Nelnet (NYSE: NNI)
Written on February 18, 2021
Price at time of writing: $68.84
Disclaimer: This report is not financial advice - please do your own due diligence.
Business Description
Nelnet has historically generated revenue by being a private originator and servicer of student loans. In 2010, however, Pres. Obama terminated the origination of new loans under the FFELP (Federal Family Education Loan Program), which led to the Department of Education outsourcing its servicing of Department-owned loans to four private companies - Nelnet, Great Lakes (which was acquired by Nelnet in 2018), and two others. Nelnet not only services $473 billion worth of loans for the Department of Education but also owns and manages a $21 billion student loan portfolio.
Since Nelnet’s core asset has effectively been in run-off mode, it has led Nelnet to diversify and invest in other education-related businesses to continue competing in a post-FFELP world. Nelnet is also the largest provider of tuition management to the K-12 market in the US through its FACTS software. It also owns stakes in Allo, an internet and broadband provider, and Hudl, a Nebraska-based video review and performance analytics tool for sports teams.
Nelnet also recently received approval from the FDIC to establish a Utah-chartered industrial bank. Since students can no longer originate loans through the federal program, Nelnet will offer its customers loans and refi solutions for those that need to finance their education.
Management
Insiders own 46% of the board. The current chairman and ex-CEO Michael Dunlap owns 18% of the Class A shares and 98% of the Class B super-voting shares. This is effectively a bet on Dunlap’s past expertise as chairman to continue compounding the company’s book value, so if you are generally averse to dual-class share structures this probably isn’t the right investment for you. However, his track record of compounding book value speaks for itself:
In terms of capital allocation, management is extremely diligent about returning capital to shareholders both in the form of share repurchases and dividends. In 2010, Nelnet had 49M shares outstanding, compared to 38.5M today - the business is dramatically shrinking. In 2019 alone, Nelnet repurchased ~700k shares for $40.4 million at an average price of $55 per share. Dividends have also steadily increased and are currently yielding ~1.3%.
Moreover, the Board is authorized to repurchase an additional 4.8 million shares until 2022.
Why now?
Ok, now that we understand the basics behind the business, let’s try to understand what makes this an attractive investment today.
Forecasted cash-flow from student loan portfolio upwards of $40/share
The company is expecting $2.3 billion of operating cash flow in the next five years. At today’s share price of $69, Nelnet trades at a $2.7 billion market cap. This represents close to $40/share of guaranteed FCF.
In low-interest rate environments, Nelnet also benefits from a mechanism called floor income. FFELP loans accrue interest at the higher of a fixed borrower rate or a floating rate set called SAP (Special Allowance Payments) by the Department of Education. When the SAP is below the fixed borrower rate (like it is today), Nelnet’s borrowers pay a fixed rate, while Nelnet finances its loan purchases with variable rates. In 2019 alone, Nelnet generated $90 million worth of floor income. The graph below illustrates this example:
Nelnet’s stock has been unduly beaten down for the loss of its contract renewal with the federal government
The Department of Education recently announced that Nelnet’s loan servicing contract will be renewed on a six-month basis, posing a significant risk to the long-term life of that portion of the business. This contract does not affect Nelnet-owned loans - only those that it services for the federal government. While the lack of the contract is undoubtedly bad news for Nelnet, the loan servicing portfolio is immaterial to Nelnet’s overall valuation. Nelnet’s current price of 1.1x P/B significantly undervalues Nelnet’s competitive positioning. I illustrate this point below where I value Nelnet on a sum-of-the-parts basis.
On a SOTP basis, Nelnet is materially undervalued
Given the diversified nature of Nelnet’s holdings, it is reasonable to use a sum-of-the-parts valuation. Below is the output of my valuation model, along with its respective assumptions (all $ are in 000’s):
Valuation Assumptions
Nelnet Financial Services: The segment was valued using the cash flow projections provided by management above. The bear, base, and bull cases use discount rates of 6%, 5%, and 4%, respectively. For the $775 million that is projected to be received on or after 2026, I spread these out to be received equally between 2026 and 2030 given their weighted average remaining life of 8.8 years. I think that these are fair and somewhat conservative given the Federal Reserve’s stance on maintaining interest rates where they are until 2023.
