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NELNET INC - Quarter Report: 2018 September (Form 10-Q)



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q

(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2018
 
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from  to .

 
Commission File Number: 001-31924

NELNET, INC.
(Exact name of registrant as specified in its charter)
NEBRASKA
(State or other jurisdiction of incorporation or organization)
84-0748903
(I.R.S. Employer Identification No.)
 
 
121 SOUTH 13TH STREET
SUITE 100
LINCOLN, NEBRASKA
(Address of principal executive offices)
 
68508
(Zip Code)
 (402) 458-2370
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes [X] No [   ]

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes [X] No [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer [X]                                                      Accelerated filer [ ]
Non-accelerated filer [ ]                    Smaller reporting company [ ]
        Emerging growth company [ ]

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes[  ] No[X]

As of October 31, 2018, there were 29,257,880 and 11,468,587 shares of Class A Common Stock and Class B Common Stock, par value $0.01 per share, outstanding, respectively (excluding a total of 11,305,731 shares of Class A Common Stock held by wholly owned subsidiaries).




NELNET, INC.
FORM 10-Q
INDEX
September 30, 2018


 
 
Item 1.
 
Item 2.
 
Item 3.
 
Item 4.
 
 
 
 
 
 
Item 1.
 
Item 1A.
 
Item 2.
 
Item 6.
 
 
 
 
 







PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
(unaudited)
 
As of

As of
 
September 30, 2018

December 31, 2017
Assets:
 
 
 
Loans receivable (net of allowance for loan losses of $60,217 and $54,590, respectively)
$
22,528,362

 
21,814,507

Cash and cash equivalents:
 

 
 

Cash and cash equivalents - not held at a related party
10,766

 
6,982

Cash and cash equivalents - held at a related party
72,771

 
59,770

Total cash and cash equivalents
83,537

 
66,752

Investments and notes receivable
246,815

 
240,538

Restricted cash
723,338

 
688,193

Restricted cash - due to customers
188,591

 
187,121

Loan accrued interest receivable
624,259

 
430,385

Accounts receivable (net of allowance for doubtful accounts of $2,426 and $1,436, respectively)
76,899

 
37,863

Goodwill
153,802

 
138,759

Intangible assets, net
95,660

 
38,427

Property and equipment, net
339,730

 
248,051

Other assets
41,889

 
73,021

Fair value of derivative instruments
2,043

 
818

Total assets
$
25,104,925

 
23,964,435

Liabilities:
 

 
 

Bonds and notes payable
$
22,251,433

 
21,356,573

Accrued interest payable
60,658

 
50,039

Other liabilities
272,891

 
198,252

Due to customers
188,591

 
187,121

Fair value of derivative instruments
4,224

 
7,063

Total liabilities
22,777,797

 
21,799,048

Commitments and contingencies


 


Equity:
 
 
 
  Nelnet, Inc. shareholders' equity:
 

 
 

Preferred stock, $0.01 par value. Authorized 50,000,000 shares; no shares issued or outstanding

 

Common stock:
 
 
 
Class A, $0.01 par value. Authorized 600,000,000 shares; issued and outstanding 29,341,791 shares and 29,341,517 shares, respectively
293

 
293

Class B, convertible, $0.01 par value. Authorized 60,000,000 shares; issued and outstanding 11,468,587 shares
115

 
115

Additional paid-in capital
4,908

 
521

Retained earnings
2,307,573

 
2,143,983

Accumulated other comprehensive earnings
3,975

 
4,617

Total Nelnet, Inc. shareholders' equity
2,316,864

 
2,149,529

Noncontrolling interests
10,264

 
15,858

Total equity
2,327,128

 
2,165,387

Total liabilities and equity
$
25,104,925

 
23,964,435

 
 
 
 
Supplemental information - assets and liabilities of consolidated education lending variable interest entities:
 
 
 
Student loans receivable
$
22,536,434

 
21,909,476

Restricted cash
683,211

 
641,994

Loan accrued interest receivable and other assets
625,122

 
431,934

Bonds and notes payable
(22,337,987
)
 
(21,702,298
)
Accrued interest payable and other liabilities
(214,554
)
 
(168,637
)
Net assets of consolidated education lending variable interest entities
$
1,292,226

 
1,112,469

See accompanying notes to consolidated financial statements.

2



NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except share data)
(unaudited)
 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
Interest income:
 
 
 
 
 
 
 
Loan interest
$
232,320

 
193,087

 
653,414

 
564,173

Investment interest
7,628

 
3,800

 
18,581

 
9,616

Total interest income
239,948

 
196,887

 
671,995

 
573,789

Interest expense:
 
 
 

 
 
 
 
Interest on bonds and notes payable
180,175

 
121,650

 
487,174

 
341,787

Net interest income
59,773

 
75,237

 
184,821

 
232,002

Less provision for loan losses
10,500

 
6,700

 
18,000

 
10,700

Net interest income after provision for loan losses
49,273

 
68,537

 
166,821

 
221,302

Other income:
 
 
 

 
 
 
 
Loan servicing and systems revenue
112,579

 
55,950

 
327,265

 
167,079

Education technology, services, and payment processing revenue
58,409

 
50,358

 
167,372

 
149,862

Communications revenue
11,818

 
6,751

 
31,327

 
17,577

Other income
16,673

 
19,756

 
44,449

 
44,874

Gain from debt repurchases

 
116

 
359

 
5,537

Derivative market value and foreign currency transaction adjustments and derivative settlements, net
17,098

 
7,173

 
100,927

 
(25,568
)
Total other income
216,577

 
140,104

 
671,699

 
359,361

Cost of services:
 
 
 
 
 
 
 
Cost to provide education technology, services, and payment processing services
19,087

 
15,151

 
44,087

 
37,456

Cost to provide communications services
4,310

 
2,632

 
11,892

 
6,789

Total cost of services
23,397

 
17,783

 
55,979

 
44,245

Operating expenses:
 

 
 

 
 
 
 
Salaries and benefits
114,172

 
74,193

 
321,932

 
220,684

Depreciation and amortization
22,992

 
10,051

 
62,943

 
27,687

Loan servicing fees
3,087

 
8,017

 
9,428

 
19,670

Other expenses
45,194

 
29,500

 
119,020

 
81,923

Total operating expenses
185,445

 
121,761

 
513,323

 
349,964

Income before income taxes
57,008

 
69,097

 
269,218

 
186,454

Income tax expense
13,882

 
25,562

 
63,369

 
70,349

Net income
43,126

 
43,535

 
205,849

 
116,105

Net (income) loss attributable to noncontrolling interests
(199
)
 
2,768

 
438

 
8,960

Net income attributable to Nelnet, Inc.
$
42,927

 
46,303

 
206,287

 
125,065

Earnings per common share:
 
 
 
 
 
 
 
Net income attributable to Nelnet, Inc. shareholders - basic and diluted
$
1.05

 
1.11

 
5.04

 
2.97

Weighted average common shares outstanding - basic and diluted
40,988,965

 
41,553,316

 
40,942,177

 
42,054,532


 See accompanying notes to consolidated financial statements.

3



NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands)
(unaudited)
 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2018
 
2017
 
2018
 
2017
Net income
$
43,126

 
43,535

 
205,849

 
116,105

Other comprehensive income (loss):
 
 
 
 
 
 
 
Available-for-sale securities:
 
 
 
 
 
 
 
Unrealized holding losses arising during period, net
2,438

 
405

 
964

 
383

Reclassification adjustment for gains recognized in net income, net of losses
(765
)
 
(504
)
 
(817
)
 
(1,244
)
Income tax effect
(402
)
 
35

 
(46
)
 
318

Total other comprehensive income (loss)
1,271

 
(64
)
 
101

 
(543
)
Comprehensive income
44,397

 
43,471

 
205,950

 
115,562

Comprehensive (income) loss attributable to noncontrolling interests
(199
)
 
2,768

 
438

 
8,960

Comprehensive income attributable to Nelnet, Inc.
$
44,198

 
46,239

 
206,388

 
124,522


See accompanying notes to consolidated financial statements.


4


NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Dollars in thousands, except share data)
(unaudited)
 
Nelnet, Inc. Shareholders
 
 
 
 
Preferred stock shares
 
Common stock shares
 
Preferred stock
 
Class A common stock
 
Class B common stock
 
Additional paid-in capital
 
 Retained earnings
 
Accumulated other comprehensive (loss) earnings
 
Noncontrolling interests
 
Total equity
 
 
Class A
 
Class B
 
 
 
 
 
 
 
 
Balance as of June 30, 2017

 
30,373,691

 
11,476,932

 
$

 
304

 
115

 
366

 
2,110,158

 
4,251

 
15,215

 
2,130,409

Issuance of noncontrolling interests

 

 

 

 

 

 

 

 

 
6,901

 
6,901

Net income (loss)

 

 

 

 

 

 

 
46,303

 

 
(2,768
)
 
43,535

Other comprehensive loss

 

 

 

 

 

 

 

 
(64
)
 

 
(64
)
Distribution to noncontrolling interests

 

 

 

 

 

 

 

 

 
(759
)
 
(759
)
Cash dividend on Class A and Class B common stock - $0.14 per share

 

 

 

 

 

 

 
(5,766
)
 

 

 
(5,766
)
Issuance of common stock, net of forfeitures

 
10,125

 

 

 

 

 
278

 

 

 

 
278

Compensation expense for stock based awards

 

 

 

 

 

 
1,042

 

 

 

 
1,042

Repurchase of common stock

 
(947,794
)
 

 

 
(10
)
 

 
(1,326
)
 
(43,800
)
 

 

 
(45,136
)
Balance as of September 30, 2017

 
29,436,022

 
11,476,932

 
$

 
294

 
115

 
360

 
2,106,895

 
4,187

 
18,589

 
2,130,440

Balance as of June 30, 2018

 
29,331,002

 
11,468,587

 
$

 
293

 
115

 
2,586

 
2,271,171

 
2,704

 
9,834

 
2,286,703

Issuance of noncontrolling interests

 

 

 

 

 

 

 

 

 
326

 
326

Net income

 

 

 

 

 

 

 
42,927

 

 
199

 
43,126

Other comprehensive income

 

 

 

 

 

 

 

 
1,271

 

 
1,271

Distribution to noncontrolling interests

 

 

 

 

 

 

 

 

 
(95
)
 
(95
)
Cash dividend on Class A and Class B common stock - $0.16 per share

 

 

 

 

 

 

 
(6,525
)
 

 

 
(6,525
)
Issuance of common stock, net of forfeitures

 
14,086

 

 

 

 

 
580

 

 

 

 
580

Compensation expense for stock based awards

 

 

 

 

 

 
1,934

 

 

 

 
1,934

Repurchase of common stock

 
(3,297
)
 

 

 

 

 
(192
)
 

 

 

 
(192
)
Balance as of September 30, 2018

 
29,341,791

 
11,468,587

 
$

 
293

 
115

 
4,908

 
2,307,573

 
3,975

 
10,264

 
2,327,128

Balance as of December 31, 2016

 
30,628,112

 
11,476,932

 
$

 
306

 
115

 
420

 
2,056,084

 
4,730

 
9,270

 
2,070,925

Issuance of noncontrolling interests

 

 

 

 

 

 

 

 

 
19,553

 
19,553

Net income (loss)

 

 

 

 

 

 

 
125,065

 

 
(8,960
)
 
116,105

Other comprehensive loss

 

 

 

 

 

 

 

 
(543
)
 

 
(543
)
Distribution to noncontrolling interests

 

 

 

 

 

 

 

 

 
(1,274
)
 
(1,274
)
Cash dividends on Class A and Class B common stock - $0.42 per share

 

 

 

 

 

 

 
(17,569
)
 

 

 
(17,569
)
Issuance of common stock, net of forfeitures

 
171,481

 

 

 
2

 

 
3,359

 

 

 

 
3,361

Compensation expense for stock based awards

 

 

 

 

 

 
3,213

 

 

 

 
3,213

Repurchase of common stock

 
(1,363,571
)
 

 

 
(14
)
 

 
(6,632
)
 
(56,685
)
 

 

 
(63,331
)
Balance as of September 30, 2017

 
29,436,022

 
11,476,932

 
$

 
294

 
115

 
360

 
2,106,895

 
4,187

 
18,589

 
2,130,440

Balance as of December 31, 2017

 
29,341,517

 
11,468,587

 
$

 
293

 
115

 
521

 
2,143,983

 
4,617

 
15,858

 
2,165,387

Issuance of noncontrolling interests

 

 

 

 

 

 

 

 

 
847

 
847

Net income (loss)

 

 

 

 

 

 

 
206,287

 

 
(438
)
 
205,849

Other comprehensive income

 

 

 

 

 

 

 

 
101

 

 
101

Distribution to noncontrolling interests

 

 

 

 

 

 

 

 

 
(351
)
 
(351
)
Cash dividends on Class A and Class B common stock - $0.48 per share

 

 

 

 

 

 

 
(19,539
)
 

 

 
(19,539
)
Issuance of common stock, net of forfeitures

 
319,365

 

 

 
3

 

 
4,662

 

 

 

 
4,665

Compensation expense for stock based awards

 

 

 

 

 

 
4,526

 

 

 

 
4,526

Repurchase of common stock

 
(319,091
)
 

 

 
(3
)
 

 
(4,801
)
 
(11,716
)
 

 

 
(16,520
)
Impact of adoption of new accounting standards

 

 

 

 

 

 

 
2,007

 
(743
)
 

 
1,264

Acquisition of noncontrolling interest

 

 

 

 

 

 

 
(13,449
)
 

 
(5,652
)
 
(19,101
)
Balance as of September 30, 2018

 
29,341,791

 
11,468,587

 
$

 
293

 
115

 
4,908

 
2,307,573

 
3,975

 
10,264

 
2,327,128

 
See accompanying notes to consolidated financial statements.

5



NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(unaudited)
 
Nine months ended
 
September 30,
 
2018
 
2017
Net income attributable to Nelnet, Inc.
$
206,287

 
125,065

Net loss attributable to noncontrolling interests
(438
)
 
(8,960
)
Net income
205,849

 
116,105

Adjustments to reconcile net income to net cash provided by operating activities, net of acquisition:
 

 
 

Depreciation and amortization, including debt discounts and loan premiums and deferred origination costs
136,816

 
99,826

Loan discount accretion
(31,315
)
 
(32,820
)
Provision for loan losses
18,000

 
10,700

Derivative market value adjustment
(49,909
)
 
(22,381
)
Unrealized foreign currency transaction adjustment

 
45,635

Proceeds from clearinghouse - initial and variation margin, net
46,418

 
58,900

Gain from debt repurchases
(359
)
 
(5,537
)
Gain from equity securities, net of losses
(8,280
)
 

Deferred income tax expense (benefit)
23,574

 
(15,012
)
Non-cash compensation expense
4,781

 
3,370

Impairment expense
3,907

 

Other
(856
)
 
3,451

Increase in loan accrued interest receivable
(193,926
)
 
(5,572
)
Increase in accounts receivable
(15,328
)
 
(19,209
)
Decrease (increase) in other assets
49,255

 
(8,660
)
Increase in accrued interest payable
10,619

 
2,147

(Decrease) increase in other liabilities
(7,159
)
 
20,548

Increase (decrease) in due to customers
1,470

 
(14,403
)
Net cash provided by operating activities
193,557

 
237,088

Cash flows from investing activities, net of acquisition:
 

 
 

Purchases of loans
(3,231,956
)
 
(183,466
)
Net proceeds from loan repayments, claims, capitalized interest, and other
2,484,596

 
2,520,197

Proceeds from sale of loans
23,712

 

Purchases of available-for-sale securities
(38,064
)
 
(109,666
)
Proceeds from sales of available-for-sale securities
58,594

 
141,206

Purchases of investments and issuance of notes receivable
(49,216
)
 
(21,823
)
Proceeds from investments and notes receivable
21,461

 
6,174

Purchases of property and equipment
(96,480
)
 
(106,656
)
Business acquisition, net of cash acquired
(109,152
)
 

Net cash (used in) provided by investing activities
(936,505
)
 
2,245,966

Cash flows from financing activities:
 

 
 

Payments on bonds and notes payable
(2,149,449
)
 
(3,679,592
)
Proceeds from issuance of bonds and notes payable
3,004,848

 
1,178,027

Payments of debt issuance costs
(10,953
)
 
(4,411
)
Dividends paid
(19,539
)
 
(17,569
)
Repurchases of common stock
(16,520
)
 
(63,331
)
Proceeds from issuance of common stock
993

 
457

Acquisition of noncontrolling interest
(13,449
)
 

Issuance of noncontrolling interests
768

 
19,475

Distribution to noncontrolling interests
(351
)
 
(1,274
)
Net cash provided by (used in) financing activities
796,348

 
(2,568,218
)
Net increase (decrease) in cash, cash equivalents, and restricted cash
53,400

 
(85,164
)
Cash, cash equivalents, and restricted cash, beginning of period
942,066

 
1,170,317

Cash, cash equivalents, and restricted cash, end of period
$
995,466

 
1,085,153


6



NELNET, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Dollars in thousands)
(unaudited)
 
Nine months ended
 
September 30,
 
2018
 
2017
Supplemental disclosures of cash flow information:
 
 
 
Cash disbursements made for interest
$
425,782

 
287,265

Cash (refunds received) disbursements made for income taxes, net
$
(6,491
)
 
71,431


Supplemental disclosures of noncash operating and investing activities regarding the Company's business acquisition during the nine months ended September 30, 2018 are contained in note 7.

The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported in the consolidated balance sheets to the total of the amounts reported in the consolidated statements of cash flows.
 
As of
 
As of
 
As of
 
As of
 
September 30, 2018
 
December 31, 2017
 
September 30, 2017
 
December 31, 2016
Total cash and cash equivalents
$
83,537

 
66,752

 
254,391

 
69,654

Restricted cash
723,338

 
688,193

 
725,463

 
980,961

Restricted cash - due to customers
188,591

 
187,121

 
105,299

 
119,702

Cash, cash equivalents, and restricted cash
$
995,466

 
942,066

 
1,085,153

 
1,170,317


See accompanying notes to consolidated financial statements.



7



NELNET, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts, unless otherwise noted)
(unaudited)

1.  Basis of Financial Reporting

The accompanying unaudited consolidated financial statements of Nelnet, Inc. and subsidiaries (the “Company”) as of September 30, 2018 and for the three and nine months ended September 30, 2018 and 2017 have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2017 and, in the opinion of the Company’s management, the unaudited consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of results of operations for the interim periods presented. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Operating results for the three and nine months ended September 30, 2018 are not necessarily indicative of the results for the year ending December 31, 2018. The unaudited consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 (the "2017 Annual Report").

Reporting Segment Name Changes

During the first quarter of 2018, the Company changed the name of the Tuition Payment Processing and Campus Commerce operating segment to Education Technology, Services, and Payment Processing to better describe the evolution of services this operating segment provides. In addition, the Loan Systems and Servicing segment was retitled as Loan Servicing and Systems. As a result, the line items "tuition payment processing, school information, and campus commerce revenue" and "loan systems and servicing revenue" on the consolidated statements of income were changed to "education technology, services, and payment processing revenue" and "loan servicing and systems revenue," respectively.

Reclassifications

Certain amounts previously reported within the Company's consolidated balance sheet, statements of income, and statements of cash flows have been reclassified to conform to the current period presentation. These reclassifications include:

Reclassifying certain non-customer receivables, which were previously included in "accounts receivable," to "other assets."

Reclassifying direct costs to provide services for education technology, services, and payment processing, which were previously included in "other expenses," to "cost to provide education technology, services, and payment processing services."

Reclassifying the line item "cost to provide communications services" on the consolidated statements of income from part of "operating expenses" and presenting such costs as part of "cost of services."

Reclassifying consumer loan activity on the consolidated statements of income, which was previously included in "investment interest" and "other expenses," to "loan interest" and "provision for loan losses" and "loan servicing fees," respectively, and reclassifying consumer loan activity on the consolidated statements of cash flows as appropriate. This did not result in a change in the Company's previously reported net cash provided by operating or investing activities.

Accounting Standards Adopted in 2018

In the first quarter of 2018, the Company adopted the following new accounting standards and other guidance:
Revenue Recognition

In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Codification Topic 606, Revenue from Contracts with Customers ("ASC Topic 606"). Under the standard, revenue is recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers.

8



The Company adopted the standard effective January 1, 2018, using the full retrospective method, which required it to restate each prior reporting period presented. As a result, the Company changed its accounting policy for revenue recognition as detailed in note 2, “Summary of Significant Accounting Policies and Practices.”
The most significant impact of the standard relates to identifying the Company's fee-based Education Technology, Services, and Payment Processing operating segment as the principal in its payment services transactions. As a result of this change, the Company presents the payment services revenue gross, with the direct costs to provide these services presented separately. The Company’s other fee-based operating segments will recognize revenue consistent with historical revenue recognition patterns. The majority of the Company's revenue earned in its non-fee-based Asset Generation and Management operating segment, including loan interest and derivative activity, is explicitly excluded from the scope of the new standard.
Impacts to Previously Reported Results
Adoption of the revenue recognition standard impacted the Company’s previously reported results on the consolidated statements of income as follows:
 
Three months ended September 30, 2017
 
As previously reported
 
Impact of adoption
 
As restated
Education technology, services, and payment processing revenue
$
35,450

 
14,908

 
50,358

 
Cost to provide education technology, services, and payment processing services

 
14,908

 
14,908

(a)

 
Nine months ended September 30, 2017
 
As previously reported
 
Impact of adoption
 
As restated
Education technology, services, and payment processing revenue
$
113,293

 
36,569

 
149,862

 
Cost to provide education technology, services, and payment processing services

 
36,569

 
36,569

(a)


(a)
In addition to the impact of adopting the new revenue recognition standard, as discussed above, the Company reclassified other direct costs to provide education technology, services, and payment processing services which were previously reported as part of "other expenses" to "cost to provide education technology, services, and payment processing services."
Adoption of the new revenue recognition standard had no impact to the consolidated balance sheets or cash provided by or used in operating, investing, or financing activities on the consolidated statements of cash flows.
Equity Investments

In January 2016, the FASB issued new accounting guidance related to the recognition and measurement of financial assets and financial liabilities. The guidance, including a related clarifying update, requires equity investments with readily determinable fair values to be measured at fair value, with changes in the fair value recognized through net income (other than those equity investments accounted for under the equity method of accounting or those that result in consolidation of the investee). An entity may choose to measure equity investments without readily determinable fair values at fair value or use the measurement alternative of cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. In addition, the impairment assessment is simplified by requiring a qualitative assessment to identify impairment.

The guidance requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption to reclassify the cumulative change in fair value of equity securities with readily determinable fair values previously recognized in accumulated other comprehensive income, and was adopted by the Company as of January 1, 2018. Upon adoption, the Company recorded an immaterial cumulative-effect adjustment to retained earnings, accumulated other comprehensive earnings, and investments and notes receivable. Subsequent to the adoption, the Company is accounting for the majority of its equity investments without readily determinable fair values using the measurement alternative.


9



Other Comprehensive Income

In February 2018, the FASB issued guidance which allows a reclassification from accumulated other comprehensive earnings to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act, which became effective on January 1, 2018. This guidance is effective for fiscal years beginning after December 15, 2018, but early adoption is permitted. The Company elected to early adopt this guidance as of January 1, 2018. Upon adoption, the Company recorded an immaterial reclassification between accumulated other comprehensive earnings and retained earnings.

Restricted Cash

In November 2016, the FASB issued accounting guidance related to restricted cash. The new guidance requires that the statement of cash flows present the change during the period in total cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents, and a reconciliation of such total to amounts on the balance sheet. The Company adopted the standard effective January 1, 2018 using the retrospective transition method. Adoption of this standard impacted the Company's previously reported amounts on the consolidated statements of cash flows as follows:
 
Nine months ended September 30, 2017
 
As previously reported
 
Impact of adoption
 
As restated
Decrease in due to customers
$

 
(14,403
)
 
(14,403
)
Proceeds from clearinghouse - initial and variation margin, net
37,744

 
21,156

 
58,900

Net cash provided by operating activities
230,335

 
6,753

 
237,088

Decrease in restricted cash, net
276,654

 
(276,654
)
 

Net cash provided by investing activities
2,522,620

 
(276,654
)
 
2,245,966


2. Summary of Significant Accounting Policies and Practices

Except for the changes below, no significant changes have been made to the Company’s significant accounting policies and practices disclosed in note 3, Summary of Significant Accounting Policies and Practices, in the 2017 Annual Report.

Revenue Recognition

The Company applies the provisions of ASC Topic 606 to its fee-based operating segments. The majority of the Company’s revenue earned in its Asset Generation and Management operating segment, including loan interest and derivative activity, is explicitly excluded from the scope of ASC Topic 606. The Company recognizes revenue under the core principle of ASC Topic 606 to depict the transfer of control of products and services to the Company’s customers in an amount reflecting the consideration to which the Company expects to be entitled. In order to achieve that core principle, the Company applies the following five-step approach: (1) identify the contract with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when a performance obligation is satisfied. Additional information related to the Company's revenue recognition of specific items is provided below.

The Company’s contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment.

Loan servicing and systems revenue - Loan servicing and systems revenue consists of the following items:

Loan servicing revenue - Loan servicing revenue consideration is determined from individual contracts with customers and is calculated monthly based on the dollar value of loans, number of loans, number of borrowers serviced for each customer, or number of transactions. Loan servicing requires a significant level of integration and the individual components are not considered distinct. The Company will perform various services, including, but not limited to, (i) application processing, (ii) monthly servicing, (iii) conversion processing, and (iv) fulfillment services, during each distinct service period. Even though the mix and quantity of activities that the Company performs each period may differ, the nature of the activities are substantially the same. Revenue is allocated to the distinct service period, typically a month, and recognized as control transfers as customers simultaneously receive and consume benefits.


