First Marblehead: A Bull's Thorough Defense

| About: The First (FMD)

I recently read Catablast Media’s write-up on Seeking Alpha “First Marblehead’s Family Affair”, which made several bearish comments on First Marblehead Corporation. After analyzing each of the points, and taking the time to confer with a friend who also follows FMD closely, I decided it was necessary tocounter Catablast’s arguments, which I believe are superficial, outdated, or immaterial.
Here’s my response to each of Catablast’s points:

FMD “ostensibly” makes money by securitizing student loans for its customers. First of all, what does he mean by the fact that FMD "ostensibly" makes money by securitizing student loans? They do, it's a fact, and it's silly to deny it.

FMD is too complicated. I disagree. The company has three revenue sources: (1) cash upfront when they securitize a loan pool (i.e. structural advisory fees), (2) two forms of residual income that will start rolling in 5-6 years down the road once the loan pools are over funded (yes, they don't receive cash up front for those residuals, but all evidence that I’ve reviewed indicates they book the residuals conservatively and according to GAAP), and (3) a trickle of revenue from TERI reimbursements and servicing the loans. Folks, it simply isn’t that complicated!

Numbered Points:

1) Stiff competition and a lack of transparency.
My response: Sort of, but not really. First of all, I have no idea what Catablast means by saying SLM Corp. (NYSE:SLM) and Student Loan Corp. (STU) have better "transparency." All of the details of FMD's securitizations and economics are fully disclosed, just like SLM and STU. No company's disclosures are any better than another's.

As for stiff competition, SLM and STU are actually competitors with FMD's CLIENTS, not FMD directly. SLM already is, and has been for a long time, the biggest student loan lender out there, but they specialize in school channel loans. FMD works the direct-to-consumer [DTC] channel, mostly, and is stronger than anyone else in that area. FMD is smaller, but so what? Since when is bigger necessarily better? FMD has little credit and interest rate risk, a faster growth rate and higher returns on capital. I have nothing against SLM or STU, but I don't see how being bigger automatically implies they are stiff competition to FMD.

Also, I would point out four things: (1) FMD has been gaining market share every year since 2001 (you can independently verify this through College Board statistics), (2) unaided awareness of private student loans is only 7%, indicating a huge untapped market that's plenty big enough for all competitors, (3) even without increasing unaided awareness, the market is growing 20%+ per year, and (4) FMD's margins have been INCREASING over the past few years, not declining.

If the market is so terribly competitive, why aren't returns declining dramatically? The answer is that FMD has one of exactly two loan databases with significant underwriting history for these loans, and is one of two companies that can adequately price the product. Therefore, the market is probably more of a duopoly (SLM and FMD) or at worst an oligopoly. Either way, I like the competitive dynamics.

2) FMD’s customer list is highly concentrated. True and no one denies it. Let me begin by stating that I love this comment: "Last time we checked, JP Morgan was 30% of FMD's sales." Well, he must not have checked recently, because it's actually closer to 45% now that JPM owns Collegiate Funding Services Inc., one of FMD's former customers.

And sure, FMD’s customer concentration is high (for now), but both of their biggest clients just signed new deals. JP Morgan's deal is through 2010 and Bank of America’s is through 2007. It appears these banks see the value of FMD's services. Also, it should be noted that FMD is diversifying their client base. Their top three customers accounted for 65% of loan volume in fiscal '06, but will account for 55-60% in fiscal '07. Even if BofA and JPM do go away when their contracts expire, which isn't a given, FMD will have had plenty of time to make up for the lost revenue. This isn't just management-speak, either. Just this year they’ve signed up GE Consumer Finance, Regions Bank and KeyCorp (Key is already a major lender of private student loans) and they have a prospect list over 100 with 20 “hot prospects” that would likely generate at least $50 million in annual loan volume each.

