Description

Note: We were had been trying to get the formatting correct and update this write-up for some small changes in numbers, and then they announced a deal last week, and the stock has rallied 20%. In the interest of time we are posting this with some minor information discrepancies that we will clear up in the message thread and through Q & A. We still think Nelnet is compelling and worth over $100-$130/share in 2-3 years.

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To understand how we manage our company, how we view the current state of the business, and where we are going in the future, it is helpful to remember where we came from. We started the company in 1996 with a $50,000 equity investment. To grow the company, we made the decision to leverage that investment with debt and guarantees – significantly, at certain points – without infusing additional equity into the company until our IPO in 2003.

With a defined set of core values and business principles, and the idea that those concepts would be maintained during all market conditions, we have turned our original investment into $1.88 billion in book value over a 20-year period [emphasis added]. The compounded annual growth rate of our per share book value from 2004 (our first full year as a publicly traded company) to 2015 was 20.0%, compared with 7.4% for the S&P 500 over the same period (with dividends included).

Source: 2015 NNI Annual Letter

“We’ve all heard the saying that a bird in the hand is worth two in the bush, but with Nelnet stock, you get two in the hand and two in the bush.”
- Mike Dunlap, Executive Chairman

Overview

Nelnet is a complex company that we believe is deeply misunderstood and undervalued by the market.  On the surface, it appears to be a highly leveraged business in decline.  The company owns a $24B portfolio of federally guaranteed student loans that is match-funded with debt.  However, since 2010, Nelnet and all other private lenders have been unable to issue new federally insured loans, leaving the current portfolio in runoff.  

What the market fails to recognize is that Nelnet has been slowly taking the cash generated by the loan portfolio and transforming itself into a highly profitable and diversified company.  These actions began over a decade ago and have accelerated in recent years.  As a result, it now possesses a number of attractive and growing businesses, all managed by an exceptional operational team, with a history of accretive capital allocation.  We have broken down each major component of Nelnet and believe the company is currently worth at least 50% more than the market price [$40] with a clear path to significantly greater future returns, all coupled with exceptional safety in the form of the federally guaranteed loan portfolio.

Background and Context

In 1996, Mike Dunlap and Stephen Butterfield each invested $25k to form Nelnet.  Over the ensuing seven years, they grew their initial investment into $109M, a return of over 2000x.  This led to Nelnet’s IPO in December of 2003, which raised an additional $168M of equity capital.  Since then, the company has compounded book value per share at 20% per annum to over $2B in aggregate without issuing any additional equity.

Nelnet’s roots lay in education finance and services.  Since its founding, the company has originated and serviced student loans under the Federal Family Education Loan Program (FFELP), whose debts are ultimately guaranteed by the US government.  In 2010, the FFELP was terminated, and private lenders such as Nelnet have since been unable to continue to issue federally guaranteed student loans.  Today, Nelnet holds a $24B portfolio of these legacy loans in runoff, match funded with low-cost debt.  This loan book represents, on an undiscounted basis, $2.02B of future cash flows, with 75% coming in the next six years.  Most importantly, the portfolio is structured so it has virtually no funding risk, and by virtue of the federal guarantee, almost no credit risk.

Nelnet’s ability to compound book value over long periods of time is a tribute to co-founder and Executive Chairman Mike Dunlap.  The most transformative decision he made, more than a decade ago, was to start pursuing recurring fee-generative businesses that complement the student loan portfolio.  At the time, he presciently recognized the political risks inherent to his business, and worked ferociously to diversify away from them.  His investments have resulted in four new business segments that currently account for over $400M of revenue and $80M of EBITDA with tremendous upside potential.

With the student loan book expected to generate $2.02B of cash going forward – greater than the company’s current market cap – one can be comfortable with the downside of an investment in Nelnet.  In order to gain conviction on the upside, one must understand the value of the other business segments, as well as trust that Dunlap will continue to make smart investment decisions.  We will attempt to explain both.

Valuation Approach

The best way to value Nelnet is as a sum of the parts as each of the five segments has unique structures and economics.  We will go through each individually, and then roll them up to obtain an entity-level valuation of what the business is worth today.  From there, we will assign a range of growth rates to provide a 3-year forward value.

