- Adriano Milani
Nelnet: an asymmetric risk/reward opportunity
Updated: Nov 18, 2020
Disclosure: Integer Investments is not an investor in Nelnet. The author owns shares in Nelnet in its personal portfolio.
Nelnet offers a 34-58% upside potential with minimal downside risk, according to my scenario analysis. I believe this asymmetric risk/reward opportunity exists thanks to a combination of conglomerate complexity, uncertainty related to one of the main operating segments, lack of sell side coverage and lack of self-promotion by the company.
Nelnet operates in four main segments: loan origination, loan servicing, education technology and communications (ALLO). I valued the company with a sum-of-the-parts approach, so I will discuss each segment separately. As an overview, the company has its roots in the student loans space, and still generates most of its revenues in the two loans-related segments. However, the education technology operations meaningfully contribute to the total operating income, despite the lowest revenue volume, thanks to higher margins. ALLO is currently losing money on an operating income base, but Nelnet is most likely getting out of this business, as we will see in the dedicated analysis.
Nelnet main business has been the origination of federally guaranteed student loans, under the Federal Family Education Loan Program (FFELP). With a book value of around 20.4 billion, the FFELP portfolio accounts for 90% of total assets in the balance sheet, and the related cash flows still support much of the current valuation. However, the portfolio is in runoff, as the government discontinued FFELP in 2010. Currently, the U.S. Department of Education originates new loans directly, and private lenders such as Nelnet can still offer student loans, but without the federal guarantee. Nelnet has a small portfolio of such unguaranteed loans, which is not material to this date. The company has been funding most of its FFELP portfolio with debt, and therefore appears to be highly levered: it has 19.7 billion of bond and notes in its books, against just 2.3 billion of equity. However, this is not as concerning as it may initially seem: virtually all the debt is issued through asset-backed securitization of the corresponding FFELP loans, so the loans themselves generate the liquidity needed to satisfy the debt obligation. Credit risk on the loan portfolio is minimal, since the federal government guarantees between 97% and 100% of both principal and interest, and liquidity risk is mitigated by matching ABS bonds maturities with those of the loans. The portfolio has a weighted average life of 10.8 years, and management anticipates it will amortize over the next 20 years, approximately.
Nelnet benefits from the current low interest rates environment, and to better illustrate how, I will oversimplify the business model a bit here. Nelnet earns the spread between the yield it receives on loans and the cost of financing them. Normally, these are both variable rates, indexed to Libor (either 1 month or 3 months), so the spread is somewhat fixed: a lower Libor translates into a decreasing cost of funding, but also into less income generated by the loans. However, many loans have a provision to pay a minimum fixed rate, if Libor falls under a certain floor level. The company refers to this as “Fixed Rate Floor Income”.
Therefore, as rates decline, the overall effect is overwhelmingly positive, although Nelnet also hedges its position with derivatives, which partially offset these gains. In the first six months of 2020, the amount of loans earning a fixed rate roughly doubled, from 3.3 to 6.6 billion (or 32% of the total loan balance of 20.4 billion).
From a cash flow perspective, the positive effect of low interest rates is even clearer: each quarter management provides a forecast of the future cash flows stemming from the portfolio of securitized loans (net of debt repayment), and they have dramatically increased their estimates in the last two quarters, as per chart below:
In Q2 2020, the total undiscounted cash flow expected from 2021 and beyond was 2.14 billion, compared 1.64 billion estimated in Q4 2019 for the same timeframe: a 30% increase in just six months. Additionally, Nelnet expects to secure most of these additional cash flows early on, as much of the increases are concentrated in the next 3-4 years.
On the other side, loans in forbearance are increasing significantly in the wake of COVID-19. The company applied a 90 day natural disaster forbearance to any loan that was 31-270 days past due, and to any current loan upon request, which increased the percentage of FFELP loans in forbearance from 6.6% at the end of 2019 to 27.7% in Q2 2020. While the situation needs to be monitored in the coming months, I am not too worried about this. First, because the number is artificially inflated by the automatic inclusion of all the 31-270 days delinquent loans, which are normally around 12% of the portfolio. Second, because the federal guarantee strongly mitigates the real cash impact of such increase: even if borrowers ultimately default, Nelnet can capitalize the accrued unpaid interests, for both the forbearance and the delinquency period, and be refunded by at least at 97% by the government, on the increased principal and interest.
I am valuing this segment starting from the future cash flow estimates provided by management, adjusting for the tax effect: as per company disclosure, roughly half of the forecasted cash flows will be taxable income, while the remaining portion is similar to principal repayment, as it represents overcollateralization included in the asset-backed securitizations.
