Nelnet: What Investors Need to Know

In this episode of Industry Focus: Wildcard, Motley Fool Canada analyst Jim Gillies joins the podcast to discuss Nelnet (NNI 0.44%). Most think of Nelnet as just a student loan servicer, but the company has even more to offer. Viewed on a sum-of-its-parts basis, Nelnet appears to offer a compelling value today. 

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This video was recorded on May 12, 2021.

Nick Sciple: Welcome to Industry Focus, I'm Nick Sciple. This week, we're discussing a sleepy student loan servicer that just could be a hidden gem. Joining me to break it down is Motley Fool Canada analyst, Jim Gillies. Jim, thanks for joining me.

Jim Gillies: Thanks for having me on, Nick. You're going to say it just could be a hidden gem. No, no, no, no, this is a hidden gem. 

Sciple: Yes. This is actually an active recommendation here from Hidden Gems Canada. The company we're going to discuss today is Nelnet. I'm familiar with the company because that's my student loan servicer back when we weren't in permanent forbearance because of the pandemic. I used to give them $400 every month. Sometime here very soon, I imagine I will resume those payments. What got Nelnet on your radar as a business to invest in? What do they do?

Gillies: Nelnet is, I think it's in the running for probably the most borrowing business you're going to find. They don't do quarterly conference calls. This is a finance company as you've mentioned, mainly student finance, mainly student loan finance, although there's a bunch of other things under the hood. The quarterly releases can be a little eye-watering, frankly. It is not a sexy business. What I love about this company because I'm kind of a weird kind of guy I've realized, what I love about this company is when I kind of started pulling Fools, hey, you ever heard Nelnet? Hey, have you heard Nelnet? To a person, when I pulled them, they said, "Oh, Nelnet, yeah, they do my student loans. God, I hate them." [laughs] Okay. That is just throwing candy at me like, "Oh, I got to go look at this." Because usually, when people hate a company but are forced to keep on giving it money, that's a powerful motivator for me as an investor.

Sciple: You talk about inverting. If you find a company that customers can't stand, but they keep coming back to every year, more often than not, you're finding a company that's monopolistic in some way. The classic example is Comcast. You won't hear very many people out there that have positive things to say about Comcast, but if you look at the stock and the company, it's done quite well over an extended period of time because you don't have another alternative. The government gives them a monopoly, and in this instance, Nelnet owns the contract for servicing government student loans, at least for now.

Gillies: At least for now. But again, my appetite was already whetted. I honestly don't remember. I saw a few things around Twitter or references to this ticker. I'm not sure what was the immediate catalyst to make me say, "Oh, you've got to look at this." because I look at a lot of blogs, I guess or sub stocks now. I go a lot of sub stocks, I go a lot of logs. I'm very active on Twitter as you know, and so this came on my radar and I started reading stuff and then flipped over and got very intrigued. There's so many really neat little factoids about this company that I think are important on, I mean, not in a specific day like today where the markets tend to be red and ugly, but just in general, if you were to ask me to buy a company, and put it away, and not look at it for 10 years, I can't look at the price quote, I just have to buy and hold, Nelnet is among the two or three companies that I would consider for that position, to be honest with you, because it is out of Nebraska. Some other companies on that list are out of Nebraska. Some, I don't know, Berkshire or something rather. But it's at Lincoln, Nebraska as opposed to Omaha, if that matters anything. It is run by a guy, they used to be two main co-founders. One has sadly passed away at a fairly young age, a couple of years ago, but the remaining co-founder is still the largest shareholder, is chairman of the board, and is also managing the estate of the other former co-founder. 

If you look at the Board level, the company, it's all Lincoln notables. Like I said, they don't do investor conference calls. Their earnings come out, but you got to go looking for it. They're so off the radar. I think if you close the stock market for 10 years and don't let these guys trade, I think they'd be fine. They'd be like, ''Whatever, it's cool.'' Unlike a Berkshire which is worth a $500-$600 billion market cap now known, that still sub $3 billion market cap. It's got its fingers in a whole bunch of really interesting pies. It scares you upon first glance at it because you look at it and it's got, "Oh my goodness, this sub $3 billion company has $20+ billion in debt?" I mean, that's enough. If you're going to run a screen or if you screened for your favorite industries or your favorite companies, that falls out there. Most people, "Nope, we're out and we're on." It's just this. There's so many neat little foibles that I find attractive from an investment that, again, not yours, is a big, sexy growth company. I'm sorry if that's what you're here for. I am not to talk, [laughs] but I think as a bedrock position in a portfolio, you could do a lot worse.

