Volatility in the market has been elevated throughout 2022, in part on worries that inflation has been stickier than many investors expected. This has led the Federal Reserve to start aggressively raising interest rates to cool off the economy, further contributing to the market's volatility.
Rising interest rates are bad for the majority of stocks because it makes it harder to fund operations through debt financing and typically lowers valuations across the board. The one sector that benefits from higher interest rates is financials. These companies, which include banks, insurance operators, and other lenders, can generally charge higher interest rates on loans when the Federal Reserve raises its benchmark rate, boosting the sector's earnings potential.
Nelnet (NNI 0.71%) is a little-known financial company with a great track record of success since going public in 2004. It's set up to crush the market for many years. Here's why.
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Steady student loan assets
Nelnet's legacy business is financing and monetizing student loan assets. It has a huge loan book on its balance sheet that will generate a steady amount of cash over the coming years as borrowers pay back their loans, which total approximately $1.83 billion over the life of the loans. This includes over $200 million each year through 2025 and then a decreasing amount every year thereafter.
The payments to cover these student loans are a stable, government-backed source of cash that Nelnet is using to reinvest into other assets. The company cannot originate new loans, since the federal government took this practice in-house a decade ago, but the existing loans are still quite sizable even a decade later and should generate more than half of Nelnet's current market cap of $2.88 billion this decade.
Investors are likely seeing one big risk with Nelnet's student loan book right now. The federal government is discussing whether to forgive and let borrowers pay back their loans early. According to Nelnet's 10-Q, if the pace of loan prepayments increased by 10x, the cash it would earn would decrease to $1.2 billion, as it would lose the advantage of financing these loans over a longer time period. However, the positive side to this is that Nelnet would see a lot of this cash quicker, close to $400 million each in 2022 and 2023.
Major diversification underway
As I mentioned, Nelnet is using its student loan cash flow to diversify its business into other assets. There are two main segments here: education software and its investment portfolio.
Nelnet has a robust education technology business that helps school administrators manage their day-to-day needs and accept payments from students, among other services. In Q1 of this year, the segment generated over $112 million in revenue and $33 million in operating income. Both numbers are up from the same period in 2021. This operating unit has grown solidly over the past five years and looks to be on pace to generate north of $100 million in operating income every year. Put a conservative price-to-operating income (P/OI) ratio of 10 on this segment, and it is likely worth at least $1 billion for Nelnet going forward.
The investment portfolio is widespread, but it has a focus on venture capital, real estate, and financing solar energy projects. This is a bit of a black box for investors, but Nelnet has poured tons of money into the division in the last few years, including a whopping $726 million in 2021. Clearly, management is seeing tons of value here. The company's cash, equivalents, and investment portfolio are valued at a book value of $1.81 billion right now, making up a significant portion of Nelnet's current market cap of $2.88 billion.
New bank license
Lastly, Nelnet recently started a bank called Nelnet Bank after getting a license in late 2020. Management started the project at a perfect time, with interest rates rapidly going up, which will help make its loan financing more profitable. Nelnet Bank is focused on student loan refinancing and private student loans but has plans to expand in the coming years. It is still early days, with only $368 million in loans and $547 million in deposits on its balance sheet, but Nelnet Bank has the potential to be a big growth driver for the company this decade.
Overall, at a market cap of $2.88 billion, Nelnet stock is trading at a significant discount to intrinsic value. If management can continue compounding book value per share at a 17% rate, as it has done since 2004, investors should do quite well owning Nelnet stock in the coming decades.