I used three different interest rates to discount those cash flows, from 5% for the bear case to 3% for the bull case. I believe this is still conservative, as the company is funding the majority of such loans at lower rates, currently in the 0.39% - 2.08% range.
Management includes in their cash flow forecast only the securitized loans, which represent 97.3% of the overall portfolio, and the associated ABS debt. The remaining 2.7%, funded with cash and several warehouse facilities, is excluded from the forecast. I am valuing this unsecuritized portion of the loan portfolio at zero, to be conservative.
Finally, Nelnet opportunistically buys other FFELP loans from competitors, and has historically done so at a pace of 2-3 billion per year, which helped slowing down the revenue decline in this segment. I am ascribing no value at all to this activity, although the company explicitly states in its 10-Q that additional loan purchase opportunities exist.
Loan servicing has been the second largest segment for Nelnet for years, in terms of both revenue and operating income. Nelnet provides loan processing services for the same federally guaranteed student loans it used to originate. Consequently, its main customer nowadays is the federal government, in the form of the Department of Education, which is responsible for around 90% of revenues in this segment. The remaining 10% comes from servicing other types of loans (legacy FFELP, private education and consumer). However, Nelnet might soon lose its main client: the current contract with the government is set to expire in December 2020, and the Department of Education is in the process of awarding new contracts with a procurement initiative entitled Next Generation Financial Services Environment (“NextGen”). This procurement process has seen multiple cancellations, reissues, and amendments, and so far, things have not gone in Nelnet favour. Briefly, the company applied for two contracts, named “Enhanced Processing Solution” (EPS) and “Business Process Operations” (BPO), but initially lost them both. Later on, the Department of Education cancelled the EPS solicitation, and should launch a new one soon, to which Nelnet can and intends to participate. The new solicitation is called “Interim Servicing Solution” (ISS), and there is no precise timeline yet. For the BPO contract, Nelnet and several other companies filed protests with the Government Accountability Office. Nelnet request has been denied recently, but the overall process is likely to be slowed down a bit by the other protests.
In the meantime, the status quo is favourable to Nelnet, as the government has indicated the intention to extend the current contract for six months, to June 2021, and has the option for an additional six-month extension.
This is a profitable segment, operating at roughly 10% net margin, but the future is uncertain. Nelnet is the largest player in the industry, so theoretically it is well positioned to compete for the ISS contract, but the odds seem unfavourable right now.
I value this segment as follows: at zero in the bear scenario, to be conservative. In the base scenario, under the hypothesis that the current contract will be extended to December 2021, at 1.85 $ per share, which is 1.5x LTM EPS.
Finally, in the bull case, I assume that the company will manage to retain half of its current business, and value it at $6.18, which is half its LTM EPS, capitalized at a 10% rate (and roughly equal to 2.5x LTM EBITDA, “half” a 5x multiple).
The education technology segment is the third main revenue generator for Nelnet, and the biggest non-loan business, although it is still education related. Labelled “Nelnet Business Services” (NBS), this is ultimately a software business, focussed on school’s payment technology and administrative functions. It offers tuition payment plans, online payment processing, and administrative platforms, primarily to private K–12 schools and higher education institutions.
Nelnet is a big player in this market, servicing 11.500 K-12 schools (4.2 million students) and 1.300 higher education institutions (7.6 million students), mostly in the US, but also in Australia, New Zealand and Southeast Asia.
It is hard to pinpoint a market share number, because the company does not disclose data by geography. According to the National Center for Education Statistics, there are almost 32,500 private K-12 schools is the US, with 5.7 million students, and 4,300 higher education institutions, with 19.8 million students. Assuming Nelnet does 80% of its business in the US, this would put its local market share in the 25-30% range. In its annual reports, the company claims to be the largest provider the private and faith based K-12 market (in the US), and to have a dominant 70% market share in Australia, among higher education institutions.
This is a very profitable business, operating at approximately 25% EBITDA margin, 20% EBIT margin and 15% net margins, all quite stable in the last five years. Nelnet sells both its information systems software and its payment technology solutions on a subscription model, which provides recurring revenues, and charges fees on top of that to administer each payment plan. More importantly, existing customers face high switching costs: Nelnet offers a tightly integrated and comprehensive suite of cloud-based solutions, providing indispensable services such as school management functions (admissions, enrolment, attendance, etc.), tuition management and financial aid assessment. Schools have a hard time replacing these systems with a competitor’s offering, due to the associated re-training needs, complementarity issues, and operational risks. Nelnet has created a positive loop around this competitive advantage, increasing the range of products/services offered over time, and cross selling them to its customer, which further increased their switching costs. This has allowed Nelnet to increase its gross profit “per customer” over time, which is visible looking at both the number of schools and the number of students.
