficient capacity to fund portfolio acquisitions, as opportunities arise, and given the less capital intensive nature of the fee-based businesses. Further, liquidity is supported by the substantial cash flows generated by the Company’s student loan securitizations. As of March 31, 2014, Nelnet forecasted undiscounted cash flows from its portfolio of FFELP securitizations to be approximately $2.17 billion, including approximately $532.1 million of overcollateralization included in the securitizations.

DBRS views Nelnet’s strengthening capitalization as a credit positive, especially considering its lower risk profile. The Company’s TCE ratio has improved by 220 bps since 2010 ending 1Q14 at 5.1%. The improvement in capital has been underpinned by a solid capital retention policy with average capital distributed to shareholders of 25% of net income (to common) over the last five years. Positively, Nelnet has utilized its sound cash flow generation to reduce corporate leverage. At March 31, 2014, unsecured corporate debt, including hybrids-to-tangible common equity was 0.1x, down from 1.7x at year-end 2009.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is the Rating Finance Companies Operating in the United States (May 2008). The other applicable methodology is the DBRS Criteria: Rating Holding Companies and Their Subsidiaries (January 2014). These can be found at:
http://www.dbrs.com/about/methodologies

[Amended on February 18, 2015 to reflect actual methodologies used.]

The primary sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: David Laterza
Rating Committee Chair: William Schwartz
Initial Rating Date: 30 July 2014
Most Recent Rating Update: 30 July 2014

For additional information on this rating, please refer to the linking document under Related Research.