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 December 31, 2004
		OR
o		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 001-31825

 

 

The First Marblehead Corporation

(Exact Name of Registrant as Specified in Its Charter)

 

 

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 ý No o

 

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes o No ý

 

As of January 31, 2005, the registrant had 65,729,769 shares of Common Stock, $0.01 par value per share, outstanding.

 

 

THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES

 

Table of Contents

 

Part I. Financial Information
Item 1—	Financial Statements
	Condensed Consolidated Balance Sheets as of December 31, 2004 and June 30, 2004	3
	Condensed Consolidated Statements of Operations for the three and six months ended December  31, 2004 and 2003	4
	Condensed Consolidated Statement of Changes in Stockholders’ Equity for the six months ended December 31, 2004	5
	Condensed Consolidated Statements of Cash Flows for the six months ended December 31, 2004 and 2003	6
	Notes to Unaudited Condensed Consolidated Financial Statements	7
Item 2—	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3—	Quantitative and Qualitative Disclosures About Market Risk	46
Item 4—	Controls and Procedures	46
Part II. Other Information
Item 2—	Unregistered Sales of Equity Securities and Use of Proceeds	47
Item 4—	Submission of Matters to a Vote of Security Holders	47
Item 6—	Exhibits	47
SIGNATURES		48
EXHIBIT INDEX		49

 

2

 

Part I. Financial Information

 

Item 1—Financial Statements

 

THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except share and per share amounts)

 

		December 31, 2004			June 30, 2004
ASSETS
Cash and other short-term investments		$	199,084		$	168,712
Service receivables:
Structural advisory fees		34,825			34,334
Residuals		175,178			108,495
Processing fees from The Education Resources Institute (TERI)		6,478			6,052
		216,481			148,881
Other receivables		1,858			438
Property and equipment		22,501			15,146
Less accumulated depreciation and amortization		(6,248		)	(4,315		)
Property and equipment, net		16,253			10,831
Goodwill		3,176			3,176
Intangible assets, net		2,922			3,180
Prepaid and other current assets		6,836			23,030
Other assets		2,008			1,808
Total assets		$	448,618		$	360,056
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Accounts payable and accrued expenses		$	21,822		$	26,285
Net deferred tax liability		67,478			40,138
Notes payable and capital lease obligations		1,651			9,179
Notes payable to TERI		5,653			6,004
Other liabilities		331			314
Total liabilities		96,935			81,920
Commitments and contingencies
Stockholders’ equity:
Preferred stock, par value $0.01 per share; 20,000,000 shares authorized; no shares issued or outstanding		—			—
Common stock, par value $0.01 per share; 150,000,000 and 100,000,000 shares authorized at December 31, 2004 and June 30, 2004, respectively; 64,690,139 and 63,975,000 shares issued and outstanding at December 31, 2004 and June 30, 2004, respectively		647			640
Additional paid-in capital		171,205			163,572
Retained earnings		183,102			113,924
Deferred compensation		(3,271		)	—
Total stockholders’ equity		351,683			278,136
Total liabilities and stockholders’ equity		$	448,618		$	360,056

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

3

 

THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share amounts)

 

		Three months ended December 31,						Six months ended December 31,
		2004			2003			2004				2003
Service revenue:
Structural advisory fees		$	75,172		$	38,977		$		75,791		$	38,699
Residuals		63,223			30,944			66,683				32,538
Administrative and other fees		863			458			1,831				771
Processing fees from TERI		16,579			7,144			33,936				14,983
Total service revenue		155,837			77,523			178,241				86,991
Operating expenses:
Compensation and benefits		15,318			7,798			30,198				16,666
General and administrative expenses		14,355			7,668			31,314				14,010
Total operating expenses		29,673			15,466			61,512				30,676
Income from operations		126,164			62,057			116,729				56,315
Other (income) expense:
Interest expense		115			131			234				251
Interest income		(873		)	(173		)	(1,355			)	(194		)
Total other (income) expense, net		(758		)	(42		)	(1,121			)	57
Income before income tax expense		126,922			62,099			117,850				56,258
Income tax expense		52,392			25,460			48,672				22,697
Net income		$	74,530		$	36,639		$	69,178			$	33,561
Net income per share, basic		$	1.15		$	0.62		$	1.07			$	0.60
Net income per share, diluted		1.12			0.58			1.04				0.55
Weighted average shares outstanding, basic		64,624			59,084			64,473				56,205
Weighted average shares outstanding, diluted		66,821			63,402			66,803				60,592

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

4

 

THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(unaudited)

(in thousands)

 

		Common Stock			Additional Paid-in Capital			Retained Earnings			Deferred Compensation
Balance at June 30, 2004		$	640		$	163,572		$	113,924		$	—
Options exercised		7			972			—			—
Stock purchases through employee stock purchase plan		—			550			—			—
Tax benefit from employee stock options		—			2,705			—			—
Grant of restricted stock units		—			3,406			—			(3,406		)
Amortization of deferred compensation											135
Net income		—			—			69,178			—
Balance at December 31, 2004		$	647		$	171,205		$	183,102		$	(3,271	)

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

5

 

THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

 

		Six months ended December 31,
		2004			2003
Cash flows from operating activities:
Net income		$	69,178		$	33,561
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		1,933			862
Amortization		631			564
Tax benefit from employee stock options		2,705			—
Non-cash compensation		135			1,642
Change in assets/liabilities:
(Increase) in processing fees from TERI and other receivables		(1,846		)	(656		)
(Increase) in structural advisory fees		(491		)	(14,199		)
(Increase) in residuals		(66,683		)	(32,537		)
Decrease (increase) in prepaid and other current assets		16,194			(947		)
(Increase) in deposits		(200		)	—
Increase in net deferred tax liability		27,340			15,582
(Decrease) increase in accounts payable, accrued expenses and other liabilities		(4,446		)	953
Net cash provided by operating activities		44,450			4,825
Cash flows from investing activities:
Purchases of property and equipment		(7,355		)	(3,244		)
Payments to TERI for loan database updates		(373		)	(374		)
Net cash used in investing activities		(7,728		)	(3,618		)
Cash flows from financing activities:
Repayment of notes payable due to TERI		(351		)	(330		)
Repayment of notes payable and capital lease obligations		(7,528		)	—
Proceeds from notes payable		—			7,000
Net proceeds from initial public offering		—			115,107
Stock options exercised		1,529			644
Net cash (used in) provided by financing activities		(6,350		)	122,421
Net increase in cash and other short-term investments		30,372			123,628
Cash and other short-term investments, beginning of period		168,712			18,327
Cash and other short-term investments, end of period		$	199,084		$	141,955
Supplemental disclosures of cash flow information:
Interest paid		$	484		$	178
Income taxes paid		$	—		$	8,635
Debt issuance costs		$	—		$	250
Supplemental disclosure of non-cash activities:
Structural advisory fees and residuals recognized		$	77,424		$	38,237
Non-cash compensation		$	135		$	1,642