Sciple: You talked about the founder still as a significant stake. If you look at S&P Capital IQ and say 20% of the stock outstanding. Yeah, some other vehicles that own a larger percentage, but you talked about this isn't necessarily a high-growth story. You're very much a cash flow basis investor. I think when you look at it now, it is very much a cash flow capital allocation store. We're getting this bucket of cash coming in. We need to trust these managers to invest that cash. You mentioned earlier that the large debt on the balance sheet and the student loan portfolio. That is one of the main generators of cash that the company will deploy. Let's talk about that first and then maybe go into some of the other places putting cash to work. Where is the cash coming from on the student loan portfolio side of the business?

Gillies: What I'm going to hit first is if you look at total insider ownership, Nick, it's actually about 44%. It's almost 50% or so. As you mentioned, former CEO, current Chairman of the Board has got a big steak, but he also has other vehicles and what have you. But yeah. Let's talk about the giant pile of money. They have about a $20 billion ballpark. What's a billion here, a billion there? A $20 billion portfolio of a type of student loan that is no longer made. These types of loans are no longer originated. I think under the Obama Administration, they were phased out. But people are still going to pay their loans. Or there's still loans that are outstanding. These guys have about $20 billion and a lot of that is financed. That's what the loans are on the balance sheet. Then they're also financed with the debt structures on the balance sheet, which makes people get scared. Don't be scared. Because the really interesting thing about this $20 billion portfolio of what I'll call obsolete types of student loans is about 98% government-backed, government-guaranteed. I guess I'm not that scared. If all students decide they're not going to pay their loans going forward, everybody defaults 100%, which of course never happens. Government's on the hook to pay it. 

Moreover, you have a cash flow forecast from this company. It's not all there. As I said, there's a financing vehicle back, but basically the long and short from this portfolio is they're going to pull out between now, and, I don't know if I have the final data from my screen here. Yes, I do. Now through probably about 2035, they are going to pull approximately $2.3 billion in cash. Just from this, what I'm going to call a slowly melting ice cube of a portfolio. Because this isn't their actual student loan business for now. This is just the cash coming in for this obsolete type of loans that are in runoff. $2.3 billion in cash over the next, say, 15-20 years. But $1.5 billion of that cash is expected to come in in the next five years. Do you remember that part where we said this is a sub $3 billion company? We haven't talked about any of the business here. We haven't talked about any other ventures. I'm just talking about the cash flow that's going to come in from the slowly melting ice cube is basically half the value of the company today. By the way, there's a real business and there are multiple real business lines under. That's the first part that makes you go. Well, this is interesting. I don't know if you want to just comment on that for a minute or you want to move on. I looked at that and said, as a cash flow guy, what discount rate, how much should you discount this $2.3 billion? Even the $1.5 billion coming in the next five years. If it's a government guarantee, be discounted 2%, 3%? I mean, in my evaluation process for Hidden Gems Canada, I think I did three cases like the 3%, 5%, and 7%. I don't believe any of them frankly. In a world we have a government guarantee for almost the entirety of this cash flow stream. Is there a reason I'm not using the five-year treasury bonds? That $1.5 billion, that's going to come in the next five years. Maybe let's call it $1.3 billion in value to the company. Now we've got $1.5 billion of other value to explain for the present value of the company, which I think we can do really easily.

Sciple: Maybe one last thing that we should talk about on the student loans. I know a lot of people are listening and they have this question. What happens if your student debt gets retired and how does that impact? The interesting thing here is it actually makes the duration of those cash flows come near to present day.

