Bear Case on First Marblehead Still Unconvincing

| About: The First (FMD)
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One of the great things about running a site like this is the negative feedback we occasionally get. It can be a wonderful reality check. Take, for instance, the following, which arrived on Wednesday:


While I don’t pretend to know First Marblehead (NYSE:FMD) as well as you, I do know it very well. I think their “output” is an awesome thing--helping kids go to college.

However, how do you not address the current land mines?

1. The securitization market is currently closed.

2. Thus, gain-on-sale margins have totally peaked out.

3. There’s the potential for a writedown, as Marblehead’s discount assumption on its residuals seems aggressive if the company can’t sell the BBBs. (Also, how about the company’s shadiness in avoiding the question of how many buyers there are of the BBBs? There’s just 1, Dillon Read, and it’s gone.)

4. While not expensive on a P/E basis, the stock trades at 3 times book value, including residuals. Nobody in his right mind should pay that.

5. There are no buyers that could take the company private, because it can’t lever up, and is losing its two largest clients in J.P. Morgan Chase (NYSE:JPM)and Bank of America (NYSE:BAC).

6. And then there’s the slimy factor: the company only disclosed the N.Y. A.G. subpoena because of the NYT article. They purposely omitted it from their 10K a few days before because they didn’t think it was a big deal. But because the NYT was going to break it, they disclosed it on a Friday before a long weekend the last day of August? Come on. . . .

I am not sure where this thing is going, but to give the bull case on Marblehead without highlighting these very material risks seems unfair.

The sender of the above is a fellow I’ll call “Bubba;” he covers financials for a large, well-known hedge fund here in New York that is said to be short First Marblehead. (I’ve cleaned up the message to fix the grammar and typos.)

I was pleased that Bubba was forthright enough to e-mail me, but was struck by how weak his objections to the company are. If this is what the Marblehead bears are left with by now, they're on shakier ground than I thought. Let’s go through Bubba’s points one at a time, and you’ll see what I mean:

1. The securitization market is currently closed.

Actually, the securitization markets aren’t closed. Just last week, NelNet completed a $1.5 billion deal. And Phoenix-based NextStudent is set to come to market next week with a $1.4 billion offering. Yes, the market has been disrupted and is challenging. That happens from time to time. But the disruption won’t last forever. It never does. In fact, I expect Marblehead will come to market with a deal of its own any day.

But even if the market were frozen solid, as Bubba seems to think, I still wouldn’t be too concerned. Granted, Bubba’s and my investment time horizons are different. I am a long-term investor and can wait these things out, while Bubba’s fund has a demonstrated record of being quite short-term oriented. A frozen market could be a disaster for Bubba. But unless the freeze lasts for years, Marblehead won’t have to change its business model an iota. As long as the company keeps facilitating loan volume at its current rapid (like, 40%-plus) rate at attractive spread to Treasuries, the company is creating a huge amount of economic value.

2. Gain-on-sale margins have totally peaked out.

Good Lord. Bears on Marblehead have been calling for margins to collapse since at least 2003—during which time margins have risen to 18% from 12%. Eventually, though, the bears will be right: margins will peak. They have to. So what? This fixation on margins to the exclusion of all other metrics (like, say, earnings per share growth) is idiotically myopic. It’s especially myopic, in my view, since the bears seem to refuse to take into account the margin expectation likely built into the stock’s valuation. With Marblehead lately trading at 7 times current-year earnings, the market apparently isn’t just looking for margins to decline a little bit; it’s looking for them to collapse. I don’t buy it.

In the meantime, lower gain-on-sale margins will not prevent First Marblehead from reporting earnings per share growth of 15% or more in fiscal (June) 2008, after a 59% E.P.S. rise in fiscal 2007. With Marblehead trading at a single-digit P/E as it is, it’s hard to see why the prospect of lower margins should be a compelling reason to be short the stock.

3. There’s the potential for a writedown, as Marblehead’s discount assumption on its residuals seems aggressive.

Bubba apparently doesn’t understand the difference between actual cash flow and the present-value accounting for future cash flows. Either that, or the details of the accounting arcana are more important to him than actual cash is.