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

6

 

THE FIRST MARBLEHEAD CORPORATION AND SUBSIDIARIES

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(1)                                 Nature of Business and Summary of Significant Accounting Policies

 

Nature of Business

 

The First Marblehead Corporation (FMC, and together with its subsidiaries, the Company), which was incorporated under the laws of the State of Delaware on August 13, 1994, provides outsourcing services for private education lending in the United States. The Company helps meet the growing demand for private education loans by providing national and regional financial institutions and educational institutions, as well as businesses and other enterprises, with an integrated suite of services for designing and implementing student loan programs for their respective customers, students, employees and members. The Company focuses primarily on loan programs for undergraduate, graduate and professional education, and, to a lesser degree, on the primary and secondary school market. The Company is entitled to receive structural advisory fees and residuals for its services in connection with securitizations of loans generated by the loan programs that it facilitates. The Company also receives fees for administrative services that it provides to the discrete bankruptcy remote, special purpose trusts that the Company forms for securitizations it facilitates.

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments (consisting of only normal recurring accruals) considered necessary for a fair statement of the results for the interim periods have been included. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Interim results are not necessarily indicative of results to be expected for the entire fiscal year. All significant intercompany balances and transactions have been eliminated in consolidation. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes for the year ended June 30, 2004 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on September 15, 2004. Certain prior period amounts have been reclassified to conform with current period presentation.

 

Student Loan Market Seasonality and Revenue Related to Securitization Transactions

 

Origination of student loans is generally subject to seasonal trends, with the volume of loan applications increasing with the approach of tuition payment dates. In general, the Company processes the greatest application volume during the summer months, as students and their families seek to borrow money in order to pay tuition costs for the fall semester or the entire school year. The Company also tends to process increased volume of loan applications during December and January, as students and their families seek to borrow money to pay tuition costs for the spring semester. This seasonality of loan originations impacts the amount of processing fees from TERI that the Company earns in a particular quarter.

 

The Company did not conduct a securitization transaction during the first quarter of either fiscal 2005 or fiscal 2004. The Company closed one securitization transaction in the second quarter, and two securitization transactions in the fourth quarter, of fiscal 2004. The Company closed one securitization transaction during the second quarter of fiscal 2005 and expects to close additional securitization transactions in the third and fourth quarters of the current fiscal year.

 

Concentrations

 

TERI

 

The Education Resources Institute, Inc. (TERI) is a private, not-for-profit Massachusetts corporation as described under section 501(c)(3) of the Internal Revenue Code of 1986, as amended. Incorporated in 1985, TERI is the oldest and largest guarantor of alternative, or private, student loans. In its role as guarantor in the private education lending market, TERI agrees to reimburse lenders for unpaid principal and interest on defaulted loans. TERI is the exclusive third-party provider of borrower default guarantees for the Company’s clients’ private student loans. As of December 31, 2004, TERI had a Baa3 counterparty rating from Moody’s Investors Service, which is the lowest investment grade rating, and an insurer financial strength rating of A+ from Fitch Ratings. If these ratings are lowered, FMC’s clients may not wish to enter into guarantee arrangements with TERI. In addition, FMC may receive lower structural advisory fees because the costs of obtaining financial guarantee insurance or structuring other credit enhancements for structuring the asset-backed securitizations could increase.

 

7

 

PHEAA

 

As of December 31, 2004, there were nine TERI-approved loan servicers to service new loan facilitation volume. As of December 31, 2004, Pennsylvania Higher Education Assistance Agency (PHEAA) serviced a majority of the loans for which the Company facilitated origination. The Company’s use of third-party loan servicers allows the Company to increase the volume of loans in its clients’ loan programs without incurring the overhead investment in servicing operations. As with any external service provider, there are risks associated with inadequate or untimely services. In addition, if the Company’s relationship with PHEAA terminates, the Company would either need to expand or develop a relationship with another TERI-approved loan servicer, which could be time-consuming and costly.

 

Significant Customers

 

During the three and six month periods ended December 31, 2004, processing fees from TERI represented approximately 11% and 19%, respectively, of total service revenue. Securitization-related fees from the National Collegiate Student Loan Trust 2004-2 (NCSLT 2004-2) represented approximately 75% of total service revenue for the first six months of fiscal 2005. NCSLT 2004-2 purchased private student loans from several lenders including Bank One N.A., Bank of America N.A. and Charter One Bank N.A. The Company did not recognize more than 10% of total service revenue from any other customer.

 

Critical Accounting Policies and Estimates

 

The preparation of the Company’s financial statements requires the Company to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and the reported amounts of income and expenses during the reporting periods. The Company bases its estimates and judgments on historical experience and on various other factors, and actual results may differ from these estimates under varying assumptions or conditions.

 

On an ongoing basis, the Company evaluates its estimates and judgments, particularly as they relate to accounting policies that the Company believes are most important to the portrayal of the Company’s financial condition and results of operations. The Company regards an accounting estimate or assumption underlying its financial statements to be a critical accounting estimate where:

 

•                                          the nature of the estimate or assumption is material due to the level of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and

 

•                                          the impact of the estimates and assumptions on the Company’s financial condition or operating performance is material.

 

The Company believes that its accounting policies involving the recognition and valuation of the Company’s securitization-related service revenue, as well as the valuation of goodwill and intangible assets, fit the definition of critical accounting estimates. The Company also considers its policy with respect to the determination of whether or not to consolidate the securitization trusts that it facilitates to be a critical accounting policy. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Application of Critical Accounting Policies and Estimates”.

 

(2)                                 Stock Options

 

The Company uses the intrinsic value method to account for stock options and provides pro forma net earnings disclosures as if the fair-value-based method had been applied.

