Nelnet: An Investment To Hedge Increasing Education Costs

Many investors are familiar with the educational loan provider SLM Corporation (aka Sallie Mae) (SLM), but most are less familiar with its smaller competitor. Nelnet (NNI) is a small-cap education services company that offers student loans, tuition payment processing, enrollment services, campus commerce, and asset generation & management. Nelnet stands to benefit from rising tuition rates and increasing college enrollment rates over the next several years. Investors in Nelnet should benefit from higher stock prices as the company's earnings are positively correlated to the rising tuition and enrollment rates. The investment can be considered as a hedge against rising tuition rates for parents of students or for students themselves. Overall, Nelnet looks like a likely investment winner for the long-term.

The cost of higher education has risen 500% since 1985. Over the same period, medical costs have risen 286% and the consumer price index increased 121%. Total enrollment in degree-granting institutions is projected to rise 15% from 2010 to 2021. Nelnet has grown earnings annually at over 20% for the past five years with the help of these rapidly rising college costs. Most experts are projecting that college costs will increase at a rate of 6% annually for the foreseeable future. Therefore, Nelnet should continue to benefit with increased revenue from higher loan amounts and with more students enrolling over the long-term.

The Student Loan and Guaranty Servicing segment comprises about 46% of Nelnet's total revenue. This segment increased 12% year-over-year to $55.6 million for Q3 2013. The segment should continue to grow the total amount of loans originated and the revenue per loan based on the expected increases in college costs and growth of enrollments in the industry. This segment's growth should also continue to be driven by a large amount of students obtaining financial aid from the federal government. The government assistance to students is one reason for the increases in college costs. The government doles out financial aid which fuels higher costs as colleges are able to charge more every year.

The Tuition Payment Processing and Campus Commerce segment comprises 19.5% of total revenue. Revenue for this segment is growing as a result of an increase in the number of managed tuition payment plans, campus commerce customers, and new school customers. This segment includes the brand Facts Management. Facts Management makes the process of tuition payment and processing easy for students and for educational institutions. This segment should continue to thrive with the expected growth of enrolled students over at least the next decade.

The Enrollment Services segment comprises about 24% of Nelnet's total revenue. This segment has experienced decreased revenue as a result of regulatory uncertainty regarding and marketing to potential students. For-profit schools have decreased spending for marketing because of this uncertainty. Nelnet has responded to this segment's declines by cutting operating expenses.

The Asset Generation and Management segment comprises 10.5% of total revenue. Nelnet acquired $2.2 billion in FFELP student loans during the first nine months of 2013. The average loan portfolio for Q3 2013 was $24.5 billion as compared to $23 billion in Q3 2012. This segment has benefited from historic low interest rates, which drives up the fixed rate floor income. The segment should continue to do well over the next few years as the difference between interest rate indices governing what Nelnet earns on its loans and what the company pays to fund the loans remains favorable.

Nelnet is Looking Better than Sallie Mae

Sallie Mae is Nelnet's primary competitor. Although SLM looks attractive as an investment, Nelnet looks even better. Nelnet is significantly undervalued and has higher expected earnings growth than SLM. SLM doesn't look all that bad as it trades at only 10.6 times next year's earnings and has a PEG of 1.24. Nelnet is significantly more undervalued with a forward PE of 7.5 and PEG of 0.46. The difference in these forward looking metrics is due to the expected earnings growth for the companies. SLM is expected to grow earnings at a modest 7.3% annually for the next five years, while Nelnet is expected to grow earnings at 17% annually over the next five years.

Nelnet's higher expected growth is tied to its competitive advantages. One of Nelnet's competitive advantages is a result of the company segmenting its non-federally insured loan servicing. This allows Nelnet to meet the needs of non-federally insured student loan borrowers, the schools they attend, and the lenders who serve them. Another competitive advantage that is driving Nelnet's growth is its market-leading status for K-12 tuition management services. The company has managed payment plans at over 4,800 K-12 educational institutions. Nelnet helps K-12 schools evaluate and determine the amount of grants and financial aid to disperse. The company's donor services help schools to evaluate and implement effective fundraising solutions. Since Nelnet is the largest provider of tuition management services in the K-12 market in the U.S., the company has the ability to expand its business to other schools. As Nelnet's track record and reputation build in the industry, other schools are likely to do business with the market leader.

Nelnet also looks undervalued as compared to SLM in terms of price to book ratio. Nelnet is trading at only 1.4 times its book value per share, while SLM is trading at 2.3 times its book value per share. This reinforces Nelnet's attractive valuation. Nelnet's valuation metrics fall within Benjamin Graham's investing requirements. Nelnet's price to book ratio is just under Graham's requirement limit of 1.5. Graham's preferred price (the Graham number) is calculated as the square root of (22.5 X EPS X book value per share). Nelnet's square root of (22.5 X 6.15 X 29.71) is equal to $64, which is higher than the current price of $42, which suggests that the stock has room to run. As a comparison, SLM's Graham number is $29, which was calculated as the square root of (22.5 X 3.26 X 11.6). This shows that SLM is trading at a 10% discount to the Graham number, while Nelnet is trading at a 34% discount to the Graham number.

The Risks

Nelnet is exposed to interest rate risk. The company's interest earned on its student loan assets is indexed to one-month LIBOR and Treasury bill rates. Nelnet also faces repricing risk due to the timing of interest rate resets on its liabilities. In a period of declining interest rates, the student loan spread compresses, while a period of rising interest rates causes the spread to increase.

The company also faces the risk of a change in government policy regarding the funding of grants and loans. The currently policy of providing government money for grants and student loans is feeding the rising costs of education. If the government were to change this policy to attempt to control rising costs, Nelnet could face revenue losses. However, I don't think a drastic change in government funding of grants/loans is likely to occur.

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Conclusion

Nelnet looks like a promising investment for the long-term. The rising costs of education and increasing enrollments will catalyze future growth. Nelnet's ability to offer quality loans and services will allow its business to grow over time. The company is undervalued and has higher expected growth as compared to its primary competitor, SLM and as compared to the S&P 500. Given this scenario, Nelnet should outperform SLM and the market over the long-term. The investment can also be considered as a hedge against rising education costs.

Source: Nelnet: An Investment To Hedge Increasing Education Costs

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Business relationship disclosure: I do use Nelnet's services for my daughter's tuition payments.

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