10



Software services revenue - Software services revenue consideration is determined from individual contracts with customers and includes license and maintenance fees associated with loan software products, generally in a remote hosted environment, and computer and software consulting. Usage-based revenue from remote hosted licenses is allocated to the distinct service period, typically a month, and recognized as control transfers as customers simultaneously receive and consume benefits. Revenue from any non-refundable up-front fee is recognized ratably over the contract period, as the fee relates to set-up activities that provide no incremental benefit to the customers. Computer and software consulting is also capable of being distinct and accounted for as a separate performance obligation. Revenue allocated to computer and software consulting is recognized as services are provided.

Outsourced services revenue - Outsourced services revenue consideration is determined from individual contracts with customers and is calculated monthly based on the volume of services. Revenue is allocated to the distinct service period, typically a month, and recognized as control transfers as customers simultaneously receive and consume benefits.

The following table provides disaggregated revenue by service offering:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Government servicing - Nelnet
$
38,907

 
38,594

 
118,015

 
117,409

Government servicing - Great Lakes (a)
45,671

 

 
122,107

 

FFELP servicing
7,422

 
3,979

 
24,259

 
11,693

Private education and consumer loan servicing
10,007

 
7,596

 
31,990

 
20,535

Software services
8,201

 
4,430

 
24,461

 
13,093

 Outsourced services and other
2,371

 
1,351

 
6,433

 
4,349

Loan servicing and systems revenue
$
112,579

 
55,950

 
327,265

 
167,079


(a)
Great Lakes Educational Loan Services, Inc. ("Great Lakes") was acquired by the Company on February 7, 2018. For additional information about the acquisition, see note 7.

Education technology, services, and payment processing revenue - Education technology, services, and payment processing revenue consists of the following items:

Tuition payment plan services - Tuition payment plan services consideration is determined from individual plan agreements, which are governed by plan service agreements, and includes access to a remote hosted environment and management of payment processing. The management of payment processing is considered a distinct performance obligation when sold with the remote hosted environment. Revenue for each performance obligation is allocated to the distinct service period, the academic school term, and recognized ratably over the service period as customers simultaneously receive and consume benefits.

Payment processing - Payment processing consideration is determined from individual contracts with customers and includes electronic transfer and credit card processing, reporting, virtual terminal solutions, and specialized integrations to business software for education and non-education markets. Volume-based revenue from payment processing is allocated and recognized to the distinct service period, based on when each transaction is completed, and recognized as control transfers as customers simultaneously receive and consume benefits.

Education technology and services - Education technology and services consideration is determined from individual contracts with customers and is based on the services selected by the customer. Services in K-12 private and faith based schools include (i) assistance with financial needs assessment, (ii) automating administrative processes such as admissions, online applications and enrollment services, scheduling, student billing, attendance, and grade book management, and (iii) professional development and educational instruction services. Revenue for these services is recognized for the consideration the Company has a right to invoice, the amount of which corresponds directly with the value provided to the customer based on the performance completed. Services provided to the higher education market include innovative education-focused technologies, services, and support solutions to help schools with the everyday challenges of collecting and processing commerce data. These services are considered distinct performance obligations. Revenue for each performance obligation is allocated to the distinct service period, typically a month or based on when each transaction is completed, and recognized as control transfers as customers simultaneously receive and consume benefits.


11



The following table provides disaggregated revenue by service offering:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Tuition payment plan services
$
19,771

 
17,885

 
63,209

 
58,543

Payment processing
26,956

 
22,541

 
62,908

 
55,371

Education technology and services
11,419

 
9,831

 
40,411

 
35,804

Other
263

 
101

 
844

 
144

Education technology, services, and payment processing revenue
$
58,409

 
50,358

 
167,372

 
149,862


Cost to provide education technology, services, and payment processing services is primarily associated with providing payment processing services. Interchange and payment network fees are charged by the card associations or payment networks. Depending upon the transaction type, the fees are a percentage of the transaction’s dollar value, a fixed amount, or a combination of the two methods. Other items included in cost to provide education technology, services, and payment processing services include salaries and benefits and third-party professional service costs directly related to providing professional development and educational instruction services to teachers, school leaders, and students.

Communications revenue - Communications revenue is derived principally from internet, television, and telephone services and is billed as a flat fee in advance of providing the service. Revenues for usage-based services, such as access charges billed to other telephone carriers for originating and terminating long-distance calls on the Company's network, are billed in arrears. These are each considered distinct performance obligations. Revenue is recognized monthly for the consideration the Company has a right to invoice, the amount of which corresponds directly with the value provided to the customer based on the performance completed. The Company recognizes revenue from these services in the period the services are rendered rather than billed. Revenue received or receivable in advance of the delivery of services is included in deferred revenue. Earned but unbilled usage-based services are recorded in accounts receivable.

The following table provides disaggregated revenue by service offering and customer type:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Internet
$
6,456

 
3,205

 
16,547

 
7,978

Television
3,385

 
2,115

 
9,250

 
5,498

Telephone
1,957

 
1,413

 
5,471

 
4,018

Other
20

 
18

 
59

 
83

Communications revenue
$
11,818

 
6,751

 
31,327

 
17,577

 
 
 
 
 
 
 
 
Residential revenue
$
8,896

 
4,680

 
23,367

 
11,851

Business revenue
2,861

 
2,013

 
7,779

 
5,525

Other
61

 
58

 
181

 
201

Communications revenue
$
11,818

 
6,751

 
31,327

 
17,577


Cost to provide communications services is primarily associated with television programming costs.  The Company has various contracts to obtain television programming from programming vendors whose compensation is typically based on a flat fee per customer. The cost of the right to exhibit network programming under such arrangements is recorded in the month the programming is available for exhibition.  Programming costs are paid each month based on calculations performed by the Company and are subject to periodic audits performed by the programmers. Other items in cost to provide communications services include connectivity, franchise, and other regulatory costs directly related to providing internet and telephone services.






12



Other income - The following table provides the components of "other income" on the consolidated statements of income:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Realized and unrealized gains on investments, net
$
1,288

 
2,201

 
11,505

 
3,818

Borrower late fee income
3,253

 
2,731

 
8,994

 
9,098

Investment advisory fees
1,183

 
5,852

 
4,169

 
11,661

Management fee revenue
1,756

 

 
4,673

 

Peterson's revenue

 
3,402

 

 
9,282

Other
9,193

 
5,570

 
15,108

 
11,015

Other income
$
16,673

 
19,756

 
44,449

 
44,874


Borrower late fee income - Late fee income is earned by the education lending subsidiaries. Revenue is allocated to the distinct service period, based on when each transaction is completed.

Investment advisory fees - Investment advisory services are provided by the Company through an SEC-registered investment advisor subsidiary under various arrangements. The Company earns monthly fees based on the monthly outstanding balance of investments and certain performance measures, which are recognized monthly as the uncertainty of the transaction price is resolved.

Management fee revenue - Management fee revenue is earned for technology and certain administrative support services provided to Great Lakes' former parent company. Revenue is allocated to the distinct service period, based on when each transaction is completed.

Peterson's revenue - The Company earned revenue related to digital marketing and content solution products and services under the brand name Peterson's. These products and services included test preparation study guides, school directories and databases, career exploration guides, on-line courses and test preparation, scholarship search and selection data, career planning information and guides, and on-line information about colleges and universities. Several content solutions services included services to connect students to colleges and universities, and were sold based on subscriptions. Revenue from sales of subscription services was recognized ratably over the term of the contract as it was earned. Subscription revenue received or receivable in advance of the delivery of services was included in deferred revenue. Revenue from the sale of print products was generally earned and recognized, net of estimated returns, upon shipment or delivery. All other digital marketing and content solutions revenue was recognized over the period in which services were provided to customers. On December 31, 2017, the Company sold Peterson's. The Company applied a practical expedient allowed for the retrospective comparative period which does not require the Company to restate revenue from contracts that began and were completed within the same annual reporting period.

Contract Balances - The following table provides information about liabilities from contracts with customers:
 
As of September 30, 2018
 
As of December 31, 2017
Deferred revenue, which is included in "other liabilities" on the consolidated balance sheets
$
42,831

 
32,276


Timing of revenue recognition may differ from the timing of invoicing to customers. The Company records deferred revenue when revenue is received or receivable in advance of the delivery of service. For multi-year contracts, the Company generally invoices customers annually at the beginning of each annual coverage period. Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 60 days. In instances where the timing of revenue recognition differs from the timing of invoicing, the Company has determined its contracts do not include a significant financing component.


13



Activity in the deferred revenue balance is shown below:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Balance, beginning of period
$
25,660

 
25,954

 
32,276

 
33,141

Deferral of revenue
45,174

 
38,705

 
97,726

 
79,435

Recognition of revenue
(27,992
)
 
(22,181
)
 
(87,303
)
 
(70,128
)
Other
(11
)
 
27

 
132

 
57

Balance, end of period
$
42,831

 
42,505

 
42,831

 
42,505


Assets Recognized from the Costs to Obtain a Contract with a Customer - The Company recognizes an asset for the incremental costs of obtaining a contract with a customer if it expects the benefit of those costs to be longer than one year. The Company has determined that certain sales incentive programs meet the requirements to be capitalized. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in “other assets” on the consolidated balance sheets.

3.  Loans Receivable and Allowance for Loan Losses

Loans receivable consisted of the following:
 
As of
 
As of
 
September 30, 2018
 
December 31, 2017
Federally insured student loans:
 
 
 
Stafford and other
$
4,956,324

 
4,418,881

Consolidation
17,434,419

 
17,302,725

Total
22,390,743

 
21,721,606

Private education loans
169,467

 
212,160

Consumer loans
112,547

 
62,111

 
22,672,757

 
21,995,877

Loan discount, net of unamortized loan premiums and deferred origination costs
(63,566
)
 
(113,695
)
Non-accretable discount
(20,612
)
 
(13,085
)
Allowance for loan losses:
 
 
 
Federally insured loans
(43,053
)
 
(38,706
)
Private education loans
(11,253
)
 
(12,629
)
Consumer loans
(5,911
)
 
(3,255
)
 
$
22,528,362

 
21,814,507


14



Activity in the Allowance for Loan Losses

The provision for loan losses represents the periodic expense of maintaining an allowance sufficient to absorb losses, net of recoveries, inherent in the portfolio of loans. Activity in the allowance for loan losses is shown below.
 
Three months ended September 30, 2018
 
Balance at beginning of period
 
Provision for loan losses
 
Charge-offs
 
Recoveries
 
Other
 
Balance at end of period
Federally insured loans
$
37,263

 
8,000

 
(2,210
)
 

 

 
43,053

Private education loans
11,664

 

 
(535
)
 
124

 

 
11,253

Consumer loans
4,788

 
2,500

 
(1,403
)
 
26

 

 
5,911

 
$
53,715

 
10,500

 
(4,148
)
 
150

 

 
60,217

 
 
 
 
 
 
 
 
 
 
 
 
 
Three months ended September 30, 2017
Federally insured loans
$
35,862

 
7,000

 
(3,464
)
 

 

 
39,398

Private education loans
13,846

 
(1,000
)
 
(491
)
 
161

 
50

 
12,566

Consumer loans
1,000

 
700

 
(33
)
 

 

 
1,667

 
$
50,708

 
6,700

 
(3,988
)
 
161

 
50

 
53,631

 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended September 30, 2018
Federally insured loans
$
38,706

 
12,000

 
(8,653
)
 

 
1,000

 
43,053

Private education loans
12,629

 

 
(1,846
)
 
470

 

 
11,253

Consumer loans
3,255

 
6,000

 
(3,376
)
 
32

 

 
5,911

 
$
54,590

 
18,000

 
(13,875
)
 
502

 
1,000

 
60,217

 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended September 30, 2017
Federally insured loans
$
37,268

 
11,000

 
(8,870
)
 

 

 
39,398

Private education loans
14,574

 
(2,000
)
 
(861
)
 
603

 
250

 
12,566

Consumer loans

 
1,700

 
(33
)
 

 

 
1,667

 
$
51,842

 
10,700

 
(9,764
)
 
603

 
250

 
53,631



15



Student Loan Status and Delinquencies

Delinquencies have the potential to adversely impact the Company’s earnings through increased servicing and collection costs and account charge-offs.  The table below shows the Company’s loan delinquency amounts for federally insured and private education loans.
 
As of September 30, 2018
 
As of December 31, 2017
 
As of September 30, 2017
Federally insured loans:
 
 
 
 
 
 
 
 
 
 
 
Loans in-school/grace/deferment
$
1,410,902

 
 
 
$
1,260,394

 
 
 
$
1,448,172

 
 
Loans in forbearance
1,487,107

 
 
 
1,774,405

 
 
 
2,406,346

 
 
Loans in repayment status:
 
 
 
 
 
 
 
 
 
 
 
Loans current
16,921,119

 
86.8
%
 
16,477,004

 
88.2
%
 
16,534,795

 
88.7
%
Loans delinquent 31-60 days
689,454

 
3.5

 
682,586

 
3.7

 
579,665

 
3.1

Loans delinquent 61-90 days
412,639

 
2.1

 
374,534

 
2.0

 
334,085

 
1.8

Loans delinquent 91-120 days
347,013

 
1.8

 
287,922

 
1.5

 
255,567

 
1.4

Loans delinquent 121-270 days
853,224

 
4.4

 
629,480

 
3.4

 
700,319

 
3.8

Loans delinquent 271 days or greater
269,285

 
1.4

 
235,281

 
1.2

 
228,335

 
1.2

Total loans in repayment
19,492,734

 
100.0
%
 
18,686,807

 
100.0
%
 
18,632,766

 
100.0
%
Total federally insured loans
$
22,390,743

 
 

 
$
21,721,606

 
 

 
$
22,487,284

 
 
Private education loans:
 
 
 
 
 
 
 
 
 
 
 
Loans in-school/grace/deferment
$
3,550

 
 
 
$
6,053

 
 
 
$
27,188

 
 
Loans in forbearance
1,577

 
 
 
2,237

 
 
 
2,904

 
 
Loans in repayment status:
 
 
 
 
 
 
 
 
 
 
 
Loans current
156,383

 
95.2
%
 
196,720

 
96.5
%
 
190,153

 
96.8
%
Loans delinquent 31-60 days
1,796

 
1.1

 
1,867

 
0.9

 
1,200

 
0.6

Loans delinquent 61-90 days
1,155

 
0.7

 
1,052

 
0.5

 
1,195

 
0.6

Loans delinquent 91 days or greater
5,006

 
3.0

 
4,231

 
2.1

 
3,989

 
2.0

Total loans in repayment
164,340

 
100.0
%
 
203,870

 
100.0
%
 
196,537

 
100.0
%
Total private education loans
$
169,467

 
 

 
$
212,160

 
 

 
$
226,629

 
 


16



4.  Bonds and Notes Payable

The following tables summarize the Company’s outstanding debt obligations by type of instrument:
 
As of September 30, 2018
 
Carrying
amount
 
Interest rate
range
 
Final maturity
Variable-rate bonds and notes issued in FFELP loan asset-backed securitizations:
 
 
 
 
 
Bonds and notes based on indices
$
20,695,887

 
2.38% - 4.07%
 
4/25/24 - 10/25/66
Bonds and notes based on auction
799,576

 
2.77% - 3.51%
 
3/22/32 - 11/26/46
Total FFELP variable-rate bonds and notes
21,495,463

 
 
 
 
FFELP warehouse facilities
705,144

 
2.34% / 2.38%
 
11/19/19 / 5/31/21
Variable-rate bonds and notes issued in private education loan asset-backed securitization
55,406

 
3.97%
 
12/26/40
Fixed-rate bonds and notes issued in private education loan asset-backed securitization
66,975

 
3.60% / 5.35%
 
12/26/40 / 12/28/43
Unsecured line of credit
160,000

 
3.65%
 
6/22/23
Unsecured debt - Junior Subordinated Hybrid Securities
20,381

 
6.91%
 
9/15/61
Other borrowings
79,669

 
2.77% - 5.22%
 
10/1/18 - 12/15/45
 
22,583,038

 
 
 
 
Discount on bonds and notes payable and debt issuance costs
(331,605
)
 
 
 
 
Total
$
22,251,433

 
 
 
 
 
As of December 31, 2017
 
Carrying
amount
 
Interest rate
range
 
Final maturity
Variable-rate bonds and notes issued in FFELP loan asset-backed securitizations:
 
 
 
 
 
Bonds and notes based on indices
$
20,352,045

 
1.47% - 3.37%
 
8/25/21 - 2/25/66
Bonds and notes based on auction
780,829

 
2.09% - 2.69%
 
3/22/32 - 11/26/46
Total FFELP variable-rate bonds and notes
21,132,874

 
 
 
 
FFELP warehouse facilities
335,992

 
1.55% / 1.56%
 
11/19/19 / 5/31/20
Variable-rate bonds and notes issued in private education loan asset-backed securitization
74,717

 
3.30%
 
12/26/40
Fixed-rate bonds and notes issued in private education loan asset-backed securitization
82,647

 
3.60% / 5.35%
 
12/26/40 / 12/28/43
Unsecured line of credit
10,000

 
2.98%
 
12/12/21
Unsecured debt - Junior Subordinated Hybrid Securities
20,381

 
5.07%
 
9/15/61
Other borrowings
70,516

 
2.44% - 3.38%
 
1/12/18 - 12/15/45
 
21,727,127

 
 
 
 
Discount on bonds and notes payable and debt issuance costs
(370,554
)
 
 
 
 
Total
$
21,356,573

 
 
 
 



17



FFELP Warehouse Facilities

The Company funds a portion of its Federal Family Education Loan Program (the "FFEL Program" or "FFELP") loan acquisitions using its FFELP warehouse facilities. Student loan warehousing allows the Company to buy and manage student loans prior to transferring them into more permanent financing arrangements.

As of September 30, 2018, the Company had two FFELP warehouse facilities as summarized below.
 
 
NFSLW-I (a)
 
NHELP-II (b)
 
Total
Maximum financing amount
 
$
550,000

 
500,000

 
1,050,000

Amount outstanding
 
531,782

 
173,362

 
705,144

Amount available
 
$
18,218

 
326,638

 
344,856

Expiration of liquidity provisions
 
September 20, 2019

 
May 31, 2019

 
 
Final maturity date
 
November 19, 2019

 
May 31, 2021

 
 
Maximum advance rates
 
92 - 98%

 
85 - 95%

 
 
Minimum advance rates
 
84 - 90%

 
85 - 95%

 
 
Advanced as equity support
 
$
21,349

 
14,797

 
36,146


(a)
On April 24, 2018, the Company increased the maximum financing amount for this warehouse facility from $500.0 million to $1.25 billion. On May 3, 2018, the Company temporarily increased the maximum financing amount for this warehouse facility an additional $75.0 million to $1.325 billion. During the three months ended September 30, 2018, the Company decreased the maximum financing amount for this warehouse facility to $550.0 million.

On November 6, 2018, the Company amended the agreement for this warehouse facility, which changed the expiration date for the liquidity provisions to May 20, 2019 and changed the final maturity date to May 20, 2020. In addition, the amendment changed the advance rates on this facility that provides for formula-based advance rates that are static until the expiration date of the liquidity provisions. In the event the liquidity provisions are not extended, the valuation agent has the right to perform a one-time mark to market on the underlying loans funded in this facility, subject to a floor. The loans would then be funded at this new advance rate until the final maturity date of the facility.

(b)
On April 24, 2018, the Company amended the agreement for this warehouse facility, which changed the expiration date for the liquidity provisions to May 31, 2019 and changed the final maturity date to May 31, 2021.



18



Asset-Backed Securitizations

The following table summarizes the asset-backed securitization transactions completed during the first nine months of 2018.
 
 
2018-1
 
2018-2
 
2018-3
 
2018-4
 
Total
 
 
Class A-1 Notes
 
Class A-2 Notes
 
2018-1 total
 
 
 
Class A-1 Notes
 
Class A-2 Notes
 
Class A-3 Notes
 
2018-3 total
 
Class A-1 Notes
 
Class A-2 Notes
 
2018-4 total
 
 
Date securities issued
 
3/29/18
 
3/29/18
 
3/29/18
 
6/7/18
 
7/26/18
 
7/26/18
 
7/26/18
 
7/26/18
 
8/30/18
 
8/30/18
 
8/30/18
 
 
Total original principal amount
 
$
98,000

 
375,750

 
473,750

 
509,800

 
220,000

 
546,900

 
220,000

 
1,001,900

 
30,500

 
451,900

 
495,700

 
$
2,481,150

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Class A senior notes:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total principal amount
 
$
98,000

 
375,750

 
473,750

 
509,800

 
220,000

 
546,900

 
220,000

 
986,900

 
30,500

 
451,900

 
482,400

 
2,452,850

Cost of funds (1-month LIBOR plus:)
 
0.32%
 
0.76%
 
 
 
0.65%
 
0.30
%
 
0.44
%
 
0.75
%
 
 
 
0.26
%
 
0.70
%
 
 
 
 
Final maturity date
 
5/25/66
 
5/25/66
 
 
 
7/26/66
 
9/27/66

 
9/27/66

 
9/27/66

 
 
 
10/25/66

 
10/25/66

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Class B subordinated notes:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total original principal amount
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
$
15,000

 
 
 
 
 
13,300

 
28,300

Bond discount
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(229
)
 
 
 
 
 

 
(229
)
Issue price
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
$
14,771

 
 
 
 
 
13,300

 
28,071

Cost of funds (1-month LIBOR plus:)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1.20
%
 
 
 
 
 
1.40
%
 
 
Final maturity date
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
9/27/66

 
 
 
 
 
10/25/66

 
 

Unsecured Line of Credit

On June 22, 2018, the Company amended its $350.0 million unsecured line of credit. The following provisions were modified under the amendment:

The maturity date was extended from December 12, 2021 to June 22, 2023.

The definition of the Company's line of business was expanded and other terms were modified to allow the formation or acquisition of a chartered bank subsidiary.

The definition for permitted acquisitions was revised to increase the aggregate amount of consideration that may be paid for the acquisition in any fiscal year of a business or businesses not in the Company's defined line of business.

The provisions for permitted investments were expanded to allow (i) a one-time, initial capital contribution of up to $150.0 million by the Company in connection with the formation or acquisition of a chartered bank subsidiary, and (ii) investments in pools of consumer loans.

The amount of loans not originated under the FFEL Program that the Company is permitted to own was increased from $500.0 million to $850.0 million.

The facility size of $350.0 million and the cost of funds did not change as part of the amendment. As of September 30, 2018, $160.0 million was outstanding under the line of credit and $190.0 million was available for future use.


19



Debt Repurchases

The following table summarizes the Company's repurchases of its own debt. Gains recorded by the Company from the repurchase of debt are included in "gain from debt repurchases" on the Company's consolidated statements of income.
 
Par value
 
Purchase price
 
Gain
 
Par value
 
Purchase price
 
Gain
 
Three months ended
 
September 30, 2018
 
September 30, 2017
Asset-backed securities
$

 

 

 
14,702

 
14,586

 
116

 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended
 
September 30, 2018
 
September 30, 2017
Asset-backed securities
$
12,905

 
12,546

 
359

 
18,790

 
17,670

 
1,120

Unsecured debt - Hybrid Securities

 

 

 
29,658

 
25,241

 
4,417

 
$
12,905

 
12,546

 
359

 
48,448

 
42,911

 
5,537


5.  Derivative Financial Instruments

The Company uses derivative financial instruments primarily to manage interest rate risk. In addition, the Company previously used derivative financial instruments to manage foreign currency exchange risk associated with student loan asset-backed notes that were denominated in Euros prior to a remarketing of such notes in October 2017. Derivative instruments used as part of the Company's risk management strategy are further described in note 6 of the notes to consolidated financial statements included in the 2017 Annual Report. A tabular presentation of such derivatives outstanding as of September 30, 2018 and December 31, 2017 is presented below.

Basis Swaps

The following table summarizes the Company’s outstanding basis swaps in which the Company receives three-month LIBOR set discretely in advance and pays one-month LIBOR plus or minus a spread as defined in the agreements (the "1:3 Basis Swaps").
 
 
 
As of September 30,
 
As of December 31,
 
 
2018
 
2017
Maturity
 
Notional amount
 
Notional amount
2018
 
$
250,000

 
4,250,000

2019
 
3,500,000

 
3,500,000

2020
 
1,000,000

 

2021
 
250,000

 

2022
 
2,000,000

 
1,000,000

2023
 
750,000

 

2024
 
250,000

 
250,000

2026
 
1,150,000

 
1,150,000

2027
 
375,000

 
375,000

2028
 
325,000

 
325,000

2029
 
100,000

 
100,000

2031
 
300,000

 
300,000

 
 
$
10,250,000

 
11,250,000

The weighted average rate paid by the Company on the 1:3 Basis Swaps as of September 30, 2018 and December 31, 2017 was one-month LIBOR plus 9.4 basis points and 12.5 basis points, respectively.

20



Interest Rate Swaps – Floor Income Hedges

The following table summarizes the outstanding derivative instruments used by the Company to economically hedge loans earning fixed rate floor income.
 
 
As of September 30, 2018
 
As of December 31, 2017
Maturity
 
Notional amount
 
Weighted average fixed rate paid by the Company (a)
 
Notional amount
 
Weighted average fixed rate paid by the Company (a)
 
 
 
 
2018
 
$
250,000

 
0.92
%
 
$
1,350,000

 
1.07
%
2019
 
3,250,000

 
0.97

 
3,250,000

 
0.97

2020
 
1,500,000

 
1.01

 
1,500,000

 
1.01

2023
 
750,000

 
2.28

 
750,000

 
2.28

2024
 
300,000

 
2.28

 
300,000

 
2.28

2025
 
100,000

 
2.32

 
100,000

 
2.32

2027
 
50,000

 
2.32

 
50,000

 
2.32

2028
 
100,000

 
3.03

 

 

 
 
$
6,300,000

 
1.26
%
 
$
7,300,000

 
1.21
%

(a)
For all interest rate derivatives, the Company receives discrete three-month LIBOR.

