DBRS Confirms Nelnet, Inc.’s Long-Term Senior Debt Ratings at BBB (low); Trend Stable

DBRS, Inc. (DBRS) has confirmed the BBB (low) Long-Term Senior Debt of Nelnet, Inc. (Nelnet or the Company), as well as assigned a Long-Term Issuer rating of BBB (low) to the Company. Nelnet’s Support Assessment is SA3 reflecting DBRS’s view that systemic support is not expected and as such, the Company’s Intrinsic Assessment is BBB (low), equalized with the final rating. The trend for all ratings is Stable.

Nelnet’s strong franchise in education-related services, low credit risk profile, and the high quality earnings generated from a well-balanced and gradually diversifying mix of revenues are key factors underpinning the ratings. The ratings also consider the Company’s continuing progress in executing its strategic transformation towards a fee-based business model, which includes growth in non-student loan servicing businesses. Rating constraints include Nelnet’s reliance on secured forms of funding, as well as the expectation for the level of revenues and earnings to moderate due to the continuing amortization of its Federal Family Education Loan Program (FFELP) loan portfolio. Moreover, the concentration of revenues from the Department of Education (the ED) servicing contract, which comprised approximately 20% of total revenue in 2016 is considered in the ratings.

The Stable trend reflects DBRS’s expectations that Nelnet will continue to generate solid earnings supported by the continuing revenue diversification despite the anticipation of a lower overall stream of revenues and earnings, as the FFELP student loan portfolio continues to run-off. The Stable trend also considers DBRS’s expectation that the Company will continue to have adequate liquidity and access to the capital markets at reasonable costs while maintaining capitalization and leverage within levels appropriate for the risk profile.

While there remains some uncertainty regarding the Company’s federal student loan servicing business after the current ED servicing contract expires in 2019, DBRS views positively the ED’s recent announcement of canceling the procurement process for a single servicing platform and the ED’s intention to introduce a new procurement process that will require separate contracts for major servicing processes, that could be performed either by a single or multiple contract servicers. In DBRS’s view, this development is a net positive for GreatNet (Nelnet’s JV with Great Lakes), as it mitigates the risk of not being selected as the single servicer by providing the opportunity for the Company to be awarded a portion of the ED’s contract. Nonetheless, a potential loss of the ED contract should be manageable for Nelnet, despite its notable contribution to total revenue, as the earnings impact should be largely mitigated by an offsetting reduction in operating expenses, given the lower margins typically associated with such contracts.

The Company’s strong franchise in the education related services market is reinforced by its top-tier position in student loan servicing, market leadership in education planning and payment processing that serves approximately half of all private and faith-based K-12 schools in the U.S., as well as being the second largest holder of FFELP student loans.

Nelnet’s earnings generation ability is solid, supported by a high quality and gradually diversifying mix of revenues. Importantly, the Company generates income before provisions and taxes (IBPT) that is more than sufficient to absorb the level of credit losses produced by the student loan portfolio, as well as potential unexpected losses. In 1H17, loan loss provisions-to (DBRS-calculated) adjusted IBPT was just 2.0%. Despite the anticipated decline of the overall spread-related earnings as the FFELP portfolio gradually winds down, DBRS continues to see Nelnet’s earnings generation capacity as supportive of the current rating level given the Company’s continuing progress in growing its fee-based businesses that should gradually translate into more recurring and predictable fee-based revenue streams, as well as solid returns and margins. Indeed, in 1H17, the Company’s total non-spread revenue, after adjusting for the discontinued businesses, debt repurchase gains and the impact of derivatives and FX, accounted for approximately 60% of total adjusted revenue, up from 51% in 1H16.

Nelnet’s overall low risk profile is an important consideration in the rating. Credit risk exposure is very modest with the vast majority (98.7%) of the Company’s student loan portfolio comprised of FFELP student loans, which are federally guaranteed to at least 97% of principal and accrued interest at default. Meanwhile, the fee generating businesses introduce no meaningful credit risk. DBRS considers operational risk a greater risk for Nelnet given its sizable servicing operations, and in particular the servicing contract with the ED, but one that DBRS views as well-managed.

Overall, Nelnet’s balance sheet strength is solid supported by a funding profile that is well-aligned with the asset base. Furthermore, liquidity is viewed as sufficient to support its operations while allowing the Company to capitalize on opportunities to acquire portfolios and conduct bolt-on acquisitions of fee generating businesses. Capital levels continue to be solid and appropriate given the Company’s risk profile. At June 30, 2017, Nelnet’s tangible common equity-to-tangible assets ratio (TCE ratio) was 7.72%, up 34 basis points (bps) from the preceding quarter, and 174 bps higher than the year ago period.

RATING DRIVERS
Although upward ratings movement is unlikely over the near-term, a further diversification of the Company’s business that would strengthen its franchise and meaningfully increase the non-ED related fee-based revenue could have positive ratings implications. Continued strengthening of capitalization as measured by the TCE ratio and funding diversification would also be viewed favorably. Conversely, a significant reduction of fee-based earnings as a result of competition or poor execution, the inability to access the capital markets at reasonable costs, or if capital distributions or leverage were to significantly increase, could potentially result in ratings being lowered. Ratings could come under pressure should a sizable acquisition or expansion into other products or businesses meaningfully alter the Company’s risk profile.

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

The applicable methodology is Global Methodology for Rating Finance Companies (October 2016) and Global Methodology for Rating Banks and Banking Organisations (May 2017), 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, Vice President, US Non-Bank FIG – Global FIG
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG – Global FIG
Initial Rating Date: July 30, 2014
Most Recent Rating Update: September 12, 2016

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.