Gillies: Hey, do you want to cancel student debt? Be my guests. That's a $20 billion check that lands in Nelnet's account tomorrow. You just can't simply say, well, we can't allow student debt, whoever owns it, you're out of luck. You're never going to get repaid. The government because they are the guarantor here, the government steps in and pays it. If you want to cancel student debt, and I know that's a big subject down there. If you want to cancel student debt, go ahead. It actually will probably benefit Nelnet by a significant dollar amount and certainly from a time perspective.

Sciple: Base case, we have $1.5 billion in cash flow coming in the next five years that the company has to deploy. Then over the next 10 years, another $800 million or $1 billion or so to roll-off, which could, depending on how things play out from a policy point of view, they accelerated earlier on. We're taking this cash and then redeploying in the other parts of the business trying to find a return. Where else is Nelnet deploying that cash? What are the other business lines where we see some growth? Because of that, the student loan business is a runoff, as you mentioned.

Gillies: The owned portfolio is in run-off. The student loan business is not. That's the thing. It's probably best to think of Nelnet as I pull my notes up here and try to delay a little bit. Nelnet is a multi-headed beast. What we'll call Nelnet Financial Services, NFS. That's the portfolio run-off. We've covered that. There is Nelnet communications, which is a wholly owned or was a wholly owned fiber-to-the-home business because what's more alike than owning student loans and collections and bringing cable to the home, but it's something that they invested in a number of years ago. They've rolled it out through Nebraska and Colorado. They recently as and I believe that transaction was completed last December. They announced that beforehand, but I think completion was December. They sold a majority stake to a private equity group who has more experience in doing this. That fleet, they pertain about 45% of that business. But the cool thing about that is we have a fairly fresh valuation on that piece of the business. Again, they are not running anymore. They just got [...] so their stake is probably worth $400 million ballpark. But they've got that. 

They've got what's called Nelnet Business Services, which is my favorite part of Nelnet. Nelnet Business Services is basically an education technology, services, and payment processing division. We get revenue flows from payment processing, some tuition payment plans, software-as-a-service products, while you SaaS heads feel a little beaten up, have I got to company for you. But their clients are Nelnet Business Services, NBS, their clients are about 12,000, 11,000 private K-12 schools and just over 1,000, 1,200 higher education institutions. Think about if you're running a large for-profit, doesn't matter for-profit, but education institution. Once you bring in software, you like, Nick, how eager are you to throw out that software system and bring in someone new?

Sciple: The switching cost becomes incredibly high. Because once the tuition stops coming in, the business stops running, and then all of a sudden, we can't pay your bills and all those sorts of things. Very high switching costs.

Gillies: I can save you 5%, are you interested? Heck no. You could almost say they're probably protected with anything up to +50% cost savings, if not more. These are very, very sticky clients. The interesting thing, now, 2020, the weird year in general, for a great many things. But we'll look at pre-pandemic, how this business is working, because basically, in 2020, year-over-year revenue and earnings were basically flat. But prior to the pandemic, NBS, again, the business services, the payments processor, tuition payments plan, blah blah blah, I believe revenue was running about 15% annualized clip. Pre-tax operating income was running 18%, 19% clip. That's interesting to me because what kind of a multiple do you put on that? What kind of valuations do you look at? Like I said, they flatlined year-over-year. But if you want to slap, say, they did about $203 million in revenue last year, what kind of a multiple do you want to slap on something like that? Four times revenue, which is basically what the market is getting a public competitor of theirs called Blackboard, which is ticker BLKB, because Blackboard's getting 4X multiple on revenue. It's getting about a 20X multiple on operating earnings. Well, that's $800 million in value than if you're slapping a 4X multiple on revenue, similar to their public competitor, that means NBS is worth $800 million.

Sciple: Which is like a third of the market cap.

Gillies: Well, remember I said if the market cap is what? $2.8 billion today, I said the communications division, which they now have a minority stake in, but we know what it was worth when the company that bought the majority stake now, what they paid, and we can scale that up and that's assuming there's no growth. We're out of market cap at this point, Nick, by the time we get rid of the big water cash flow coming through. We get rid of Nelnet business services if we assume it's valued similar to what's public competitor, and we get rid of the communications. We're out of market cap, and I'm not done.