Finally, this business is also a growing at double-digit speed: gross profit, EBIT and EBITDA have all roughly doubled in the last five years, for a CAGR of approximately 15%, and have done so in a relatively stable way. Organic growth is probably lower, as Nelnet has made several acquisitions in this space over the years. In particular, the jump in 2019 figures is partly attributable to the acquisition of TMS in November 2018, which added 380 colleges and 170 private K-12 schools to the customer base. Nelnet will probably have to keep spending on strategic acquisition to sustain this growth rate in the future.
For the bear and base cases, I valued this segment with two DCF models. In each DCF, I assumed a flat second half of 2020, similarly to what happened in the first half of the year, due to COVID-19. From 2021 onwards, the bear case assumes 10% growth for 5 years, while the base case assumes 15% growth for 5 years, followed by another 5-year-period at 10% growth. At the end of each growth phases, both DCF assume a terminal growth rate of 1.55%, which is equal to the risk free rate I used in the cost of equity calculation (30 years US Treasury bond). The resulting valuation is $20.56 for the bear case and $30.28 for the base case.
To forecast the reinvestments needed to sustain the growth phase, I estimated a Sales/Invested Capital ratio of 1.5, requiring 66 cents of net reinvestment for each dollar of additional revenue. Unfortunately, the company does not disclose capex and working capital separately for this segment, so this is an approximation that I derived looking at proxies like depreciation and total assets.
There is minimal debt associated with this segment, so I discounted the cash flows at a cost of equity of 8.66%.
For the bull case, I looked at market multiples of comparable companies. The closest peer publicly traded is Blackbaud, which is trading at 25x EV/EBITDA. Blackbaud serves a broader array of customers, but competes directly with Nelnet on both K-12 schools and higher education institutions. Another company active in this space, Heartland Payments, has been acquired by Global Payments in 2016 for 22x EBITDA. Many other payment technology companies are too big and diversified to be considered peers, but they normally trade north of 20x EBITDA. Using a 22x multiple on LTM EBITDA, my bull case price is $ 38.08.
ALLO is a fiber network company providing high-speed internet, telephone, and television services to business, governmental, and residential customers in Nebraska and Colorado. Nelnet owns 98.9% of the economic rights, trough standard equity and preferred unit membership. This was the first large investment Nelnet made outside the education space, as it acquired its stake at the end of 2015 for 46.25 million. Since then, the company invested heavily in capex, about 300 million, and accumulated net losses every year. EBITDA turned positive only in 2019, and management guided for reduced capex investments going forward, as the fiber network has been almost completed.
Nelnet recently entered in a deal to sell roughly half of its ownership to SDC Capital Partners. As per the agreement, SDC will pay 197 million for a 48% stake in ALLO, while Nelnet will retain 45% of the equity, and ALLO’s management will own the remaining 7%. The transaction puts the value of Nelnet’s remaining 45% equity at 185 million. Nelnet will also receive a cash payment of 260 million for some its preferred units, which ALLO will redeem. 160 million will be coming from the SDC payment, and 100 million from debt, to be issued by ALLO. Afterwards, on or before the three and one-half-year anniversary of this first transaction, ALLO is expected to redeem the remaining preferred units of Nelnet, for another 126 million, plus the preferred return, plus any amount funded by Nelnet in the meantime. This would put the total payments for Nelnet to 571 million, or $14.89 per share, which is the value I am assigning to this segment in all scenarios.
If Nelnet decides to sell its remaining 45% equity, the deal includes a payment of $25/35 million from Nelnet to SDC, contingent to Nelnet realizing a certain (undisclosed) profit on the transaction. This suggests that the company might be willing to dispose of ALLO entirely, and it is likely to do so at higher prices than the 185 million I am accounting for here. I will not include such potential upside in my valuation.
I think it is worth mentioning another non-education investment of Nelnet: Hudl. This is an industry-leading sport performance analysis platform, providing video analysis and scouting software solution in sports, with a media library of over one billion videos. It is private, and Nelnet owns a 19% stake, which used to carry in its balance sheet as a 51.8 million investment. In May 2020, Hudl raised additional equity, and Nelnet made and additional investment of 26 million. More importantly, the company had to adjust its carrying value, to align it with the most recent observable market transaction. Consequently, Nelnet recognized a 51 million gain under “other income”, to bring the total Hudl book value to 128.8 million, or $3.29 per share. I am adding this to my sum-of-the-parts valuation, under each scenario.