1. Asset Generation & Management

Nelnet holds a $24B portfolio of FFELP loans that are match-funded through a series of asset-based securitizations.  The funding for these assets is non-recourse to the parent company, but must be consolidated for financial reporting purposes, leaving outsiders with the impression that Nelnet is highly leveraged.  The credit loss exposure here is actually minimal due to the government backstop, meaning the $2.02B of future cash flow is effectively guaranteed.  It is worth noting that this number includes some super prime private loans.  However, given the small size and credit profile of these loans, they do not impact the broader story.

Nelnet not only has a financial interest in their portfolio, but also services the loans through a complimentary business line (which we will discuss later).  As a scale provider in these two verticals, Nelnet is able to acquire the residual loans of other subscale competitors whose portfolios are also in runoff.  Historically, Nelnet has been able to stem the decline of their book through these acquisitions, and with the exception of last year, has acquired $3-4B of loan assets annually.  This is illustrated by the fact that, in 2012, Nelnet predicted their portfolio of $24.8B would generate $1.97B in undiscounted future cash flow.  Five years later, the company has acquired enough loans so that these numbers are effectively unchanged.  

Nelnet publishes an updated table each quarter showing the expected future cash flows of their portfolio.  These numbers are prepared by management, and while somewhat subjective, they do take into account the latest information on interest rates and prepayment activity.  Management has historically been very conservative with their projections and we have included the current table below along with the NPV at a range of discount rates.

We believe the most appropriate discount rate for these cash flows is 2.5%, slightly above the current yield on the 10-Year Bond, as Nelnet’s loan portfolio has credit profile similar to the 10-Year.  The reason we chose to use such a low discount rate is that we are shorting a corresponding basket of US treasuries with similar duration, and this represents our cost of capital on this segment.  If we were not doing this, then we would use a markedly higher rate of closer to 10%.  Of the $2.02B of cash flows, approximately $775M will represent a return of capital, while the remaining will be subject to taxes.  We have tax affected our numbers assuming a ratable distribution of the $775M and a tax rate of 35%.

                                                                                             Source: NNI Q1 2017 10-Q

There are three factors that could cause the value of this segment to be impaired.  The first would be a significant rise in rates.  On the surface, this would be detrimental as Nelnet largely borrows at a variable market rate and the student debt is locked into interest rate floors.  Significant and sustained rate growth would then shrink the spread Nelnet makes, decreasing the value of future cash flows.  That said, we believe this is a lesser concern than it appears since a majority of the cash comes in the next five years and Nelnet has notional hedges on $6.5B of debt in place that is termed out over the next 7+ years.  A rapid rise in rates would certainly hurt long-term value, but does not present a terminal risk.  In fact, in the short-term a big spike in rates would actually be cash flow positive given the hedges.  

The second is similar to the interest rate risk in that there is also some level of basis risk.  Nelnet funds loans with 1-Month LIBOR and receives 3-Month LIBOR.  In management’s cash flow projections, they assume a spread of 12 bps between the rates during the life of the loans.  However, if this spread widens dramatically for a sustained period of time, the cash flows would decrease.  Again, the company has entered into hedges that severely limit the prospect of any terminal impairment.  It is important to note that during the 2008 crisis this spread did widen, and as recently as this quarter temporally reached 30 bps.  However, measured over long periods of time, the 12 bps spread has been accurate.  Per the most recent 10-Q, if the forecast is computed assuming a spread of 24 bps (double the current assumption) for the life of the portfolio, the cash flow forecast would be reduced by $85-125M, or roughly 5%.  In other words, a sustained widening of the spread would hurt a little, but is not an existential threat to the company.  

Lastly, there exists the risk of a legislative change that would allow or incent borrowers to consolidate (e.g. refinance).  This outcome (prepayment) would greatly reduce the value of the loan book, but we view it as very unlikely, and again is mitigated by the relatively rapid amortization of the loans.

2. Nelnet Diversified Solutions (Loan Servicing)

Nelnet has historically serviced FFELP and private loans, which has been the largest revenue source for the company outside of the loan portfolio.  In 2009, the Department of Education decided to outsource the servicing of all loans issued through the Federal Direct Student Loan Program, the largest pool of government student loans.  Nelnet was one of four private sector companies selected to be Title IV Additional Servicers (TIVAS).  Today, Nelnet services $194.8B of FFELP, private and government loans for 7.64M borrowers, generating over $260M of revenue.   

