Both Bank of America (NYSE:BAC) and J.P. Morgan Chase (NYSE:JPM) have shouted themselves hoarse over the past few weeks insisting that, no, they don’t plan any changes to their student lending operations once their deal to acquire 49% of Sallie Mae closes. Which is to say, they’re going to keep on originating loans via First Marblehead (NYSE:FMD) the way they always have.
This is of more than passing interest to Marblehead investors. BofA and Chase, recall, will account for 44% of the company’s revenues this fiscal year. A lot of people assume that once they close on their Sallie stake, they’ll pull their private student lending business from Marblehead and run it through Sallie, instead.
I happen to take the banks’ statements at face value--not least because it looks like sticking with Marblehead would be their best move financially. But let’s suppose for a minute that the skeptics are right, and BofA and Chase dump Marblehead. What then?
News flash: the world wouldn’t end. From what I can tell, in fact, Marblehead’s business would barely skip a beat. The company would still be highly profitable and generate very rapid earnings growth. More to the point, it would still nearly meet the out-year consensus earnings estimates the Street has set for it.
Let’s look at some numbers, and you’ll see what I mean. First, we’ll make the following assumptions:
1. Annual revenue growth from partners other than BofA and Chase decelerates from the 100%-plus it’s been in the past three years to something like 20% by fiscal 2012.
2. Operating margin declines to 80% by fiscal 2012, from 87% in 2007. This is driven by increased marketing cost as the company moves to originate on its own, as well as declining loan margins.
3. “Other income” listed below is simply the whole loan fees (I assumed 4%) Marblehead receives for facilitating loans in-house under its “Astrive” brand. (I assume 55% growth in Astrive in fiscal 2008, declining to 25% growth in 2012)
4. No share buybacks--despite the fact that all of the after-tax income would be excess capital. Cash would simply pile up.
OK? Now, remember that the fiscal 2009 consensus is $4.43. Now, the pro forma numbers, without BofA and Chase:
So even if the worst happens and both BofA and Chase skedaddle, the effect on Marblehead’s earnings, vs. current expectations, would consist of an earnings miss next fiscal year, when the company would figure to earn $3.03 per share rather than the $4.01 the Street has penciled in. But by fiscal 2009, earnings would (again, using the assumptions above) likely be close to expectations. According to my numbers, the company would generate average annual earnings per share growth of 31% between now and 2012--without BofA and Chase.
(And don’t forget, too, that this is a worst-case hypothetical. Chase’s contract with Marblehead runs through 2010, and commits the Chase to spending a meaningful amount annually on marketing Marblehead-facilitated loans.)
In any event, this would all imply that by 2012, Marblehead has roughly 14% market share (including 3% for Astrive) of the entire private loan market, assuming the market grows by 22.5% per year. That definitely seems reasonable, given that the company will have roughly 8% share this year, ex BofA and Chase, and that the other partners are growing much faster (like nearly six times) than those two.
Oh, and the company’s stock is lately trading at 9.7 times earnings for the year that ends in three weeks. That’s a 9.7 earnings multiple for a company that is expected to be growing at 31% annually for the next five years--without BofA and Chase. Also, don’t forget all the excess cash the company will be generating (both from earnings and as its residuals start to throw off cash) that can be used to pay dividends and buy back stock between now and 2012.
What was the problem, again?
Disclosure: Author has a position in FMD
FMD 1-yr chart
Tom Brown is head of BankStocks.com.