3) FMD’s revenue recognition policy screams for attention. I guess FMD should be shorted for following GAAP. Sure, about 43% of their revenues are booked as residual receivables, but they are conservatively estimated based on prepayment and default expectations (using FMD's proprietary student loan database with over 20 years of history) and they are discounted at 12%. FMD will start collecting on these receivables 5-6 years after the loan pool is securitized. And keep in mind that FMD is expected to bring in $3 for every $1 of receivables booked. Even without collecting all that cash up front, the business model requires so little capital that they've been able to buy back shares, pay a dividend, grow the company substantially and still maintain a big pile of cash on the balance sheet...oh, and they don't have a dime of long-term debt. That means while any significant change in loan performance would impact profitability, the company is not put at risk in any material way. That's different than a bank – when its loans underperform, they still have lenders and depositors that must be made whole.

4) Gifting issue from last year and insider sales are cause for alarm. The gifting issue is old news and upon closer inspection, the insider sales aren’t that alarming. Anbinder, one of the big insiders selling, was going to leave anyway; it likely had nothing to do with the BofA issue. Also, based on my sources, the CEO wasn't swapping gifts to land deals – it was a romantic affair and the gift was an expensive watch. The CEO was promptly fired and the new CEO is an improvement over the old. He's a seasoned executive from KeyCorp, a large regional bank that has experience in private student lending as well (now a FMD customer, I might add).

As for insider sales, Anbinder is one of the founders, and he is likely selling now that he is no longer affiliated with the company. I look at that as basically cashing out of a great business you've built over time. I think Anbinder's making a mistake selling now, but it's his business, not mine. Anyway, he's no longer affiliated with the company, so I don't place any special merit on his sales. Hupalo's sales are likely just diversification and raising some cash, but do raise a red flag.

5) Allowing an insider’s firm to manage FMD’s money market funds. I’ll concede that this is a concern, but the amount actually benefiting the director’s family is immaterial in my opinion. The director in question is Dort Cameron III. Here’s his bio from the most recent proxy statement:

Dort A. Cameron III has served as a director since December 1995. Mr. Cameron is a private investor who has served as the Managing Member of the Airlie Group, a money management firm, since 1994. From 1993 to 2000, Mr. Cameron served as Chairman of Entex Information Services, Inc., a provider of distributed computing infrastructure services and hardware. In 2003, Mr. Cameron founded The Airlie Opportunity Capital Management, L.P., a registered investment advisor, which manages hedge funds that invest in stressed and distressed high yield debt markets. Mr. Cameron currently serves as a Trustee Emeritus of Middlebury College and serves on the Rippowam Cisqua School and Westchester Land Trust Boards. Mr. Cameron received an A.B. from Middlebury College.

Now, here’s more detail on the related party transaction noted by Catablast (also from the most recent proxy; emphasis added):

…Immediate family members of one of our directors, Dort A. Cameron III, indirectly own approximately 65% in the aggregate of the membership interests of Milestone Capital Management, LLC. As a result, these family members may receive a portion of the net income (after expenses), if any, that Milestone Capital Management, LLC distributes to its members. The aggregate amount of net revenues (before expenses) that Mr. Cameron’s family members could be entitled to receive in light of their membership interests during fiscal 2005 attributable to our average historical assets under management in the portfolio during fiscal 2005 was $52,192.

So let me get this straight. Here we have a person who is most likely independently wealthy, who does not appear to directly receive the benefit, and the amount in question is something less than $52,000 per year…and someone is going to tell me this is “how FMD’s friends and family pay the bills”? I don’t buy it. Sure, I’d rather there were no related transactions. But when you consider the nature of the relationship and the amount involved, it certainly doesn’t make me question the director’s independence nor does it lead me to believe this could be the next Enron.

Overall, this type of analysis helps explain why FMD is hated by so many investors. I believe many have failed to take the time to really dig into the company’s business model, risk profile and competitive position. A quick glance at FMD’s chart shows the bears have been on the wrong side of this trade:

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