Nelnet Communication Services: On October 2020, Nelnet sold 48% of Allo to SDC Capital at a $410 million valuation. SDC paid Nelnet $260 million as part of the deal and allows it to continue to take part in the economics of a growing business. Nelnet’s remaining equity stake in Allo is priced at $129.7 million given the recent sale to SDC. SDC will make a reasonable effort to buyout Nelnet’s remaining stake before 2024, as specified in the 01/19/2021 8-K. The bulk of the CapEx needed to set up the network has already been paid for and can be explained by the growing number of households served and passed in its network. In fact, Allo did $6M of EBITDA in 2019 but recently did $13M for the first three quarters of 2020 alone. This has a very real possibility of generating $50M in EBITDA in less than five years, which is when SDC is expected to buyout Nelnet’s remaining stake. Given the network’s growing profitability, it is in SDC’s interest to execute this buyout sooner rather than later.
Nelnet Diversified Services: As mentioned previously, the loan servicing contract with the government is being renewed on a six-month basis, so I conservatively valued it at 1x TTM EBITDA as its base due to the risk of this going eventually to zero. The FSA is conducting a procurement process for the NextGen contract, but Nelnet’s bid keeps getting rejected in favor of a more nascent company.
Nelnet Business Services: Despite the bad press that Nelnet keeps getting on the loan servicing front, this segment is the crown jewel of the portfolio. It is the clear market leader in terms of market share and operating margins. Blackbaud is Nelnet’s main competitor in this space – it has revenues of $913 million and EBITDA of $131 million. Its EBITDA has grown at an annualized rate of 6% for the past ten years, and yet it trades at 31x TTM EBITDA. Nelnet, on the other hand, has generated $61 million of EBITDA on just $217 million of revenues in the first three quarters of 2020.
Hudl: Nelnet owns 19% of Hudl. Hudl is used by more than 6 million coaches and athletes in 139 countries, ranging from high school to professional sports teams. This includes teams in the Premier League, Spanish Liga, NFL, among others. Nelnet participated in Hudl’s most recent equity raise in May 2020 (that Bain Capital participated in), leading Nelnet to book a $51M gain in 2Q 2020. After starting out as a <$1M investment, this has been an extremely profitable venture for Nelnet.
Other Investments: This segment includes corporate overhang and other venture investments in real estate and green energy. None of the investments has stood out yet to the degree that Hudl has, so I will not dive too deep into them.
Nelnet Bank: To be perfectly honest, I have no idea how to peg a valuation to a charter bank and it would be intellectually dishonest for me to even try to do so. I am glad that they got the license as it still allows Nelnet to maintain upside in refinancing student loans, an industry that is extremely familiar to them. Management has not provided a lot of guidance around this, so remains to be seen. The closest competitors are Square, which was recently granted a similar bank charter, and Sofi, which is expected to go public later this year.
Risks
What happens if interest rates dramatically rise again?
Just subtract out the $90M in floor income a year that Nelnet makes. Even still, I think the bear case of a discount rate of 6% more than compensates for an interest rate rise, especially since Nelnet hedges its risk via interest rate swaps.
What if ‘cancel student debt’ actually happens?
Nelnet’s loans are 97-100% federally insured, so this would result in a dramatic acceleration of the forecasted cash flows of its loan book to today.
Conclusion
Nelnet has done a fantastic job of positioning itself for a post-FFELP world. On a sum-of-the-parts basis, Nelnet is materially underpriced. From receiving $40/share from its loan portfolio to the outstanding growth and success of Nelnet’s education technology portfolio, Nelnet presents an opportunity with very limited downside and significant upside.