On August 20, 2014, the Company paid $9.1 million for an interest rate swap option to economically hedge loans earning fixed rate floor income. The interest rate swap option gives the Company the right, but not the obligation, to enter into a $250.0 million notional interest rate swap in which the Company would pay a fixed amount of 3.30% and receive discrete one-month LIBOR. If the interest rate swap option is exercised, the swap would become effective on August 21, 2019 and mature on August 21, 2024.

Interest Rate Caps

In June 2015, in conjunction with the entry into a $275.0 million private education loan warehouse facility, the Company paid $2.9 million for two interest rate cap contracts with a total notional amount of $275.0 million. The first interest rate cap has a notional amount of $125.0 million and a one-month LIBOR strike rate of 2.50%, and the second interest rate cap has a notional amount of $150.0 million and a one-month LIBOR strike rate of 4.99%. In the event that the one-month LIBOR rate rises above the applicable strike rate, the Company would receive monthly payments related to the spread difference. Both interest rate cap contracts have a maturity date of July 15, 2020. The private education loan warehouse facility was terminated by the Company on December 21, 2016. During the first quarter of 2017, the Company received $913,000 to terminate the interest rate cap contracts that were held in the private education loan warehouse legal entity and paid $929,000 to enter into new interest rate cap contracts with identical terms at Nelnet, Inc. (the parent company). The Company currently intends to keep these derivatives outstanding to partially mitigate a rise in interest rates and its impact on earnings related to the Company's student loan portfolio earning a fixed rate.

Interest Rate Swaps – Unsecured Debt Hedges

As of September 30, 2018 and December 31, 2017, the Company had $20.4 million of unsecured Hybrid Securities outstanding. The interest rate on the Hybrid Securities through September 29, 2036 is equal to three-month LIBOR plus 3.375%, payable quarterly. The Company had the following derivatives outstanding as of September 30, 2018 and December 31, 2017 that are used to effectively convert the variable interest rate on a designated notional amount with respect to the Hybrid Securities to a fixed rate of 7.66%.
 
Maturity
 
Notional amount
 
Weighted average fixed rate paid by the Company (a)
2036
 
$
25,000

 
4.28
%
(a)
For all interest rate derivatives, the Company receives discrete three-month LIBOR.


21



Consolidated Financial Statement Impact Related to Derivatives

Balance Sheet

The following table summarizes the fair value of the Company’s derivatives as reflected in the consolidated balance sheets:
 
Fair value of asset derivatives
 
Fair value of liability derivatives
 
As of September 30, 2018
 
As of December 31, 2017
 
As of September 30, 2018
 
As of December 31, 2017
Interest rate swap option - floor income hedge
$
1,200

 
543

 

 

Interest rate caps
843

 
275

 

 

Interest rate swaps - hybrid debt hedges

 

 
4,224

 
7,063

Total
$
2,043

 
818

 
4,224

 
7,063


Offsetting of Derivative Assets/Liabilities

The following tables include the gross amounts related to the Company's derivative portfolio recognized in the consolidated balance sheets, reconciled to the net amount when excluding derivatives subject to enforceable master netting arrangements and cash collateral received/pledged.
 
 
 
 
Gross amounts not offset in the consolidated balance sheets
 
 
Derivative assets
 
Gross amounts of recognized assets presented in the consolidated balance sheets
 
Derivatives subject to enforceable master netting arrangement
 
Cash collateral received
 
Net asset
Balance as of September 30, 2018
 
$
2,043

 

 

 
2,043

Balance as of December 31, 2017
 
818

 

 

 
818

 
 
 
 
Gross amounts not offset in the consolidated balance sheets
 
 
Derivative liabilities
 
Gross amounts of recognized liabilities presented in the consolidated balance sheets
 
Derivatives subject to enforceable master netting arrangement
 
Cash collateral pledged
 
Net asset (liability)
Balance as of September 30, 2018
 
$
(4,224
)
 

 
7,520

 
3,296

Balance as of December 31, 2017
 
(7,063
)
 

 
8,520

 
1,457


22



Income Statement Impact

The following table summarizes the components of "derivative market value and foreign currency transaction adjustments and derivative settlements, net" included in the consolidated statements of income.
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Settlements:
 

 
 

 
 
 
 
1:3 basis swaps
$
3,361

 
(2,172
)
 
4,676

 
(1,836
)
Interest rate swaps - floor income hedges
19,087

 
3,883

 
46,752

 
5,877

Interest rate swaps - hybrid debt hedges
(124
)
 
(191
)
 
(410
)
 
(593
)
Cross-currency interest rate swap

 
(2,093
)
 

 
(5,762
)
Total settlements - income (expense)
22,324

 
(573
)
 
51,018

 
(2,314
)
Change in fair value:
 

 
 

 
 
 
 
1:3 basis swaps
1,283

 
5,916

 
12,058

 
(5,499
)
Interest rate swaps - floor income hedges
(7,427
)
 
(185
)
 
34,008

 
(13,670
)
Interest rate swap option - floor income hedge
(31
)
 
(500
)
 
437

 
(2,212
)
Interest rate caps
119

 
(103
)
 
567

 
(936
)
Interest rate swaps - hybrid debt hedges
830

 
44

 
2,839

 
10

Cross-currency interest rate swap

 
16,257

 

 
44,831

Other

 

 

 
(143
)
Total change in fair value - income (expense)
(5,226
)
 
21,429

 
49,909

 
22,381

Re-measurement of Euro Notes (foreign currency transaction adjustment)

 
(13,683
)
 

 
(45,635
)
Derivative market value and foreign currency transaction adjustments and derivative settlements, net - income (expense)
$
17,098

 
7,173

 
100,927

 
(25,568
)


23



6.  Investments and Notes Receivable

A summary of the Company's investments and notes receivable follows:
 
As of September 30, 2018
 
Amortized cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Fair value
 
 
 
 
Investments (at fair value):
 
 
 
 
 
 
 
Student loan asset-backed and other debt securities - available-for-sale (a)
$
52,232

 
5,178

 

 
57,410

Equity securities
12,318

 
4,835

 
(380
)
 
16,773

Total investments (at fair value)
$
64,550

 
10,013

 
(380
)
 
74,183

 
 
 
 
 
 
 
 
Other Investments and Notes Receivable (not measured at fair value):
 
 
 
 
Venture capital and funds:
 
 
 
 
 
 
 
Measurement alternative (b)
 
 
 
 
 
 
70,881

Equity method
 
 
 
 
 
 
17,526

Other
 
 
 
 
 
 
883

  Total venture capital and funds
 
 
 
 
 
 
89,290

Real estate:
 
 
 
 
 
 
 
Equity method
 
 
 
 
 
 
30,135

Other
 
 
 
 
 
 
29,058

  Total real estate
 
 
 
 
 
 
59,193

 
 
 
 
 
 
 
 
Notes receivable
 
 
 
 
 
 
16,373

Tax liens and affordable housing
 
 
 
 
 
 
7,776

Total investments and notes receivable (not measured at fair value)
 
 
 
 
 
 
172,632

Total investments and notes receivable
 
 
 
 
 
 
$
246,815

 
As of December 31, 2017
 
Amortized cost
 
Gross unrealized gains
 
Gross unrealized losses
 
Fair value
 
 
 
 
Investments (at fair value):
 
 
 
 
 
 
 
Available-for-sale investments:
 
 
 
 
 
 
 
Student loan asset-backed and other debt securities
$
71,943

 
5,056

 
(25
)
 
76,974

Equity securities
1,630

 
2,298

 

 
3,928

Total available-for-sale investments
$
73,573

 
7,354

 
(25
)
 
80,902

 
 
 
 
 
 
 
 
Other Investments and Notes Receivable (not measured at fair value):
 
 
 
 
 
 
 
Venture capital and funds
 
 
 
 
 
 
84,752

Real estate
 
 
 
 
 
 
49,464

Notes receivable
 
 
 
 
 
 
16,393

Tax liens and affordable housing
 
 
 
 
 
 
9,027

Total investments and notes receivable
 
 
 
 
 
 
$
240,538

    
(a)
As of September 30, 2018, the stated maturities of substantially all of the Company's student loan asset-backed and other debt securities classified as available-for-sale were greater than 10 years.

(b)
The Company accounts for the majority of its equity securities without readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of the same issuer (the measurement alternative method). During the three months ended March 31, 2018 and June 30, 2018, the Company recorded upward adjustments of $6.9 million and $0.3 million, respectively, on these investments. There were no adjustments recorded by the Company during the three months ended September 30, 2018. The impacts related to the adjustments to these investments are included in "other income" in the consolidated statements of income. The upward adjustments were made as a result of observable price changes. The Company has recorded no impairments in 2018 on these investments.

24



7. Business Combination

Great Lakes Educational Loan Services, Inc. ("Great Lakes")

On February 7, 2018, the Company acquired 100 percent of the outstanding stock of Great Lakes for total cash consideration of $150.0 million. Great Lakes provides servicing for federally-owned student loans for the U.S. Department of Education (the "Department"), FFELP loans, and private education loans. The acquisition of Great Lakes has expanded the Company's portfolio of loans it services. The operating results of Great Lakes are included in the Loan Servicing and Systems operating segment.

As part of the acquisition, the Company acquired the remaining 50 percent ownership in GreatNet Solutions, LLC ("GreatNet"), a joint venture formed prior to the acquisition between Nelnet Servicing, LLC ("Nelnet Servicing"), a subsidiary of the Company, and Great Lakes. Prior to the acquisition of the remaining 50 percent of GreatNet, the Company consolidated the operating results of GreatNet, as the Company was deemed to have control over the joint venture. The proportionate share of membership interest (equity) and net loss of GreatNet that was attributable to Great Lakes was reflected as a noncontrolling interest in the Company's consolidated financial statements. The Company recognized a $19.1 million reduction to consolidated shareholders' equity as a result of acquiring Great Lakes' 50 percent ownership in GreatNet. This transaction resulted in a $5.7 million decrease in noncontrolling interests and a $13.4 million decrease in retained earnings.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the acquisition date. During the three months ended June 30, 2018, the Company recognized certain adjustments to the provisional amounts recorded on the acquisition date that were needed to reflect new information obtained about facts and circumstances that existed as of the acquisition date. The net impact of these adjustments was a decrease to goodwill, and the adjustments had no impact on operating results. The fair value assigned to the acquisition of the noncontrolling interest in GreatNet reduced the total consideration allocated to the assets acquired and liabilities assumed of Great Lakes from $150.0 million to $136.6 million.

Cash and cash equivalents
$
27,399

Accounts receivable
23,708

Property and equipment
35,919

Other assets
14,018

Intangible assets
75,329

Excess cost over fair value of net assets acquired (goodwill)
15,043

Other liabilities
(54,865
)
Net assets acquired
$
136,551


The $75.3 million of acquired intangible assets on the date of acquisition had a weighted-average useful life of approximately 4 years. The intangible assets that made up this amount include customer relationships of $70.2 million (4-year average useful life) and a trade name of $5.1 million (7-year useful life).

The $15.0 million of goodwill was assigned to the Loan Servicing and Systems operating segment and is not expected to be deductible for tax purposes. The amount allocated to goodwill was primarily attributed to the deferred tax liability related to the difference between the carrying amount and tax bases of acquired identifiable intangible assets and the synergies and economies of scale expected from combining the operations of the Company and Great Lakes.

The Great Lakes assets acquired and liabilities assumed were recorded by the Company at their respective fair values at the date of acquisition, and Great Lakes' operating results from the date of acquisition forward are included in the Company's consolidated operating results. During the second quarter of 2018, the Company converted Great Lakes' FFELP and private education loan servicing volume to Nelnet Servicing's servicing platform. In addition, the Company began to combine certain shared services and overhead functions between Great Lakes and the Company. As a result of these operational changes, the results of operations for the three and nine months ended September 30, 2018 attributed to Great Lakes since the acquisition are not provided since the results of the Great Lakes legal entity are no longer reflective of the entity acquired.

The following unaudited pro forma information for the Company has been prepared as if the acquisition of Great Lakes had occurred on January 1, 2017. The information is based on the historical results of the separate companies and may not necessarily be indicative of the results that could have been achieved or of results that may occur in the future. The pro forma adjustments include the impact of depreciation and amortization of property and equipment and intangible assets acquired.


25



 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Loan servicing and systems revenue
$
112,579

 
117,044

 
347,312

 
348,752

 
 
 
 
 
 
 
 
Net income attributable to Nelnet, Inc.
$
42,927

 
48,794

 
207,783

 
135,523

 
 
 
 
 
 
 
 
Net income per share - basic and diluted
$
1.05

 
1.17

 
5.08

 
3.22


8. Intangible Assets

Intangible assets consist of the following:
 
Weighted average remaining useful life as of September 30, 2018 (months)
 
As of
 
As of
 
September 30,
December 31,
 
 
2018
 
2017
Amortizable intangible assets, net:
 
 
 
Customer relationships (net of accumulated amortization of $28,023 and $12,715, respectively)
73
 
$
79,070

 
24,168

Trade names (net of accumulated amortization of $4,978 and $2,498, respectively)
86
 
11,715

 
9,074

Computer software (net of accumulated amortization of $14,061 and $10,013, respectively)
21
 
4,674

 
4,958

Covenants not to compete (net of accumulated amortization of $153 and $127, respectively)
68
 
201

 
227

Total - amortizable intangible assets, net
72
 
$
95,660

 
38,427


The Company recorded amortization expense on its intangible assets of $7.9 million and $2.3 million during the three months ended September 30, 2018 and 2017, respectively, and $21.9 million and $7.1 million during the nine months ended September 30, 2018 and 2017, respectively. The Company will continue to amortize intangible assets over their remaining useful lives. As of September 30, 2018, the Company estimates it will record amortization expense as follows:
2018 (October 1 - December 31)
$
7,650

2019
27,854

2020
24,656

2021
14,629

2022
4,671

2023 and thereafter
16,200

 
$
95,660


9. Goodwill

The change in the carrying amount of goodwill by reportable operating segment was as follows:
 
Loan Servicing and Systems
 
Education Technology, Services, and Payment Processing
 
Communications
 
Asset Generation and Management
 
Corporate and Other Activities
 
Total
Balance as of December 31, 2017
$
8,596

 
67,168

 
21,112

 
41,883

 

 
138,759

Goodwill acquired during the period
19,697

 

 

 

 

 
19,697

Balance as of March 31, 2018
28,293


67,168


21,112


41,883




158,456

Great Lakes purchase price allocation adjustment - second quarter of 2018
(4,654
)
 

 

 

 

 
(4,654
)
Balance as of June 30, 2018 and September 30, 2018
$
23,639

 
67,168

 
21,112

 
41,883

 

 
153,802


26




10. Property and Equipment

Property and equipment consisted of the following:
 
 
 
As of
 
As of
 
Useful life
 
September 30, 2018
 
December 31, 2017
Non-communications:
 
 
 
 
 
Computer equipment and software
1-5 years
 
$
146,831

 
124,708

Building and building improvements
5-48 years
 
49,128

 
24,003

Office furniture and equipment
1-10 years
 
22,445

 
15,210

Leasehold improvements
1-15 years
 
9,310

 
7,759

Transportation equipment
4-10 years
 
4,447

 
3,813

Land
 
3,328

 
2,628

Construction in progress
 
2,073

 
4,127

 
 
 
237,562

 
182,248

Accumulated depreciation - non-communications
 
 
(119,535
)
 
(105,017
)
Non-communications, net property and equipment
 
 
118,027

 
77,231

 
 
 
 
 
 
Communications:
 
 
 
 
 
Network plant and fiber
5-15 years
 
195,015

 
138,122

Customer located property
5-10 years
 
19,146

 
13,767

Central office
5-15 years
 
13,584

 
10,754

Transportation equipment
4-10 years
 
6,379

 
5,759

Computer equipment and software
1-5 years
 
4,988

 
3,790

Other
1-39 years
 
2,669

 
2,516

Land
 
70

 
70

Construction in progress
 
11,364

 
11,620

 
 
 
253,215

 
186,398

Accumulated depreciation - communications
 
 
(31,512
)
 
(15,578
)
Communications, net property and equipment
 
 
221,703

 
170,820

Total property and equipment, net
 
 
$
339,730

 
248,051


The Company recorded depreciation expense on its property and equipment of $15.1 million and $7.7 million during the three months ended September 30, 2018 and 2017, respectively, and $41.1 million and $20.6 million during the nine months ended September 30, 2018 and 2017, respectively.

As part of integrating technology and becoming more efficient and effective in meeting borrower needs, the Company continues to evaluate the best use of its servicing systems on a post-Great Lakes acquisition basis.  As a result of this evaluation, during the three months ended September 30, 2018, the Company recorded an impairment charge of $3.9 million within its Loan Servicing and Systems operating segment related to certain external software development costs that were previously capitalized. The impairment charge is included in "other expenses" on the Company's consolidated statements of income for the three and nine months ended September 30, 2018. There were no impairment charges recognized for the three and nine months ended September 30, 2017.


27



11.  Earnings per Common Share

Presented below is a summary of the components used to calculate basic and diluted earnings per share. The Company applies the two-class method in computing both basic and diluted earnings per share, which requires the calculation of separate earnings per share amounts for common stock and unvested share-based awards. Unvested share-based awards that contain nonforfeitable rights to dividends are considered securities which participate in undistributed earnings with common stock.
 
Three months ended September 30,
 
2018
 
2017
 
Common shareholders
 
Unvested restricted stock shareholders
 
Total
 
Common shareholders
 
Unvested restricted stock shareholders
 
Total
Numerator:
 
 
 
 
 
 
 
 
 
 
 
Net income attributable to Nelnet, Inc.
$
42,354

 
573

 
42,927

 
45,850

 
453

 
46,303

 
 
 
 
 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
 
 
 
 
Weighted-average common shares outstanding - basic and diluted
40,441,783

 
547,182

 
40,988,965

 
41,146,424

 
406,892

 
41,553,316

Earnings per share - basic and diluted
$
1.05

 
1.05

 
1.05

 
1.11

 
1.11

 
1.11


 
Nine months ended September 30,
 
2018
 
2017
 
Common shareholders
 
Unvested restricted stock shareholders
 
Total
 
Common shareholders
 
Unvested restricted stock shareholders
 
Total
Numerator:
 
 
 
 
 
 
 
 
 
 
 
Net income attributable to Nelnet, Inc.
$
203,881

 
2,406

 
206,287

 
123,816

 
1,249

 
125,065

 
 
 
 
 
 
 
 
 
 
 
 
Denominator:
 
 
 
 
 
 
 
 
 
 
 
Weighted-average common shares outstanding - basic and diluted
40,464,638

 
477,539

 
40,942,177

 
41,634,578

 
419,954

 
42,054,532

Earnings per share - basic and diluted
$
5.04

 
5.04

 
5.04

 
2.97

 
2.97

 
2.97




28




12.  Segment Reporting

See note 15 of the notes to consolidated financial statements included in the 2017 Annual Report for a description of the Company's operating segments. As discussed in note 1 above, the names of certain operating segments were changed during the first quarter of 2018. The following tables include the results of each of the Company's operating segments reconciled to the consolidated financial statements.
 
Three months ended September 30, 2018
 
Loan Servicing and Systems
 
Education Technology, Services, and Payment Processing
 
Communications
 
Asset
Generation and
Management
 
Corporate and Other Activities
 
Eliminations
 
Total
Total interest income
$
381

 
1,513

 
1

 
236,039

 
6,860

 
(4,846
)
 
239,948

Interest expense

 
3

 
4,174

 
176,874

 
3,968

 
(4,846
)
 
180,175

Net interest income
381

 
1,510

 
(4,173
)
 
59,165

 
2,892

 

 
59,773

Less provision for loan losses

 

 

 
10,500

 

 

 
10,500

Net interest income (loss) after provision for loan losses
381

 
1,510

 
(4,173
)
 
48,665

 
2,892

 

 
49,273

Other income:
 
 
 
 
 
 
 
 
 
 
 
 
 
Loan servicing and systems revenue
112,579

 

 

 

 

 

 
112,579

Intersegment servicing revenue
12,290

 

 

 

 

 
(12,290
)
 

Education technology, services, and payment processing revenue

 
58,409

 

 

 

 

 
58,409

Communications revenue

 

 
11,818

 

 

 

 
11,818

Other income
1,948

 

 
950

 
3,267

 
10,508

 

 
16,673

Derivative settlements, net

 

 

 
22,448

 
(124
)
 

 
22,324

Derivative market value and foreign currency transaction adjustments, net

 

 

 
(6,056
)
 
830

 

 
(5,226
)
Total other income
126,817

 
58,409

 
12,768

 
19,659

 
11,214

 
(12,290
)
 
216,577

Cost of services:
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost to provide education technology, services, and payment processing services

 
19,087

 

 

 

 

 
19,087

Cost to provide communications services

 

 
4,310

 

 

 

 
4,310

Total cost of services

 
19,087

 
4,310

 

 

 

 
23,397

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Salaries and benefits
70,440

 
19,972

 
4,554

 
424

 
18,782

 

 
114,172

Depreciation and amortization
8,957

 
3,435

 
6,167

 

 
4,433

 

 
22,992

Loan servicing fees

 

 

 
3,087

 

 

 
3,087

Other expenses
19,638

 
4,943

 
3,151

 
845

 
16,616

 

 
45,194

Intersegment expenses, net
15,029

 
2,494

 
598

 
12,378

 
(18,208
)
 
(12,290
)
 

Total operating expenses
114,064

 
30,844

 
14,470

 
16,734

 
21,623

 
(12,290
)
 
185,445

Income (loss) before income taxes
13,134

 
9,988

 
(10,185
)
 
51,590

 
(7,517
)
 

 
57,008

Income tax (expense) benefit (a)
(3,152
)
 
(2,397
)
 
2,444

 
(12,381
)
 
1,604

 

 
(13,882
)
Net income (loss)
9,982

 
7,591

 
(7,741
)
 
39,209

 
(5,913
)
 

 
43,126

  Net income attributable to noncontrolling interests

 

 

 

 
(199
)
 

 
(199
)
Net income (loss) attributable to Nelnet, Inc.
$
9,982

 
7,591

 
(7,741
)
 
39,209

 
(6,112
)
 

 
42,927

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total assets as of September 30, 2018
$
276,153

 
243,497

 
271,370

 
23,927,156

 
723,985

 
(337,236
)
 
25,104,925


(a)
As a result of the Tax Cuts and Jobs Act, beginning January 1, 2018, income taxes are allocated based on 24% of income before taxes for each individual operating segment. The difference between the consolidated income tax expense and the sum of the taxes calculated for each operating segment, if any, is included in income taxes in Corporate and Other Activities.