Sciple: Right. Let's finish that off as well. Nelnet launched a bank in 2020. They don't do quarterly earnings calls, but they do do a call once a year for the annual meeting. The chairman of the company said during that annual meeting back in 2020, they say in the next three to five years, it will be a $1 billion bank. They're going to invest a significant amount of their capital coming in from the student loan portfolio into the bank. What potential do you see there for that business?

Gillies: Anything over zero is great. I think it was only December. I come from a country where you have like five supersized banks and one or two mid-sized, and then nothing. I know you guys are a lot more familiar with having small and regional banks everywhere and there's really great values in that space too, which I'm a big fan of. But this is a start-up bank. I think these guys have done a really great job over the years, going into new spaces and growing in some pretty boring, pretty plain vanilla financial handling areas. They don't have a lot of experience in banking, obviously, but they have great experience in student loan origination because that's the other division we haven't talked about, and servicing. They're transferring some of that from the government. One of their other business divisions is -- I'm trying to think what they call it here -- it's NDS, Nelnet Diversified Services. That's their student loan origination and servicing arm. They get paid per account. They work for the federal government for state agencies, banks, and other FinTech companies. 

They're servicing about $500 billion, give or take, loans in that space. They were about to lose a good chunk of that business, or maybe they're going to lose a good chunk of that business. Maybe they won't. That's because the government has essentially informed them that they lost two long-term loan servicing contracts, which are up pretty much this coming June, so next month. Except one of them is up this June. I think one is out for another year. But one of them, they have the right for extensions and I believe it's already been extended to December 2021. There's a possibility it gets extended another two years because what it sounds like is that the government really doesn't have a plan to go to. They just decided they want to shake up the system a little bit, I guess, or what have you. I'm not too sure where they're going to go with this, but we'll heavily discount this area. But they're still getting loan servicing fees from NDS and this is going to work well. In the meantime, they're generating new loans. They still service and manage loans for various federal and private education groups. They do consumer loans, and I think that's where this Nelnet bank is coming in. 

Also, a little sidebar, I believe that day they got their bank charter, and they were advertising it for a while beforehand, saying we're planning for this, we're going to try and get this. But the day they got it I believe it was same day that Square got their bank charter. I saw all kinds of headlights. Square is now a bank. I don't remember seeing a single headline about Nelnet, and I'm thinking like, I think Nelnet is probably going to do just as well as Square on the banking front. But I do know they did see, it was about $100 million of their own capital in December. I think they're using this as an arm to try to offset some of the servicing for the big federal contract that will probably go away or some of it will go away. But even without that, they still had about $50 billion, $55 billion worth of loans for over two million customers on their books at the end of last year. These are absent those big government contracts. They're going to start adding via their bank and I think it's another, I'm looking for a proper metaphor. I'm struggling for one. It's another arrow in the quiver. It's another brick in the wall, to Pink Floyd myself. Yeah. I look at this and go, OK. 

Look, I know a lot of people, you might debate the morality of their student loan or of student lending in general. They might argue that education is too expensive. I'm not here to litigate that because I can't. I think personal finance is, as they say, personal. I certainly benefited from going to school, so I don't mind the tuition I paid, but you're going to pay more today if you replicate my education. I think it's a complex subject, but for now, it costs what it costs. We know it's beneficial for the future. We know most people can't pay for it with cash flow out of pocket, and so there will continue to be student loans, I think for the foreseeable future, that might morph and change, but it will still be there. Someone's got to do the boring day-to-day administration and servicing work, and Nelnet has a pretty long, pretty strong history. Again, I'm still not done.

Sciple: Yeah. Let's get to the last part, I think you're going to mention it here, Jim.

Gillies: You know where we're going. Well, also too, they've done a lot of things. They make acquisitions from time to time. The fiber-to-the-home, they bought a much smaller version of that, and they're buying loans over time. They're adding to their owned portfolio all the time. They've bought back their own debt. When they've had some debt, they don't have a lot. The debt on the balance sheet, I should emphasize, is tied to the big portfolios, student loans, it's not corporate debt. Although from time to time, they maybe tapped their credit line. I don't think they've got anything on it right now. They do stock repurchases and they do a small amount of dividend sometimes. I think they're doing $0.22 a quarter. Not going to make you rich, 0.5%, 0.6%, but it's better than nothing. 