 

For purposes of pro forma disclosures, the estimated fair value of the stock options is amortized to expense over the vesting period of the options. The Company’s consolidated pro forma net income and net income per share for the three and six month periods ended December 31, 2004 and 2003, had the Company elected to recognize compensation expense for the granting of options under SFAS No. 123 using the Black-Scholes option pricing model, are as follows:

 

8

 

		Three months ended December 31,
		(in thousands, except per share amounts)
		2004			2003
Net income—as reported		$	74,530		$	36,639
Less: Total stock-based employee compensation expense determined under the fair-value-based method for all awards, net of tax		(102		)	(146		)
Net income—pro forma		$	74,428		$	36,493
Net income per share—basic—as reported		$	1.15		$	0.62
Net income per share—basic—pro forma		$	1.15		$	0.62
Net income per share—diluted—as reported		$	1.12		$	0.58
Net income per share—diluted—pro forma		$	1.11		$	0.58

 

		Six months ended December 31,
		(in thousands, except per share amounts)
		2004			2003
Net income—as reported		$	69,178		$	33,561
Less: Total stock-based employee compensation expense determined under the fair-value-based method for all awards, net of tax		(773		)	(377		)
Net income—pro forma		$	68,405		$	33,184
Net income per share—basic—as reported		$	1.07		$	0.60
Net income per share—basic—pro forma		$	1.06		$	0.59
Net income per share—diluted—as reported		$	1.04		$	0.55
Net income per share—diluted—pro forma		$	1.02		$	0.55

 

(3)                                 Net Income per Share

 

The following table sets forth our computation of basic and diluted net income per share of the Company’s stock:

 

		Three months ended December 31,						Six months ended December 31,
		(in thousands, except per share amounts)
		2004			2003			2004			2003
Net income		$	74,530		$	36,639		$	69,178		$	33,561
Shares used in computing net income per common share –basic		64,624			59,084			64,473			56,205
Effect of dilutive securities:
Stock options		2,193			4,318			2,330			4,387
Restricted stock units		4			—			—			—
Dilutive potential common shares		2,197			4,318			2,330			4,387
Shares used in computing net income per common share – diluted		66,821			63,402			66,803			60,592
Net income per common share:
Basic		$	1.15		$	.62		$	1.07		$	.60
Diluted		$	1.12		$	.58		$	1.04		$	.55

 

9

 

(4)                                 Service Receivables

 

Structural advisory fees and residuals receivables represent the present value of additional structural advisory fees and residuals expected to be collected over the life of the student loans, net of prepayment, default, recovery and cost of funding estimates. The fees are paid to the Company from the various separate securitization trusts established by The National Collegiate Trust (NCT trusts), and from The National Collegiate Master Student Loan Trust I (NCMSLT), The National Collegiate Student Loan Trust 2003-1 (NCSLT 2003), The National Collegiate Student Loan Trust 2004-1 (NCSLT 2004-1) and NCSLT 2004-2. Processing fees receivable from TERI represents amounts due from TERI for expenses incurred by First Marblehead Education Resources, Inc. (FMER), a wholly owned subsidiary of FMC, on TERI’s behalf.

 

The Company conducted securitization transactions in the second quarter of fiscal 2005 and 2004. The Company, on a quarterly basis, updates its estimate of the present value of its structural advisory fees and residuals receivables to reflect the passage of time, any change in discount rates used to estimate their present value, and any changes to the trust performance metrics that the Company considers in its present value estimates, such as default, recovery, prepayment and forward London Interbank Offered Rate (LIBOR) rates.

 

The Company made no changes in its assumptions regarding default rates, prepayment rates and recovery rates during the first six months of either fiscal 2005 or 2004 for the NCT trusts, NCMSLT, NCSLT 2003, NCSLT 2004-1 or NCSLT 2004-2.

 

The Company uses an implied forward LIBOR curve to estimate trust cash flows. During the six months ended December 31, 2004, the implied forward LIBOR curve flattened. This flattening of the LIBOR curve did not have a material effect on the estimated fair value of the structural advisory fees receivable during the six months ended December 31, 2004. The flattening of the curve improved the net excess spread between the trust assets and liabilities, resulting in an increase in the estimated fair value of residuals receivable during the period. During the six months ended December 31, 2003, the rates along the implied forward LIBOR curve increased. These increases in rates resulted in an increase in the average life of the underlying trust assets, thereby having the effect of increasing the estimated fair value of the structural advisory fees and residuals receivables during the period.

 

The Company bases the discount rate that it uses to calculate the present value of its additional structural advisory fees on the 10-year U.S. Treasury rate plus 200 basis points. From July 1, 2004 to December 31, 2004, this rate decreased by 36 basis points from 6.58% to 6.22%. From July 1, 2003 to December 31, 2003, this rate increased by 92 basis points from 5.33% to 6.25%. A decrease in the 10-year U.S. Treasury rate has the effect of increasing the estimated fair value of the Company’s structural advisory fees receivable, while an increase in the rate has the opposite effect on the Company’s estimate of their fair value. In determining an appropriate discount rate for valuing residuals, we review the rates used by student loan securitizers, as well as rates used in the much broader asset-backed securities (ABS) market. We believe that the 12% discount rate we use is appropriate given the expected 24-year life of the trust assets and residuals.

 

The following table summarizes the changes in the structural advisory fees receivable for the six month periods ended December 31, 2004 and 2003:

 

		Six months ended December 31,
		(in thousands)
		2004			2003
Fair value of structural advisory fees at beginning of period		$	24,084	(1)	$	10,785
Additions from structuring new securitizations		9,931			5,925
Fair value adjustments		810			(226		)
Fair value of structural advisory fees at end of period		$	34,825		16,484		(1)

 

(1) Excludes additional up-front structural advisory fees received in July 2004 related to the December 2003 securitization transaction. See Note 7(b) for additional information.

 

The following table summarizes the changes in the residuals receivable for the six month periods ended December 31, 2004 and 2003:

 

		Six months ended December 31,
		(in thousands)
		2004			2003
Fair value of residuals at beginning of period		$	108,495		$	43,600
Additions from structuring new securitizations		57,057			29,730
Fair value adjustments		9,626			2,808
Fair value of residuals at end of period		$	175,178		$	76,138

 

10

 

The effect on the fair value of the structural advisory fees and residuals receivables based on variations of 10% or 20%, except for the forward LIBOR rates, which are based on variations of 1% and 2% from the forward LIBOR rates at December 31, 2004, and changes in the assumed spread between one month LIBOR rates and the auction rates which are based on .05% and .10% changes, from the assumed levels for each key assumption are as follows:

 

(dollars in thousands)

 

Structural advisory fees receivables, December 31, 2004		$	34,825
Default rate					Default rate
+10%		$	(186	)	-10%		$	194
+20%		(377		)	-20%		378
Default recovery rate					Default recovery rate
+10%		—			-10%		(130		)
+20%		142			-20%		(130		)
Prepayment rate					Prepayment rate
+10%		(887		)	-10%		936
+20%		(1,728		)	-20%		1,922
Discount rate					Discount rate
+10%		(1,282		)	-10%		1,346
+20%		(2,507		)	-20%		2,785
Forward LIBOR rates					Forward LIBOR rates
+1%		1,092			-1%		(1,202		)
+2%		2,332			-2%		(2,321		)
Change in assumed spread between LIBOR and auction rate					Change in assumed spread between LIBOR and auction rate
+.05%		(1		)	-.05%		1
+.10%		(1		)	-.10%		2

 

(dollars in thousands)

 

Residuals receivables, December 31, 2004		$	175,178
Default rate					Default rate
+10%		$	(1,528	)	- 10%		$	1,016
+20%		(4,854		)	- 20%		1,865
Default recovery rate					Default recovery rate
+10%		421			- 10%		(505		)
+20%		485			- 20%		(1,186		)
Prepayment rate					Prepayment rate
+10%		(7,710		)	- 10%		8,083
+20%		(15,069		)	- 20%		16,572
Discount rate					Discount rate
+10%		(15,867		)	- 10%		17,779
+20%		(29,971		)	- 20%		37,797
Forward LIBOR rates					Forward LIBOR rates
+1%		7,821			- 1%			(7,842	)
+2%		15,557			- 2%		(15,607		)
Change in assumed spread between LIBOR and auction rate					Change in assumed spread between LIBOR and auction rate
+.05%		(1,922		)	-.05%		1,923
+.10%		(3,840		)	-.10%		3,847

 

11

 

(5)                                 Related Party Transaction

 

At December 31, 2004 and June 30, 2004, Milestone Capital Management (MCM), an institutional money management firm, was managing approximately $181.8 million and $145.2 million, respectively, of cash and other short-term investments for the Company and charging its standard fees for its services.  Members of the immediate family of one of the Company’s directors own approximately 20% of MCM’s outstanding equity.

