altidude

FBR's Latest First Marblehead Downgrade Makes No Sense

Well, FIG, it'll be interesting to see where this is in a year's time. I'm personally less concerned about FMD missing a securitization this quarter and more interested in its prospects to maintain a profitable business going forward, which I feel are much better than the market seems to be implying at $14 per share. Count me in the bullish camp.

FBR's Latest First Marblehead Downgrade Makes No Sense

FIG, I did like it at $35 and do think it looks like (even more of) a bargain here (below $15 now). Market cap is $1.4bn.

FMD had $163mn in net cash plus $1.14bn in Loans held for sale and Service Receivables (although that book value is potentially overstated) on its last quarterly balance sheet. It's pretax cash profits were $106mn and $135mn in 2005 and 2006. (Pretax cash profits in 2007 were $370mn, but they benefited from BBB-rated tranches in the securitization trusts that are no longer saleable at similar prices.) FMD had another $168mn and $241mn in pretax profit from non-cash revenue in 2005 and 2006. These are financials that seem to be able to support a market cap much higher than $1.4bn, IF the future looks like even a small fraction of the past.

FIG, do you think the securitization market is gone forever for FMD? Or, do you think it will remain a viable way for FMD to monetize its business? And do you have a view on a "fair" price for FMD's shares today?

I've enjoyed reading your posts (both here and on your blog). Would love to hear your thoughts on a "reasonable" price today, if you think it's worth "doing more homework".

First Marblehead Unfairly Battered

If anyone's interested, I tried to put some numbers to FMD to come up with a valuation. I posted my thoughts here:
seekingalpha.com/artic...

FBR's Latest First Marblehead Downgrade Makes No Sense

I guess I'm still not buying the bear case here.

Until FMD's recent inability to securitize its loans, the firm never showed any chinks in its business armour. On the contrary, cash profits (i.e., when you totally ignore the effect of non-cash revenue from the income statement) have been growing nicely for the past 5 years, hitting $370mn (pretax) in 2007, up from $19mn in 2003.

As for its inability to securitize loans this quarter, that is a concern. But--to me--it's a slight one right now. I wouldn't expect them to do a new securitization when a ratings agency has some of their past debt tranches under review. We'll see if FMD can close a securitization when that review is over. If not, that would be a serious concern, unless it is able to monetize its business in other ways.

As for the ratings agencies, Fitch's has recently reiterated its ratings on FMD's various tranches of debt and Moody's has (I believe) just the non-AAA tranches under review. Well, those non-AAA tranches traditionally represent about 12% or 13% of the value of the private student loans securitized. The vast majority of the tranches are AAA rated, and those are not under review. So, it seems that the vast majority of FMD's securitization debt financing is solid.

Even if Moody's perceives a problem with the non-AAA rated tranches, it looks to me like FMD has the financial wherewithal to effectively address any potential concerns. FMD's cash profits (again, that's cold hard cash, ignoring the effect of non-cash revenue) have generally amounted to about 5% of the value of the private student loans it has securitized in any given quarter / year. So, one way to alleviate any potential concerns might be to use some of that money and provide an extra cash cushion in the trusts. If FMD provided an extra 3% cash cushion in the trusts, would that alleviate potential concerns of the non-AAA bond holders? (That would be an additional 3% relative to the non-AAA bonds that represent about 12% or 13% of the private loans, so that extra cash cushion would amount to about 25% of the total value of those loans in the trust! That seems pretty substantial.) I'd point out that if FMD did this, they might get that 3% out on the back end of the trusts, provided the student loans performed as they expected.

Furthermore, it seems to me that if FMD received feedback (from the ratings agencies, debt investors, or the student loan performance) that they weren't making profitable loans, it seems like they could just change their underwriting criteria. Jack up the interest rates on any "problem" borrows for future loans they make. Or just don't loan to them at all. FMD controls the underwriting (with TERI), so they can just change the criteria to avoid the "problems" in future securitizations.

As for putting numbers on a valuation, here are my major assumptions:
DCF model
Average volume growth over next 8 years of 17% annually (incorporates loss of BofA and JPM at current contract ends, roughly 20% industry volume growth otherwise, and 35% volume growth in 2008)
Upfront fee yields dropping to 4.8% for all future securitizations (represents additional 3% cash cushion left in the trusts--and this 4.8% yield is relative to 7.8% achieved in 2006 and 8.7% achieved in September 2007 securitization)
Residual yield of 1.3% for all future securitizations (relative to 6.5% in 2006 and 5.8% in September 2007 securitization)
Balance sheet residuals of $800 million are worth only $96 million in real economic value (i.e., haircut of 80% and then after tax)
Expenses growing 30% in 2008 and then growing with rate of revenue growth thereafter
Balance sheet cash value of $237.5 million
Discount rate of 10%

Using these assumptions, I'm getting a no-growth value (based on projected 2008 results) of $20 per share. I get a value of $35 per share using an 8-year forecast. And I think FMD stands a very good chance of significantly overachieving these assumptions.

Of course this assumes that FMD has a viable business, it will be able to conduct future securitizations on reasonable terms (i.e., leaving an extra 3% cash cushion in the trusts), and will continue to operate indefinitely.

But based on this information, it looks like FMD is a bargain at today's $18 per share.

First Marblehead: Worth $10 or $60?

FMD has $3+ per share in net cash on the BS, and--even with your suggested (minimum) 12% haircut for their residuals--another $8-$9 per share (maybe $5-$6 after tax) there. So, $10 seems like a liquidation-type downside.

Also, their latest securitization came during the doldrums of the credit crunch in September, yet they exceeded expectations regarding the size of the deal and the yields they received. (Consensus analyst expectations were consistently revised upward after FMD released its preliminary deal size and fee estimates.)

While prepayment risk in the trusts is a concern, the debt is generally floating rate, so I wouldn't think the debt investors in those trust are too concerned about reinvestment risk anyway. (Of course, prepayments could lower FMD's residual takes.) And, for the average student loan in the trust to be worthless, you'd need to see the student default, then the co-signors, then TERI (which guarantees the loans).

Also, as regards undercollateralization of the trusts, this "seems" (to me) to be worse than it is, as the loans generally acrue non-cash interest while the kid is in school. This non-cash interest gets applied to the loan balance. So, the undercollateralization rectifies itself reasonably quickly, as the non-cash interest increases the size of the trust assets relative to liabilities.

I'd put a no-growth value on FMD's FY07 results at about $45-$50 per share. And that's a no-growth assumption in the private student loan industry, which will benefit seemingly indefinitely from the 1) increased demand for higher education; 2) large and growing funding gap between federal assistance and the actual cost of higher-level education; and 3) higher-level education inflation, which has been (and looks to continue) growing significantly faster than personal incomes.

FMD is a high-growth business being valued like it's going out of business. I just don't see that happening. (And we haven't even discussed its plans to use its connections with students to offer other financial products like banking services, insurance, credit cards, etc. to further leverage its processing infrastructure and connections with students.)

Needless to say, I'm long FMD.