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The First Marblehead bears’ fondest dreams came true last week when the company wrote down the value of the residuals that sit on its balance sheet. Back in the good old days, during the Golden Age of gain-on-sale accounting hijinks in the 1990s, that would have been enough to lay the stock out flat on its back. I even got a few I-told-you-so emails from nostalgics after the company’s conference call. (“When gain on sale companies start to pull nonsense like that, it’s the beginning of the end!”) And sure enough, the notes from the sell-side were all atwitter. The reaction of FBR’s Matt Snowling was typical: “We are reiterating our Underperform rating, and are lowering our 12-month target by $10 to $33 until we can gain further clarity into the fallout of the [acquisition of competitor Sallie Mae] and the impact of prepayments going forward.”

Once again, Snowling is being overly excitable. In fact, Marblehead’s quarter was extremely strong. (I’ll get to the details in a minute.) And yet the Matt Snowlings of the world continue to be transfixed by their own fantasies about Marblehead that have nothing to do with the long-term value of the business.

About that residual writedown, for instance. Marblehead made the move after it boosted the assumed payment rate on its loans to 8%, from 7%, and cut the assumed discount rate to 11.52% from 12%. Neither action should come as a surprise. Prepays have been running somewhat higher than the company initially expected, in large measure because the flat yield curve has, at the margin, made variable-into-fixed refinancings into longer-term consolidation loans a marginally economic proposition for certain borrowers. As for the discount rate cut, the rate on the company’s sale of a BBB tranche in recent securitizations helped provide a more accurate (i.e., market-determined) number to replace Marblehead’s earlier assumption. The assumed discount rate on lower rated residuals stayed at 13%. None of these moves were momentous or unreasonable. Regardless, given the current, single-digit interest rate environment, an 11.52% assumed discount rate strikes me as exceedingly conservative.

And yet it’s all put Snowling in semi-hysterics. “We lack any confidence the [the writedown] will be enough,” he wrote in a note on Friday. “Management indicated that prepayment activity was more a function of the inverted yield curve [which it is --TKB], while our research suggests the problem goes beyond the rate environment, and the advent of competing private consolidation loans are a factor—something that a steeper yield curve will not rectify.”

Which part of his research suggests that “the problem goes beyond the rate environment”, Snowling doesn’t say. In fact, he’s simply accusing management of lying. In the real world, figuring out the economics of loan consolidation under a variety of interest rate environments isn’t difficult. It’s fair to say that if consolidations aren’t booming in now, when the curve’s flat, they never will. And yet even under current environment, the change Marblehead made was minimal.

In the meantime, the quarterly results that the company reported last week were extraordinarily strong. Customer concentration is coming down fast, and the company’s proprietary Astrive test is booming. Volumes are soaring. The company continues to sign up new lending partners at a rapid rate.

The numbers: First Marblehead reported fiscal third quarter results of 76 cents per share, up 23% from a year ago. Total loan facilitations rose by 24%, to $872 million. Year-on-year growth in the (relatively more profitable) direct-to-consumer channel was 39%. School channel growth was 8%. All these numbers looked good.

Astrive going gangbusters

As I mentioned earlier, Marblehead’s in-house test Astrive brand has gained considerable momentum. So far in fiscal 2007, Astrive has accounted for roughly 10% of facilitations; that implies it’s done roughly $300 million year-to-date, and will finish the year at around $375 million. By my reckoning, that would make Astrive bigger than Bank of America for Marblehead in the direct-to-consumer channel. Recall, too, that this is extremely profitable business, since Marblehead doesn’t have to pay out a whole loan premium to a lending partner.

The emergence of Marblehead’s Astrive business in the past few years is highly significant, in my view. Ever since we started talking about this company, the skeptics have worried that Marblehead would be toast if BofA and Chase ever severed their relationships with it. In fact, that hasn’t happened; both BofA and Chase have continued to grow their business with Marblehead very rapidly. And yet at the same time, Marblehead has been able to build up its in-house Astrive brand, from basically zero three years ago, into a business that now generates earnings that rival the earnings Marblehead gets from those same worrisome Big Two. Tell me again how reliant the company is on them?

Client concentration down

Along that line, BofA and Chase accounted for just 44% of revenues this past quarter. That’s down from 52% last year. The number should almost surely continue to decline given the rate the company is adding new partners. In particular, Marblehead signed 12 new partners during the quarter. Management indicated one was a large consumer finance company, while the balance were banks, credit unions, and affinity groups. Additionally, the company extended or expanded relationships with eleven existing partners.

Revenues from its other partners excluding BofA and Chase and TERI are growing very, very fast. Take a look:

FMD chart

And that's why I really don't get all this hub-bub surrounding First Marblehead's business with Chase and BofA when revenues from its other partners are growing more than 100%!

Impact of the prepayment increase

In all, last quarter’s results were the picture of a company that’s shooting the lights out. Yet the bears insist on details that are beside the point. The long-term earnings effect of that writedown, for instance, is nearly immaterial. Marblehead’s DTC residual margins should fall by 40 basis points as a result of it, on a base of around 470 bps, while school channel margins should come down 10 bps. Inasmuch as some margin compression is universally expected at Marblehead anyway, this can hardly come as a shock. Nor should the move significantly affect long-term cash flows. Marblehead’s residuals are still set to start generating cash in 2008 or 2009. And that cash flow should be enormous. By my calculation, the company should receive roughly $3 in cash for every $1 it has reported in residual income.

In the meantime, if Snowling is kidding himself about Marblehead’s writedown, he’s positively delusional about the effect that Sallie Mae’s privatization will have on the company. “We believe much of the economic rationale for [Chase and BofA’s decision to acquire roughly 50% of Sallie] was dependent on shifting part of the fees away from the First Marblehead [sic] to the banks or to Sallie Mae,” he writes. But that’s nutty. With just a 25% stake in the Sallie venture each, BofA and Chase would retain just 25 cents on the dollar of any earnings from private lending they pull from Marblehead and run through Sallie. As things stand now, they get to keep the whole dollar, ex the 18 cents or so they pay in fees to Marblehead. That’s nobody’s idea of a smart deal, in my view. Which is one reason why we take BofA and Chase at their word when they say that their existing student lending practices won’t change. Based on the numbers, it should be obvious. Why Snowling doesn’t get this, I can’t understand.

I’ve given up on waiting for Snowling’s views on Marblehead to square with the obvious realities of the company’s fundamentals. As it is, the company is set to report a 58% increase in earnings per share in fiscal (June) 2007, on top of a 54% rise in 2006. There is no sign of slowing of growth in demand for higher education, or colleges’ pricing power. Marblehead has a clear sustainable competitive advantage in the higher-education finance business, yet its stock trades at just 9 times current-year earnings. Why the bears on the stock don’t get all this I don’t know. Heaven help them.

Disclosure: We have a position in FMD

Source: First Marblehead Reports Terrific Quarter; Bears Missing The Boat