 

(6)                                 Borrowings from Related Parties

 

(a)  Line of Credit

 

The Company entered into a $975,000 revolving line of credit with a bank effective April 24, 2002. The line of credit matured on April 24, 2003 and was renewed through December 31, 2003 subject to the same terms and conditions, with interest payable at the greater of 6% or 1% above the highest published Wall Street Journal prime rate. The terms of the line of credit required that: the Company maintain accurate books and records; the assets be free of all liens, encumbrances and financing not approved by the lender; and when there was a balance outstanding under the line, no dividends or payments of principal and interest on any loans held by any guarantor, officer, director or stockholder could be made. A member of the board of directors of the Company is also a director and significant stockholder of a company that owns the bank. The Company believes that the line of credit was on substantially the same terms as those prevailing at the same time for comparable transactions with third parties. The Company did not renew this credit facility upon expiration. The Company had no amounts outstanding under this line of credit at June 30, 2003 or any time thereafter.

 

(b)  Notes Payable to TERI

 

In connection with the Company’s acquisition of TERI’s loan processing operations in June 2001, the Company entered into a note payable agreement with TERI on June 20, 2001, amounting to $3.9 million, $2.0 million of which related to the acquisition of TERI’s software and network assets and $1.9 million of which related to the Company’s acquisition of a workforce-in-place. Principal and interest at an annual rate of 6% are payable in 120 monthly installments of $43,298 commencing on July 20, 2001 and ending on June 20, 2011. The note payable is secured by the software and network assets and workforce-in-place intangible assets. The outstanding balance of this note payable at December 31, 2004 and June 30, 2004 amounted to $2.8 million and $3.0 million, respectively.

 

The Company also entered into a second note payable with TERI on June 20, 2001, amounting to $4.0 million, to fund the Company’s acquisition of TERI’s loan database in June 2001. Principal and interest at an annual rate of 6% are payable in 120 monthly installments of $44,408 commencing on July 20, 2001 and ending on June 20, 2011. The note payable is secured by the loan database. The outstanding balance of this note payable was approximately $2.9 and $3.0 million at December 31, 2004 and June 30, 2004, respectively.

 

(7)                                 Other Borrowings

 

(a)   Revolving Line of Credit

 

On August 28, 2003, the Company entered into an agreement with Fleet National Bank to establish a revolving line of credit in the amount of $10 million, which includes a sub-limit for letters of credit. Fleet National Bank was recently acquired by Bank of America, and our agreement has been assigned to Bank of America. The revolving credit facility matures on August 28, 2005, with interest currently payable, at the Company’s option, at the bank’s prime rate or LIBOR plus 2%. The revolving credit line contains financial covenants, including minimum trailing 12-month up-front structural advisory fees, minimum tangible net worth, maximum liabilities to net worth ratios and minimum cash flow to debt service ratios, as well as certain financial reporting covenants. This agreement restricts the Company’s ability to pay cash dividends in the event it is in default. No amounts were outstanding under this revolving line of credit at December 31, 2004 or June 30, 2004. The proceeds, if any, will be used for working capital and general corporate purposes. Bank of America has also issued on the Company’s behalf a letter of credit in the amount of $0.5 million in lieu of security deposits for the lease of office space. Third party beneficiaries have not drawn upon this letter of credit, which reduces the amount the Company may borrow under the revolving credit facility.

 

(b)   Note Payable Related to December 2003 Securitization

 

In December 2003, the Company received $7.0 million upon the issuance of a $7.25 million note to the lead underwriter of the Company’s December 2003 securitization transaction.  The Company agreed to repay this note with the first $7.25 million of the up-front structural advisory fee that it received in July 2004 in connection with the December 2003 securitization. This July 2004 up-front

 

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structural advisory fee payment was in addition to the $24.5 million up-front structural advisory fee payment received at the time of the December 2003 securitization transaction and, at December 31, 2003, was estimated to be $8.5 million. Because the performance of the trust created by the December 2003 securitization transaction during its first six months was better than anticipated at December 31, 2003, the Company received an additional $1.75 million in July 2004 resulting in a total second up-front structural advisory fee payment of $10.25 million. The note was further collateralized by the first $6.3 million of residual cash flow from the December 2003 securitization as well as $700,000 of restricted cash. The note was paid in full in July 2004.

 

(8)                                 Stockholders’ Equity

 

Initial Public Offering

 

In November 2003, an aggregate of 14,375,000 shares of the Company’s common stock were sold in an initial public offering at a price of $16.00 per share, including:

 

•                  7,906,250 shares sold by the Company; and

 

•                  6,468,750 shares sold by the Company’s selling stockholders.

 

Net proceeds of the initial public offering to the Company, after underwriting discounts and offering expenses, were approximately $115.1 million. The Company did not receive any of the proceeds from the selling stockholders.

 

Follow-on Offering

 

In June 2004, an aggregate of 7,406,312 shares of the Company’s common stock were sold in a follow-on public offering at a price of $36.50 per share. The Company did not sell any shares in this offering and therefore did not receive any proceeds from the sale of stock. Immediately prior to the follow-on offering, employees participating in the offering exercised options to purchase 2,044,390 shares of common stock which were then sold in the offering. The Company received approximately $3.0 million in the aggregate in payment of the exercise prices for these options. The Company incurred approximately $1.0 million in offering costs related to this offering, which were recorded as general and administrative expenses during the fourth quarter of fiscal 2004.

 

Equity Transactions

 

An executive officer of the Company had an agreement with two principal stockholders of the Company relating to shares of common stock of the Company owned by these stockholders. Pursuant to this agreement, the executive officer earned non-cash compensation of approximately $1.6 million during the first quarter of fiscal 2004. On September 30, 2003, the agreement was terminated in exchange for vested options issued by these two principal stockholders.