Then they have what I'm going to call a venture capital arm, where they make venture capital-style debts. I think they've got 30, 32 of them out right now or that they've admitted to. A bunch of those are going to go to zero. A bunch of those will fail, but not all. One of the ones that I don't think is going to fail, that I think is probably the most interesting, is a company or a business called Hudl, where they own about just shy of 20%, and they've also participated in recent years adding to their stake. As Hudl has grown and required more capital, they have stepped up and added capital along the way, additional financing. It's not impossible to think about Hudl, we'll get into what Hudl is in a moment, because I know when I mentioned Hudl to you, when we first talked about this company, I'd never heard of Hudl. You immediately knew who Hudl was. There's a generational difference there, I guess. [laughs] But I think Hudl could end up getting IPO'd or spun out at some point, and that'll be very interesting to me. Hudl does essentially, how do I put this this way? If you are an amateur athlete, a student-athlete, an athlete at a high school level, at a college level, junior hockey level, and you're in any of those programs, the school programs will use Hudl to do tape, to run tape, to dissect your play. There's scheduling in there as well. I know when I've talked to former student-athletes, I know a couple of guys who've played football at a U.S. college. They'd never heard Nelnet. As soon as I mentioned Hudl, they went, "Oh, well, yeah. We used Hudl exclusively. It was how our school did analysis of our sports performance, period." I know you've got some thoughts about the financial implications of Hudl and what that could be, but Hudl claims they've got more than six million coaches and athletes in 140 countries, 160,000 teams across 35 sports. This is fairly big. Nelnet owns 20% of Hudl, and the CEO and Co-Founder of Hudl is on Nelnet's board. Like I said, they brought in some other deep pockets like Bain Capital. There could be a unicorn hiding in plain sight here because Nelnet is so off the radar, people don't realize it.

Sciple: I think the really interesting thing with Hudl is a couple of things, first of, you mentioned earlier that they have the existing business where they do the tuition for some of these private schools, which obviously gives them a natural sales pitch to attach Hudl to some of these private school programs that tend to have some pretty strong athletic program. That's interesting and obviously gets the athletes in the ecosystem. 

What you can also do is you can take that and create your own highlight videos, promote yourself, all that thing if you ever watch, I follow the college football recruiting every year, you'll see these highlight videos of different athletes, all their plays through the year and Hudl is one of the providers of that. Why I think that's particularly interesting now obviously folks have been more and more involved on social media and all these things, being able to package their highlights and promote themselves. But the thing that's really interesting is the opportunity for amateur athletes to monetize their name, image, and likeness is opening up in a really significant way this year. You saw in 2019, California passed a law allowing name, image, and likeness for, I think this is going to go into effect in 2023, the California Law, and basically allows if you're a college athlete, you can sell autographs or you could maybe sponsor the local car dealership or what have you, which runs counter to the traditional inventories and rules you see in the NCAA, and this has been a really huge groundswell. So 15 states have passed name, image, and likeness rules to date, six of them are going into effect in July 2021. One of those is in Alabama. You already see the University of Alabama promoting how we can monetize your name, image, and likeness as a recruiting tactic. We have nine more states that are going to go into effect between now and 2025. 

There was a statement, I believe it was this morning from Mark Emmert, who's the Head of NCAA, saying they would like to have a name, image, and likeness rule in place by July 1st so they have a national standard. What you're seeing, obviously it's a great tailwind for Hudl because this is the way you as an amateur athlete can put together your highlights and start marketing yourself to both programs that are going to be able to help you monetize your likeness and also just in general. You can see this tailwind. This is a software that is designed to let athletes market themselves and we have the market for athletes being able to do that growing in a really significant way, I think, starting this year. You've already seen strong growth for the business over the past several years and now removing what would've been a hurdle to growth from a regulatory point of view. I would agree with you that I think there's a lot of tailwinds behind Hudl and you could see that company, in just a few years, maybe being as big as Nelnet is.