With the TIVAS contract set to expire in 2019, the Department of Education has decided to select a single servicing platform and fewer servicers in an effort to simplify and lower costs.  Nelnet, sensing the all-or-nothing nature of the RFP process, has partnered with Great Lakes, another TIVAS servicer.  Nelent and Great Lakes have created a 50-50 joint venture, GreatNet, that will compete for the contract.  While the economics would be split under the JV, the chances of being selected are greatly enhanced and the total economics would likely more than double.  GreatNet was recently selected as one of three parties to move on to Phase II of the process, along with Navient and PHEAA.   

While the RFP process was initiated under the Obama administration, Betsy DeVos has indicated that she may want to take a new approach to servicing.  DeVos seems to be proposing not only a single platform for servicing, but also a single servicer.  Furthermore, her commentary and guidance have indicated that she might depart from the selection criteria espoused under the prior administration. Based on her comments, this will represent one of the largest non-military contracts ever awarded by the federal government.  

In our view, there are three potential outcomes.  The first is that GreatNet does not win the contract, in which case Nelnet will continue servicing federal loans through 2019 and begin transitioning their government loans to another provider.  They will continue servicing their private loans, which account for 4% of the current book, as well as the legacy FFELP loans.  The second is that GreatNet wins, which would be a massive boost to Nelnet and guarantee a huge future earnings stream.  The third is that the process drags on for a number of years and the status quo extends beyond 2019, which is quite likely given the new set of requirements.  We have done our best to handicap the outcome, and believe GreatNet has a greater than 50% chance of winning.  That said, the Department of Education remains the greatest uncertainty for Nelnet going forward.

In our analysis, we have created three cases.  The low case assumes they lose the contract in two years, for which we have valued the business at 3x 2016 EBITDA of $63.3M.  This assumes two more years of servicing government loans, a transition period to another servicer, and the cash generated from continuing to service private loans.  The base case assumes this process drags out and volumes are unchanged.  We assign the servicing business an 8x EBITDA multiple under this scenario.  In the high case, we assume GreatNet wins the government contract and volumes increase significantly.  We assigned this scenario a 12x multiple of 2016 EBITDA. [Nelnet has since acquired Great Lakes outright -more in the message string on this]

3. Nelnet Business Solutions (Education Commerce & Payment Processing)

Nelnet’s education commerce and payment processing segment is comprised of a number of businesses, two of which serve private, faith-based K-12 schools in the US and Australia.  FACTS, acquired in 2005, provides payment solutions that enable schools to bill and collect tuition payments in a manner that is efficient and convenient for all parties.  FACTS is the market leader in actively managed tuition payment plans, serving over 13,500 schools, and has built a strong moat in this vertical.  That moat was widened by the 2014 purchase of RenWeb, a tool that allows schools to automate administrative processes such as admissions, billing, attendance, class scheduling, grade reporting and the like.  The businesses are extremely complimentary and the RenWeb acquisition has led to great cross-selling opportunities as the products have been integrated into a single cloud-based platform.  The offerings were recently expanded to Australia and Nelnet has been encouraged by the early feedback and results.

Nelnet Campus Commerce (NCC) is, like FACTS, focused on tuition payment plans, but for higher education institutions.  NCC earns fees by administering actively managed payment plans that allow students and families to make monthly tuition payments.  They also work to facilitate on-campus transactions such as parking and meals that tie back to the college’s accounting system.  NCC works with 970 higher education institutions worldwide, serving over 7M student and families.

When Nelnet acquired FACTS in 2005, it was producing $24M of revenue.  Over the last decade, they have grown that number to $120M and continue to see ample growth opportunities ahead.  Additionally, the payment and transaction processing space has been red hot of late, with takeout multiples consistently in the 20-35x EBITDA range.  This is for good reason.  These businesses are capital efficient, have great margins, and enjoy mostly recurring revenue.  Specific to Nelnet, management has consistently stated they believe this will be a big area of future growth.  In our valuation, we used a multiple range of 10-20x 2016 EBITDA of $45.3M to value this segment.

4. Telecommunications (ALLO)

In 2016, Nelnet acquired a 91.5% stake in ALLO Communications, a Nebraska-based telecom company, for $46M, with ALLO management retaining the rest.  What made this purchase so significant is that it represented Nelnet’s first meaningful departure from its educational roots.  Pre-2010, when the company was able to issue FFELP loans, we don’t believe Nelnet would have considered a transaction such as ALLO.  However, with the loan book in runoff, the ALLO purchase demonstrated that Nelnet is simply focused on making high-return investments, even if that means entering new markets.