29



 
Three months ended September 30, 2017
 
Loan Servicing and Systems
 
Education Technology, Services, and Payment Processing
 
Communications
 
Asset
Generation and
Management
 
Corporate and Other
Activities
 
Eliminations
 
Total
Total interest income
$
147

 
5

 
1

 
194,971

 
3,903

 
(2,139
)
 
196,887

Interest expense

 

 
1,551

 
121,074

 
1,165

 
(2,139
)
 
121,650

Net interest income
147

 
5

 
(1,550
)
 
73,897

 
2,738

 

 
75,237

Less provision for loan losses

 

 

 
6,700

 

 

 
6,700

Net interest income (loss) after provision for loan losses
147

 
5

 
(1,550
)
 
67,197

 
2,738

 

 
68,537

Other income:
 
 
 
 
 
 
 
 
 
 
 
 
 
Loan servicing and systems revenue
55,950

 

 

 

 

 

 
55,950

Intersegment servicing revenue
10,563

 

 

 

 

 
(10,563
)
 

Education technology, services, and payment processing revenue

 
50,358

 

 

 

 

 
50,358

Communications revenue

 

 
6,751

 

 

 

 
6,751

Other income

 

 

 
2,753

 
17,003

 

 
19,756

Gain from debt repurchases

 

 

 
116

 

 

 
116

Derivative settlements, net

 

 

 
(382
)
 
(191
)
 

 
(573
)
Derivative market value and foreign currency transaction adjustments, net

 

 

 
7,702

 
44

 

 
7,746

Total other income
66,513

 
50,358

 
6,751

 
10,189

 
16,856

 
(10,563
)
 
140,104

Cost of services:
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost to provide education technology, services, and payment processing services

 
15,151

 

 

 

 

 
15,151

Cost to provide communications services

 

 
2,632

 

 

 

 
2,632

Total cost of services

 
15,151

 
2,632

 

 

 

 
17,783

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Salaries and benefits
38,435

 
17,432

 
4,099

 
392

 
13,834

 

 
74,193

Depreciation and amortization
549

 
2,316

 
3,145

 

 
4,040

 

 
10,051

Loan servicing fees

 

 

 
8,017

 

 

 
8,017

Other expenses
10,317

 
3,981

 
2,278

 
676

 
12,248

 

 
29,500

Intersegment expenses, net
7,774

 
2,219

 
470

 
10,659

 
(10,559
)
 
(10,563
)
 

Total operating expenses
57,075

 
25,948

 
9,992

 
19,744

 
19,563

 
(10,563
)
 
121,761

Income (loss) before income taxes
9,585

 
9,264

 
(7,423
)
 
57,642

 
31

 

 
69,097

Income tax (expense) benefit
(4,937
)
 
(3,520
)
 
2,821

 
(21,904
)
 
1,978

 

 
(25,562
)
Net income (loss)
4,648

 
5,744

 
(4,602
)
 
35,738

 
2,009

 

 
43,535

  Net loss (income) attributable to noncontrolling interests
3,408

 

 

 

 
(640
)
 

 
2,768

Net income (loss) attributable to Nelnet, Inc.
$
8,056

 
5,744

 
(4,602
)
 
35,738

 
1,369

 

 
46,303

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total assets as of September 30, 2017
$
98,555

 
208,290

 
179,206

 
23,724,413

 
863,700

 
(305,454
)
 
24,768,710



30



 
Nine months ended September 30, 2018
 
Loan Servicing and Systems
 
Education Technology, Services, and Payment Processing
 
Communications
 
Asset
Generation and
Management
 
Corporate and Other
Activities
 
Eliminations
 
Total
Total interest income
$
931

 
2,927

 
3

 
662,881

 
17,673

 
(12,420
)
 
671,995

Interest expense

 
3

 
9,987

 
480,729

 
8,875

 
(12,420
)
 
487,174

Net interest income
931

 
2,924

 
(9,984
)
 
182,152

 
8,798

 

 
184,821

Less provision for loan losses

 

 

 
18,000

 

 

 
18,000

Net interest income (loss) after provision for loan losses
931

 
2,924

 
(9,984
)
 
164,152

 
8,798

 

 
166,821

Other income:
 
 
 
 
 
 
 
 
 
 
 
 
 
Loan servicing and systems revenue
327,265

 

 

 

 

 

 
327,265

Intersegment servicing revenue
34,670

 

 

 

 

 
(34,670
)
 

Education technology, services, and payment processing revenue

 
167,372

 

 

 

 

 
167,372

Communications revenue

 

 
31,327

 

 

 

 
31,327

Other income
5,196

 

 
950

 
9,032

 
29,272

 

 
44,449

Gain from debt repurchases

 

 

 
359

 

 

 
359

Derivative settlements, net

 

 

 
51,428

 
(410
)
 

 
51,018

Derivative market value and foreign currency transaction adjustments, net

 

 

 
47,070

 
2,839

 

 
49,909

Total other income
367,131

 
167,372

 
32,277

 
107,889

 
31,701

 
(34,670
)
 
671,699

Cost of services:
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost to provide education technology, services, and payment processing services

 
44,087

 

 

 

 

 
44,087

Cost to provide communications services

 

 
11,892

 

 

 

 
11,892

Total cost of services

 
44,087

 
11,892

 

 

 

 
55,979

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Salaries and benefits
198,411

 
58,552

 
13,284

 
1,183

 
50,502

 

 
321,932

Depreciation and amortization
23,237

 
10,062

 
16,585

 

 
13,058

 

 
62,943

Loan servicing fees

 

 

 
9,428

 

 

 
9,428

Other expenses
51,591

 
14,950

 
8,811

 
2,982

 
40,686

 

 
119,020

Intersegment expenses, net
43,968

 
7,630

 
1,802

 
34,943

 
(53,672
)
 
(34,670
)
 

Total operating expenses
317,207

 
91,194

 
40,482

 
48,536

 
50,574

 
(34,670
)
 
513,323

Income (loss) before income taxes
50,855

 
35,015

 
(30,081
)
 
223,505

 
(10,075
)
 

 
269,218

Income tax (expense) benefit (a)
(12,399
)
 
(8,404
)
 
7,220

 
(53,641
)
 
3,855

 

 
(63,369
)
Net income (loss)
38,456

 
26,611

 
(22,861
)
 
169,864

 
(6,220
)
 

 
205,849

  Net loss (income) attributable to noncontrolling interests
808

 

 

 

 
(371
)
 

 
438

Net income (loss) attributable to Nelnet, Inc.
$
39,264

 
26,611

 
(22,861
)
 
169,864

 
(6,591
)
 

 
206,287

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total assets as of September 30, 2018
$
276,153

 
243,497

 
271,370

 
23,927,156

 
723,985

 
(337,236
)
 
25,104,925


(a)
As a result of the Tax Cuts and Jobs Act, beginning January 1, 2018, income taxes are allocated based on 24% of income before taxes for each individual operating segment. The difference between the consolidated income tax expense and the sum of the taxes calculated for each operating segment, if any, is included in income taxes in Corporate and Other Activities.


31



 
Nine months ended September 30, 2017
 
Loan Servicing and Systems
 
Education Technology, Services, and Payment Processing
 
Communications
 
Asset
Generation and
Management
 
Corporate and Other
Activities
 
Eliminations
 
Total
Total interest income
$
361

 
10

 
2

 
568,665

 
10,026

 
(5,274
)
 
573,789

Interest expense

 

 
3,367

 
340,898

 
2,794

 
(5,274
)
 
341,787

Net interest income
361

 
10

 
(3,365
)
 
227,767

 
7,232

 

 
232,002

Less provision for loan losses

 

 

 
10,700

 

 

 
10,700

Net interest income (loss) after provision for loan losses
361

 
10

 
(3,365
)
 
217,067

 
7,232

 

 
221,302

Other income:
 
 
 
 
 
 
 
 
 
 
 
 
 
Loan servicing and systems revenue
167,079

 

 

 

 

 

 
167,079

Intersegment servicing revenue
30,839

 

 

 

 

 
(30,839
)
 

Education technology, services, and payment processing revenue

 
149,862

 

 

 

 

 
149,862

Communications revenue

 

 
17,577

 

 

 

 
17,577

Other income

 

 

 
9,152

 
35,722

 

 
44,874

Gain from debt repurchases

 

 

 
1,097

 
4,440

 

 
5,537

Derivative settlements, net

 

 

 
(1,721
)
 
(593
)
 

 
(2,314
)
Derivative market value and foreign currency transaction adjustments, net

 

 

 
(23,121
)
 
(133
)
 

 
(23,254
)
Total other income
197,918

 
149,862

 
17,577

 
(14,593
)
 
39,436

 
(30,839
)
 
359,361

Cost of services:
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost to provide education technology, services, and payment processing services

 
37,456

 

 

 

 

 
37,456

Cost to provide communications services

 

 
6,789

 

 

 

 
6,789

Total cost of services

 
37,456

 
6,789

 

 

 

 
44,245

Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
Salaries and benefits
116,932

 
50,986

 
10,489

 
1,156

 
41,121

 

 
220,684

Depreciation and amortization
1,644

 
7,053

 
7,880

 

 
11,109

 

 
27,687

Loan servicing fees

 

 

 
19,670

 

 

 
19,670

Other expenses
28,333

 
13,185

 
5,422

 
2,487

 
32,497

 

 
81,923

Intersegment expenses, net
23,496

 
6,430

 
1,472

 
31,114

 
(31,673
)
 
(30,839
)
 

Total operating expenses
170,405

 
77,654

 
25,263

 
54,427

 
53,054

 
(30,839
)
 
349,964

Income (loss) before income taxes
27,874

 
34,762

 
(17,840
)
 
148,047

 
(6,386
)
 

 
186,454

Income tax (expense) benefit
(14,410
)
 
(13,210
)
 
6,779

 
(56,258
)
 
6,749

 

 
(70,349
)
Net income (loss)
13,464

 
21,552

 
(11,061
)
 
91,789

 
363

 

 
116,105

  Net loss (income) attributable to noncontrolling interests
10,050

 

 

 

 
(1,090
)
 

 
8,960

Net income (loss) attributable to Nelnet, Inc.
$
23,514

 
21,552

 
(11,061
)
 
91,789

 
(727
)
 

 
125,065

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total assets as of September 30, 2017
$
98,555

 
208,290

 
179,206

 
23,724,413

 
863,700

 
(305,454
)
 
24,768,710




32


13.  Major Customer
Nelnet Servicing earns loan servicing revenue from a servicing contract with the Department that is currently scheduled to expire on June 16, 2019. Revenue earned by Nelnet Servicing related to this contract was $38.9 million and $38.6 million for the three months ended September 30, 2018 and 2017, and $118.0 million and $117.4 million for the nine months ended September 30, 2018 and 2017, respectively.

In addition, Great Lakes, which was acquired by the Company on February 7, 2018, also earns loan servicing revenue from a similar servicing contract with the Department that is currently scheduled to expire on June 16, 2019. Revenue earned by Great Lakes related to this contract was $45.7 million for the three months ended September 30, 2018, and $122.1 million for the period from February 7, 2018 to September 30, 2018.

On February 20, 2018, the Department’s Office of Federal Student Aid ("FSA") released information regarding a contract procurement process entitled Next Generation Financial Services Environment (“NextGen”) for the servicing of all student loans owned by the Department. The Company is part of a team that responded to the initial phase of the NextGen procurement on April 17, 2018.
 
On August 27, August 29, and September 24, 2018, FSA made announcements that included canceling certain components of the NextGen process, issuing a solicitation for a separate new procurement process for certain of those NextGen components that were canceled, and outlining the next steps, components, and entities that are eligible to respond to the next phase for certain of the remaining NextGen components (which for each applicable component included the Company or an entity the Company is teaming with).
 
Currently, FSA has four ongoing components between the two procurement processes:
 
·         Enterprise-Wide Digital and Customer Care Platforms and Services (new procurement process)
·         NextGen Future State Core Platform
·         NextGen Transitional Core Processing and Related Support Activities
·         NextGen Business Process Operations
 
The Company is part of a team that has responded or will be responding to the next applicable phase for each of these four components.  The Company cannot predict the timing, nature, or outcome of the next steps for these processes.

14. Related Parties

On August 22, 2018, the Company entered into agreements with Union Bank and Trust Company ("Union Bank") in which the Company will provide marketing, origination, and loan servicing services to Union Bank related to private education loans. The Company has committed to purchase, or arrange for a designee to purchase, a 95% participation interest in private education loans originated by Union Bank under these agreements upon a request for purchase by Union Bank. In addition, Union Bank has agreed to sell a 95% participation interest in private education loans originated by Union Bank under these agreements to the Company or its designee upon a request for sale by the Company. As of September 30, 2018, no loans had been originated under these agreements.


33



15.  Fair Value

The following tables present the Company’s financial assets and liabilities that are measured at fair value on a recurring basis. There were no transfers into or out of level 1, level 2, or level 3 for the nine months ended September 30, 2018.
 
As of September 30, 2018
 
Level 1
 
Level 2
 
Total
Assets:
 
 
 
 
 
Investments:
 
 
 
 


Student loan and other asset-backed securities - available-for-sale
$

 
57,304

 
57,304

Equity securities
3,123

 

 
3,123

Equity securities measured at net asset value (a)

 

 
13,650

Debt securities - available-for-sale
106

 

 
106

Total investments
3,229

 
57,304

 
74,183

Derivative instruments

 
2,043

 
2,043

Total assets
$
3,229

 
59,347

 
76,226

Liabilities:
 

 
 

 
 

Derivative instruments
$

 
4,224

 
4,224

Total liabilities
$

 
4,224

 
4,224


 
As of December 31, 2017
 
Level 1
 
Level 2
 
Total
Assets:
 
 
 
 
 
Investments (available-for-sale):
 
 
 
 
 
Student loan and other asset-backed securities
$

 
76,866

 
76,866

Equity securities
3,928

 

 
3,928

Debt securities
108

 

 
108

Total investments (available-for-sale)
4,036

 
76,866

 
80,902

Derivative instruments

 
818

 
818

Total assets
$
4,036

 
77,684

 
81,720

Liabilities:
 
 
 
 
 
Derivative instruments
$

 
7,063

 
7,063

Total liabilities
$

 
7,063

 
7,063


(a)
In accordance with the Fair Value Measurements Topic of the FASB Accounting Standards Codification, certain investments that are measured at fair value using the net asset value per share (or its equivalent) practical expedient have not been classified in the fair value hierarchy.


34



The following table summarizes the fair values of all of the Company’s financial instruments on the consolidated balance sheets:
 
As of September 30, 2018
 
Fair value
 
Carrying value
 
Level 1
 
Level 2
 
Level 3
Financial assets:
 
 
 
 
 
 
 
 
 
Loans receivable
$
23,868,803

 
22,528,362

 

 

 
23,868,803

Cash and cash equivalents
83,537

 
83,537

 
83,537

 

 

Investments (at fair value)
74,183

 
74,183

 
3,229

 
57,304

 

Notes receivable
16,373

 
16,373

 

 
16,373

 

Restricted cash
723,338

 
723,338

 
723,338

 

 

Restricted cash – due to customers
188,591

 
188,591

 
188,591

 

 

Loan accrued interest receivable
624,259

 
624,259

 

 
624,259

 

Derivative instruments
2,043

 
2,043

 

 
2,043

 

Financial liabilities:
 

 
 

 
 
 
 
 
 
Bonds and notes payable
22,525,479

 
22,251,433

 

 
22,525,479

 

Accrued interest payable
60,658

 
60,658

 

 
60,658

 

Due to customers
188,591

 
188,591

 
188,591

 

 

Derivative instruments
4,224

 
4,224

 

 
4,224

 

 
As of December 31, 2017
 
Fair value
 
Carrying value
 
Level 1
 
Level 2
 
Level 3
Financial assets:
 
 
 
 
 
 
 
 
 
Loans receivable
$
23,106,440

 
21,814,507

 

 

 
23,106,440

Cash and cash equivalents
66,752

 
66,752

 
66,752

 

 

Investments (available-for-sale)
80,902

 
80,902

 
4,036

 
76,866

 

Notes receivable
16,393

 
16,393

 

 
16,393

 

Restricted cash
688,193

 
688,193

 
688,193

 

 

Restricted cash – due to customers
187,121

 
187,121

 
187,121

 

 

Loan accrued interest receivable
430,385

 
430,385

 

 
430,385

 

Derivative instruments
818

 
818

 

 
818

 

Financial liabilities:
 

 
 

 
 
 
 
 
 
Bonds and notes payable
21,521,463

 
21,356,573

 

 
21,521,463

 

Accrued interest payable
50,039

 
50,039

 

 
50,039

 

Due to customers
187,121

 
187,121

 
187,121

 

 

Derivative instruments
7,063

 
7,063

 

 
7,063

 

 
The methodologies for estimating the fair value of financial assets and liabilities are described in note 21 of the notes to consolidated financial statements included in the 2017 Annual Report.

16.  Subsequent Event

On October 16, 2018, the Company terminated its investment in a proprietary payment processing platform. This decision was made as a result of decreases in price and advancements of technology by established processors in the industry. As a result of this decision, the Company will record an impairment charge of approximately $8 million during the three-month period ending December 31, 2018. The charge represents computer equipment and external software development costs related to the payment processing platform. The decision will not impact the Company's existing payment processing revenue or customers. The Company is continuing to evaluate other costs that may be incurred as a result of this decision, including the termination of certain contracts and severance for affected employees. The Company currently believes contract termination and employee severance costs will not be material.

35




ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Management’s Discussion and Analysis of Financial Condition and Results of Operations is for the three and nine months ended September 30, 2018 and 2017. All dollars are in thousands, except per share amounts, unless otherwise noted.)

The following discussion and analysis provides information that the Company’s management believes is relevant to an assessment and understanding of the consolidated results of operations and financial condition of the Company.  The discussion should be read in conjunction with the Company’s consolidated financial statements included in the 2017 Annual Report.

Forward-looking and cautionary statements

This report contains forward-looking statements and information that are based on management's current expectations as of the date of this document.  Statements that are not historical facts, including statements about the Company's plans and expectations for future financial condition, results of operations or economic performance, or that address management's plans and objectives for future operations, and statements that assume or are dependent upon future events, are forward-looking statements. The words “may,” “should,” “could,” “would,” “predict,” “potential,” “continue,” “expect,” “anticipate,” “future,” “intend,” “scheduled,” “plan,” “believe,” “estimate,” “assume,” “forecast,” “will,” and similar expressions, as well as statements in future tense, are intended to identify forward-looking statements.
The forward-looking statements are based on assumptions and analyses made by management in light of management's experience and its perception of historical trends, current conditions, expected future developments, and other factors that management believes are appropriate under the circumstances. These statements are subject to known and unknown risks, uncertainties, assumptions, and other factors that may cause the actual results and performance to be materially different from any future results or performance expressed or implied by such forward-looking statements. These factors include, among others, the risks and uncertainties set forth in the “Risk Factors” section of the 2017 Annual Report and elsewhere in this report, and include such risks and uncertainties as:

loan portfolio risks such as interest rate basis and repricing risk resulting from the fact that the interest rate characteristics of the student loan assets do not match the interest rate characteristics of the funding for those assets, the risk of loss of floor income on certain student loans originated under the Federal Family Education Loan Program (the "FFEL Program" or "FFELP"), risks related to the use of derivatives to manage exposure to interest rate fluctuations, uncertainties regarding the expected benefits from purchased securitized and unsecuritized FFELP, private education, and consumer loans and initiatives to purchase additional FFELP, private education, and consumer loans, and risks from changes in levels of loan prepayment or default rates;
financing and liquidity risks, including risks of changes in the general interest rate environment, including the availability of any relevant money market index rate such as LIBOR, and in the securitization and other financing markets for loans, including adverse changes resulting from unanticipated repayment trends on student loans in FFELP securitization trusts that could accelerate or delay repayment of the associated bonds, which may increase the costs or limit the availability of financings necessary to purchase, refinance, or continue to hold student loans;
risks from changes in the educational credit and services markets resulting from changes in applicable laws, regulations, and government programs and budgets, such as the expected decline over time in FFELP loan interest income and fee-based revenues due to the discontinuation of new FFELP loan originations in 2010 and potential government initiatives or legislative proposals to consolidate existing FFELP loans to the Federal Direct Loan Program or otherwise allow FFELP loans to be refinanced with Federal Direct Loan Program loans;
the uncertain nature of the expected benefits from the acquisition of Great Lakes Educational Loan Services, Inc. ("Great Lakes") on February 7, 2018 and the ability to successfully integrate technology, shared services, and other activities and successfully maintain and increase allocated volumes of student loans serviced under existing and any future servicing contracts with the U.S. Department of Education (the "Department"), which current contract between the Company and the Department accounted for 21 percent of the Company's revenue in 2017, risks to the Company related to the Department's initiative to procure new contracts for federal student loan servicing, including the risk that the Company on a post-Great Lakes acquisition basis may not be awarded a contract, risks related to the development by the Company and Great Lakes of a new student loan servicing platform, including risks as to whether the expected benefits from the new platform will be realized, and risks related to the Company's ability to comply with agreements with third-party customers for the servicing of Federal Direct Loan Program, FFELP, and private education and consumer loans;

36



risks related to a breach of or failure in the Company's operational or information systems or infrastructure, or those of third-party vendors, including cybersecurity risks related to the potential disclosure of confidential student loan borrower and other customer information, the potential disruption of the Company's systems or those of third-party vendors or customers, and/or the potential damage to the Company's reputation resulting from cyber-breaches;
uncertainties inherent in forecasting future cash flows from student loan assets and related asset-backed securitizations;
the uncertain nature of the expected benefits from the acquisition of ALLO Communications LLC on December 31, 2015 and the ability to successfully expand its fiber network in existing service areas and additional communities and manage related construction risks;
risks and uncertainties related to initiatives to pursue additional strategic investments and acquisitions, including investments and acquisitions that are intended to diversify the Company both within and outside of its historical core education-related businesses; and
risks and uncertainties associated with litigation matters and with maintaining compliance with the extensive regulatory requirements applicable to the Company's businesses, reputational and other risks, including the risk of increased regulatory costs, resulting from the politicization of student loan servicing, and uncertainties inherent in the estimates and assumptions about future events that management is required to make in the preparation of the Company's consolidated financial statements.

All forward-looking statements contained in this report are qualified by these cautionary statements and are made only as of the date of this document. Although the Company may from time to time voluntarily update or revise its prior forward-looking statements to reflect actual results or changes in the Company's expectations, the Company disclaims any commitment to do so except as required by securities laws.

37




OVERVIEW

The Company is a diverse company with a focus on delivering education-related products and services and loan asset management. The largest operating businesses engage in student loan servicing; education technology, services, and payment processing; and communications. A significant portion of the Company's revenue is net interest income earned on a portfolio of federally insured student loans. The Company also makes investments to further diversify the Company both within and outside of its historical core education-related businesses, including, but not limited to, investments in real estate and start-up ventures.

GAAP Net Income and Non-GAAP Net Income, Excluding Adjustments

The Company prepares its financial statements and presents its financial results in accordance with U.S. GAAP. However, it also provides additional non-GAAP financial information related to specific items management believes to be important in the evaluation of its operating results and performance. A reconciliation of the Company's GAAP net income to net income, excluding derivative market value and foreign currency transaction adjustments, and a discussion of why the Company believes providing this additional information is useful to investors, is provided below.
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
GAAP net income attributable to Nelnet, Inc.
$
42,927

 
46,303

 
206,287

 
125,065

Realized and unrealized derivative market value adjustments
5,226

 
(21,429
)
 
(49,909
)
 
(22,381
)
Unrealized foreign currency transaction adjustments

 
13,683

 

 
45,635

Net tax effect (a)
(1,254
)
 
2,943

 
11,978

 
(8,837
)
Net income attributable to Nelnet, Inc., excluding derivative market value and foreign currency transaction adjustments (b)
$
46,899

 
41,500

 
168,356

 
139,482

 
 
 
 
 
 
 
 
Earnings per share:
 
 
 
 
 
 
 
GAAP net income attributable to Nelnet, Inc.
$
1.05

 
1.11

 
5.04

 
2.97

Realized and unrealized derivative market value adjustments
0.12

 
(0.51
)
 
(1.22
)
 
(0.53
)
Unrealized foreign currency transaction adjustments

 
0.33

 

 
1.09

Net tax effect (a)
(0.03
)
 
0.07

 
0.29

 
(0.21
)
Net income attributable to Nelnet, Inc., excluding derivative market value and foreign currency transaction adjustments (b)
$
1.14

 
1.00

 
4.11

 
3.32


(a)
The tax effects are calculated by multiplying the realized and unrealized derivative market value adjustments and unrealized foreign currency transaction adjustments by the applicable statutory income tax rate.

(b)
"Derivative market value and foreign currency transaction adjustments" include (i) both the realized portion of gains and losses (corresponding to variation margin received or paid on derivative instruments that are settled daily at a central clearinghouse) and the unrealized portion of gains and losses that are caused by changes in fair values of derivatives which do not qualify for "hedge treatment" under GAAP; and (ii) the unrealized foreign currency transaction gains or losses caused by the re-measurement of the Company's previously Euro-denominated bonds to U.S. dollars. "Derivative market value and foreign currency transaction adjustments" does not include "derivative settlements" that represent the cash paid or received during the current period to settle with derivative instrument counterparties the economic effect of the Company's derivative instruments based on their contractual terms.

The accounting for derivatives requires that changes in the fair value of derivative instruments be recognized currently in earnings, with no fair value adjustment of the hedged item, unless specific hedge accounting criteria is met. Management has structured all of the Company’s derivative transactions with the intent that each is economically effective; however, the Company’s derivative instruments do not qualify for hedge accounting. As a result, the change in fair value of derivative instruments is reported in current period earnings with no consideration for the corresponding change in fair value of the hedged item. Under GAAP, the cumulative net realized and unrealized gain or loss caused by changes in fair values of derivatives in which the Company plans to hold to maturity will equal zero over the life of the contract. However, the net realized and unrealized gain or loss during any given reporting period fluctuates significantly from period to period. In addition, the Company incurred unrealized foreign currency transaction adjustments for periodic fluctuations in currency exchange rates between the U.S. dollar and Euro in connection with its student loan asset-backed previously Euro-denominated bonds with an interest rate based on a spread to the EURIBOR index. The principal and accrued interest on these bonds were remeasured at each reporting period and recorded in the Company's consolidated balance sheet in U.S. dollars based on the foreign currency exchange rate on that date.

The Company believes these point-in-time estimates of asset and liability values related to its derivative instruments and previously Euro-denominated bonds that are or were subject to interest and currency rate fluctuations are or were subject to volatility mostly due to timing and market factors beyond the control of management, and affect the period-to-period comparability of the results of operations. Accordingly, the Company’s management utilizes operating results excluding these items for comparability purposes when making decisions regarding the Company’s performance and in presentations with credit rating agencies, lenders, and investors. Consequently, the Company reports this non-GAAP information because the Company believes that it provides additional information regarding operational and performance indicators that are closely assessed by management. There is no comprehensive, authoritative guidance for the presentation of such non-GAAP information, which is only meant to supplement GAAP results by providing additional information that management utilizes to assess performance.


38



On October 25, 2017, the Company completed a remarketing of the Company’s bonds that were prior to that date denominated in Euros, to denominate those bonds in U.S. dollars and reset the interest rate to be based on the 3-month LIBOR index. The Company also terminated a cross-currency interest rate swap associated with those bonds. As a result, there are no foreign currency transaction adjustments with respect to those bonds after October 25, 2017.

GAAP net income increased for the nine months ended September 30, 2018 compared to the same period in 2017 primarily due to the following factors:

The contribution to net income from the acquisition of Great Lakes;
The increase in core spread on the Company's loan portfolio;
The decrease in the Company's effective tax rate due to the Tax Cuts and Jobs Act, effective January 1, 2018;
The recognition of unrealized losses in 2017 related to foreign currency transaction adjustments caused by the re-measurement of the Company's previously Euro-denominated bonds to U.S. dollars, which bonds were remarketed in October 2017, to denominate them in U.S. dollars; and
The recognition of a larger net gain during 2018 as compared to 2017 due to changes in the fair values of derivative instruments that do not qualify for hedge accounting.

These factors were partially offset by the following items:

The increase in expenses for the continued build-out of the Company's ALLO fiber communications network in Lincoln, Nebraska;
The decrease in the average balance of loans due to the run-off of the portfolio;
The increase in the provision for loan losses related to the Company's portfolio of federally insured student loans and consumer loans;
The impairment of software development costs in the Company's Loan Servicing and Systems operating segment; and
A decrease in revenue from the Company's SEC-registered investment advisor subsidiary.

Operating Results

The Company earns net interest income on its loan portfolio, consisting primarily of FFELP loans, in its Asset Generation and Management ("AGM") operating segment. This segment is expected to generate a stable net interest margin and significant amounts of cash as the FFELP portfolio amortizes. As of September 30, 2018, the Company had a $22.5 billion loan portfolio that management anticipates will amortize over the next approximately 20 years and has a weighted average remaining life of 7.5 years. The Company actively works to maximize the amount and timing of cash flows generated by its FFELP portfolio and seeks to acquire additional loan assets to leverage its servicing scale and expertise to generate incremental earnings and cash flow. However, over time, due to the continued amortization of the Company’s FFELP loan portfolio and anticipated increases in interest rates, the Company's net income generated by the AGM segment will continue to decrease. The Company currently believes that in the short-term it will most likely not be able to invest the excess cash generated from the FFELP loan portfolio into assets that immediately generate the rates of return historically realized from that portfolio.