 

Authorized Shares

 

In July 2003, the Board of Directors approved, and in August 2003 the stockholders approved, an increase in the total number of authorized shares of common stock from 14,280,440 to 25,000,000. In October 2003, the Board of Directors and stockholders approved an increase in the total number of authorized shares of common stock from 25,000,000 to 100,000,000. On August 10, 2004, the Board of Directors approved, and on November 18, 2004 the Company’s stockholders’ approved, an increase in the total number of authorized shares of common stock from 100,000,000 to 150,000,000. Also, see “Stock Splits” below.

 

2002 Director Stock Plan

 

In September 2002, the Board of Directors approved, and in August 2003, the Company’s stockholders approved, the 2002 Director Stock Plan and reserved 200,000 shares of common stock for issuance to the Company’s non-employee directors.  As of December 31, 2004, options to purchase 64,000 shares of common stock have been issued under this plan.

 

2003 Stock Incentive Plan

 

In September 2003, the Board of Directors and stockholders approved the 2003 Stock Incentive Plan and reserved 1,200,000 shares of common stock for issuance under this plan. As of December 31, 2004, 70,000 restricted stock units have been issued under this plan.

 

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Stock Splits

 

In August 2003, the stockholders approved a 10-for-1 stock split which became effective on August 25, 2003. In October 2003, the Board of Directors approved a 4-for-1 stock split to be effected as a stock dividend immediately prior to the Company’s initial public offering. On October 29, 2003, the stockholders became entitled to payment of such stock dividend. All prior period share data have been retroactively adjusted to reflect these stock splits.

 

2003 Employee Stock Purchase Plan

 

In October 2003, the Board of Directors and stockholders approved the 2003 Employee Stock Purchase Plan (Stock Purchase Plan). A total of 400,000 shares of common stock are authorized for issuance under this plan. The Stock Purchase Plan permits eligible employees to purchase shares of common stock at the lower of 85% of the fair market value of the common stock at the beginning or at the end of each offering period. Employees who own 5% or more of the Company’s common stock are not eligible to participate in the Stock Purchase Plan. Participation is voluntary. Prior to June 30, 2004, no shares had been issued under this plan. During July 2004 and January 2005, a total of 40,499 and 10,050 shares, respectively, were issued under the Stock Purchase Plan.

 

(9)  Pension Plan

 

FMER has a non-contributory defined benefit pension plan that covers substantially all FMER employees. During the second quarter of fiscal 2005, the Company recorded a net curtailment gain of $655,000 as the benefits under the plan were frozen. The following table sets forth the amounts recognized related to FMER’s defined benefit pension plan in the Company’s condensed consolidated financial statements for the three and six month periods ended December 31, 2004 and 2003:

 

		Three months ended December 31, (in thousands)						Six months ended December 31, (in thousands)
		2004			2003			2004			2003
Components of net periodic pension cost:
Service cost		$	157		$	149		$	315		$	298
Interest on projected benefit obligations		62			53			124			106
Loss recognized		9			17			18			34
Expected return on plan assets		(42		)	(34		)	(84		)	(68		)
Net periodic pension cost before curtailment		186			185			373			370
Curtailment gain		(655		)	—			(655		)	—
Net periodic pension (gain) cost		$	(469	)	$	185		$	(282	)	$	370

 

Employer Contributions

 

During the six months ended December 31, 2004, the Company made contributions of $312,000 to FMER’s defined benefit pension plan. The Company expects to make additional aggregate contributions of approximately $300,000 during the remainder of fiscal 2005.

 

(10)                          New Accounting Pronouncements

 

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment” (Statement 123R), which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation.” Statement 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.” Statement 123R requires a public company to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant-date fair value of the award, with limited exceptions. That cost will be recognized over the period during which the employee is required to provide service in exchange for the award, which is typically the vesting period. Statement 123R eliminates the alternative to use Opinion 25’s intrinsic value method of accounting that was provided in Statement 123 as originally issued.

 

The Company expects to adopt Statement 123R on July 1, 2005. Statement 123R permits public companies to adopt its requirements using one of two methods:

 

1.                                     A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123R for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123R that remain unvested on the effective date.

 

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2.                                       A “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate its previously issued financial statements to include in its income statement amounts previously recognized under Statement 123 for purposes of pro forma disclosures for either (a) all prior periods presented or (b) prior interim periods of the year of adoption.

 

The Company plans to adopt Statement 123R using the modified-prospective method.

 

As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. The adoption of Statement 123R’s fair-value method will impact the Company’s results of operations, although the impact of adoption of Statement 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted Statement 123R in prior periods, the impact of that standard would have approximately the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 to the Company’s condensed consolidated financial statements. Statement 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what the impact on the cash flow statement will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $2.7 million during the six months ended December 31, 2004 and $29.9 million during the year ended June 30, 2004.

 

Beginning July 1, 2003, and for securitization trusts created after January 31, 2003, the Company applied FASB Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51,” in assessing consolidation. FIN No. 46 provided a new framework for identifying variable interest entities and determining when a company should include the assets, liabilities, non-controlling interests and results of activities of a variable interest entity in its consolidated financial statements.

 

On December 24, 2003, the FASB issued FIN No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” (FIN No. 46R), which addressed how a business enterprise should evaluate whether it has a controlling interest in an entity through means other than voting rights and accordingly should consolidate the entity.  FIN No. 46R has replaced FIN No. 46.  At December 31, 2004, the securitization trusts created after January 31, 2003 have either met the criteria to be a qualified special-purpose entity (QSPE), as defined in paragraph 35 of FASB Statement No. 140, “Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” or the Company has determined that it is not the primary beneficiary of the securitization trusts, as defined by FIN No. 46R. Accordingly, the Company did not consolidate these existing securitization trusts in these financial statements. In addition, the securitization trusts created prior to January 31, 2003 have been amended in order for them to be considered QSPEs. The adoption of FIN No. 46R, which the Company began to apply in December 2003, did not have a material impact on the Company’s consolidated financial condition, results of operations, earnings per share or cash flows.

 

The FASB issued an Exposure Draft, “Qualifying Special-Purpose Entities and Isolation of Transferred Assets—an amendment of FASB Statement No. 140.” This proposal would, among other things, change the requirements that an entity must meet to be considered a QSPE. The FASB has announced that it expects to issue in the third calendar quarter of 2005 a revised exposure draft that would include all of the proposed amendments to FASB Statement No. 140.  The Company is monitoring the status of this exposure draft to assess its impact on its consolidated financial statements.

 

(11) Subsequent Events

 

Equipment Financing Lease

 

In January 2005, the Company entered into an equipment financing lease agreement which will be used to finance the purchases of furniture and equipment. The agreement allows the Company to finance up to $20 million of furniture and equipment purchased before December 30, 2005.