ALLO offers fiber-optic service to homes and residences, specializing in ultra-fast internet that is not offered by competitors.  It originated in Western Nebraska and was focused locally until being acquired by Nelnet.  Now, they have begun a multi-year program to pass all homes and businesses in Nelnet’s hometown of Lincoln and potentially beyond.  

The logic behind the purchase was that ALLO is a capital-intensive business that lacked a deep pool of capital, and Nelnet is a non-capital-intensive business with a significant pool of capital.  With management committed to making investments that generate returns in the teens or above, ALLO clearly fit the criteria and will be a big source of investment going forward.  This is illustrated by the $39M of investment in laying fiber during 2016 and an additional $80M expected in 2017.

To date, management has indicated they are pleased with the performance of the investment, and the thesis is playing out as expected.  We believe that over time, this business will absorb significant capital as fiber assets are deployed, and will begin to cash flow over the ensuing years.  From a financial perspective, fiber looks a great deal like real estate in that it is cash consumptive during construction, and then can be leveraged upon stabilization.  Management has gone as far as to indicate that earnings will be depressed through 2018 as they wait for the investments to mature.  

For now, given that the investment is performing within expectations and lacks normalized earnings, we believe using book value is appropriate.  Our valuation model ranges from using 1x book on the low end to 2x book on the high side.  We calculate current book value to be $97M, representing Nelnet’s $46M purchase price plus a 91.5% stake in the $55.7M of fiber investments through Q1 2017.

5. Corporate & Other

The final of the five segments is effectively a catch-all for a number of ancillary businesses as well as unallocated corporate overhead.  The two most notable businesses here are Peterson’s, which provides prep services for standardized tests, and Whitetail Rock Capital Management, an investment advisor with about $1B under management.

With the negative earnings stemming from the allocation of corporate expenses, we view this segment as effectively being the overhead that supports the other businesses.  In our valuation, we have tried to normalize for one-time gains and losses in the operating businesses to reach a more accurate number.  Please note that this segment’s numbers do not represent corporate overhead in isolation, but rather expenses net of some smaller earnings streams.  We have used a range of 8-12x 2016 EBITDA of -21.1M to value to segment.

Hudl

While Hudl does not fall under any of the five segments, it is worth discussing since it represents a significant piece of Nelnet’s value.  Hudl is a cloud-based software company that allows coaches and athletes to edit and share video, study associated play diagrams, and create quality highlight reels for entertainment, coaching and recruiting purposes.  It was founded in 2006, and Nelnet has been a small equity investor from the beginning.  Since then, Hudl has become the preferred game film solution for teams from the smallest youth organizations to professional franchises.  In total, it now has nearly 5.5M unique users and 150k active teams including 29 NBA teams, FC Barcelona and the New Zealand All Blacks.

In 2014, Lincoln-based Hudl was listed in the Inc. 5000 as the 269th fastest growing private company in America and carried that momentum to a $72.5M Series B in 2015 led by Accel Partners that valued the company at $250M.  Nelnet added to their seed investment with $40.5M participation in the round, bringing their ownership to 18.6% of the company. 

In terms of valuing Nelnet’s stake in Hudl, we view the baseline as $46.5M, or Nelnet’s 18.6% of the $250M valuation in 2015.  [They have since raised another round - update to follow]. Given the company has made a number of bolt-on acquisitions and grown its userbase by over 50% since that time, we estimate the value of the investment has roughly doubled to $93M.  We firmly believe that if Hudl sustains its current growth trajectory, the entire business could be worth $1B to strategic buyers such as Nike, ESPN, Amazon and Google within 5 years.  While Hudl’s value isn’t as material as any of the standalone segments, it is indicative of the potential upside that is latent within Nelnet and to which we have ascribed no value.  

article from TC

Other Valuation Considerations

Given the complex structure of Nelnet, we have combed through the balance sheet to identify cash or debt of the parent company that would affect our valuation.  For assets, we determined that there is $418.5M of cash & investments in excess of the working capital needs of the various segments.  This consists of cash on the balance sheet, investments & notes receivable, and $77.9M of equity in the warehouse facilities.  We backed out the $41.5M investment in Hudl from investments since we value that separately.  For liabilities, we isolated $76.4M of debt that is recourse to the company.  That consists of $50.2M of unsecured debt and $18.3M of other borrowings.

