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

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

The confirmation of the rating reflects Nelnet’s strong franchise in education-related services, low-risk profile, solid and strengthening capital base, and the high quality earnings generated from a well-balanced mix of revenues. DBRS notes that the Company continues to make progress executing on its strategic transformation towards a fee-based business model, including its non-student loan servicing businesses. The rating also considers Nelnet’s reliance on secured forms of funding and the concentration of revenues from the Department of Education (the ED) servicing contract.

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 despite the anticipation of a lower overall stream of revenues and earnings, as the Federal Family Education Loan Program (FFELP) student loan portfolio runs-off, and as a result of the cessation of the FFELP guaranty servicing business. 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.

In April 2016, the ED disclosed its initiative for a single servicing solution for all loans owned by the ED. The ED’s contract procurement process to select the single servicing solution involves two phases. After forming a joint venture (JV) called GreatNet, Nelnet and Great Lakes Higher Education Corporation (Great Lakes) submitted a response to the ED’s first phase of the selection process. In June 2016, GreatNet was one of three entities selected to respond to the second phase of the procurement selection process. While the ED’s contract procurement process for a single servicing solution creates uncertainty regarding the Company’s servicing business, DBRS views favorably Nelnet’s JV with Great Lakes and its selection to respond to phase two of the solicitation process. From DBRS’s perspective, the potential loss of the ED contract may be manageable for Nelnet, despite the notable revenue concentration, since the overall contribution to pre-tax margin is currently considered modest. Nonetheless, the timing of a potential outright loss of the ED servicing contract could be a key determinant of the associated impact on the Company’s franchise, as well as earnings, and thereby the rating.

The Company’s strong franchise in the education related services market is reinforced by its top-tier position in student loan servicing, education planning and payment processing, as well as being the second largest holder of FFELP student loans. Nelnet’s earnings generation ability is solid, supported by a high quality, well-balanced mix of revenues and an appropriately managed cost base. Moreover, 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 unexpected losses. In 1H16, loan loss provisions to DBRS-calculated adjusted IBPT was only 2.4%. Over the longer-term, as the FFELP portfolio gradually winds down, DBRS anticipates that the overall level of spread revenue and associated earnings flows will decline, resulting in a more fee-based business model. Nevertheless, DBRS still sees the lower revenue and earnings streams as supportive of the current rating level given the stable, predictable nature of the fee-based revenue.

Nelnet’s low risk profile is a key factor in the rating. The risk profile is underpinned by low and predictable credit risk exposure on the student loan portfolio, of which 98.9% is comprised of FFELP student loans, which are federally guaranteed to at least 97% of principal and accrued interest at default. Furthermore, the Company’s fee-based business lines are not substantial generators of credit risk. Given its sizable servicing operations, and in particular the servicing contract with the ED, DBRS considers operational risk a greater risk for Nelnet, but one that DBRS’s considers well-managed.

DBRS sees Nelnet’s funding profile as acceptable given the business model mix that is appropriately aligned with the asset base. Further, liquidity is viewed as sufficient allowing the Company to capitalize on opportunities to acquire portfolios when available and meet the lower liquidity demands of the fee-based businesses. Liquidity is enhanced by the substantial residual cash flows from the Company’s student loan securitizations coming in over an extended period of time. As of June 30, 2016, the Company forecasts future undiscounted cash flows from the FFELP securitizations to be $2.37 billion, including $726.5 million of overcollateralization.

DBRS views favorably Nelnet’s solid capital levels, given the overall risk profile. Capital as measured by tangible common equity-to-tangible assets (TCE ratio), continues to improve reflecting solid retention of organically generated capital and prudent capital management. Specifically, Nelnet’s TCE ratio was a solid 6.0% at June 30, 2016, approximately 55 basis points higher than the year ago period.

RATING DRIVERS
While upward rating movement is unlikely over the near-term, a further diversification of the Company’s business that would strengthen its franchise and increase the non-ED related fee-based revenue could have positive rating implications. Continued strengthening of capitalization as measured by the TCE ratio and funding diversification would also be viewed favorably. Conversely, pressure on fee-based earnings as the result of competition or poor execution, inability to access the capital markets at reasonable costs, or if capital distributions or leverage were to substantially increase, could potentially result in negative rating implications. Rating pressures could also result from an increase of the Company’s risk profile resulting from a sizeable acquisition or expansion into other products or businesses. Furthermore, a substantial reduction in earnings resulting from a sustained reduction in allocated volumes under the ED contract or from an outright loss of the ED servicing contract that may result from the GreatNet JV not being selected as the single servicing solution could have a negative impact on the rating.

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

The applicable methodology is Global Methodology for Rating Finance Companies (October 2015), which can be found on our website under 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.

Lead Analyst: Yanni Koulouriotis, CFA
Rating Committee Chair: Michael Driscoll
Initial Rating Date: July 30, 2014
Most Recent Rating Update: September 14, 2015

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.