 

Follow-on Offering

 

In January 2005, an aggregate of 3,933,605 shares of the Company’s common stock were sold in a follow-on public offering at a price of $57.40 per share. The Company did not sell any shares in this offering and therefore did not receive any proceeds from the sale of stock. Immediately prior to the follow-on offering, an employee participating in the offering exercised an option to purchase 1,012,980 shares of common stock which were then sold in the offering. The Company received approximately $1.9 million in payment of the exercise price for this option. The Company has recorded as general and administrative expenses approximately $0.4 million in offering costs related to this offering, most of which was recorded during the second quarter of fiscal 2005.

 

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Item 2-Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

You should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and accompanying notes included elsewhere in this filing. In addition to the historical information, the discussion contains certain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those expressed or implied by the forward-looking statements due to our critical accounting policies and factors including, but not limited to, those set forth under “Factors That May Affect Future Results” below.

 

Executive Summary

 

Overview

 

We provide outsourcing services for private education lending in the United States. We provide services in connection with each of the five typical phases of the student loan lifecycle, offering our clients a single point of interface for:

 

•                  program design and marketing;

 

•                  borrower inquiry and application;

 

•                  loan origination and disbursement;

 

•                  loan securitization; and

 

•                  loan servicing.

 

We receive fees for the services we provide in connection with both processing our clients’ private student loans and structuring and administering securitizations of those loans. Securitization refers to the technique of pooling loans and selling them to a special purpose, bankruptcy remote entity, typically a trust, which issues securities to investors backed by those loans.

 

We do not take a direct ownership interest in the loans our clients generate, nor do we serve as a lender or guarantor with respect to any loan programs that we facilitate. We assist the lenders in our loan programs in selecting the underwriting criteria used in deciding whether a student loan will be made to an applicant. However, each lender has ultimate control over the selection of these criteria, and in providing our services, we are obligated by contract to observe them. Lenders who wish to have their loans guaranteed by TERI are required to meet TERI’s underwriting criteria. Although we oversee loan servicing as a component of our administrative duties, we do not act as a loan servicer.

 

We currently focus on facilitating private student loans for undergraduate, graduate and professional education, although we also provide service offerings for continuing education programs, primary and secondary schools, career training and study abroad programs. During the first six months of fiscal 2005, we processed approximately 533,000 loan applications and facilitated $1.6 billion in loans at over 4,800 schools. During fiscal 2004, we processed over 560,000 loan applications and facilitated $1.8 billion in loans at over 4,800 schools. We have provided structural, advisory and other services for 23 securitization transactions since our formation in 1991.

 

We offer services in connection with loan programs targeted at two primary marketing channels:

 

Private label programs that:

 

•                  lenders market directly to prospective student borrowers and their families;

 

•                  lenders market directly to educational institutions;

 

•                  third parties who are not themselves lenders design and market directly to prospective student borrowers and their families; loans under these programs are made by referral lenders;

 

•                  third parties who are not themselves lenders design and market directly to educational institutions; loans under these

 

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programs are made by referral lenders; and

 

•                  businesses, unions, affinity groups and other organizations offer to their employees or members.

 

Guaranteed Access to Education, or GATE, programs that educational institutions offer directly to their students.

 

During fiscal 2004, we securitized both private label loans and GATE loans. During the first six months of fiscal 2005, we facilitated one securitization of only private label loans. We expect we will securitize GATE loans, including those we have facilitated during the first six months of our current fiscal year, in the fourth fiscal quarter. During fiscal 2004, our private label programs contributed $191.1 million, or 96%, of our total service revenue, while our GATE programs contributed $8.2 million, or 4%, of our total service revenue.

 

In June 2001, we significantly enhanced our risk management and loan processing capabilities through a strategic relationship with The Education Resources Institute, Inc., or TERI, the nation’s oldest and largest guarantor of private student loans. We acquired TERI’s loan processing operations, including its historical database, but not its investment assets or guarantee liabilities. In connection with this acquisition, 161 members of TERI’s staff became our employees. In addition, we entered into a master servicing agreement pursuant to which TERI engages us to provide loan origination and processing services with respect to the loans generated through the private label programs we facilitate, as well as other TERI-guaranteed loans. TERI reimburses us for the expenses we incur in providing these services. Under the terms of a master loan guaranty agreement that we entered into with TERI in 2001, we also agreed to provide a beneficial interest for TERI of 25% of the residual value of TERI-guaranteed loans owned by the securitization trusts that purchase the loans, and a right of first refusal to guarantee our private label clients’ existing and future loan programs. In October 2004, we renewed our master servicing agreement, master loan guaranty agreement and certain additional agreements with TERI, in each case for an additional term through June 2011.  In addition, we entered into a supplement to the master loan guaranty agreement, under which we granted to TERI a right to elect once each fiscal year to increase the amount of its administration fees by 25 basis points, with a corresponding reduction from 25 percent to 20 percent in TERI’s ownership of the residual value of the TERI-guaranteed loans purchased during that year by the securitization trust and a resulting increase from 75 percent to 80 percent in our residual ownership.  TERI has made such an election for the fiscal year ending June 30, 2005.

 

The primary driver of our results of operations and financial condition is the volume of loans for which we provide outsourcing services from loan origination through securitization. We facilitated the securitization of $1.25 billion of student loans during fiscal 2004, up from $560 million during fiscal 2003.

 

During the first six months of fiscal 2005, we facilitated approximately 176,000 loans in an aggregate principal amount of approximately $1.6 billion. Approximately $1.3 billion of this amount was available to us for securitization. During the first six months of fiscal 2004, we facilitated approximately 112,000 loans in an aggregate principal amount of approximately $981 million. Approximately $747 million of this amount was available to us for securitization. During fiscal 2004, we facilitated approximately 200,000 loans in an aggregate principal amount of approximately $1.8 billion. Approximately $1.38 billion of this amount was available to us for securitization.

 

The dollar volume of the loans that we facilitated in the first six months of fiscal 2005 increased 62% as compared to the first six months of fiscal 2004. The loans that we facilitated that are available to us for securitization increased 76% in the first six months of fiscal 2005 as compared to the first six months of fiscal 2004.

 

Although we offer our clients a fully integrated suite of outsourcing services, we do not charge separate fees for many of these services. Moreover, although we receive fees for providing loan processing services to TERI in connection with TERI-guaranteed loans, these fees represent reimbursement of the direct expenses we incur. Accordingly, we do not earn a profit on these fees. Although we provide these various services without charging a separate fee, or at “cost” in the case of TERI-guaranteed loans, we generally enter into agreements with the private label lenders, and Bank of America, N.A. in the case of GATE programs, giving us the exclusive right to securitize the loans that they do not intend to hold, and we receive structural advisory fees and residuals for facilitating securitizations of these loans. Our level of profitability depends on these structural advisory fees and residuals. We discuss the manner in which we recognize them as revenue in greater detail below. We may in the future enter into arrangements with private label lenders under which we provide outsourcing services, but do not have the exclusive right to securitize the loans that they originate.