Valuation Summary

To create a valuation range for Nelnet, we look at each key segment on a low, base and high case as described above.  The valuation is the most sensitive to the loan servicing business, which makes sense given the uncertainty surrounding the federal contract.  Each investor can select a set of assumptions that fits their outlook.  We have chosen the base case for each segment besides asset generation.  For that, we have taken the high case of a 2.5% discount rate due to our interest rate hedges.  This provides us with a net valuation of $74 a share, 64% higher than the current price.

The table above shows what we believe the company is worth today.  Integral to the Nelnet investment thesis is that the company will be able to compound value by reinvesting the substantial cash proceeds of the loan book into new loan purchases, buybacks, ALLO and the like.  In order to account for this, we have assumed that Nelnet grows value per share at between 10-20% annually over the next three years.  The table below provides our estimates of future value (2020) based on this range of growth rates.

Capital Allocation

The single most important factor that will determine the success of an investment in Nelnet is Mike Dunlap’s capital allocation acumen.  Most of the operating segments are capital light, growing and generating meaningful cash.  In particular, the student loan book will produce $1.4B of cash in the next six years, with decreasing reinvestment opportunity into new loans.  We believe this dynamic is what led to the purchase of ALLO, where significant capital can be deployed at attractive returns.  In our view, ALLO is to Nelnet what railroads were to Berkshire - it absorbs lots of capital while providing attractive returns.

We take comfort in the fact that Mike Dunlap is leading the capital allocation efforts.  He co-founded the company with $50k, has only done one equity raise, has compounded book value at 20% since, and owns over 20% of the company.  In 2013, he stepped down as CEO to take a role as Executive Chairman to focus primarily on how to invest the cash generated by the loan book.  

He has also shown a propensity to return capital to shareholders when appropriate.  Nelnet has repurchased over 25% of its shares since 2006, instituted a dividend in 2007, and has opportunistically retired its debt.  There is a buyback in place and the current dividend yield is 1.2%.  We believe Nelnet will continue to repurchase stock going forward and this will be a real source of value.  Lastly, Nelnet is uniquely transparent with their capital allocation and the company’s recent shareholder letters (which are Exhibits A & B and we strongly recommend reading) include tables such as those below that give you a deep understanding of their thinking and performance.  

Source: 2016 Shareholder Letter

Source: 2016 Shareholder Letter

Source: Recent Corp Preso

Risks

We have identified three key risks that would impair the future value of Nelnet.  The first is losing the government loan servicing contract.  While we believe there is a less than 50% chance of this happening, it would result in the loss of a majority of a business that generated over $60M of EBITDA in 2016.  Even if this were to occur, our valuation points to Nelnet still being an attractive investment.  The second risk is poor capital allocation.  With the company now expanding into non-education businesses, it is possible that capital is reinvested in subpar opportunities.  After reading every shareholder letter (again, we strongly recommend this), we have become more comfortable that Dunlap is uniquely skilled in this area and his track record is not a fluke.  Lastly, there is a small risk that legislative action could reduce the value of the loan book by incentivizing pre-payments. We view this as highly unlikely.

We also came across a short thesis by Pine Capital Partners from a couple of years ago that raises three reasonable concerns about Nelnet’s business model.  The first is that the spread Nelnet earns on its loan book has been inflated by low rates.  While that is true, three quarters of the cash comes back during the next six years, during which rates should continue to be low, not to mention the risk is hedged.  The second is that income-based prepayment plans will lead to markedly slower cash collection going forward.  This is also true, but that does not concern us given the federal guarantee of the payments. The third risk they highlight is the potential loss of the government servicing contract, which we have already discussed at length.  While we do think these risks are overstated, we recommend reading the write-up here: http://bit.ly/2toDDee

Other Resources:

Shareholder Letter's - Good place to start. http://www.nelnetinvestors.com/financial-information/annual-reports/default.aspx

Latest Preso

Summary

Nelnet possesses many of the traits we seek in an ideal investment.  It is run by an owner-operator, is conservatively financed and has an asymmetric return profile.  Further, we can understand why the mispricing might exist as it screens as a highly leveraged entity with declining earnings and a key contract exposed to a fickle government process.  We believe elements of Nelnet are highly uncertain, but a careful analysis demonstrates that even under the most adverse circumstances, Nelnet is a great business that can be purchased at a bargain price.

Catalyst

Patience