First Marblehead assumes a discount rate of Libor plus 175 basis points in valuing the cash flows related to the BBB tranche of the student loans it securitizes. Given risk-phobia prevalent in the credit markets today, the company clearly can’t sell a BBB tranche at Libor plus 175. Who cares? The company doesn’t need the cash from the sale to run its business. (One of the biggest “problems” at Marblehead is figuring out how to deploy huge vats of free cash it’s generating as it is.) Besides, the market’s illiquidity won’t last forever. In the meantime, Marblehead can (and should) retain the BBB tranche. But changing the discount rate, up or down, doesn’t change the underlying excess cash flow the loans will eventually throw off.

4. While not expensive on a P/E basis, the stock trades at 3 times book value, including residuals. Nobody in his right mind should pay that.

Bubba, it’s hard for me to imagine how you could be more wrong. The people who’ve known the company longest and know it the best, like founder and former CEO Dan Meyers and board member and longtime fixed-income whiz Dort Cameron, would gladly purchase the First Marblehead’s residuals at the value the company holds them on its balance sheet.

Remember, these are very long-term assets (25 years), with the BBB residuals discounted at Libor plus 175. The other residuals, meanwhile, are being discounted at 13%! Bubba and the other short sellers, who believe that the residuals are either overvalued or outright worthless, will be scrambling when these supposedly overblown assets start throwing off rising levels of excess cash beginning in fiscal 2009.

More generally, book value just isn’t relevant to this company. Marblehead’s business model simply isn’t capital intensive. The company could even operate with a negative book value—which, come to think about it, J.C. Flowers plans to do with Sallie Mae should its deal ever close.

5. There are no buyers that could take the company private, because it can’t lever up and is losing its two largest clients in J.P. Morgan Chase and Bank of America.

First Marblehead can’t lever up? Why not? The company has $842 million in shareholders equity, and essentially nothing in the way of capital spending needs. (Capex will run just $27 million or so in fiscal 2008.) Marblehead is certainly not constrained by any capital requirement related to overcollateralization levels of its securitizations, since the rating agencies don’t require that Marblehead’s securitizations be overcollateralized in the first place.

The eventual departure of BofA and Chase, meanwhile, is a non-issue. The two companies have been of diminishing importance at Marblehead for years. Three years ago, they accounted for 65% of the company’s revenue. Last year, that had fallen to 41%; we estimate their share of revenues will fall again, to between 31% and 36% this fiscal year. Why, BofA isn’t even one of Marblehead’s “Big Two” anymore. The company’s in-house Astrive brand, which is considerably more profitable to Marblehead than BofA is, took that spot as of the fourth quarter of fiscal 2007. Astrive's revenues grew by 364% last fiscal year.

In addition to the growing importance of Marblehead’s internal brands, its non-top 2 clients are growing loan volumes at four times the pace of BofA and Chase.

Don’t forget, too, that the bears have been looking for the imminent departure of Chase and BofA for the past three years. (During which time, recall, Chase renewed its deal with the company through 2010.) Yes, the two will likely eventually leave at some point. But by the time that happens, Marblehead’s own brands and its other partners will more than make up for any lost business.

As for a sale of the company, First Marblehead’s board is just not interested given stock’s depressed price, the company’s record-setting performance, and the wave of excess cash that will begin to flow to the company in 2009. I don’t blame them.

I continue to believe First Marblehead has a great business model. (Notably, recent federal student loan legislation that had the bears so concerned has turned out to be a positive for Marblehead. First, student loan pricing should go up because federal lenders can no longer offer schools cut-rate private loans in return for their federal loan volume. In addition, the legislation didn't raise federal loan limits.) Macro demand for private student loans is strong and growing fast. The company has a durable competitive advantage in its ability to underwrite loans and tailor loan products for individual schools. What’s more, the company has done a great job of signing up new partners and developing its internal brands. Its earnings outlook is bright.

I also believe First Marblehead at today’s $32 stock price is exceptionally attractive. As noted, the stock trades at just 7 times current-year earnings. And the negative case on the company, if Bubba’s e-mail is an accurate and complete summary, just isn’t that strong.

Peter Lynch has two great quotes that summarizes some of my feelings about First Marblehead:

“Perhaps there’s some poetic justice in the fact that the stock you take the furthest in the long run gives you the most bumps and bruises along the way.”


“You need to find only a few good stocks to make a lifetime of investing worthwhile.”

Both those thoughts are relevant to First Marblehead. Yes, there have been some bumps and bruises. But by the time we’re done, I expect that this is one company that will have taken us a long, long way.

Tom Brown is head of