Gillies: Well, and that's the thing is that, remember that part where I said we pretty much explained the entire market cap just by the big river of cash coming down the pipe, the cable business and the business services. Basically, you're getting Hudl for free. I like free, I'm cheap.

Sciple: Right. We're going to end it here, Jim. When you look at the valuation today, what do you make of it and then also how do you think the company looks different five years from now as the student loan book that we talked about moves on?

Gillies: Well, I will make a bold prediction. I don't know how bold it is, but we'll try. My bold prediction is that they won't, in fact, lose those servicing contracts that the president administration, I think, favors stability because they've got a lot of other irons in the fire, pandemic infrastructure. I think they're actually going to very quietly probably retain a lot of their servicing business. Could be wrong, but I think that's which way I think the winds are blowing. But again, I don't really care if that's not, because they don't really need it. I think that they are going to use that river of cash to move more heavily into the present type of student loans, whether they're facilitating out of the bank or servicing with other financial partners, which they've done. I think a lot of the melting ice cube part that was obsolete style loans will roll off, but a good portion of that cash flow is going to roll into new student loans because it is a business that they know and are quite good at. I think they'll probably end up selling the remainder of the communications business. Like I said, I got it worth $384 million. That's based on what the price was. The majority of guys took that stake last year. It wouldn't shock me if in less than five years, we see the rest of that value sold at $500-$600 million, frankly, and I think I can see this more emphasis on the bank, number 1, and then also on some of these venture bats. They are also doing some stuff. They've got all kinds of little irons in the fire. 

The other part is, I look at this, here is a business. Also, if anyone's interested in Nelnet, I would highly encourage you to go to their investor relations site and seek out their annual letters to shareholders because much like that company down the road in Omaha, the chairman likes to write an annual letter. It's a very interesting read. I'll put it that way. These are guys who are not concerned about the next quarter, they're not concerned about hitting Wall Street estimates. They don't care. This is a company that is absolutely thinking for the long term and for the health and wealth of their shareholders. So I look at that and go, I wonder what other little venture things they're going to roll this capital into. Also, I think Hudl will be public by that point. I know 2011, 10 years in the past, Fools. 2021 has been a difficult time for a lot of investors after 2020 turned out to be an exceptionally good year, and I personally think that I think you want to balance your growth companies and the stuff that makes you happy in bull markets, but maybe makes you unhappy in bear markets. I think you want to mix that with some good bedrock companies and mention that little company down the road in Omaha, that's a bedrock solid company. 

I look at Nelnet and I think this is a bedrock style company that you can buy, put away, forget you own it. You're going to get a nice dividend, probably a growing dividend. Again, that's not why we're owning it, but you're going to get it anyway. I wouldn't be shocked, frankly, Nick, to see a share repurchase plan also ramp up. They've always got one going, they've always returned a little bit of money via share repurchases, but if they truly do lose the servicing end of the business and they don't see a lot of opportunities for some of that cash coming in, it wouldn't shock me to see them buy back significant amounts of stock, not saying it's going to happen, but it wouldn't shock me. The company is trading at 1.1 times book value today, which is nothing.

Sciple: People are like, "Well, there's limitations to book value." For a company in the financial services realm, it's a very, very legitimate valuation metric to use for the company. Yeah, to Jim's point, a lot of times we've heard over the past year folks talking about how much upside companies have and I think there is some upside to Nelnet, but I think the really thing that pops out for me is how little downside there appears to be when you start doing the math of the cash coming in and all the other parts of the business may not have the most growth potential on the face of the planet, but it's hard to see a scenario where you lose significant capital today. Would you agree with that?

Gillies: 100%.

Sciple: Yeah. All right. Well, Jim, thank you so much for joining me. Folks want to keep track with no net will have you on sometime in the future. Until then, thanks as always.

Gillies: Thank you.

Sciple: As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against the stock discussed, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for making this show. For Jim Gillies, I'm Nick Sciple, thanks for listening and Fool on!