In addition, the Company earns fee-based revenue through the following reportable operating segments:
 
Loan Servicing and Systems ("LSS") - referred to as Nelnet Diversified Solutions ("NDS")
Education Technology, Services, and Payment Processing ("ETS&PP") - referred to as Nelnet Business Solutions ("NBS")
Communications - referred to as ALLO Communications ("ALLO")

Other business activities and operating segments that are not reportable are combined and included in Corporate and Other Activities ("Corporate"). Corporate and Other Activities also includes income earned on certain investments and interest expense incurred on unsecured debt transactions.

39



The information below provides the operating results for each reportable operating segment and Corporate and Other Activities for the three and nine months ended September 30, 2018 and 2017 (dollars in millions). See "Results of Operations" for each reportable operating segment under this Item 2 for additional detail.

segopresults2018q3a03.jpg

(a)    Revenue includes intersegment revenue earned by LSS as a result of servicing loans for AGM.

(b)
Total revenue includes "net interest income" and "total other income" from the Company's segment statements of income, excluding the impact from changes in fair values of derivatives and foreign currency transaction adjustments. Net income excludes changes in fair values of derivatives and foreign currency transaction adjustments, net of tax. For information regarding the exclusion of the impact from changes in fair values of derivatives and foreign currency transaction adjustments, see "GAAP Net Income and Non-GAAP Net Income, Excluding Adjustments" above.

Certain events and transactions from 2018, which have impacted or will impact the operating results of the Company and its operating segments, are discussed below.

Impact from the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act, signed into law on December 22, 2017, and effective January 1, 2018, lowered the Company's effective tax rate to 24.44 percent and 23.50 percent for the three and nine months ended September 30, 2018, respectively, compared to 35.57 percent and 36.00 percent for the same periods in 2017. The Company currently expects its effective tax rate will be approximately 23 to 24 percent for the remainder of 2018.

Loan Servicing and Systems

On February 7, 2018, the Company paid $150.0 million in cash for 100 percent of the stock of Great Lakes. The Great Lakes assets acquired and liabilities assumed were recorded by the Company at their respective fair values at the date of acquisition, and Great Lakes' operating results from the date of acquisition forward are included in the Company's consolidated operating results. For additional information on the acquisition of Great Lakes, see note 7 of the notes to consolidated financial statements included under Part I, Item 1 of this report.

Nelnet Servicing, LLC ("Nelnet Servicing") and Great Lakes are two companies that have student loan servicing contracts awarded by the Department in June 2009 to provide servicing for loans owned by the Department. As of September 30, 2018, Nelnet Servicing was servicing $179.3 billion of student loans for 5.8 million borrowers under its contract, and Great Lakes was servicing $232.7 billion of student loans for 7.5 million borrowers under its contract. These contracts are currently scheduled to expire on June 16, 2019.

Under the performance metrics measurements used by the Department for the period July 1, 2017 through December 31, 2017, Nelnet Servicing's and Great Lakes' overall rankings among the nine current servicers for the Department were fourth and second, respectively. These results increased Nelnet Servicing's and Great Lakes' allocations of new student loan servicing volumes under their current respective contracts with the Department from 11 percent to 12 percent and from 14 percent to 16 percent, respectively, for the period March 1, 2018 through August 31, 2018.

40



Under the performance metrics measurements used by the Department for the period January 1, 2018 through June 30, 2018, Nelnet Servicing's and Great Lakes' overall rankings among the nine current servicers for the Department remained at fourth and second, respectively; however, these results changed Nelnet Servicing's and Great Lakes' allocations of new student loan servicing volumes under their current respective contracts with the Department from 12 percent to 11 percent and from 16 percent to 17 percent, respectively, for the period September 1, 2018 through February 28, 2019.

Going forward, Great Lakes and Nelnet Servicing will continue to service their respective government-owned portfolios on behalf of the Department, while maintaining their distinct brands, independent servicing operations, and teams. Likewise, each entity will continue to compete for new student loan volume under its respective existing contract with the Department. The Company will integrate technology, as well as shared services and other activities, to become more efficient and effective in meeting borrower needs. During the second quarter of 2018, the Company converted Great Lakes' FFELP and private education loan servicing volume to Nelnet's servicing platform to leverage the efficiencies of supporting more volume on fewer systems.

The Company and Great Lakes have also been working together for almost two years to develop a new, state-of-the-art servicing system for government-owned student loans through their GreatNet joint venture.  The efficiencies gained by leveraging a single platform for government-owned loans supporting millions more borrowers will give the Company and Great Lakes opportunities to invest in strategies to further enhance borrower experiences.

As part of integrating technology and becoming more efficient and effective in meeting borrower needs, the Company continues to evaluate the best use of its servicing systems on a post-Great Lakes acquisition basis. As a result of this evaluation, during the three months ended September 30, 2018, the Company recorded an impairment charge of $3.9 million related to certain external software development costs that were previously capitalized.

On February 20, 2018, the Department’s Office of Federal Student Aid ("FSA") released information regarding a contract procurement process entitled Next Generation Financial Services Environment (“NextGen”) for the servicing of all student loans owned by the Department. The Company is part of a team that responded to the initial phase of the NextGen procurement on April 17, 2018.
 
On August 27, August 29, and September 24, 2018, FSA made announcements that included canceling certain components of the NextGen process, issuing a solicitation for a separate new procurement process for certain of those NextGen components that were canceled, and outlining the next steps, components, and entities that are eligible to respond to the next phase for certain of the remaining NextGen components (which for each applicable component included the Company or an entity the Company is teaming with).
 
Currently, FSA has four ongoing components between the two procurement processes:
 
·         Enterprise-Wide Digital and Customer Care Platforms and Services (new procurement process)
·         NextGen Future State Core Platform
·         NextGen Transitional Core Processing and Related Support Activities
·         NextGen Business Process Operations
 
The Company is part of a team that has responded or will be responding to the next applicable phase for each of these four components.  The Company cannot predict the timing, nature, or outcome of the next steps for these processes.

As of September 30, 2018, the Company (including Great Lakes) was servicing $464.9 billion in government owned, FFELP, and private education and consumer loans, as compared with $211.4 billion of loans serviced by the Company as of December 31, 2017.

Education Technology, Services, and Payment Processing

During the first quarter of 2018, the Company changed the name of its Tuition Payment Processing and Campus Commerce operating segment to Education Technology, Services, and Payment Processing to better describe the evolution of services this operating segment provides.

In May 2014, the FASB issued a new revenue recognition standard. The Company adopted the standard effective January 1, 2018, using the full retrospective method, which required it to restate each prior reporting period presented. The most significant impact of the standard relates to identifying the Company's Education Technology, Services, and Payment Processing operating segment as the principal in its payment services transactions. As a result of this change, the Company

41



presents the payment services revenue gross, with the direct costs to provide these services presented separately. For additional information on the new revenue recognition standard and its impact to the Company, see notes 1 and 2 of the notes to consolidated financial statements included under Part I, Item 1 of this report.

This segment is subject to seasonal fluctuations. Based on the timing of when revenue is recognized and when expenses are incurred, revenue and operating margin are higher in the first quarter as compared to the remainder of the year.

On October 16, 2018, the Company terminated its investment in a proprietary payment processing platform. This decision was made as a result of decreases in price and advancements of technology by established processors in the industry. As a result of this decision, the Company will record an impairment charge of approximately $8 million during the three-month period ending December 31, 2018. The charge represents computer equipment and external software development costs related to the payment processing platform. The decision will not impact the Company's existing payment processing revenue or customers. The Company is continuing to evaluate other costs that may be incurred as a result of this decision, including the termination of certain contracts and severance for affected employees. The Company currently believes contract termination and employee severance costs will not be material.

Communications

In the fourth quarter of 2017, ALLO announced plans to expand its network to make services available in Hastings, Nebraska and Fort Morgan, Colorado.  This will expand total households in ALLO’s current markets from 137,500 to over 152,000.  In December 2017, the Fort Morgan city council approved a 40-year agreement with ALLO for ALLO to provide broadband service over a fiber network that the city will build and own, and ALLO will lease and operate to provide services to subscribers.  In August 2018, ALLO began to provide its services in Fort Morgan, increasing households in current markets to 142,602 from 137,500. ALLO plans to continue expansion to additional communities in Nebraska and Colorado over the next several years. As of September 30, 2018, ALLO provided services to 32,529 households, compared to 20,428 households as of December 31, 2017 and 16,394 households as of September 30, 2017.

For the three and nine months ended September 30, 2018, ALLO incurred capital expenditures of $21.7 million and $66.8 million, respectively. The Company currently anticipates total network expenditures for the remainder of 2018 (October 1, 2018 to December 31, 2018) will be approximately $25 million; however, the amount of capital expenditures could change based on the customer demand for ALLO's services.

The Company currently anticipates ALLO's operating results will be dilutive to the Company's consolidated earnings as it continues to build its network in Lincoln, Nebraska, and other communities, due to large upfront capital expenditures and associated depreciation and upfront customer acquisition costs.

Asset Generation and Management

During the nine months ended September 30, 2018, the Company purchased $3.2 billion in loans, including $0.6 billion during the third quarter of 2018. The vast majority of these loans are federally insured student loans.

The Company's average balance of loans decreased to $23.0 billion for the third quarter of 2018, compared with $23.2 billion for the same period in 2017. Core loan spread increased to 1.30 percent for the quarter ended September 30, 2018, compared with 1.19 percent for the same period in 2017.

The Company began to purchase consumer loans in the second quarter of 2017. Consumer loans are currently funded by the Company using operating cash, until they can be funded in a secured financing transaction. As such, consumer loans do not have a cost of funds (debt) associated with them. Core loan spread, excluding consumer loans, would have been 1.25 percent and 1.17 percent for the three months ended September 30, 2018 and 2017, respectively.

The Company recognized $32.7 million and $28.5 million in fixed rate floor income during the three months ended September 30, 2018 and 2017, respectively (which includes $19.1 million and $3.9 million of settlement payments received on derivatives used to hedge student loans earning fixed rate floor income). Fixed rate floor income contributed 57 basis points and 49 basis points of core loan spread for the three months ended September 30, 2018 and 2017, respectively.

Provision for loan losses was $10.5 million and $6.7 million for the three months ended September 30, 2018 and 2017, respectively, and $18.0 million and $10.7 million for the nine months ended September 30, 2018 and 2017, respectively.


42



Provision for loan losses for federally insured loans was $8.0 million and $7.0 million for the three months ended September 30, 2018 and 2017, respectively, and $12.0 million and $11.0 million for the nine months ended September 30, 2018 and 2017, respectively. During the three months ended September 30, 2018, the Company determined an additional allowance was necessary related to a $2.2 billion (principal balance as of September 30, 2018) portfolio of federally insured loans that were purchased in 2013 and 2014, and recognized $5.0 million (pre-tax) in provision expense related to these loans. During the three months ended September 30, 2017, the Company determined an additional allowance was necessary related to a $1.6 billion (principal balance as of September 30, 2017) portfolio of federally insured loans that were purchased in 2014 and 2015, and recognized $5.0 million (pre-tax) in provision expense related to these loans.

The Company did not record a provision for private education loan losses for the three and nine months ended September 30, 2018. For the three and nine months ended September 30, 2017, the Company recorded a negative provision for private education loan losses of $1.0 million and $2.0 million, respectively.

Provision for loan losses for consumer loans was $2.5 million and $0.7 million for the three months ended September 30, 2018 and 2017, respectively, and $6.0 million and $1.7 million for the nine months ended September 30, 2018 and 2017, respectively. The increase in provision is a result of the Company continuing to purchase consumer loans.

Corporate and Other Activities

On September 25, 2018, the Company announced it had withdrawn its application with the Federal Deposit Insurance Corporation and the Utah Department of Financial Institutions to establish Nelnet Bank, a Utah-chartered industrial bank. The Company originally filed its application on June 28, 2018.

Liquidity and Capital Resources

As of September 30, 2018, the Company had cash and cash equivalents of $83.5 million. In addition, the Company had a portfolio of available-for-sale investments, consisting primarily of student loan asset-backed securities, with a fair value of $57.4 million as of September 30, 2018.

For the nine months ended September 30, 2018, the Company generated $193.6 million in net cash from operating activities.

On June 22, 2018, the Company amended its unsecured $350.0 million line of credit to, among other things, extend the maturity date of the facility from December 12, 2021 to June 22, 2023. See note 4 of the notes to consolidated financial statements included under Part I, Item 1 of this report for additional information regarding other provisions of the line of credit that were amended. As of September 30, 2018, the unsecured line of credit had $160.0 million outstanding and $190.0 million was available for future use.

The majority of the Company’s portfolio of student loans is funded in asset-backed securitizations that will generate significant earnings and cash flow over the life of these transactions.  As of September 30, 2018, the Company currently expects future undiscounted cash flows from its securitization portfolio to be approximately $2.09 billion, of which approximately $1.18 billion is expected to be generated over the next approximately four years (October 1, 2018 through December 31, 2022). 

During the nine months ended September 30, 2018, the Company repurchased a total of 319,091 shares of Class A common stock for $16.5 million ($51.77 per share), including 3,297 shares of Class A common stock for $0.2 million ($58.13 per share) repurchased by the Company during the three months ended September 30, 2018.

During the nine months ended September 30, 2018, the Company paid cash dividends of $19.5 million ($0.48 per share), including $6.5 million ($0.16 per share) paid during the three months ended September 30, 2018. In addition, the Company's Board of Directors has declared a fourth quarter 2018 cash dividend on the Company's outstanding shares of Class A and Class B common stock of $0.18 per share. The fourth quarter cash dividend will be paid on December 14, 2018 to shareholders of record at the close of business on November 30, 2018.

The Company intends to use its liquidity position to capitalize on market opportunities, including FFELP and private education and consumer loan acquisitions; strategic acquisitions and investments; expansion of ALLO's telecommunications network; and capital management initiatives, including stock repurchases, debt repurchases, and dividend distributions. The timing and size of these opportunities will vary and will have a direct impact on the Company's cash and investment balances.


43



CONSOLIDATED RESULTS OF OPERATIONS

An analysis of the Company's operating results for the three and nine months ended September 30, 2018 compared to the same periods in 2017 is provided below.

The Company’s operating results are primarily driven by the performance of its existing portfolio and the revenues generated by its fee-based businesses and the costs to provide such services. The performance of the Company’s portfolio is driven by net interest income (which includes financing costs) and losses related to credit quality of the assets, along with the cost to administer and service the assets and related debt.

The Company operates as distinct reportable operating segments as described above. For a reconciliation of the reportable segment operating results to the consolidated results of operations, see note 12 of the notes to consolidated financial statements included under Part I, Item 1 of this report. Since the Company monitors and assesses its operations and results based on these segments, the discussion following the consolidated results of operations is presented on a reportable segment basis.

44



 
Three months ended
 
Nine months ended
 
 
 
September 30,
 
September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Loan interest
$
232,320

 
193,087

 
653,414

 
564,173

 
Increase was due to an increase in the gross yield earned on loans, partially offset by a decrease in the average balance of loans outstanding and a decrease in fixed rate floor income as a result of an increase in interest rates.
Investment interest
7,628

 
3,800

 
18,581

 
9,616

 
Includes income from unrestricted interest-earning deposits and investments and funds in asset-backed securitizations. Increase was due to an increase in interest-earning investments and an increase in interest rates.
Total interest income
239,948

 
196,887

 
671,995

 
573,789

 
 
Interest expense
180,175

 
121,650

 
487,174

 
341,787

 
Increase was due primarily to an increase in the Company's cost of funds, partially offset by a decrease in the average balance of debt outstanding.
Net interest income
59,773

 
75,237

 
184,821

 
232,002

 
See table below for additional analysis.
Less provision for loan losses
10,500

 
6,700

 
18,000

 
10,700

 
Represents the periodic expense of maintaining an allowance appropriate to absorb losses inherent in the portfolio of loans. See AGM operating segment - results of operations.
Net interest income after provision for loan losses
49,273

 
68,537

 
166,821

 
221,302

 
 
Other income:
 

 
 

 
 

 
 

 
 
LSS revenue
112,579

 
55,950

 
327,265

 
167,079

 
See LSS operating segment - results of operations.
ETS&PP revenue
58,409

 
50,358

 
167,372

 
149,862

 
See ETS&PP operating segment - results of operations.
Communications revenue
11,818

 
6,751

 
31,327

 
17,577

 
See Communications operating segment - results of operations.
Other income
16,673

 
19,756

 
44,449

 
44,874

 
See table below for the components of "other income."
Gain from debt repurchases

 
116

 
359

 
5,537

 
Gains are from the Company repurchasing its own debt. During the first quarter of 2017, the Company initiated a cash tender offer to purchase any and all of its outstanding Hybrid Securities. The Company paid $25.3 million to redeem $29.7 million of these notes and recognized a gain of $4.4 million. Other gains are from the repurchase of the Company's asset-backed debt securities.
Derivative settlements, net
22,324

 
(573
)
 
51,018

 
(2,314
)
 
The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. Derivative settlements for each applicable period should be evaluated with the Company's net interest income. See table below for additional analysis.
Derivative market value and foreign currency transaction adjustments, net
(5,226
)
 
7,746

 
49,909

 
(23,254
)
 
Includes (i) the realized and unrealized gains and losses that are caused by changes in fair values of derivatives which do not qualify for "hedge treatment" under GAAP; and (ii) the foreign currency transaction gains or losses in 2017 caused by the re-measurement of the Company's previously Euro-denominated bonds to U.S. dollars.
Total other income
216,577

 
140,104

 
671,699

 
359,361

 
 
Cost of services:
 
 
 
 
 
 
 
 
 
Cost to provide education technology, services, and payment processing services
19,087

 
15,151

 
44,087

 
37,456

 
Represents primarily direct costs to provide payment processing services in the ETS&PP operating segment.
Cost to provide communications services
4,310

 
2,632

 
11,892

 
6,789

 
Represents costs of services and products primarily associated with television programming costs in the Communications operating segment.
Total cost of services
23,397

 
17,783

 
55,979

 
44,245

 
 
Operating expenses:
 

 
 

 
 

 
 

 
 
Salaries and benefits
114,172

 
74,193

 
321,932

 
220,684

 
Increase was due to (i) an increase in personnel as a result of the acquisition of Great Lakes on February 7, 2018, the increase in volume of loans serviced for the government entering repayment status, and the increase in private education and consumer loan servicing volume in the LSS operating segment; (ii) an increase in personnel to support the growth in revenue in the ETS&PP operating segment; and (iii) an increase in personnel at ALLO to support the Lincoln, Nebraska network expansion. See each individual operating segment results of operations discussion for additional information.
Depreciation and amortization
22,992

 
10,051

 
62,943

 
27,687

 
Increase was due to the amortization of intangible assets related to the acquisition of Great Lakes on February 7, 2018 and increased depreciation expense at ALLO. Since the acquisition of ALLO on December 31, 2015, there has been a significant amount of property and equipment purchases to support the Lincoln, Nebraska network expansion.
Loan servicing fees
3,087

 
8,017

 
9,428

 
19,670

 
Decrease was due to runoff of the Company's student loan portfolio on third-party platforms, the conversion of loans to the Company's LSS operating segment from third-party platforms, and the acquisition of Great Lakes on February 7, 2018, which prior to the acquisition was a third-party servicer to the Company.
Other expenses
45,194

 
29,500

 
119,020

 
81,923

 
Increase was due primarily to the acquisition of Great Lakes on February 7, 2018, additional costs to support the increase in payment plans and campus commerce activity, and an increase in operating expenses at ALLO to support the Lincoln, Nebraska network expansion and the number of households served. As part of integrating technology and becoming more efficient and effective in meeting its servicing borrower needs, the Company continues to evaluate the best use of its servicing systems on a post-Great Lakes acquisition basis.  As a result of this evaluation, during the three months ended September 30, 2018, the Company recorded an impairment charge of $3.9 million related to certain external software development costs that were previously capitalized. See each individual operating segment results of operations discussion for additional information.

45



Total operating expenses
185,445

 
121,761

 
513,323

 
349,964

 
 
Income before income taxes
57,008

 
69,097

 
269,218

 
186,454

 
 
Income tax expense
13,882

 
25,562

 
63,369

 
70,349

 
The effective tax rate was 24.44% and 35.57% for the three months ended September 30, 2018 and 2017, respectively, and 23.50% and 36.00% for the nine months ended September 30, 2018 and 2017, respectively. The lower effective tax rates in 2018 were due to the Tax Cuts and Jobs Act, signed into law on December 22, 2017 and effective January 1, 2018.
Net income
43,126

 
43,535

 
205,849

 
116,105

 
 
Net (income) loss attributable to noncontrolling interests
(199
)
 
2,768

 
438

 
8,960

 
Represents primarily the net loss of GreatNet attributable to Great Lakes, prior to the Company's acquisition of Great Lakes on February 7, 2018.
Net income attributable to Nelnet, Inc.
$
42,927

 
46,303

 
206,287

 
125,065

 
 
 
 
 
 
 
 
 
 
 
 
Additional information:
 
 
 
 
 
 
 
 
 
Net income attributable to Nelnet, Inc.
$
42,927

 
46,303

 
206,287

 
125,065

 
See "Overview - GAAP Net Income and Non-GAAP Net Income, Excluding Adjustments" above for additional information about non-GAAP net income, excluding derivative market value and foreign currency transaction adjustments.
Derivative market value and foreign currency transaction adjustments, net
5,226

 
(7,746
)
 
(49,909
)
 
23,254

 
Net tax effect
(1,254
)
 
2,943

 
11,978

 
(8,837
)
 
Net income attributable to Nelnet, Inc., excluding derivative market value and foreign currency transaction adjustments
$
46,899

 
41,500

 
168,356

 
139,482

 

The following table summarizes the components of “net interest income” and “derivative settlements, net.”

Derivative settlements represent the cash paid or received during the current period to settle with derivative instrument counterparties the economic effect of the Company's derivative instruments based on their contractual terms. Derivative accounting requires that net settlements with respect to derivatives that do not qualify for "hedge treatment" under GAAP be recorded in a separate income statement line item below net interest income. The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. As such, management believes derivative settlements for each applicable period should be evaluated with the Company’s net interest income as presented in the table below. Net interest income (net of settlements on derivatives) is a non-GAAP financial measure, and the Company reports this non-GAAP information because the Company believes that it provides additional information regarding operational and performance indicators that are closely assessed by management. There is no comprehensive, authoritative guidance for the presentation of such non-GAAP information, which is only meant to supplement GAAP results by providing additional information that management utilizes to assess performance. See note 5 of the notes to consolidated financial statements included under Part I, Item 1 of this report for additional information on the Company's derivative instruments, including the net settlement activity recognized by the Company for each type of derivative for the periods presented in the table under the caption "Income Statement Impact" in note 5 and in the table below. 
 
Three months ended September 30,
 
Nine months ended September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Variable loan interest margin
$
42,455

 
48,017

 
129,756

 
140,805

 
Represents the yield the Company receives on its loan portfolio less the cost of funding these loans. Variable loan spread is also impacted by the amortization/accretion of loan premiums and discounts and the 1.05% per year consolidation loan rebate fee paid to the Department. See AGM operating segment - results of operations.
Settlements on associated derivatives
3,361

 
(4,265
)
 
4,676

 
(7,598
)
 
Includes the net settlements received (paid) related to the Company’s 1:3 basis swaps, and the cross-currency interest rate swap in place prior to the October 2017 remarketing of previously Euro-denominated bonds.
Variable loan interest margin, net of settlements on derivatives
45,816

 
43,752

 
134,432

 
133,207

 
 
Fixed rate floor income
13,659

 
24,586

 
45,359

 
84,382

 
The Company has a portfolio of student loans that are earning interest at a fixed borrower rate which exceeds the statutorily defined variable lender rates, generating fixed rate floor income. See Item 3, "Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk" for additional information.
Settlements on associated derivatives
19,087

 
3,883

 
46,752

 
5,877

 
Includes the net settlements received related to the Company’s floor income interest rate swaps.
Fixed rate floor income, net of settlements on derivatives
32,746

 
28,469

 
92,111

 
90,259

 
 
Investment interest
7,628

 
3,800

 
18,581

 
9,616

 
 
Corporate debt interest expense
(3,969
)
 
(1,166
)
 
(8,875
)
 
(2,801
)
 
Includes interest expense on the Junior Subordinated Hybrid Securities and unsecured line of credit.
Non-portfolio related derivative settlements
(124
)
 
(191
)
 
(410
)
 
(593
)
 
Includes the net settlements paid related to the Company’s hybrid debt hedges.
Net interest income (net of settlements on derivatives)
$
82,097

 
74,664

 
235,839

 
229,688

 
 

46



The following table summarizes the components of "other income."
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Realized and unrealized gains on investments, net (a)
$
1,288

 
2,201

 
11,505

 
3,818

Borrower late fee income
3,253

 
2,731

 
8,994

 
9,098

Investment advisory fees (b)
1,183

 
5,852

 
4,169

 
11,661

Management fee revenue (c)
1,756

 

 
4,673

 

Peterson's revenue (d)

 
3,402

 

 
9,282

Other
9,193

 
5,570

 
15,108

 
11,015

Other income
$
16,673

 
19,756

 
44,449

 
44,874


(a) During the first and second quarters of 2018, the Company recognized unrealized gains totaling $7.2 million related to the change in fair value of certain equity securities, and during the first quarter of 2018 recognized a realized gain of $1.7 million related to the sale of a real estate investment.

