First Marblehead: Multiple Uncertainties Hide Underpriced Stock

First Marblehead (FMD) helps lenders design and sell private student loans, then packages these loans into securities for sale in the secondary market. It is a deeply misunderstood company, facing multiple uncertainties and with a revenue stream that has a complicated accounting structure. Because of these factors, the strengths of First Marblehead have been ignored by the market, and the stock has sunk to a ridiculously underpriced level.

A prospective college student has 3 sources of funds to cover tuition. Low income students can apply for federal Pell grants, which do not have to be repaid. Students can also apply for government-subsidized student loans, securitized by firms such as Sallie Mae (SLM) and Nelnet (NNI), at below-market interest rates, with the loans guaranteed by the government. However, these loans are capped at $3500 to $5500 annually, which means students must often obtain additional private loans from banks to cover the full cost of tuition, currently running at an annual cost of $12000 for a public university, and $20000 for a private one. FMD has acquired the loan database of TERI, a non-profit organization that has guaranteed private student loans since 1985, and uses the proprietary database to help banks correctly price their student loans. FMD makes its money by aggregating student loans from different financial institutions into a securitization trust stamped with the guarantee of TERI and resold in the secondary market. FMD's primary competitors are Sallie Mae, and the Servus Corporation, a division of Wells Fargo (WFC), offering substantially the same services, both of which are much better capitalized than FMD.

FMD's business is plagued by multiple uncertainties. Firstly, its largest clients, Bank of America (BAC) and JPMorgan Chase (JPC), are currently trying to acquire Sallie Mae, and may subsequently securitize their student loans through Sallie Mae instead of FMD. Secondly, FMD has been earning what many analysts consider to be unsustainable large profit margins, and margin compression is widely expected to occur. Thirdly, the student loan industry is heavily regulated, and adverse regulation (e.g. Congress raising the annual caps on government-subsidized loans) may affect earnings.

Lastly, the subprime crisis which has paralyzed the ABS market may also affect the securitization of student loans. Further analysis will reveal that many of these uncertainties have been exaggerated, or have been resolved by recent events. While and BoA and JPC account for 15% and 29% of 2007 revenue respectively, JPC is unlikely to divert loans to SLM even if the acquisition goes through, as it has a long-term contract with FMD lasting till 2010. In fact, both BoA and JPC have asserted repeatedly that they do not intend to divert student loans to SLM if the acquisition closes, probably due to anti-trust concerns. The regulatory risk that borrowing caps on federal student loans will be increased has been resolved with the passing of the new student lending bill on Sep 7. The new bill slashed interest rates on government subsidized loans from 6.8% to 3.4%, and pays for the cost by eliminating 80% of the subsidies to lenders such as SLM and Nelnet. This is truly a spectacularly beneficial bill to FMD, since in one stroke it inflicts a lot of damage to FMD's primary competitor SLM and jeopardizes the SLM acquisition by BoA and JPC. As regards the danger of margin compression due to competition, I believe that competitive pressures on FMD have been overhyped. FMD underwrites a complicated long-term loan product that does not produce cash flow for 4 years (while the student is in college), and is very fragmented (possibly with different majors of study resulting in different default and prepayment rates), requiring a lot of information to price correctly. Small local banks in particular lack the information and the scale to resell student loans, and is likely to prefer FMD to SLM to avoid giving SLM more market power, as it already dominates the federal loan market. Even large banks which can muster together the information and the scale may elect to take advantage of FMD's established network of relationships with bankers, insurers, and the secondary market, as long as the FMD's profit margin remains reasonable. It should be noted that FMD has operated for years in the presence of much better capitalized competitors such as Sallie Mae and Servus, and that has not stopped its dramatic revenue and margin growth.

Therefore, I consider a dramatic collapse in margins in the near-future as extremely unlikely, though a gradual decrease of margins to more reasonable levels is probable.

Lastly, despite the moribund secondary market, FMD just completed one of its largest securitization trusts, a clear sign that the subprime crisis has not affected investors' appetite for FMD's product. Student loans are insured and guaranteed, are frequently co-signed by parents with excellent credit ratings, and represent a way to invest in the products of the world's greatest tertiary education system, in people who will command the world's highest salaries.

Finally, I would be remiss in not praising the FMD's excellent management. Recognizing the danger in excessive concentration of revenues, management acquired a bank in 2006, and used it as a vehicle to originate its own brand of student loans, named Astrive. Astrive carries higher margins compared to loans originated by client banks, and made up 4% of revenues in 2006, and 12% of revenues in 2007. Therefore, Astrive is now poised to overtake BoA as a source of revenue, and as a captive brand carrying higher margins, it will provide a stable source of revenue to FMD in the future. Management has compounded its excellent performance by using returning the excess cash the business provides to buy back shares at below intrinsic value, and issue dividends. Hence, management shows rational use of capital in both business operations and share buybacks, suggesting that excess cash will be returned to shareholders in a prompt manner in the future.

