DBRS Morningstar Revises Trend on Nelnet, Inc. to Negative, Confirms BBB (low) LT Issuer Rating

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Nelnet, Inc. (Nelnet or the Company), including its Long-Term Issuer Rating and Long-Term Senior Debt, both at BBB (low). The trend for all ratings has been revised to Negative from Stable. Nelnet’s Support Assessment is unchanged at SA3, reflecting DBRS Morningstar’s view that systemic support is not expected and as such, the Company’s Intrinsic Assessment of BBB (low) is equalized with the final rating.

KEY RATING CONSIDERATIONS
The Negative trend reflects DBRS Morningstar’s view that that the abruptness and the severity of the economic contraction caused by the Coronavirus Disease (COVID-19) coupled with the uncertainty of the extent and the duration of this downturn is likely to add pressures to the Company’s profitability. Specifically, we expect Nelnet’s servicing revenue to decline in the near term as a result of both the Company’s initiatives as well as legislative mandates to assist borrowers during the pandemic. Nelnet’s revenue from serving K-12 schools and higher education institutions could also be adversely impacted from potentially lower college and university enrolments or uneven school openings this fall. Further, the high levels of unemployment and forbearance, if prolonged, could lead to elevated credit costs.

The ratings confirmation considers the Company’s sound franchise in education-related business services that includes growing fee-based businesses. The ratings also consider the Company’s limited credit risk exposure, proper liquidity management and acceptable capitalization. Nelnet’s solid earnings generation capacity and the headwinds to earnings growth from the ongoing runoff of the Company’s Federal Family Education Loan Program (FFELP) portfolio are considered in the ratings. Further, the Company’s reliance on secured forms of funding constrains the ratings.

The ratings also contemplate the recently announced adverse outcomes in the Company’s pursuit of the Department of Education’s (the ED) new servicing contract components, where Nelnet initially failed to secure a new contract from the ED. We view the ED’s recently cancelled solicitation of the Enhanced Processing Solution (EPS) servicing component of the new contract, with the intent to introduce a new solicitation in the future, as an incrementally positive development since it enables Nelnet to compete again for the EPS procurement. While the ED has the discretion to extend the current servicing contract through year-end 2021, it is uncertain whether Nelnet’s follow-on efforts will result in gaining any portion of the ED’s new contract for the back office and call center operational functions (the BPO component). In our view, the outright loss of all components of the ED’s new servicing contract would be a material setback for Nelnet’s servicing franchise but it would be manageable from a bottom line earnings perspective given the thin margins typically associated with such contracts. While the ED servicing contract contributed approximately 30% to Nelnet’s revenue in 2019, we estimate the percentage contribution to net income (excl. derivative value adjustments) was in the low teens range. Moreover, the anticipated launch of Nelnet Bank should help the Company to further diversify its product offerings and revenue streams over the longer-term.

RATING DRIVERS
Given the Negative trend and the current economic environment, an upgrade of the ratings is unlikely. Nonetheless, if Nelnet demonstrates earnings resilience while maintaining sound balance sheet fundamentals throughout the coronavirus-induced downturn, the trend could revert to Stable. Conversely, a significant weakening of the Company’s earnings power resulting from a protracted economic downturn or from lack of progress in diversifying its revenue streams would result in a downgrade of the ratings.

RATING RATIONALE
The Company has a sound franchise supported by its leading position in the education services market. Nelnet, including its subsidiary Great Lakes, is currently the largest servicer for the ED. Further, Nelnet provides servicing for private education and consumer loans for 64 third-party customers and provides backup servicing arrangements for 14 entities. The Company is also a leading provider of school management and payment solutions serving approximately half of the private faith based K-12 schools and nearly 20% of colleges and universities in the U.S.

For 1Q20, the Company reported a net loss of $40.5 million mainly due to higher loan loss provisions, as well as from impairment charges for certain investments that were negatively impacted by the current economic environment. After adjusting for the impairment charges and the derivative market value adjustments, core net income was approximately $1.0 million. We anticipate Nelnet’s profitability will remain pressured in the near term due to the adverse implications on revenues and credit costs from the coronavirus pandemic. Nelnet has historically demonstrated solid earnings generation capacity driven by gradually diversifying revenue comprised of fee and interest income. The anticipated decline of the spread-related income due to the ongoing runoff of the FFELP portfolio has been partially offset by opportunistic portfolio acquisitions and expansion of its fee-based business. Further, in 2019, non-spread net revenue accounted for nearly 72% of total net revenue (excluding the impact of derivative market value adjustments), up from 68% in 2018.

We view Nelnet’s overall low risk profile as being supportive of the ratings. The Company’s credit risk profile is limited and compares favorably relative to other consumer lenders since 98% of its $20.6 billion loan portfolio is comprised of FFELP student loans that benefit from the federal government guarantees of at least 97% of the defaulted principal and interest. Following a large reserve build incorporating the implementation of CECL, as well as the pandemic, Nelnet’s loan loss reserves for the FFELP loan portfolio now accounts for nearly one-fourth of its potential maximum risk sharing liability. While credit risk is limited, Nelnet is subject to greater operational and regulatory risk given its sizeable servicing operations but we view such risks as properly managed by the Company given its expertise and long track record as a servicer of federal student loans.

Nelnet has a narrow funding profile with key reliance on secured forms of funding resulting in the Company having a highly encumbered balance sheet with approximately 97% of its total student loan portfolio supporting securitized debt. However, we view Nelnet’s funding profile as well-suited for its business model and asset base. Nelnet has effectively managed the magnitude and availability of its liquidity sources to support its operations while enabling it to pursue bolt-on acquisitions or portfolio purchases. As of March 31, 2020, Nelnet had total available liquidity of nearly $1.6 billion comprised of cash, available for sale securities and untapped capacity from its unsecured line of credit and warehouse facilities. The liquidity is also supported by the forecasted undiscounted future cash flows of $2.3 billion from the its student loan ABS.

We view Nelnet’s capitalization as appropriate given its lower risk profile and the less capital intensive business services segments. Capital levels have an adequate cushion relative to bank facility covenants to absorb losses under stressed conditions. The Company’s capitalization continues to strengthen, with tangible common equity-to-tangible assets (TCE) ratio at 9.1% as of March 31, 2020, up from 8.4% at the comparable prior year period.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (September 24, 2019) which can be found on our website under methodologies and criteria: https://www.dbrsmorningstar.com/research/350802/global-methodology-for-rating-non-bank-financial-institutions

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The primary sources of information used for this rating include Company Documents and S&P Global Market Intelligence. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

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

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com

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