DBRS Confirms Nelnet, Inc. Senior Unsecured Debt Ratings at BBB (low); Trend Stable

DBRS, Inc. (DBRS) has today confirmed the BBB (low) Senior Unsecured Debt ratings of Nelnet, Inc. (Nelnet or the Company). The trend on the ratings is Stable. Today’s rating action follows an in-depth review of the Company’s fundamentals, operating performance and future prospects.

The confirmation of the ratings reflect Nelnet’s strong franchise in the education-related services market that is underpinned by its top-tier position in student loan servicing as well as the second largest holder of FFELP student loans. The ratings also consider the Company’s low-risk profile, solid capital base, and the high quality earnings generated from the franchise including a well-balanced mix of revenues. While Nelnet has made good progress in executing its strategic transformation to a fee-based business model from a lending-oriented model, the ratings also consider the additional work to be done to expand the fee-related businesses, in particular the non-student loan servicing businesses. Moreover, the ratings factor in the Company’s reliance on secured forms of funding and the concentration of revenues from a single customer, as the Department of Education (ED) servicing contract becomes a larger contributor to overall revenue generation.

The Stable trend reflects DBRS’s expectations that over the medium-term Nelnet will continue to generate solid earnings and returns, underpinned by a balanced revenue mix. This expectation is despite DBRS’s anticipation of a lower overall quantum of revenues and earnings as the FFELP student loan portfolio runs-down. The Stable trend also considers 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, strengthening of the franchise in businesses outside of student loan servicing leading to further diversification of fee-based revenues, especially those not related to the ED contract, could have positive rating implications. Strengthening of capitalization as measured by tangible common equity-to-tangible assets (TCE ratio) would also be viewed favorably. Conversely, any prolonged material reduction in the volume of loans serviced under the ED contract or material change in the Company’s risk appetite 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.

Following the elimination of the FFELP student loan program in 2010, Nelnet set out to transform its business to be more focused on fee-generating activities. Nelnet continues to make good progress on this transformation with the 2014 acquisition of school systems provider, RenWeb supportive of the process. As a result fee-based revenues have grown by 22% since 2010 to $475.5 million for full year 2014, or a high 51% of total revenues.

However, this transformation is not without its challenges. During 2Q15, Nelnet disclosed that its largest guaranty servicing client, which accounts for most of the Company’s guaranty servicing revenue, notified the Company that it would not renew its contract that expires at the end of October 2015. While a negative for the Company, DBRS sees the impact as manageable from an earnings perspective, as the relationship accounted for just 5% of 2014 revenues and there will be some offsetting costs removed from Nelnet’s expense base with the relationship expiring.

Nelnet benefits from its high-quality, balanced mix of revenues which supports the Company’s solid earnings generation ability. Importantly for the ratings, Nelnet generates income before provisions and taxes (IBPT) that is more than sufficient to absorb the level of credit losses produced by the FFELP portfolio, as well as other potential unexpected losses. While DBRS expects the overall quantum of revenues and earnings to decline over the longer-term as the FFELP portfolio slowly winds down, but to become more fee-oriented. DBRS sees 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.

Nelnet’s low risk profile is a key factor in the ratings. Credit risk is minimal with the vast majority of the Company’s student loan portfolio comprised of FFELP student loans, which are guaranteed to at least 97% of principal and interest by the ED. Recently, Nelnet entered into agreements to acquire private education loans that meet the Company’s underwriting specifications. DBRS views these agreements as not representing a shift in Nelnet’s traditionally conservative risk appetite, and notes that the commitments are for relatively modest amounts (approximately $150 million). Operational risk continues to be a notable risk component for Nelnet, given its sizable servicing operations, but one that DBRS’s considers well-managed.

From DBRS’s perspective, Nelnet’s liquidity is sufficient to allow the Company to capitalize on opportunities to acquire portfolios of FFELP student loans when available while also meeting the lower liquidity demands of the fee-based businesses. Liquidity also benefits from the substantial cash flows generated by the Company’s student loan securitizations. As of June 30, 2015, Nelnet forecasted undiscounted cash flows from its portfolio of FFELP securitizations to be approximately $2.32 billion, including approximately $618.4 million of overcollateralization included in the securitizations.

Capital is viewed as appropriate given the low risk balance sheet. At June 30, 2015, Nelnet’s TCE ratio was 5.5%, 100 bps higher than at the comparable period a year ago.

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

The principal applicable methodology is the Global Methodology for Rating Finance Companies (October 2014). Other applicable methodologies include the DBRS Criteria – Rating Holding Companies and Their Subsidiaries (January 2015). These can be found at: http://www.dbrs.com/about/methodologies.

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: Roger Lister
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.