(b) The Company provides investment advisory services through Whitetail Rock Capital Management, LLC, the Company's SEC-registered investment advisor subsidiary, under various arrangements and earns annual fees of 25 basis points on the outstanding balance of investments and up to 50 percent of the gains from the sale of securities or securities being called prior to the full contractual maturity for which it provides advisory services. As of September 30, 2018, the outstanding balance of investments subject to these arrangements was $935.3 million. The decrease in advisory fees in 2018 as compared to 2017 was the result of a decrease in performance fees earned.

(c) Represents revenue earned from providing administrative support services primarily to Great Lakes’ former parent company in accordance with a one-year contract that is subject to an optional annual renewal by the former parent company. The current contract expires in October 2019.

(d) On December 31, 2017, the Company sold Peterson's.


47



LOAN SERVICING AND SYSTEMS OPERATING SEGMENT – RESULTS OF OPERATIONS

The Company purchased Great Lakes on February 7, 2018. The results of Great Lakes' operations are reported in the Company's consolidated financial statements from the date of acquisition.

Loan Servicing Volumes (dollars in millions)

During the second quarter of 2018, the Company converted Great Lakes' FFELP and private education servicing volume to Nelnet's servicing platform to leverage the efficiencies of supporting more volume on fewer systems.

loanservvol2018q3a01.jpg
Company owned
$16,962
 
$16,352
 
$15,789
 
$18,403
 
$17,827
 
$17,866
 
$19,113
 
$19,206
% of total
8.7%
 
8.2%
 
7.9%
 
8.9%
 
8.4%
 
3.8%
 
4.1%
 
4.1%
Number of servicing borrowers:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Government servicing:
5,972,619

 
5,924,099

 
5,849,283

 
5,906,404

 
5,877,414

 
5,819,286

 
7,456,830

 
5,745,181

 
7,378,875

 
5,805,307

 
7,486,311

FFELP servicing:
1,312,192

 
1,263,785

 
1,218,706

 
1,317,552

 
1,420,311

 
1,399,280

 
461,553

 
1,787,419

 

 
1,754,247

 

Private education and consumer loan servicing:
355,096

 
389,010

 
454,182

 
478,150

 
502,114

 
508,750

 
118,609

 
672,520

 
3,987

 
692,763

 

Total:
7,639,907

 
7,576,894

 
7,522,171

 
7,702,106

 
7,799,839

 
7,727,316

 
8,036,992

 
8,205,120

 
7,382,862

 
8,252,317

 
7,486,311

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Number of remote hosted borrowers:
2,230,019

 
2,305,991

 
2,317,151

 
2,714,588

 
2,812,713

 
6,207,747
 
6,145,981
 
6,406,923


48



Summary and Comparison of Operating Results
 
Three months ended September 30,
 
Nine months ended September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Net interest income
$
381

 
147

 
931

 
361

 

Loan servicing and systems revenue
112,579

 
55,950

 
327,265

 
167,079

 
See table below for additional analysis.
Intersegment servicing revenue
12,290

 
10,563

 
34,670

 
30,839

 
Represents revenue earned by the LSS operating segment as a result of servicing loans for the AGM operating segment. The increase in 2018 was a result of significant purchases of loans by AGM during the second quarter of 2018 of which LSS is the servicer, and the acquisition of Great Lakes on February 7, 2018. Prior to the acquisition, Great Lakes was a third-party servicer to the Company's AGM operating segment.
Other income
1,948

 

 
5,196

 

 
Represents revenue earned from providing administrative support services primarily to Great Lakes’ former parent company in accordance with a one-year contract that is subject to an optional annual renewal by the former parent company. The current contract expires in October 2019.
Total other income
126,817

 
66,513

 
367,131

 
197,918

 

Salaries and benefits
70,440

 
38,435

 
198,411

 
116,932

 
Increase was due to the Great Lakes acquisition, an increase in personnel to support the increase in volume of loans serviced for the government entering repayment status, and the increase in private education and consumer loan servicing volume.
Depreciation and amortization
8,957

 
549

 
23,237

 
1,644

 
Amortization of intangible assets and depreciation of fixed assets recorded as a result of the Great Lakes acquisition was $4.9 million and $13.1 million for the three and nine months ended September 30, 2018, respectively. Increase in 2018 as compared to 2017 was also due to continued investment in servicing and related support systems.
Other expenses
19,638

 
10,317

 
51,591

 
28,333

 
Increase was due primarily to the Great Lakes acquisition. In addition, as part of integrating technology and becoming more efficient and effective in meeting borrower needs, the Company continues to evaluate the best use of its servicing systems on a post-Great Lakes acquisition basis.  As a result of this evaluation, during the three months ended September 30, 2018, the Company recorded an impairment charge of $3.9 million related to certain external software development costs that were previously capitalized.
Intersegment expenses
15,029

 
7,774

 
43,968

 
23,496

 
Intersegment expenses represent costs for certain corporate activities and services that are allocated to each operating segment based on estimated use of such activities and services. Increase was due to Great Lakes acquisition.
Total operating expenses
114,064

 
57,075

 
317,207

 
170,405

 

Income before income taxes
13,134

 
9,585

 
50,855

 
27,874

 

Income tax expense
(3,152
)
 
(4,937
)
 
(12,399
)
 
(14,410
)
 
Reflects income tax expense at an effective tax rate of 24% and 38% in 2018 and 2017, respectively, on income before taxes and the net loss attributable to noncontrolling interest. The lower effective tax rate in 2018 was due to the Tax Cuts and Jobs Act, signed into law on December 22, 2017 and effective January 1, 2018.
Net income
9,982

 
4,648

 
38,456

 
13,464

 

  Net loss attributable to noncontrolling interest

 
3,408

 
808

 
10,050

 
Represents 50 percent of the net loss of GreatNet that was attributable to Great Lakes prior to the Company's acquisition of Great Lakes on February 7, 2018.
Net income attributable to
Nelnet, Inc.
$
9,982

 
8,056

 
39,264

 
23,514

 
 
Before tax and noncontrolling interest operating margin
10.4
%
 
19.5
%
 
14.1
%
 
19.2
%
 
Excluding the amortization of intangibles recorded as a result of the Great Lakes acquisition and the impairment of external software development costs recognized during the three months ended September 30, 2018 as discussed above, before tax and noncontrolling interest operating margin was 17.3% and 18.7% for the three and nine months ended September 30, 2018, respectively.


49



Loan servicing and systems revenue
 
Three months ended September 30,
 
Nine months ended September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Government servicing - Nelnet
$
38,907

 
38,594

 
118,015

 
117,409

 
Represents revenue from Nelnet Servicing's Department servicing contract. Revenue increased in the three and nine months ended September 30, 2018 due to a shift in the portfolio of loans serviced to a greater portion of loans in higher paying repayment statuses compared to the same periods in 2017. This factor was partially offset by a decrease in the number of servicing borrowers in 2018 compared to 2017.
Government servicing - Great Lakes
45,671

 

 
122,107

 

 
Represents revenue from the Great Lakes' Department servicing contract from the date of acquisition, February 7, 2018.
FFELP servicing
7,422

 
3,979

 
24,259

 
11,693

 
Increase was due to the Great Lakes acquisition. Over time, FFELP servicing revenue will decrease as third-party customers' FFELP portfolios run off.
Private education and consumer loan servicing
10,007

 
7,596

 
31,990

 
20,535

 
Increase was due to growth in loan servicing volume from existing and new clients, along with the Great Lakes acquisition. During the first quarter of 2018, Great Lakes recognized $4.6 million in revenue related to a private loan customer deconverting from the Great Lakes servicing platform subsequent to the Company's acquisition of Great Lakes on February 7, 2018.
Software services
8,201

 
4,430

 
24,461

 
13,093

 
Historically, the majority of software services revenue related to providing hosted student loan servicing. As a result of the Great Lakes acquisition, LSS now also provides hosted guaranty servicing and support to Great Lakes Higher Education Guaranty Corporation, an unrelated third-party FFELP guaranty agency. Increase in 2018 as compared to 2017 was due to an increase in hosted student loan servicing volume and providing the new hosted guaranty servicing.
 Outsourced services and other
2,371

 
1,351

 
6,433

 
4,349

 
The majority of this revenue relates to providing contact center outsourcing activities.
Loan servicing and systems revenue
$
112,579

 
55,950

 
327,265

 
167,079

 
 

50



EDUCATION TECHNOLOGY, SERVICES, AND PAYMENT PROCESSING OPERATING SEGMENT – RESULTS OF OPERATIONS

This segment of the Company’s business is subject to seasonal fluctuations which correspond, or are related to, the traditional school year. Higher amounts of revenue are typically recognized during the first quarter due to fees related to assistance with financial needs assessment as well as online applications and enrollment services. The Company’s operating expenses do not follow the seasonality of the revenues. This is primarily due to generally fixed year-round personnel costs and seasonal marketing costs. Revenues from tuition payment plan services are recognized over the course of the academic term, but the peak operational activities take place in summer and early fall. Based on the timing of revenue recognition and when expenses are incurred, revenue and pre-tax operating margin are higher in the first quarter as compared to the remainder of the year.

Summary and Comparison of Operating Results
 
Three months ended September 30,
 
Nine months ended September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Net interest income
$
1,510

 
5

 
2,924

 
10

 
Increase was due to additional interest earnings on cash deposits.
Education technology, services, and payment processing revenue
58,409

 
50,358

 
167,372

 
149,862

 
See table below for additional information.
Cost to provide education technology, services, and payment processing services
19,087

 
15,151

 
44,087

 
37,456

 
Costs primarily relate to payment processing revenue. Increase was due to an increase in payments volume.
Salaries and benefits
19,972

 
17,432

 
58,552

 
50,986

 
Increase was due to additional personnel to support the increase in payment plans and campus commerce activity and continued investments in and enhancements of payment systems and products.
Depreciation and amortization
3,435

 
2,316

 
10,062

 
7,053

 
Amortization of intangible assets related to business acquisitions was $2.8 million and $2.1 million for the three months ended September 30, 2018 and 2017, respectively, and was $8.2 million and $6.4 million for the nine months ended September 30, 2018 and 2017, respectively. Increase in 2018 as compared to 2017 was also due to continued investment in payment and related support systems.
Other expenses
4,943

 
3,981

 
14,950

 
13,185

 
Increase was due to an increase in the number of managed tuition payment plans, campus commerce customer transactions and payments volume, and new school customers.
Intersegment expenses
2,494

 
2,219

 
7,630

 
6,430

 
Intersegment expenses represent costs for certain corporate activities and services that are allocated to each operating segment based on estimated use of such activities and services.
Total operating expenses
30,844

 
25,948

 
91,194

 
77,654

 
 
Income before income taxes
9,988

 
9,264

 
35,015

 
34,762

 
 
Income tax expense
(2,397
)
 
(3,520
)
 
(8,404
)
 
(13,210
)
 
Reflects income tax expense based on effective tax rates of 24% and 38% in 2018 and 2017, respectively. The lower effective tax rate in 2018 was due to the Tax Cuts and Jobs Act, signed into law on December 22, 2017 and effective January 1, 2018.
Net income
$
7,591

 
5,744

 
26,611

 
21,552

 
 

On October 16, 2018, the Company terminated its investment in a proprietary payment processing platform. This decision was made as a result of decreases in price and advancements of technology by established processors in the industry. As a result of this decision, the Company will record an impairment charge of approximately $8 million during the three-month period ending December 31, 2018. The charge represents computer equipment and external software development costs related to the payment processing platform. The decision will not impact the Company's existing payment processing revenue or customers. The Company is continuing to evaluate other costs that may be incurred as a result of this decision, including the termination of certain contracts and severance for affected employees. The Company currently believes contract termination and employee severance costs will not be material.



51



Education technology, services, and payment processing revenue

The following table provides disaggregated revenue by service offering and before tax operating margin for each reporting period.
 
Three months ended September 30,
 
Nine months ended September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Tuition payment plan services
$
19,771

 
17,885

 
63,209

 
58,543

 
Increase was due to an increase in the number of managed tuition payment plans resulting from the addition of new school customers.
Payment processing
26,956

 
22,541

 
62,908

 
55,371

 
Increase was due to an increase in payments volume from new school and non-education customers.
Education technology and services
11,419

 
9,831

 
40,411

 
35,804

 
Increase was due to an increase in the number of customers using the Company’s financial needs assessment services and school administration software and services. Additionally, FACTS Education Solutions has experienced growth in the number of students and teachers receiving its professional development and educational instruction services.
Other
263

 
101

 
844

 
144

 
 
Education technology, services, and payment processing revenue
58,409

 
50,358

 
167,372

 
149,862

 
 
Cost to provide education technology, services, and payment processing services
19,087

 
15,151

 
44,087

 
37,456

 
Costs primarily relate to payment processing revenue. Increase was due to an increase in payments volume.
Net revenue
$
39,322

 
35,207


123,285


112,406

 
 
Before tax operating margin
25.4
%
 
26.3
%

28.4
%
 
30.9
%
 
Decrease was primarily the result of higher investment in products and software during 2018 as compared to 2017.


52



COMMUNICATIONS OPERATING SEGMENT – RESULTS OF OPERATIONS

Summary and Comparison of Operating Results
 
Three months ended September 30,
 
Nine months ended September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Net interest expense
$
(4,173
)
 
(1,550
)
 
(9,984
)
 
(3,365
)
 
Nelnet, Inc. (parent company) has a non-participating capital interest in ALLO that has a preferred return. The interest expense incurred by ALLO and related interest income earned by Nelnet, Inc. associated with the capital interest was eliminated for the Company's consolidated financial statements. The average amount outstanding on the non-participating capital interest balance for the three months ended September 30, 2018 and 2017 was $248.5 million and $131.4 million, respectively, and $222.6 million and $98.3 million for the nine months ended September 30, 2018 and 2017, respectively. ALLO used the proceeds from Nelnet's capital contribution for network capital expenditures and related expenses.
Communications revenue
11,818

 
6,751

 
31,327

 
17,577

 
Communications revenue is derived primarily from the sale of pure fiber optic services to residential and business customers in Nebraska, including internet, television, and telephone services. Increase was primarily due to additional residential households served. See additional financial and operating data for ALLO in the tables below.
Other income
950

 

 
950

 

 
During the three months ended September 30, 2018, ALLO became eligible for certain tax incentives related to prior reporting periods. Income was not recognized until all qualifications were met.
Total other income
12,768

 
6,751

 
32,277

 
17,577

 
 
Cost to provide communications services
4,310

 
2,632

 
11,892

 
6,789

 
Cost of services and products are primarily associated with television programming costs. Other costs include connectivity, franchise, and other regulatory costs directly related to providing internet and voice services.
Salaries and benefits
4,554

 
4,099

 
13,284

 
10,489

 
Since the acquisition of ALLO on December 31, 2015, there has been a significant increase in personnel to support the Lincoln, Nebraska network expansion. As of December 31, 2016, September 30, 2017, December 31, 2017, and September 30, 2018, ALLO had 318, 464, 508, and 527 employees, respectively, including part-time employees. ALLO also uses temporary employees in the normal course of business. Certain costs qualify for capitalization as ALLO builds its network.
Depreciation and amortization
6,167

 
3,145

 
16,585

 
7,880

 
Depreciation reflects the allocation of the costs of ALLO's property and equipment over the period in which such assets are used. Since the acquisition of ALLO on December 31, 2015, there has been a significant amount of property and equipment purchases to support the Lincoln, Nebraska network expansion. Amortization reflects the allocation of costs related to intangible assets recorded at fair value as of the date the Company acquired ALLO over their estimated useful lives.
Other expenses
3,151

 
2,278

 
8,811

 
5,422

 
Other expenses includes selling, general, and administrative expenses necessary for operations, such as advertising, occupancy, professional services, construction materials, and personal property taxes. Increase was due to expansion of the Lincoln, Nebraska network and number of households served.
Intersegment expenses
598

 
470

 
1,802

 
1,472

 
Intersegment expenses represent costs for certain corporate activities and services that are allocated to each operating segment based on estimated use of such activities and services.
Total operating expenses
14,470

 
9,992

 
40,482

 
25,263

 
 
Loss before income taxes
(10,185
)
 
(7,423
)
 
(30,081
)
 
(17,840
)
 
 
Income tax benefit
2,444

 
2,821

 
7,220

 
6,779

 
Reflects income tax benefit based on effective tax rates of 24% and 38% in 2018 and 2017, respectively. The lower effective tax rate in 2018 was due to the Tax Cuts and Jobs Act, signed into law on December 22, 2017 and effective January 1, 2018.
Net loss
$
(7,741
)
 
(4,602
)
 
(22,861
)
 
(11,061
)
 
The Company anticipates this operating segment will be dilutive to consolidated earnings as it continues to build its network in Lincoln, Nebraska and other communities, due to large upfront capital expenditures and associated depreciation and upfront customer acquisition costs.
 
 
 
 
 
 
 
 
 
 
Additional information:
 
 
 
 
 
 
 
 
 
Net loss
$
(7,741
)
 
(4,602
)
 
(22,861
)
 
(11,061
)
 
 
Net interest expense
4,173

 
1,550

 
9,984

 
3,365

 
 
Income tax benefit
(2,444
)
 
(2,821
)
 
(7,220
)
 
(6,779
)
 
 
Depreciation and amortization
6,167

 
3,145

 
16,585

 
7,880

 
 
Earnings (loss) before interest, income taxes, depreciation, and amortization (EBITDA)
$
155

 
(2,728
)
 
(3,512
)
 
(6,595
)
 
For additional information regarding this non-GAAP measure, see the table below.

53



Certain financial and operating data for ALLO is summarized in the tables below.
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Residential revenue
$
8,896

 
4,680

 
23,367

 
11,851

Business revenue
2,861

 
2,013

 
7,779

 
5,525

Other
61

 
58

 
181

 
201

Communications revenue
$
11,818

 
6,751

 
31,327

 
17,577

 
 
 
 
 
 
 
 
Net (loss) income
$
(7,741
)
 
(4,602
)
 
(22,861
)
 
(11,061
)
EBITDA (a)
155

 
(2,728
)
 
(3,512
)
 
(6,595
)
 
 
 
 
 
 
 
 
Capital expenditures
21,728

 
29,417

 
66,816

 
78,430

 
 
 
 
 
 
 
 
Revenue contribution:
 
 
 
 
 
 
 
Internet
54.6
%
 
47.5
%
 
52.8
%
 
45.3
%
Television
28.6

 
31.3

 
29.5

 
31.3

Telephone
16.6

 
20.9

 
17.5

 
22.9

Other
0.2

 
0.3

 
0.2

 
0.5

 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%

 
As of September 30, 2018
 
As of
June 30,
2018
 
As of
March 31, 2018
 
As of
December 31, 2017
 
As of September 30, 2017
 
As of
June 30,
2017
 
As of
March 31, 2017
 
As of
December 31, 2016
Residential customer information:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Households served
32,529

 
27,643

 
23,541

 
20,428

 
16,394

 
12,460

 
10,524

 
9,814

Households passed (b)
110,687

 
98,538

 
84,475

 
71,426

 
54,815

 
45,880

 
34,925

 
30,962

Total households in current markets (c)
142,602

 
137,500

 
137,500

 
137,500

 
137,500

 
137,500

 
137,500

 
137,500

Total households in current markets and new markets announced (d)
152,840

 
152,840

 
152,840

 
152,626

 
137,500

 
137,500

 
137,500

 
137,500


(a)
Earnings (loss) before interest, income taxes, depreciation, and amortization ("EBITDA") is a supplemental non-GAAP performance measure that is frequently used in capital-intensive industries such as telecommunications. ALLO's management uses EBITDA to compare ALLO's performance to that of its competitors and to eliminate certain non-cash and non-operating items in order to consistently measure performance from period to period. EBITDA excludes interest and income taxes because these items are associated with a company's particular capitalization and tax structures. EBITDA also excludes depreciation and amortization expense because these non-cash expenses primarily reflect the impact of historical capital investments, as opposed to the cash impacts of capital expenditures made in recent periods, which may be evaluated through cash flow measures. The Company reports EBITDA for ALLO because the Company believes that it provides useful additional information for investors regarding a key metric used by management to assess ALLO's performance. There are limitations to using EBITDA as a performance measure, including the difficulty associated with comparing companies that use similar performance measures whose calculations may differ from ALLO's calculations. In addition, EBITDA should not be considered a substitute for other measures of financial performance, such as net income or any other performance measures derived in accordance with GAAP. A reconciliation of EBITDA from net income (loss) under GAAP is presented under "Summary and Comparison of Operating Results" in the table above.
(b)
Represents the number of single residence homes, apartments, and condominiums that ALLO already serves and those in which ALLO has the capacity to connect to its network distribution system without further material extensions to the transmission lines, but have not been connected.
(c)
During the third quarter of 2018, ALLO began providing service in Fort Morgan, Colorado.
(d)
During the fourth quarter of 2017, ALLO announced plans to expand its network to make services available in Hastings, Nebraska and Fort Morgan, Colorado. ALLO plans to expand to additional communities in Nebraska and Colorado over the next several years.

54



ASSET GENERATION AND MANAGEMENT OPERATING SEGMENT – RESULTS OF OPERATIONS

Loan Portfolio

As of September 30, 2018, the Company had a $22.5 billion loan portfolio, consisting primarily of federally insured loans, that management anticipates will amortize over the next approximately 20 years and has a weighted average remaining life of 7.5 years. For a summary of the Company’s loan portfolio as of September 30, 2018 and December 31, 2017, see note 3 of the notes to consolidated financial statements included under Part I, Item 1 of this report.
 
Loan Activity

The following table sets forth the activity of loans:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Beginning balance
$
22,856,285

 
23,415,159

 
21,995,877

 
25,103,643

Loan acquisitions:
 
 
 
 
 
 
 
Federally insured student loans
591,196

 
37,409

 
3,124,154

 
141,688

Private education loans

 
123

 
194

 
698

Consumer loans
42,819

 
19,279

 
80,385

 
45,270

Total loan acquisitions
634,015

 
56,811


3,204,733


187,656

Repayments, claims, capitalized interest, and other
(502,474
)
 
(449,837
)
 
(1,714,820
)
 
(1,647,430
)
Consolidation loans lost to external parties
(292,749
)
 
(267,331
)
 
(789,321
)
 
(889,067
)
Loans sold
(22,320
)
 

 
(23,712
)
 

Ending balance
$
22,672,757

 
22,754,802


22,672,757


22,754,802

 
Allowance for Loan Losses and Loan Delinquencies

The Company maintains an allowance that management believes is appropriate to absorb losses, net of recoveries, inherent in the portfolio of loans, which results in periodic provisions for loan losses. Delinquencies have the potential to adversely impact the Company’s earnings through increased servicing and collection costs and account charge-offs.  

For a summary of the activity in the allowance for loan losses for the three and nine months ended September 30, 2018 and 2017, and a summary of the Company's loan delinquency amounts as of September 30, 2018, December 31, 2017, and September 30, 2017, see note 3 of the notes to consolidated financial statements included under Part I, Item 1 of this report.

Provision for loan losses for federally insured loans was $8.0 million and $7.0 million for the three months ended September 30, 2018 and 2017, respectively, and $12.0 million and $11.0 million for the nine months ended September 30, 2018 and 2017, respectively. During the three months ended September 30, 2018, the Company determined an additional allowance was necessary related to a $2.2 billion (principal balance as of September 30, 2018) portfolio of federally insured loans that were purchased in 2013 and 2014, and recognized $5.0 million (pre-tax) in provision expense related to these loans. During the three months ended September 30, 2017, the Company determined an additional allowance was necessary related to a $1.6 billion (principal balance as of September 30, 2017) portfolio of federally insured loans that were purchased in 2014 and 2015, and recognized $5.0 million (pre-tax) in provision expense related to these loans.

For loans purchased where there is evidence of credit deterioration since the origination of the loan, the Company records a credit discount, separate from the allowance for loan losses, which is non-accretable to interest income.  Remaining discounts and premiums for purchased loans are recognized in interest income over the remaining estimated lives of the loans.  The Company continues to evaluate credit losses associated with purchased loans based on current information and changes in expectations to determine the need for any additional allowance for loan losses.

The Company did not record a provision for private education loan losses for the three and nine months ended September 30, 2018. For the three and nine months ended September 30, 2017, the Company recorded a negative provision for private education loan losses of $1.0 million and $2.0 million, respectively.


55



Provision for loan losses for consumer loans was $2.5 million and $0.7 million for the three months ended September 30, 2018 and 2017, respectively, and $6.0 million and $1.7 million for the nine months ended September 30, 2018 and 2017, respectively. The increase in provision is a result of the Company continuing to purchase consumer loans.

Loan Spread Analysis

The following table analyzes the loan spread on the Company’s portfolio of loans, which represents the spread between the yield earned on loan assets and the costs of the liabilities and derivative instruments used to fund the assets. The spread amounts included in the following table are calculated by using the notional dollar values found in the table under the caption "Net interest income, net of settlements on derivatives" below, divided by the average balance of student loans or debt outstanding.
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Variable loan yield, gross
4.57
 %
 
3.64
 %
 
4.40
 %
 
3.45
 %
Consolidation rebate fees
(0.83
)
 
(0.85
)
 
(0.84
)
 
(0.84
)
Discount accretion, net of premium and deferred origination costs amortization
0.03

 
0.07

 
0.04

 
0.07

Variable loan yield, net
3.77

 
2.86

 
3.60

 
2.68

Loan cost of funds - interest expense
(3.10
)
 
(2.09
)
 
(2.89
)
 
(1.91
)
Loan cost of funds - derivative settlements (a) (b)
0.06

 
(0.07
)
 
0.03

 
(0.04
)
Variable loan spread
0.73

 
0.70

 
0.74

 
0.73

Fixed rate floor income, gross
0.23

 
0.42

 
0.27

 
0.47

Fixed rate floor income - derivative settlements (a) (c)
0.34

 
0.07

 
0.28

 
0.03

Fixed rate floor income, net of settlements on derivatives
0.57

 
0.49

 
0.55

 
0.50

Core loan spread (d)
1.30
 %
 
1.19
 %
 
1.29
 %
 
1.23
 %
 
 
 
 
 
 
 
 
Average balance of loans
$
22,971,361

 
23,188,577

 
22,600,841

 
23,948,108

Average balance of debt outstanding
22,557,437

 
22,892,789

 
22,165,059

 
23,687,067


(a)
Derivative settlements represent the cash paid or received during the current period to settle with derivative instrument counterparties the economic effect of the Company's derivative instruments based on their contractual terms. Derivative accounting requires that net settlements with respect to derivatives that do not qualify for "hedge treatment" under GAAP be recorded in a separate income statement line item below net interest income. The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. As such, management believes derivative settlements for each applicable period should be evaluated with the Company’s net interest income (loan spread) as presented in this table. The Company reports this non-GAAP information because it believes that it provides additional information regarding operational and performance indicators that are closely assessed by management. There is no comprehensive, authoritative guidance for the presentation of such non-GAAP information, which is only meant to supplement GAAP results by providing additional information that management utilizes to assess performance. See note 5 of the notes to consolidated financial statements included under Part I, Item 1 of this report for additional information on the Company's derivative instruments, including the net settlement activity recognized by the Company for each type of derivative for the periods presented in the table under the caption "Income Statement Impact" in note 5 and in this table.