 

Changes in any of the following factors can materially affect our financial results:

 

•                  the demand for private education financing;

 

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•                  the competition for providing private education financing;

 

•                  the education financing preferences of students and their families;

 

•                  applicable laws and regulations, which may affect the terms upon which our clients agree to make private student loans and the cost and complexity of our loan facilitation operations;

 

•                  the private student loan securitization market, including the costs or availability of financing;

 

•                  the general interest rate environment, including its effect on our discount rates;

 

•                  our critical accounting policies and estimates;

 

•                  borrower default rates; and

 

•                  prepayment rates on private student loans, including prepayments through loan consolidation.

 

Securitizations and Related Revenue

 

We structure and facilitate securitization transactions for our clients through a series of bankruptcy remote, qualified special purpose statutory trusts. The trusts purchase private student loans from the originating lenders, which relinquish to the trust their ownership interest in the loans. The debt instruments that the trusts issue to finance the purchase of these student loans are obligations of the trusts, rather than our obligations or those of originating lenders. As of December 31, 2004, we have utilized the following special purpose entities for the securitizations we have structured:

 

•                  The National Collegiate Student Loan Trust 2004-2, or NCSLT 2004-2, was formed in October 2004 to purchase exclusively TERI-guaranteed private label loans.

 

•                  The National Collegiate Student Loan Trust 2004-1, or NCSLT 2004-1, was formed in May 2004 to purchase exclusively TERI-guaranteed private label loans.

 

•                  The National Collegiate Student Loan Trust 2003-1, or NCSLT 2003, was formed in December 2003 to purchase exclusively TERI-guaranteed private label loans.

 

•                  The National Collegiate Master Student Loan Trust I, or NCMSLT, was formed in fiscal 2002 to purchase exclusively TERI-guaranteed private label loans.

 

•                  The National Collegiate Trust, or NCT, was formed in fiscal 1993 and has established separate securitization trusts, which we refer to as the NCT trusts, that have purchased primarily GATE loans and a limited number of TERI-guaranteed and other loans.

 

In the future, we may securitize private label or GATE loans using new trust vehicles.

 

Under the terms of some of our contracts with key lender clients, we have an obligation to securitize periodically, typically twice per year, the private student loans that these clients originate, and we may agree with other lenders to securitize more frequently in the future. If we do not honor our obligations to these lenders, we may be required to pay liquidated damages, generally not exceeding an amount equal to 1% of the face amount of the loans available for securitization.

 

We receive several types of fees in connection with our securitization services:

 

Structural advisory fees.  We charge structural advisory fees that are paid in two portions:

 

•                  Up-front.  We receive a portion of the structural advisory fees at the time the securitization trust purchases the loans, or soon thereafter. For these fees, we structure the securities sold in the securitization, coordinate the attorneys, accountants, trustees, loan servicers, loan originators and other transaction participants and prepare the cash flow modeling for rating agencies and financial guarantee insurers, as needed. In securitizations we facilitated in fiscal

 

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2005 and 2004, these fees have ranged from 4.7% to 8.1% of the principal and accrued interest of the loans securitized; and

 

•                  Additional.  We receive a portion of the structural advisory fees over time, based on the amount of loans outstanding in the trust from time to time over the life of the trust. This portion accumulates monthly from the date of a securitization transaction at a rate of 15 basis points per year. We begin to receive this additional portion, plus interest, once the ratio of trust assets to trust liabilities, which we refer to as the “parity ratio,” reaches a stipulated

level, which ranges from 103.0% to 105.0%. The level applicable to a particular trust is determined at securitization. We currently expect to receive the additional fees beginning five to seven years after the date of a particular securitization transaction.

 

Residuals.  We also have the right to receive a portion of the residual interests that these trusts create. This interest is junior in priority to the rights of the holders of the debt sold in the securitizations and entitles us to receive:

 

•                  in connection with the securitizations in NCSLT 2004-2, 80% of the residual cash flows once a parity ratio of 103.0% is reached and maintained;

 

•                  in connection with the securitizations in NCSLT 2004-1 and NCSLT 2003, 75% of the residual cash flows once a parity ratio of 103.0% is reached and maintained;

 

•                  in connection with securitizations in NCMSLT, 75% of the residual cash flows once a parity ratio of 103.5% is reached and maintained; and

 

•                  in connection with securitizations in the NCT trusts, our share of residual cash flows once all of the debtholders of the securitization trust have been repaid, plus, in the case of securitized GATE loans, an additional 10% of the residual cash flows.

 

Our residual interest derives almost exclusively from the services we perform in connection with each securitization rather than from a direct cash contribution to the securitization trust. We contributed no capital to NCSLT 2004-2, NCSLT 2004-1, NCSLT 2003 or NCMSLT, the trusts that have securitized solely TERI-guaranteed private label loans. In connection with the three most recent securitizations of GATE loans in the NCT trusts, in order to accommodate a limited number of schools, we invested in the aggregate approximately one-third of our GATE-related up-front structural advisory fees to eliminate the risk exposure of those schools. These investments, which reduced our up-front structural advisory fees that would have been recognized in these periods, totaled $1.3 million, $2.0 million and $1.8 million in fiscal 2004, 2003 and 2002, respectively. In fiscal 2004, our investment comprised 1.5% of our total up-front structural advisory fees. In exchange for these investments, we received the rights to the residual interest that these schools would otherwise hold in the trust and accounted for these rights as residuals, consistent with the manner in which we account for our other residuals. The value of these residual interests is primarily affected by the loan performance at each school. In the case of securitizations in NCSLT 2004-2, NCSLT 2004-1, NCSLT 2003 and NCMSLT, we currently expect to receive the residuals beginning approximately five to six years after the date of a particular securitization. In the case of securitizations in the NCT trusts, we currently expect to receive the residuals beginning 12 to 15 years after the date of a particular securitization.

 

Administrative and other fees.  Our administrative and other fees represent primarily the administrative fees we receive from the trusts for their daily management and for the services we provide in obtaining information from the loan servicers and reporting this and other information to the parties related to the securitization. We receive fees ranging from 5 to 20 basis points per year of the student loan balance in the trust. In addition, in connection with some securitizations, we receive other fees from originating lenders when their loans are purchased by the securitization trust, although these fees have not been material and we do not expect them to be material in the future. We also record as administrative and other fees the reimbursement we receive for certain call center costs. These fees were approximately $0.4 million and $0.2 million for the first six months of fiscal 2005 and fiscal 2004, respectively. The increase in these fees is primarily due to the increase in loan facilitations.

 

Processing Fees from TERI

 

We provide outsourcing services to TERI, including loan origination, customer service, default prevention, default processing and administrative services under a master servicing agreement between TERI and us. We recognize as revenue the monthly reimbursement that TERI provides us for the expenses we incur in providing these services.