Understanding the accounting for this company is unfortunately a rather daunting task. The company has 3 main revenue streams from securitizations : 1) upfront fees, 2) additional fees over the life of the trust, and 3) residual interest. Both the additional fees and residual interest represent cash flow in the future over the life of the trust, but FMD discounts them to the present and books the present value as receivables on the balance sheet upon completion of securitization. A residual interest is paid out from the trust only after all interest has been paid out to debt holders in the upper tranches, therefore its present value depends on key assumptions such as prepayment rates, future interest rates, and default rates. The suitability of the rates used by FMD is essentially unknown to investors, since it depends on proprietary information, so there is concern that accounting has been overly aggressive and massive write-downs of assets already on the balance sheet will impact earnings in the future. Nonetheless, the assumptions used in discounting the residuals look reasonable to my untrained eye, and is broadly in line with the assumptions used by SLM. Unless one believes that the economy will deteriorate to the point where masses of college-educated middle class workers will be unable to make their student loan payments, sharp declines in the value of residuals appear unlikely.

Ironically, one of the main problems FMD has is its excessive margins. In 2007, FMD securitized loans worth $3.75B in principal and accrued interest (up 35% from 2006), and derived $457M in upfront fees (12%), $44M in additional fees (1.17%), and $182.7M in residuals (4.9%), for a whopping total of 18% in fees. By contrast, the bank gets only a 5% marketing fee from the securitization. Analysts have also compared FMD's margins to the margins in mortgage securitization (which is typically 9-10%), although this comparison is probably irrelevant since the two are securities with completely different characteristics (in terms of prepayment, default and interest rates).

However, it is likely that margins will come down in the future, and fees to banks may have to increase. To see how far fees will have to come down, it is instructive to look at FMD's latest securitization announced on Sep 20, with $2.04B in principal and accrued interest. In this securitization, FMD derived $176.9M in upfront fees (8.7%), $24.4M in additional fees (1.2%), and $105M in residuals (5.1%), or a total margin of 15%. Executed in the midst of the subprime crisis, the sheer size of this securitization indicate that student loan volume is still growing at a rapid clip, and the respectable margin achieved indicate that both banks and debt investors will accept these margins even under adverse circumstances.

The business model of FMD makes heavy use of IT and requires minimal capital expenditures to support increasing revenue, so almost all of its $35M cash and $800M in receivables on the balance sheet is excess assets not required in business. This means FMD is worth $0.37 in cash and $8.56 in receivables per share. FMD's running expenses are substantially covered by service fees charged to TERI and to banks, leaving the proceeds from securitizations as pure profit, therefore for the purposes of this discussion, we will assume that proceeds from securitizations are pure operating profit, and after a 40% income tax, becomes net income. Assuming that loan volume growth slows to 10%, and the margin remains at 15%, loans securitized in 2008 will come out at $4.12B, with $618M in ops earnings for FMD, which translates to $371 in net income, or $3.97 EPS.

Applying a discount rate of 10% on future cash flows which is growing at 10% yields a PE of 20. This means with no detrimental events, and with a dramatic leveling off of growth rates, FMD is worth about $88 per share. If all of the following adverse events occur: 1) BoA departs (15% hit to revenue), 2) margins shrink to 12.5% (banks now get 7.5% in marketing fees), 3) receivables value is halved to $400M, and 4) loan growth rate slow to 5% (I assume educational expense growth will always outpace inflation slightly in the near-future), the loan securitized in 2008 drops to $3.94B, and after the 15% hit from the departure of BoA becomes $3.35B. A 12.5% margin gives ops earnings of $418M, or net income of $251M, for an EPS of $2.69. Applying a discount rate of 10% to a future cash flow growing at 5% yields a PE ratio of 14, or a value of $37.66 due to cash flow. With the receivables valued halved to $4.28 per share, that gives FMD a very conservative value of about $42. Therefore, the intrinsic value of FMD is in the range of $42-$88 (not taking into account value added through share buyback shrinking share base), and we are currently below the lower end of that range.

In the final analysis, I think investing in education is perhaps one of the best investments one can make in a lifetime, and continued growth in demand for student loans and spiraling educational costs will fuel FMD's stock price for quite some time to come.

Disclosure: Author has a long position in FMD