(b)
Derivative settlements include the net settlements received (paid) related to the Company’s 1:3 basis swaps and previous cross-currency interest rate swap. 

(c)
Derivative settlements include the net settlements received (paid) related to the Company’s floor income interest rate swaps.

(d)
The Company began to purchase consumer loans in the second quarter of 2017. Consumer loans are currently funded by the Company using operating cash, until they can be funded in a secured financing transaction. As such, consumer loans do not have a cost of funds (debt) associated with them. Core loan spread, excluding consumer loans, would have been 1.25% and 1.17% for the three months ended September 30, 2018 and 2017, respectively, and 1.25% and 1.22% for the nine months ended September 30, 2018 and 2017, respectively.

56



A trend analysis of the Company's core and variable loan spreads is summarized below.
slsgraph2018q3aa06.jpg
(a)
The interest earned on the majority of the Company's FFELP student loan assets is indexed to the one-month LIBOR rate. The Company funds a large portion of its assets with three-month LIBOR indexed floating rate securities. The relationship between the indices in which the Company earns interest on its loans and funds such loans has a significant impact on loan spread. This table (the right axis) shows the difference between the Company's liability base rate and the one-month LIBOR rate by quarter. See Item 3, “Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk,” which provides additional detail on the Company’s FFELP student loan assets and related funding for those assets.

Variable loan spread increased during the three and nine months ended September 30, 2018 as compared to the same periods in 2017 due to the impact of the Company beginning to purchase consumer loans in the second quarter of 2017. Variable loan spread without consumer loans was 0.68% for both the three months ended September 30, 2018 and 2017, and 0.70% and 0.72% for the nine months ended September 30, 2018 and 2017, respectively.

The difference between variable loan spread and core loan spread is fixed rate floor income. A summary of fixed rate floor income and its contribution to core loan spread follows:
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Fixed rate floor income, gross
$
13,659

 
24,586

 
45,359

 
84,382

Derivative settlements (a)
19,087

 
3,883

 
46,752

 
5,877

Fixed rate floor income, net
$
32,746

 
28,469

 
92,111

 
90,259

Fixed rate floor income contribution to spread, net
0.57
%
 
0.49
%
 
0.55
%
 
0.50
%
 
(a)
Includes settlement payments on derivatives used to hedge student loans earning fixed rate floor income.

The decrease in gross fixed rate floor income for the three and nine months ended September 30, 2018 compared to the same periods in 2017 was due to an increase in interest rates. The Company has a portfolio of derivative instruments in which the Company pays a fixed rate and receives a floating rate to economically hedge loans earning fixed rate floor income. See Item 3, “Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Risk,” which provides additional detail on the Company’s portfolio earning fixed rate floor income and the derivatives used by the Company to hedge these loans.

57



Summary and Comparison of Operating Results
 
Three months ended September 30,
 
Nine months ended September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Net interest income after provision for loan losses
$
48,665

 
67,197

 
164,152

 
217,067

 
See table below for additional analysis.
Other income
3,267

 
2,753

 
9,032

 
9,152

 
The primary component of other income is borrower late fees. The increase in the three months ended September 30, 2018 as compared to the same period in 2017 was due to an increase in federally insured loan delinquencies. The decrease in the nine months ended September 30, 2018 as compared to the same period in 2017 was due to a decrease in the average balance of loans.
Gain from debt repurchases

 
116

 
359

 
1,097

 
Gains were from the Company repurchasing its own asset-backed debt securities.
Derivative settlements, net
22,448

 
(382
)
 
51,428

 
(1,721
)
 
The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. Derivative settlements for each applicable period should be evaluated with the Company's net interest income as reflected in the table below.
Derivative market value and foreign currency transaction adjustments, net
(6,056
)
 
7,702

 
47,070

 
(23,121
)
 
Includes (i) the realized and unrealized gains and losses that are caused by changes in fair values of derivatives which do not qualify for "hedge treatment" under GAAP; and (ii) the unrealized foreign currency transaction gains or losses in 2017 caused by the re-measurement of the Company's previously Euro-denominated bonds to U.S. dollars.
Total other income (expense)
19,659

 
10,189

 
107,889

 
(14,593
)
 
 
Salaries and benefits
424

 
392

 
1,183

 
1,156

 
 
Loan servicing fees
3,087

 
8,017

 
9,428

 
19,670

 
Third party loan servicing fees decreased due to runoff of the Company's loan portfolio on third-party platforms, significant conversions of loans to the LSS operating segment in August 2017 (in which the Company incurred $2.8 million in conversion fees), July 2018, and September 2018, and the acquisition of Great Lakes in February 2018, which prior to the acquisition was a third-party servicer to the Company. Servicing fees on loans serviced by Great Lakes are included in intersegment expenses effective as of the acquisition date.
Other expenses
845

 
676

 
2,982

 
2,487

 
 
Intersegment expenses
12,378

 
10,659

 
34,943

 
31,114

 
Amounts include fees paid to the LSS operating segment for the servicing of the Company’s loan portfolio. These amounts exceed the actual cost of servicing the loans. Increase was due to significant purchases of loans during the second quarter of 2018 of which LSS is the servicer, significant conversions of loans in August 2017, July 2018, and September 2018, and the acquisition of Great Lakes in February 2018, as described above. Intersegment expenses also represent costs for certain corporate activities and services that are allocated to each operating segment based on estimated use of such activities and services.
Total operating expenses
16,734

 
19,744

 
48,536

 
54,427

 
Total operating expenses were 29 basis points and 35 basis points of the average balance of student loans for the three months ended September 30, 2018 and 2017, respectively, and 29 basis points and 31 basis points for the nine months ended September 30, 2018 and 2017, respectively. When excluding the $2.8 million of conversion fees paid in August 2017 to a third-party to transfer loans to the LSS operating segment's servicing platform, total operating expenses were 29, 30, 29, and 30 basis points for the three months ended September 30, 2018 and 2017 and nine months ended September 30, 2018 and 2017, respectively.
Income before income taxes
51,590

 
57,642

 
223,505

 
148,047

 


Income tax expense
(12,381
)
 
(21,904
)
 
(53,641
)
 
(56,258
)
 
Reflects income tax expense based on effective tax rates of 24% and 38% in 2018 and 2017, respectively. The lower effective tax rate in 2018 was due to the Tax Cuts and Jobs Act, signed into law on December 22, 2017 and effective January 1, 2018.
Net income
$
39,209

 
35,738

 
169,864

 
91,789

 
 
 
 
 
 
 
 
 
 
 
 
Additional information:
 
 
 
 
 
 
 
 
 
Net income
$
39,209

 
35,738

 
169,864

 
91,789

 
 
Derivative market value and foreign currency transaction adjustments, net
6,056

 
(7,702
)
 
(47,070
)
 
23,121

 
See "Overview - GAAP Net Income and Non-GAAP Net Income, Excluding Adjustments" above for additional information about non-GAAP net income, excluding derivative market value and foreign currency transaction adjustments. Net income, excluding derivative market value and foreign currency transaction adjustments, increased in 2018 compared to the same periods in 2017, due to a decrease in the segment's effective tax rate from 38% in 2017 to 24% in 2018 as the result of the Tax Cuts and Jobs Act and an increase in core student loan spread. These items were partially offset by a decrease in the average balance of loans.
Net tax effect
(1,453
)
 
2,927

 
11,297

 
(8,786
)
 
Net income, excluding derivative market value and foreign currency transaction adjustments
$
43,812

 
30,963

 
134,091

 
106,124

 
 
 
 
 
 
 
 
 
 
 
Additional information - before income taxes:
 
 
 
 
 
 
 
 
 
Income before income taxes
$
51,590

 
57,642


223,505


148,047

 
 
Derivative market value and foreign currency transaction adjustments, net
6,056

 
(7,702
)

(47,070
)

23,121

 
 
Income before income taxes, excluding derivative market value and foreign currency transaction adjustments
$
57,646

 
49,940


176,435


171,168

 
 

58



Net interest income, net of settlements on derivatives

The following table summarizes the components of "net interest income after provision for loan losses" and "derivative settlements, net." 
 
Three months ended September 30,
 
Nine months ended September 30,
 
Additional information
 
2018
 
2017
 
2018
 
2017
 
 
Variable interest income, gross
$
264,675

 
213,118

 
742,938

 
618,197

 
Increase was due to an increase in the gross yield earned on loans, partially offset by a decrease in the average balance of loans.
Consolidation rebate fees
(47,868
)
 
(48,986
)
 
(143,091
)
 
(151,469
)
 
Decrease was due to a decrease in the average consolidation loan balance.
Discount accretion, net of premium and deferred origination costs amortization
1,855

 
4,371

 
8,207

 
13,064

 
Net discount accretion was due to the Company's purchases of loans at a net discount over the last several years. The decrease in 2018 as compared to the same periods in 2017 was due to significant loan purchases made by the Company during 2018 at a net premium.
Variable interest income, net
218,662

 
168,503

 
608,054

 
479,792

 
 
Interest on bonds and notes payable
(176,207
)
 
(120,486
)
 
(478,298
)
 
(338,987
)
 
Increase was due to an increase in cost of funds, partially offset by a decrease in the average balance of debt outstanding.
Derivative settlements, net (a)
3,361

 
(4,265
)
 
4,676

 
(7,598
)
 
Derivative settlements include the net settlements received (paid) related to the Company’s 1:3 basis swaps and the previous cross-currency interest rate swap.
Variable loan interest margin, net of settlements on derivatives (a)
45,816

 
43,752

 
134,432

 
133,207

 
 
Fixed rate floor income, gross
13,659

 
24,586

 
45,359

 
84,382

 
Fixed rate floor income decreased due to the rising interest rate environment.
Derivative settlements, net (a)
19,087

 
3,883

 
46,752

 
5,877

 
Derivative settlements include the settlements received related to the Company's floor income interest rate swaps. Increase in settlements due to the rising interest rate environment.
Fixed rate floor income, net of settlements on derivatives
32,746

 
28,469

 
92,111

 
90,259

 
 
Core loan interest income (a)
78,562

 
72,221

 
226,543

 
223,466

 
 
Investment interest
3,719

 
1,882

 
9,467

 
4,491

 
Increase was due to a higher balance of interest-earning investments and an increase in interest rates.
Intercompany interest
(668
)
 
(588
)
 
(2,430
)
 
(1,911
)
 
 
Provision for loan losses - federally insured loans
(8,000
)
 
(7,000
)
 
(12,000
)
 
(11,000
)
 
See "Allowance for Loan Losses and Loan Delinquencies" included above under "Asset Generation and Management Operating Segment - Results of Operations."
Negative provision for loan losses - private education loans

 
1,000

 

 
2,000

 
Provision for loan losses - consumer loans
(2,500
)
 
(700
)
 
(6,000
)
 
(1,700
)
 
 
Net interest income after provision for loan losses (net of settlements on derivatives) (a)
$
71,113

 
66,815

 
215,580

 
215,346

 
 

(a)
Derivative settlements represent the cash paid or received during the current period to settle with derivative instrument counterparties the economic effect of the Company's derivative instruments based on their contractual terms. Derivative accounting requires that net settlements on derivatives that do not qualify for "hedge treatment" under GAAP be recorded in a separate income statement line item below net interest income. The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to reduce the economic effect of interest rate volatility. As such, management believes derivative settlements for each applicable period should be evaluated with the Company’s net interest income as presented in this table. Core loan interest income and net interest income after provision for loan losses (net of settlements on derivatives) are non-GAAP financial measures, and the Company reports this non-GAAP information because the Company believes that it provides additional information regarding operational and performance indicators that are closely assessed by management. There is no comprehensive, authoritative guidance for the presentation of such non-GAAP information, which is only meant to supplement GAAP results by providing additional information that management utilizes to assess performance. See note 5 of the notes to consolidated financial statements included under Part I, Item 1 of this report for additional information on the Company's derivative instruments, including the net settlement activity recognized by the Company for each type of derivative referred to in the "Additional information" column of this table, for the periods presented in the table under the caption "Income Statement Impact" in note 5 and in this table.

59



LIQUIDITY AND CAPITAL RESOURCES

The Company’s Loan Servicing and Systems and Education Technology, Services, and Payment Processing operating segments are non-capital intensive and both produce positive operating cash flows. As such, a minimal amount of debt and equity capital is allocated to these segments and any liquidity or capital needs are satisfied using cash flow from operations. Therefore, the following Liquidity and Capital Resources discussion is concentrated on the Company’s liquidity and capital needs to meet existing debt obligations in the Asset Generation and Management operating segment and capital needs to expand ALLO's communications network in the Communications operating segment.

Sources of Liquidity and Available Capacity

The Company has historically generated positive cash flow from operations.  For the nine months ended September 30, 2018, the Company's net cash provided from operating activities was $193.6 million.

As of September 30, 2018, the Company had cash and cash equivalents of $83.5 million. The Company also had a portfolio of available-for-sale investments, consisting primarily of student loan asset-backed securities, with a fair value of $57.4 million as of September 30, 2018.

The Company also has a $350.0 million unsecured line of credit that matures on June 22, 2023. As of September 30, 2018, there was $160.0 million outstanding on the unsecured line of credit and $190.0 million was available for future use.

In addition, the Company has repurchased certain of its own asset-backed securities (bonds and notes payable) in the secondary market. For accounting purposes, these notes are eliminated in consolidation and are not included in the Company's consolidated financial statements. However, these securities remain legally outstanding at the trust level and the Company could sell these notes to third parties or redeem the notes at par as cash is generated by the trust estate. Upon a sale of these notes to third parties, the Company would obtain cash proceeds equal to the market value of the notes on the date of such sale. As of September 30, 2018, the Company holds $15.0 million (par value) of its own asset-backed securities.

The Company intends to use its liquidity position to capitalize on market opportunities, including FFELP, private education, and consumer loan acquisitions; strategic acquisitions and investments; expansion of ALLO's telecommunications network; and capital management initiatives, including stock repurchases, debt repurchases, and dividend distributions. The timing and size of these opportunities will vary and will have a direct impact on the Company's cash and investment balances.

Cash Flows

During the nine months ended September 30, 2018, the Company generated $193.6 million from operating activities, compared to $237.1 million for the same period in 2017. The decrease in cash provided by operating activities reflects the adjustments to net income from derivative market value and foreign currency transaction adjustments and the impact of changes in loan accrued interest receivable and other liabilities during the nine months ended September 30, 2018 as compared to the same period in 2017. These factors were partially offset by the increase in net income, an increase in the adjustments to net income for depreciation and amortization and deferred taxes, and the impact of changes in other assets.

The primary items included in the statement of cash flows for investing activities are the purchase and repayment of loans. The primary items included in financing activities are the proceeds from the issuance of and payments on bonds and notes payable used to fund loans. Cash used in investing activities and provided by financing activities for the nine months ended September 30, 2018 was $0.9 billion and $0.8 billion, respectively. Cash provided by investing activities and used in financing activities for the nine months ended September 30, 2017 was $2.2 billion and $2.6 billion, respectively. Investing and financing activities are further addressed in the discussion that follows.


60



Liquidity Needs and Sources of Liquidity Available to Satisfy Debt Obligations Secured by Loan Assets and Related Collateral

The following table shows the Company's debt obligations outstanding that are secured by loan assets and related collateral.
 
 
As of September 30, 2018
 
Carrying
amount
 
Final maturity
Bonds and notes issued in asset-backed securitizations
$
21,617,844

 
4/25/24 - 10/25/66
FFELP warehouse facilities
705,144

 
11/19/19 / 5/31/21
 
$
22,322,988

 
 

Bonds and Notes Issued in Asset-backed Securitizations

The majority of the Company’s portfolio of student loans is funded in asset-backed securitizations that are structured to substantially match the maturity of the funded assets, thereby minimizing liquidity risk. Cash generated from student loans funded in asset-backed securitizations provide the sources of liquidity to satisfy all obligations related to the outstanding bonds and notes issued in such securitizations. In addition, due to (i) the difference between the yield the Company receives on the loans and cost of financing within these transactions, and (ii) the servicing and administration fees the Company earns from these transactions, the Company has created a portfolio that will generate earnings and significant cash flow over the life of these transactions.

As of September 30, 2018, based on cash flow models developed to reflect management’s current estimate of, among other factors, prepayments, defaults, deferment, forbearance, and interest rates, the Company currently expects future undiscounted cash flows from its portfolio to be approximately $2.09 billion as detailed below. 

The forecasted cash flow presented below includes all loans funded in asset-backed securitizations as of September 30, 2018.  As of September 30, 2018, the Company had $21.8 billion of loans included in asset-backed securitizations, which represented 96.4 percent of its total loan portfolio. The forecasted cash flow does not include cash flows that the Company expects to receive related to loans funded in its warehouse facilities as of September 30, 2018, private education and consumer loans funded with operating cash, and loans acquired subsequent to September 30, 2018.




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Asset-backed Securitization Cash Flow Forecast
$2.09 billion
(dollars in millions)
abscashflowfcst2018q3a03.jpg
The forecasted future undiscounted cash flows of approximately $2.09 billion include approximately $0.90 billion (as of September 30, 2018) of overcollateralization included in the asset-backed securitizations. These excess net asset positions are reflected variously in the following balances in the consolidated balance sheet: "loans receivable," "restricted cash," and "loan accrued interest receivable." The difference between the total estimated future undiscounted cash flows and the overcollateralization of approximately $1.19 billion, or approximately $0.90 billion after estimated income taxes based on the current effective tax rate, is expected to be accretive to the Company's September 30, 2018 balance of consolidated shareholders' equity.

Certain of the Company’s asset-backed securitizations are structured as “Turbo Transactions” which require all cash generated from the student loans (including excess spread) to be directed toward payment of interest and any remaining principal until such time as all principal on the notes has been paid in full.  Once the notes in such transactions are paid in full, the remaining unencumbered student loans (and other remaining assets, if any) in the securitization will be released to the Company, at which time the Company will have the option to refinance or sell these assets, or retain them on the balance sheet as unencumbered assets.

The Company uses various assumptions, including prepayments and future interest rates, when preparing its cash flow forecast.  These assumptions are further discussed below.

Prepayments:  The primary variable in establishing a life of loan estimate is the level and timing of prepayments. Prepayment rates equal the amount of loans that prepay annually as a percentage of the beginning of period balance, net of scheduled principal payments.  A number of factors can affect estimated prepayment rates, including the level of consolidation activity, borrower default rates, and utilization of debt management options such as income-based repayment, deferments, and forbearance.  Should any of these factors change, management may revise its assumptions, which in turn would impact the projected future cash flow. The Company’s cash flow forecast above assumes prepayment rates that are generally consistent with those utilized in the Company’s recent asset-backed securitization transactions. If management used a prepayment rate assumption two times greater than what was used to forecast the cash flow, the cash flow forecast would be reduced by approximately $175 million to $210 million.

Interest rates:  The Company funds a large portion of its student loans with three-month LIBOR indexed floating rate securities.  Meanwhile, the interest earned on the Company’s student loan assets is indexed primarily to a one-month LIBOR rate.  The different interest rate characteristics of the Company’s loan assets and liabilities funding these assets result in basis risk.  The Company’s cash flow forecast assumes three-month LIBOR will exceed one-month LIBOR by 12 basis points for the life of the portfolio, which approximates the historical relationship between these indices.  If the forecast is computed assuming a spread of 24 basis points between three-month and one-month LIBOR for the life of the portfolio, the cash flow forecast would

62



be reduced by approximately $110 million to $130 million. As the percentage of the Company's outstanding debt financed by three-month LIBOR declines, the Company's basis risk will be reduced.

The Company uses the current forward interest rate yield curve to forecast cash flows.  A change in the forward interest rate curve would impact the future cash flows generated from the portfolio.  An increase in future interest rates will reduce the amount of fixed rate floor income the Company is currently receiving.  The Company attempts to mitigate the impact of a rise in short-term rates by hedging interest rate risks. The forecasted cash flow does not include cash flows the Company expects to pay/receive related to derivative instruments used by the Company to manage interest rate risk. As of September 30, 2018, the net fair value of the Company's interest rate derivatives used to hedge loans earning fixed rate floor income was a net asset of $118.5 million. See Item 3, "Quantitative and Qualitative Disclosures About Market Risk — Interest Rate Risk."

FFELP Warehouse Facilities

The Company funds a portion of its FFELP loan acquisitions using its FFELP warehouse facilities. Student loan warehousing allows the Company to buy and manage student loans prior to transferring them into more permanent financing arrangements. As of September 30, 2018, the Company had two FFELP warehouse facilities with an aggregate maximum financing amount available of $1.05 billion, of which $0.71 billion was outstanding, and $0.34 billion was available for additional funding. Prior to November 6, 2018, one warehouse facility provided for formula-based advance rates, depending on FFELP loan type, up to a maximum of the principal and interest of loans financed. The advance rates for collateral could have increased or decreased based on market conditions. On November 6, 2018, the Company amended the agreement for this warehouse facility, which changed the formula-based advance rates to be static until the expiration of the current liquidity provisions. In the event the liquidity provisions are not extended, the valuation agent has the right to perform a one-time mark to market on the underlying loans funded in this facility, subject to a floor. The loans would then be funded at this new advance rate until the final maturity date of the facility. The other warehouse facility has static advance rates that requires initial equity for loan funding, but does not require increased equity based on market movements. As of September 30, 2018, the Company had $36.1 million advanced as equity support on these facilities. For further discussion of the Company's FFELP warehouse facilities outstanding at September 30, 2018, see note 4 of the notes to consolidated financial statements included under Part I, Item 1 of this report.

Upon termination or expiration of the warehouse facilities, the Company would expect to access the securitization market, obtain replacement warehouse facilities, use operating cash, consider the sale of assets, or transfer collateral to satisfy any remaining obligations.

Other Uses of Liquidity

Effective July 1, 2010, no new loan originations can be made under the FFEL Program and all new federal loan originations must be made through the Federal Direct Loan Program.  As a result, the Company no longer originates new FFELP loans, but continues to acquire FFELP loan portfolios from third parties and believes additional loan purchase opportunities exist, including opportunities to purchase private education and consumer loans.

The Company plans to fund additional loan acquisitions using current cash and investments; using its Union Bank participation agreement (as described below); using its FFELP warehouse facilities (as described above); establishing new warehouse facilities; and continuing to access the asset-backed securities market.

Union Bank Participation Agreement

The Company maintains an agreement with Union Bank, a related party, as trustee for various grantor trusts, under which Union Bank has agreed to purchase from the Company participation interests in student loans. As of September 30, 2018, $620.9 million of loans were subject to outstanding participation interests held by Union Bank, as trustee, under this agreement. The agreement automatically renews annually and is terminable by either party upon five business days' notice. This agreement provides beneficiaries of Union Bank’s grantor trusts with access to investments in interests in student loans, while providing liquidity to the Company.  The Company can participate loans to Union Bank to the extent of availability under the grantor trusts, up to $750.0 million or an amount in excess of $750.0 million if mutually agreed to by both parties.  Loans participated under this agreement have been accounted for by the Company as loan sales.  Accordingly, the participation interests sold are not included on the Company’s consolidated balance sheets.





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Asset-Backed Securities Transactions

During the first three quarters of 2018, the Company completed four asset-backed securitizations totaling $2.5 billion (par value). See note 4 of the notes to consolidated financial statements included under Part I, Item I of this report for additional information on these securitizations. The proceeds from these transactions were used primarily to refinance student loans included in the Company's FFELP warehouse facilities.

Depending on future market conditions, the Company currently anticipates continuing to access the asset-backed securitization market. Such asset-backed securitization transactions would be used to refinance student loans included in its warehouse facilities, loans purchased from third parties, and/or student loans in its existing asset-backed securitizations.

Liquidity Impact Related to Hedging Activities

The Company utilizes derivative instruments to manage interest rate sensitivity. By using derivative instruments, the Company is exposed to market risk which could impact its liquidity. Based on the derivative portfolio outstanding as of September 30, 2018, the Company does not currently anticipate any movement in interest rates having a material impact on its capital or liquidity profile, nor does the Company expect that any movement in interest rates would have a material impact on its ability to meet potential collateral deposits with its counterparties and/or variation margin payments with its third-party clearinghouse. However, if interest rates move materially and negatively impact the fair value of the Company's derivative portfolio or if the Company enters into additional derivatives for which the fair value becomes negative, the Company could be required to deposit additional collateral with its derivative instrument counterparties and/or pay variation margin to a third-party clearinghouse. The collateral deposits or variation margin, if significant, could negatively impact the Company's liquidity and capital resources. In addition, clearing requirements require the Company to post amounts of liquid collateral when executing new derivative instruments, which could prevent or limit the Company from utilizing additional derivative instruments to manage interest rate sensitivity and risks. See note 5 of the notes to consolidated financial statements included under Part I, Item 1 of this report for additional information on the Company's derivative portfolio.