 

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Recognition and Valuation of Service Revenue

 

We recognize up-front structural advisory fees as revenue at the time the securitization trust purchases the loans. In order for the securitization trust to purchase the loans, all of the applicable services must be performed, rating agencies must deliver their ratings letters, transaction counsel must deliver the required legal opinions and the underwriters must receive the debt securities created by the securitization trust. These events indicate that the securitization transaction has been properly structured and loans have been properly sold to the securitization trust.

 

As required under accounting principles generally accepted in the United States, we also recognize additional structural advisory fees and residuals as revenue at that time, as they are deemed to be earned at the time of the securitization and before we actually receive payment. These amounts are deemed earned because evidence of an arrangement exists, we have provided the services, the fee is fixed and determinable based upon a discounted cash flow analysis, there are no future contingencies or obligations and collection is reasonably assured. We estimate the present value of the additional structural advisory fees and residuals based on certain assumptions we make about the timing and amount of payment.

 

We are required to measure the additional structural advisory fees and residuals like investments in debt securities classified as available-for-sale or trading, similar to retained interests in securitizations. Accordingly, we record additional structural advisory fees and residuals receivables on our balance sheet at fair value using a discounted cash flow model. We estimate the fair value both initially and at each subsequent quarter and reflect the change in value in earnings for that period.

 

Because there are no quoted market prices for our additional structural advisory fees and residuals receivables, we use certain key assumptions to estimate their values. See “Application of Critical Accounting Policies and Estimates—Service Revenue.”

 

We recognize administrative and other fees, as well as processing fees from TERI, as revenue at the time that we perform the underlying services.

 

Quarterly Fluctuations

 

Our quarterly revenue, operating results and profitability have varied and are expected to continue to vary on a quarterly basis primarily because of the timing of the securitizations that we structure. During fiscal 2005 and fiscal 2004, we facilitated securitizations in the second fiscal quarter. During fiscal 2004, we also facilitated two securitization transactions in the fourth fiscal quarter. We expect to close additional securitization transactions in the third and fourth quarters of fiscal 2005. The following tables set forth our quarterly service revenue and net income (loss) for each of the first and second quarters of fiscal 2005 and for each of the quarters of fiscal 2004:

 

		2005 fiscal quarter
		First			Second
		(in thousands)
Service revenue		$	22,404		155,837
Net (loss) income		(5,352		)	74,530

 

		2004 fiscal quarter
		First			Second			Third			Fourth
					(in thousands)
Service revenue		$	9,469		$	77,523		$	11,127		$	101,141
Net (loss) income		(3,077		)	36,639			(3,566		)	45,276

 

Application of Critical Accounting Policies and Estimates

 

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and the reported amounts of income and expenses during the reporting periods. We base our estimates, assumptions and judgments on historical experience and on various other factors that we believe are reasonable under the circumstances. Actual results may differ from these estimates under varying assumptions or conditions.

 

Our significant accounting policies are more fully described in Note 2 of the notes to the audited consolidated financial statements for the year ended June 30, 2004, which are included in our annual report on Form 10-K filed with the Securities and Exchange Commission on September 15, 2004. On an ongoing basis, we evaluate our estimates and judgments, particularly as they relate to accounting policies that we believe are most important to the portrayal of our financial condition and results of operations.

 

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We regard an accounting estimate or assumption underlying our financial statements to be a “critical accounting estimate” where:

 

•                  the nature of the estimate or assumption is material due to the level of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and

 

•                  the impact of the estimates and assumptions on our financial condition or operating performance is material.

 

We have discussed our accounting policies with the audit committee of our Board of Directors, and we believe that our estimates relating to the recognition and valuation of our securitzation-related service revenue, as well as the valuation of goodwill and intangible assets, fit the definition of critical accounting estimates. We also consider our policy with respect to the determination of whether or not to consolidate the securitization trusts that we facilitate to be a critical accounting policy.

 

Service Revenue

 

For a discussion of our revenue recognition policy, see “—Recognition and Valuation of Service Revenue.”

 

Because there are no quoted market prices for our additional structural advisory fees and residuals receivables, we use the following key assumptions to estimate their values:

 

•                  the discount rate, which we use to calculate the present value of our additional structural advisory fees and residuals;

 

•                  the annual compound rate of student loan prepayments, which we refer to as the constant prepayment rate, or CPR;

 

•                  the trend of interest rates over the life of the loan pool, including the forward London Interbank Offered Rate, or LIBOR, and the spread between LIBOR and auction rates; and

 

•                  expected defaults, net of recoveries.

 

We base these estimates on our proprietary historical data, third-party data and our industry experience, adjusting for specific program and borrower characteristics such as loan type and borrower creditworthiness. We also monitor trends in loan performance over time, and make adjustments we believe are necessary to value properly our receivables balance. We recognize the revenue associated with our processing fees from TERI and our administrative and other fees as we perform these services.

 

The following table shows the loan performance assumptions for the life of each trust at December 31, 2004:

 

				Percentage rate						Discount rate
Trust		Loan type		Default		Recovery		CPR		Structural advisory fees		Residuals
NCSLT 2004-2		Private label		9.12	%	40	%	7	%	6.22	%	12	%
NCSLT 2004-1		Private label		8.76		40		7		6.22		12
NCSLT 2003		Private label		9.06		40		7		6.22		12
NCMSLT		Private label		8.08		40		7		6.22		12
NCT trusts		Private label		7.11		46		7		6.22		12
NCT trusts		GATE		23.23		47		4		6.22		12

 

In selecting loan performance assumptions, we consider the underlying creditworthiness of the student loan borrowers as well as the type of loans being securitized. We analyze creditworthiness in several tiers, and select appropriate loan performance assumptions based on these tiers. For example, approximately five percent of the loans securitized in NCSLT 2004-2, three percent of the loans securitized in NCSLT 2004-1 and four percent of the loans securitized in NCSLT 2003 represent a new product line offered beginning in fiscal 2003 by some of our private label clients. This new product line includes co-signed loans for which the co-signer has a Fair, Isaac and Company, or FICO, credit score between 625 and 644, which is lower than our other tiered products, which require a FICO score of 645 or above. We worked, in consultation with TERI and our bank clients, to structure and price this loan product to reflect its increased default risk. Accordingly, the interest rate being charged on these loans and the segregated reserves that TERI provided to NCSLT 2004-2, NCSLT 2004-1 and NCSLT 2003 to cover projected default exposure on these loans are greater than those provided for our clients’ other loan products. Although the inclusion of these new loans contributed to estimated overall default rates for NCSLT 2004-2, NCSLT 2004-1 and NCSLT 2003 that are 104 basis points, 68 basis points and 98 basis points higher, respectively, than what we estimated for NCMSLT, the average FICO score for loans in each of the trusts remained above 700.

 

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