Corporate & other
“Corporate and other” is a catch all segment that mainly accounts for unallocated expenses, but also includes income generated by other investments, such as real estate, renewable energy, and an investment advisory business. Nelnet accounts for Hudl here, but I excluded it, as I valued it separately. I estimated a normalized contribution to earnings for this segment of -25 million yearly, which, capitalized at a 10% rate, subtracts $6.38 per share to the overall valuation.
Sum of the parts
As of Q2 2020, the company had a cash balance of 68 million and 142 million debt not related to the loan business, for a 74 million net debt position, or -$1.94 per share.
Putting all the pieces together, I value Nelnet $70.97 in the bear case, $84.53 in the base case, and $99.75 in the bull case, for an upside of 34-58%, against virtually no downside at today’s market price of $63.
Dividend and share repurchase
Speaking of how the company returns money to its shareholders, there is a quarterly dividend of $0.20, currently offering a modest 1.2% yield. However, Nelnet increased it slowly but steadily, by $0.02 in Q4 of each of the last 5 years. More interestingly, Nelnet has repurchased 19% of its shares since 2015, and have done so sensibly, increasing the activity in times of depressed market price. This year has been no exception, with almost 1.5 million shares repurchased only in the second quarter, after the COVID-19 related market collapse. The current stock repurchase program ends in May 2022 and allows for additional repurchases up to 3.3 million shares.
Executive officers and directors own 43.7% of the company, mostly in the person of Michael Dunlap, co-founder and former CEO, now Executive Chairman, who also has the absolute majority of voting rights, thanks to dual class of shares structure. He stepped down from the CEO role in 2013, to focus on capital deployment and business diversification, a key role, considering Nelnet need to find alternatives to its legacy FFELP loan business. Mr Dunlap said he has been influenced by Warren Buffet’s philosophy, and has read all Buffet’s letters and annual reports while attending college. He looks at potential acquisition targets with a long-term perspective, focussing on the excess cash flow that the businesses can generate over a decade or two, if they are run well. The current CEO, Jeff Noordhoek, is fully aligned with this philosophy and has been a part of Nelnet since it started.
I see these as good news for the equity investor, but there is another side to the story: the company does not have quarterly calls with sell side analysts, and seems generally uninterested in self-advertising. As the CEO states in his letters to shareholders: “we would rather see Nelnet’s stock price at a fair level than at an artificial level”. For example, in describing the Education Technology business, they put no emphasis on the cloud-based software, the recurrent revenue model or the fact that there is a Software as a Service component at all. Searching for “cloud” or “SaaS” in the latest 10-Q returns zero results. Their presentations do not mention share repurchases, not even when they are substantial, like in Q2 2020. While I appreciate the Buffet-like mentality, I think management could do more to generate healthy awareness on some of the key features of the company.
I am not too worried about the potential loss of the government loan-servicing contract, as it might be already priced in the stock. However, shrinking the business to a smaller scale could be painful in the short term. In 2018, Nelnet acquired Great Lakes, one of its main competitors in this space, and currently has a lot of personnel and assets at work here: loan servicing accounts for 60% of the company’s total salaries expense, and 30% of depreciation.
The main risk I see for shareholders is poor capital allocation in the future: the FFELP portfolio produces cash flows than cannot be reinvested in the same business, if not for the temporary activity of purchasing other loans from former competitors. Ultimately, this business will disappear, and Nelnet might not be able to generate similar rates of return with new investments. The next substantial venture should be Nelnet Bank: the company has obtained a bank charter in March 2020, and will fund the new subsidiary with an initial capital commitment of $100 million. It will operate as an online bank, focussed on private education and consumer loans. Nelnet has experience in this space, but these loans are sensibly riskier than government-guaranteed ones, so success is not a given. With ALLO and Hudl, the company has shown willingness to invest significant money outside the education space, and shareholders should closely monitor the returns on such investments.
Nelnet is a conglomerate in transformation: its profitable student loan portfolio is runoff, and it is struggling to get new loan servicing contracts from the government, but has built a great education technology business and has diversified in several other ventures. It is managed by sensible capital allocators, who have been inspired by Warren Buffet’s philosophy and have plenty of skin in the game. I like the risk/reward here, and I think the current stock price is fair only in a bear scenario: I see little downside risk, against a 34-58% upside potential in base and bull scenarios.
Updated on November 18, 2020: the original analysis valued the communication segment (ALLO) around $10 per share, instead of $14.89. At the time, it was unclear whether Nelnet would have had to sell its remaining 45% stake in ALLO or not, as part of the deal with SDC. As Q3 results have clarified, Nelnet will retain its 45% minority holding, and sell only the preferred membership units. The valuation has been adjusted upwards accordingly.