Liquidity Impact Related to the Communications Operating Segment

ALLO has made significant investments in its communications network and currently provides fiber directly to homes and businesses in seven communities in Nebraska and one in Colorado. In 2016, ALLO began to expand its network to make its services available to substantially all commercial and residential premises in Lincoln, Nebraska, and currently plans to expand to additional communities in Nebraska and Colorado over the next several years. For the nine months ended September 30, 2018, ALLO's capital expenditures were $66.8 million. The Company anticipates total ALLO network capital expenditures for the remainder of 2018 (October 1, 2018 - December 31, 2018) will be approximately $25 million. However, this amount could change based on customer demand for ALLO's services. As of December 31, 2017, ALLO had a $270.0 million line of credit with Nelnet, Inc. (parent company) that ALLO used for its operating activities and capital expenditures. The outstanding amount owed by ALLO to Nelnet, Inc. and the related interest expense incurred by ALLO and the interest income recognized by Nelnet, Inc. under this line of credit was eliminated in the Company's consolidated financial statements. On January 1, 2018, ALLO received funds contributed by Nelnet, Inc. for a non-participating capital interest in ALLO that has a preferred return.  ALLO used the proceeds from this capital contribution to pay off all of the outstanding balance on its line of credit with Nelnet, Inc., including all accrued and unpaid interest on such line of credit.  For financial reporting purposes, the capital interest recorded by ALLO is classified as debt and such debt and the preferred return paid to Nelnet, Inc. on the capital interest (reflected as interest expense for ALLO) is eliminated in the consolidated financial statements. 

The Company currently plans to use cash from operating activities and its third-party $350.0 million unsecured line of credit to fund ALLO's capital expenditures and operating expenses.

Other Debt Facilities

As discussed above, the Company has a $350.0 million unsecured line of credit with a maturity date of June 22, 2023. On June 22, 2018, the Company amended this line of credit. See note 4 of the notes to consolidated financial statements included under Part I, Item 1 of this report for information regarding the provisions of the line of credit that were amended. As of September 30, 2018, the unsecured line of credit had $160.0 million outstanding and $190.0 million was available for future use. Upon the maturity date in 2023, there can be no assurance that the Company will be able to maintain this line of credit, increase the amount outstanding under the line, or find alternative funding if necessary.


64



The Company has issued Junior Subordinated Hybrid Securities (the "Hybrid Securities") that have a final maturity of September 15, 2061. The Hybrid Securities are unsecured obligations of the Company. As of September 30, 2018, the outstanding balance of Hybrid Securities was $20.4 million.

The Company has other notes payable included in its consolidated financial statements which were issued by partnerships in connection with the development of certain real estate projects in Lincoln, Nebraska, including a project involving Hudl, a related party. Although the Company's ownership of these partnerships are 50 percent or less, because the Company was the developer of and is a current tenant in these buildings, the operating results of these partnerships are included in the Company's consolidated financial statements. The total amount of real estate debt outstanding issued by these partnerships and included in the Company's consolidated financial statements as of September 30, 2018 was $33.9 million, of which $7.8 million was recourse to the Company.

Debt Repurchases

Due to the Company's positive liquidity position and opportunities in the capital markets, the Company has repurchased its own debt over the last several years, and may continue to do so in the future. See note 5 of the notes to consolidated financial statements included in the 2017 Annual Report for information on debt repurchased by the Company during the years 2015 through 2017 and note 4 of the notes to consolidated financial statements included under Part I, Item 1 of this report for information on debt repurchased by the Company during the three and nine months ended September 30, 2018.

Stock Repurchases

The Board of Directors has authorized a stock repurchase program to repurchase up to a total of five million shares of the Company's Class A common stock during the three-year period ending May 25, 2019. Shares may be repurchased from time to time depending on various factors, including share prices and other potential uses of liquidity. Shares repurchased by the Company during the three months ended March 31, 2018, June 30, 2018 and September 30, 2018 are shown below. Certain of these repurchases were made pursuant to a trading plan adopted by the Company in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934. For additional information on stock repurchases during the third quarter of 2018, see "Stock Repurchases" under Part II, Item 2 of this report.
 
Total shares repurchased
 
Purchase price (in thousands)
 
Average price of shares repurchased (per share)
 
 
 
Quarter ended March 31, 2018
222,174

 
$
11,418

 
51.39

Quarter ended June 30, 2018
93,620

 
4,910

 
52.44

Quarter ended September 30, 2018
3,297

 
192

 
58.13

  Total
319,091

 
$
16,520

 
51.77


Dividends

On September 14, 2018, the Company paid a third quarter 2018 cash dividend on the Company's Class A and Class B common stock of $0.16 per share. In addition, the Company's Board of Directors has declared a fourth quarter 2018 cash dividend on the Company's outstanding shares of Class A and Class B common stock of $0.18 per share. The fourth quarter cash dividend will be paid on December 14, 2018 to shareholders of record at the close of business on November 30, 2018.

The Company currently plans to continue making regular quarterly dividend payments, subject to future earnings, capital requirements, financial condition, and other factors.  In addition, the payment of dividends is subject to the terms of the Company’s outstanding Hybrid Securities, which generally provide that if the Company defers interest payments on those securities it cannot pay dividends on its capital stock.

Off-Balance Sheet Arrangements

The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that are material to investors.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management's Discussion and Analysis of Financial Condition and Results of Operations addresses the Company's consolidated financial statements, which have been prepared in accordance with GAAP. A discussion of the Company's critical accounting

65



policies and estimates, which include those for the allowance for loan losses, income taxes, and accounting for derivatives, can be found in the 2017 Annual Report. There were no significant changes to these critical accounting policies and estimates during the first nine months of 2018.

RECENT ACCOUNTING PRONOUNCEMENTS

Leases
In February 2016, the FASB issued a new standard regarding the accounting for leases. The standard will require the identification of arrangements that should be accounted for as leases by lessees and the disclosure of key information about leasing arrangements. The new standard establishes a right-of-use model (“ROU”) that requires a lessee to recognize a ROU asset and lease liability for all leases with a term longer than twelve months and classify the lease as operating or financing. The income statement will reflect lease expense for operating leases and amortization/interest expense for financing leases.

The standard requires the use of the modified retrospective transition method, applying the new standard to all leases existing at the date of initial application. An entity may choose to use either (1) its effective date or (2) the beginning of the earliest comparative period presented in the financial statements as its date of initial application. The Company expects to adopt the new standard on its effective date of January 1, 2019 and use the effective date as its date of initial application. Consequently, financial information will not be updated and the disclosures required under the new standard will not be provided for dates and periods before January 1, 2019. The new standard provides a number of optional practical expedients in transition. The Company expects to elect the ‘package of practical expedients’, which permits it to not reassess under the new standard its prior conclusions about lease identification, lease classification, and initial direct costs.
While the Company is continuing to evaluate the impact this pronouncement will have on its ongoing financial reporting, it currently believes the most significant changes will relate to (1) the recognition of new ROU assets and lease liabilities on its balance sheet primarily for office and dark fiber operating leases; (2) the derecognition of existing assets and liabilities for certain sale-leaseback transactions arising from build-to-suit lease arrangements for which construction is complete and the Company is leasing the constructed assets that currently do not qualify for sale accounting; and (3) providing significant new disclosures about the Company’s leasing activities. The Company does not expect a significant change in its leasing activities between now and adoption.
The new standard also provides practical expedients for an entity’s ongoing accounting. The Company currently expects to elect the short-term lease recognition exemption for all leases that qualify and to elect the practical expedient to not separate lease and non-lease components for all of its leases.
In addition, the Company has identified itself as the lessor in its Communications operating segment for services provided to customers that include customer-premise equipment. The Company expects to apply the practical expedient to account for those services and associated leases as a single, combined component. The Company has determined the non-lease services are ‘predominant’ in those contracts, which will require the Company to continue to account for the combined component as a single performance obligation under ASC Topic 606.
Allowance for Loan Losses
In June 2016, the FASB issued accounting guidance regarding the measurement of credit losses on financial instruments, which will change the way entities recognize impairment of many financial assets by requiring immediate recognition of estimated credit losses expected to occur over the asset's remaining life. The Company currently uses an incurred loss model when calculating its allowance for loan losses. As a result, the Company expects the new guidance will increase the allowance for loan losses. This guidance will be effective for the Company beginning January 1, 2020. This standard represents a significant departure from existing GAAP, and may result in significant changes to the Company's accounting for the allowance for loan losses. The Company is evaluating the impact this pronouncement will have on its ongoing financial reporting.
Hedging Activities
In August 2017, the FASB issued accounting guidance to better align risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. The amendments expand and refine hedge accounting for both nonfinancial and financial risk components and in some situations better align the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements. This guidance will be effective for the Company beginning January 1, 2019 with early adoption permitted. The Company is evaluating the impact this pronouncement will have on its ongoing financial reporting.

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ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
(All dollars are in thousands, except share amounts, unless otherwise noted)

Interest Rate Risk

The Company’s primary market risk exposure arises from fluctuations in its borrowing and lending rates, the spread between which could impact the Company due to shifts in market interest rates.

The following table sets forth the Company’s loan assets and debt instruments by rate characteristics:
 
As of September 30, 2018
 
As of December 31, 2017
 
Dollars
 
Percent
 
Dollars
 
Percent
Fixed-rate loan assets
$
3,171,134

 
14.0
%
 
$
4,966,125

 
22.6
%
Variable-rate loan assets
19,501,623

 
86.0

 
17,029,752

 
77.4

Total
$
22,672,757

 
100.0
%
 
$
21,995,877

 
100.0
%
 
 
 
 
 
 
 
 
Fixed-rate debt instruments
$
90,105

 
0.4
%
 
$
101,002

 
0.5
%
Variable-rate debt instruments
22,492,933

 
99.6

 
21,626,125

 
99.5

Total
$
22,583,038

 
100.0
%
 
$
21,727,127

 
100.0
%

FFELP loans originated prior to April 1, 2006 generally earn interest at the higher of the borrower rate, which is fixed over a period of time, or a floating rate based on the special allowance payment ("SAP") formula set by the Department. The SAP rate is based on an applicable index plus a fixed spread that depends on loan type, origination date, and repayment status. The Company generally finances its student loan portfolio with variable rate debt. In low and/or declining interest rate environments, when the fixed borrower rate is higher than the SAP rate, the Company’s student loans earn at a fixed rate while the interest on the variable rate debt typically continues to reflect the low and/or declining interest rates. In these interest rate environments, the Company may earn additional spread income that it refers to as floor income.

Depending on the type of loan and when it was originated, the borrower rate is either fixed to term or is reset to an annual rate each July 1. As a result, for loans where the borrower rate is fixed to term, the Company may earn floor income for an extended period of time, which the Company refers to as fixed rate floor income, and for those loans where the borrower rate is reset annually on July 1, the Company may earn floor income to the next reset date, which the Company refers to as variable rate floor income. All FFELP loans first originated on or after April 1, 2006 effectively earn at the SAP rate, since lenders are required to rebate fixed rate floor income and variable rate floor income for those loans to the Department.

No variable-rate floor income was earned by the Company during the nine months ended September 30, 2018 and 2017. A summary of fixed rate floor income earned by the Company follows.
 
Three months ended September 30,
 
Nine months ended September 30,
 
2018
 
2017
 
2018
 
2017
Fixed rate floor income, gross
$
13,659

 
24,586

 
45,359

 
84,382

Derivative settlements (a)
19,087

 
3,883

 
46,752

 
5,877

Fixed rate floor income, net
$
32,746

 
28,469

 
92,111

 
90,259


(a)
Includes settlement payments on derivatives used to hedge student loans earning fixed rate floor income.

Gross fixed rate floor income decreased for the three and nine months ended September 30, 2018 as compared to the same periods in 2017 due to an increase in interest rates.

Absent the use of derivative instruments, a rise in interest rates will reduce the amount of floor income received and this has an impact on earnings due to interest margin compression caused by increasing financing costs, until such time as the federally insured loans earn interest at a variable rate in accordance with their SAP formulas. In higher interest rate environments, where the interest rate rises above the borrower rate and fixed rate loans effectively become variable rate loans, the impact of the rate fluctuations is reduced.

67



The following graph depicts fixed rate floor income for a borrower with a fixed rate of 6.75% and a SAP rate of 2.64%.

image75.jpg
The following table shows the Company’s federally insured student loan assets that were earning fixed rate floor income as of September 30, 2018.
Fixed interest rate range
 
Borrower/lender weighted average yield
 
Estimated variable conversion rate (a)
 
Loan balance
4.5 - 4.99%
 
4.87
%
 
2.23
%
 
$
224,158

5.0 - 5.49%
 
5.22
%
 
2.58
%
 
525,656

5.5 - 5.99%
 
5.67
%
 
3.03
%
 
349,857

6.0 - 6.49%
 
6.19
%
 
3.55
%
 
399,150

6.5 - 6.99%
 
6.70
%
 
4.06
%
 
384,416

7.0 - 7.49%
 
7.17
%
 
4.53
%
 
137,146

7.5 - 7.99%
 
7.71
%
 
5.07
%
 
234,915

8.0 - 8.99%
 
8.18
%
 
5.54
%
 
539,835

> 9.0%
 
9.05
%
 
6.41
%
 
197,587

 
 
 
 
 
 
$
2,992,720


(a)
The estimated variable conversion rate is the estimated short-term interest rate at which loans would convert to a variable rate. As of September 30, 2018, the weighted average estimated variable conversion rate was 4.00% and the short-term interest rate was 214 basis points.


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The following table summarizes the outstanding derivative instruments as of September 30, 2018 used by the Company to economically hedge loans earning fixed rate floor income.
Maturity
 
Notional amount
 
Weighted average fixed rate paid by the Company (a)
 
 
2018
 
$
250,000

 
0.92
%
2019
 
3,250,000

 
0.97

2020
 
1,500,000

 
1.01

2023
 
750,000

 
2.28

2024
 
300,000

 
2.28

2025
 
100,000

 
2.32

2027
 
50,000

 
2.32

2028
 
100,000

 
3.03

 
 
$
6,300,000

 
1.26
%
(a)
For all interest rate derivatives, the Company receives discrete three-month LIBOR.
In addition, on August 20, 2014, the Company paid $9.1 million for an interest rate swap option to economically hedge loans earning fixed rate floor income. The interest rate swap option gives the Company the right, but not the obligation, to enter into a $250.0 million notional interest rate swap in which the Company would pay a fixed amount of 3.30% and receive discrete one-month LIBOR. If the interest rate swap option is exercised, the swap would become effective on August 21, 2019 and mature on August 21, 2024.

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The Company is also exposed to interest rate risk in the form of basis risk and repricing risk because the interest rate characteristics of the Company’s assets do not match the interest rate characteristics of the funding for those assets. The following table presents the Company’s FFELP student loan assets and related funding for those assets arranged by underlying indices as of September 30, 2018.
Index
 
Frequency of variable resets
 
Assets
 
Funding of student loan assets
1 month LIBOR (a)
 
Daily
 
$
20,770,474

 

3 month H15 financial commercial paper
 
Daily
 
1,002,707

 

3 month Treasury bill
 
Daily
 
617,562

 

3 month LIBOR (a)
 
Quarterly
 

 
10,522,798

1 month LIBOR
 
Monthly
 

 
10,173,089

Auction-rate (b)
 
Varies
 

 
799,576

Asset-backed commercial paper (c)
 
Varies
 

 
705,144

Other (d)
 
 
 
1,301,946

 
1,492,082

 
 
 
 
$
23,692,689

 
23,692,689


(a)
The Company has certain basis swaps outstanding in which the Company receives three-month LIBOR and pays one-month LIBOR plus or minus a spread as defined in the agreements (the "1:3 Basis Swaps"). The Company entered into these derivative instruments to better match the interest rate characteristics on its student loan assets and the debt funding such assets. The following table summarizes the 1:3 Basis Swaps outstanding as of September 30, 2018.
Maturity
 
Notional amount
2018
 
$
250,000

2019
 
3,500,000

2020
 
1,000,000

2021
 
250,000

2022
 
2,000,000

2023
 
750,000

2024
 
250,000

2026
 
1,150,000

2027
 
375,000

2028
 
325,000

2029
 
100,000

2031
 
300,000

 
 
$
10,250,000

The weighted average rate paid by the Company on the 1:3 Basis Swaps as of September 30, 2018 was one-month LIBOR plus 9.4 basis points.

(b)
As of September 30, 2018, the Company was sponsor for $799.6 million of asset-backed securities that are set and periodically reset via a "dutch auction" (“Auction Rate Securities”). The Auction Rate Securities generally pay interest to the holder at a maximum rate as defined by the indenture. While these rates will vary, they will generally be based on a spread to LIBOR or Treasury Securities, or the Net Loan Rate as defined in the financing documents.

(c)
The interest rates on the Company's warehouse facilities are indexed to asset-backed commercial paper rates.

(d)
Assets include accrued interest receivable and restricted cash.  Funding represents overcollateralization (equity) and other liabilities included in FFELP asset-backed securitizations and warehouse facilities.

70



Sensitivity Analysis

The following tables summarize the effect on the Company’s earnings, based upon a sensitivity analysis performed by the Company assuming hypothetical increases in interest rates of 100 basis points and 300 basis points while funding spreads remain constant. In addition, a sensitivity analysis was performed assuming the funding index increases 10 basis points and 30 basis points while holding the asset index constant, if the funding index is different than the asset index. The sensitivity analysis was performed on the Company’s variable rate assets (including loans earning fixed rate floor income) and liabilities. The analysis includes the effects of the Company’s interest rate and basis swaps in existence during these periods.
 
Interest rates
 
Asset and funding index mismatches
 
Change from increase of 100 basis points
 
Change from increase of 300 basis points
 
Increase of 10 basis points
 
Increase of 30 basis points
 
 
 
 
Dollars
 
Percent
 
Dollars
 
Percent
 
Dollars
 
Percent
 
Dollars
 
Percent
 
Three months ended September 30, 2018
Effect on earnings:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Decrease in pre-tax net income before impact of derivative settlements
$
(5,285
)
 
(9.2
)%
 
$
(10,007
)
 
(17.6
)%
 
$
(2,948
)
 
(5.2
)%
 
$
(8,843
)
 
(15.5
)%
Impact of derivative settlements
15,134

 
26.5

 
45,403

 
79.6

 
1,966

 
3.5

 
5,897

 
10.3

Increase (decrease) in net income before taxes
$
9,849

 
17.3
 %
 
$
35,396

 
62.0
 %
 
$
(982
)
 
(1.7
)%
 
$
(2,946
)
 
(5.2
)%
Increase (decrease) in basic and diluted earnings per share
$
0.18

 
 
 
$
0.66

 
 
 
$
(0.02
)
 
 
 
$
(0.05
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Three months ended September 30, 2017
Effect on earnings:
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 

Decrease in pre-tax net income before impact of derivative settlements
$
(9,044
)
 
(13.1
)%
 
$
(16,828
)
 
(24.4
)%
 
$
(3,296
)
 
(4.8
)%
 
$
(9,889
)
 
(14.3
)%
Impact of derivative settlements
14,179

 
20.5

 
42,534

 
61.6

 
1,890

 
2.7

 
5,671

 
8.2

Increase (decrease) in net income before taxes
$
5,135

 
7.4
 %
 
$
25,706

 
37.2
 %
 
$
(1,406
)
 
(2.1
)%
 
$
(4,218
)
 
(6.1
)%
Increase (decrease) in basic and diluted earnings per share
$
0.08

 
 
 
$
0.38

 
 
 
$
(0.02
)
 
 
 
$
(0.06
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended September 30, 2018
Effect on earnings:
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 

Decrease in pre-tax net income before impact of derivative settlements
$
(15,559
)
 
(5.8
)%
 
$
(27,145
)
 
(10.1
)%
 
$
(8,998
)
 
(3.3
)%
 
$
(26,993
)
 
(10.0
)%
Impact of derivative settlements
47,781

 
17.7

 
143,341

 
53.2

 
5,822

 
2.2

 
17,466

 
6.6

Increase (decrease) in net income before taxes
$
32,222

 
11.9
 %
 
$
116,196

 
43.1
 %
 
$
(3,176
)
 
(1.1
)%
 
$
(9,527
)
 
(3.4
)%
Increase (decrease) in basic and diluted earnings per share
$
0.60

 
 
 
$
2.16

 
 
 
$
(0.06
)
 
 
 
$
0.17

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine months ended September 30, 2017
Effect on earnings:
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Decrease in pre-tax net income before impact of derivative settlements
$
(30,205
)
 
(16.2
)%
 
$
(54,221
)
 
(29.1
)%
 
$
(10,314
)
 
(5.5
)%
 
$
(30,943
)
 
(16.6
)%
Impact of derivative settlements
45,396

 
24.3

 
136,182

 
73.1

 
4,368

 
2.3

 
13,105

 
7.0

Increase (decrease) in net income before taxes
$
15,191

 
8.1
 %

$
81,961

 
44.0
 %
 
$
(5,946
)
 
(3.2
)%
 
$
(17,838
)
 
(9.6
)%
Increase (decrease) in basic and diluted earnings per share
$
0.23

 
 
 
$
1.20

 
 
 
$
(0.08
)
 
 
 
$
(0.25
)
 
 
 

71



Financial Statement Impact – Derivatives and Foreign Currency Transaction Adjustments

For a table summarizing the effect of derivative instruments in the consolidated statements of income, including the components of "derivative market value and foreign currency transaction adjustments and derivative settlements, net" included in the consolidated statements of income, see note 5 of the notes to consolidated financial statements included under Part I, Item 1 of this report.

ITEM 4.  CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

The Company’s management, with the participation of the Company's principal executive and principal financial officers, evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of September 30, 2018. Based on this evaluation, the Company’s principal executive and principal financial officers concluded that the Company's disclosure controls and procedures were effective as of September 30, 2018.

Changes in Internal Control over Financial Reporting

There was no change in the Company’s internal control over financial reporting during the fiscal quarter ended September 30, 2018 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Effective January 1, 2018, the Company implemented ASC Topic 606, Revenue from Contracts with Customers. Although the new revenue standard has an immaterial impact on the Company's revenue recognition patterns and ongoing net income, management did implement changes to its processes related to revenue recognition and the control activities within them. These included the development of new policies based on the five-step model provided in the new revenue standard, new training, ongoing contract review requirements, and gathering of information provided for disclosures.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

There have been no material changes from the information set forth in the Legal Proceedings section of the Company's Annual Report on Form 10-K for the year ended December 31, 2017 under Item 3 of Part I of such Form 10-K.

ITEM 1A.  RISK FACTORS

There have been no material changes from the risk factors described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 in response to Item 1A of Part I of such Form 10-K.

72




ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Stock Repurchases

The following table summarizes the repurchases of Class A common stock during the third quarter of 2018 by the Company or any “affiliated purchaser” of the Company, as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934.
Period
 
Total number of shares purchased (a)
 
Average price paid per share
 
Total number of shares purchased as part of publicly announced plans or programs (b)
 
Maximum number of shares that may yet be purchased under the plans or programs (b)
July 1 - July 31, 2018
 
327

 
$
60.90

 

 
2,852,355

August 1 - August 31, 2018
 

 

 

 
2,852,355

September 1 - September 30, 2018
 
2,970

 
57.83

 

 
2,852,355

Total
 
3,297

 
$
58.13

 

 
 


(a)
These shares were owned and tendered by employees to satisfy tax withholding obligations upon the vesting of restricted shares, and were purchased at the closing price of the Company’s shares on the date of vesting.

(b)
On August 4, 2016, the Company announced that its Board of Directors authorized a new stock repurchase program in May 2016 to repurchase up to a total of five million shares of the Company's Class A common stock during the three-year period ending May 25, 2019.

Working capital and dividend restrictions/limitations

The Company's $350 million unsecured line of credit, which is available through June 22, 2023, imposes restrictions on the payment of dividends through covenants requiring a minimum consolidated net worth and a minimum level of unencumbered cash, cash equivalent investments, and available borrowing capacity under the line of credit. In addition, trust indentures and other financing agreements governing debt issued by the Company's education lending subsidiaries generally have limitations on the amounts of funds that can be transferred to the Company by its subsidiaries through cash dividends at certain times. Further, the payment of dividends by the Company is subject to the terms of the Company's outstanding junior subordinated hybrid securities, which generally provide that if the Company defers interest payments on those securities it cannot pay dividends on its capital stock. These provisions do not currently materially limit the Company's ability to pay dividends, and, based on the Company's current financial condition and recent results of operations, the Company does not currently anticipate that these provisions will materially limit the future payment of dividends.


73



ITEM 6.  EXHIBITS
 
10.1*
 
 
10.2*+
 
 
10.3*+
 
 
10.4*+
 
 
31.1*
 
 
31.2*
 
 
32**
 
 
101.INS*
XBRL Instance Document
 
 
101.SCH*
XBRL Taxonomy Extension Schema Document
 
 
101.CAL*
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.DEF*
XBRL Taxonomy Extension Definition Linkbase Document
 
 
101.LAB*
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE*
XBRL Taxonomy Extension Presentation Linkbase Document
 
 
*   Filed herewith
** Furnished herewith
+ Certain portions of this exhibit have been redacted pursuant to a request for confidential treatment and have been filed separately with the U.S. Securities and Exchange Commission.

74



SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
NELNET, INC.
 
 
 
 
 
 
Date:
November 8, 2018
By:
/s/ JEFFREY R. NOORDHOEK
 
 
 
Name:
Jeffrey R. Noordhoek
 
 
 
Title:
Chief Executive Officer
Principal Executive Officer
 
 
 
 
 
 
Date:
November 8, 2018
By:
/s/ JAMES D. KRUGER
 
 
 
Name:
James D. Kruger
 
 
 
Title: 
Chief Financial Officer
Principal Financial Officer and Principal Accounting Officer
 



75