First Marblehead: Miracles Do Happen

| About: The First (FMD)

Monday’s news that Goldman Sachs Capital Partners would be completing its deal with First Marblehead (NYSE:FMD) should be viewed as a significant positive event for the company and its shareholders.  The deal is set to give First Marblehead $132.7M  in additional capital along with a much needed boost in credibility in the eyes of the credit and equity markets. 

While the deal took longer then expected and will likely not allow the company to return to its former business model anytime soon, it nevertheless leaves investors with hope that the company’s fortunes will begin to turn around in the first half of 2009. 

The deal itself gives Goldman Sachs a significant position in the company, although their voting power may never rise above 9.9%.  The majority of the firm’s stake will be in preferred convertible securities and the investment on average has a breakeven point of $15 dollars a share.  This figure is substantially above the stocks current price and has likely caused Goldman to recognize a substantial short-term loss.  For this reason, I expected the deal to not go through and I am greatly relieved that I was proven wrong.  The members of the Goldman Sachs team are without a doubt always some of the smartest guys in the room, so I am pleased that they are willing to sit out the short-term loss in favor of the potential for large long-term gains. 

Goldman could have easily fought the agreement and their unwillingness to do so speaks volumes about their opinion of First Marblehead and its potential to succeed once the credit markets thaw.  In addition, I believe that the closure of this deal sets a minimum for any potential buyout of the company.   

The deal, by my calculations, leavesFirst Marblehead with over $250M in cash and cash equivalents and $100M in short term investments, in addition to the value left in the company’s residuals and their wholly owned banks subsidiary, which I last talked about here.  Given the firm's $57M dollar loss this quarter, which reflects a $60M dollar loss relating to the reduction in the value of the company’s residuals, we are clearly looking at a company that has made many difficult choices over the past year in an effort to reduce its costs. 

The company has undoubtedly eliminated its large marketing budget and has scaled the company’s operations down to a level that reflects the current student loan market and the company’s reduced number of lending partners.  While losses are to be expected into 2009, I believe that the company will not have to do any subsequent equity offerings.  The company now has the ability to support well-secured student loans through its Astrive brand and a select group of regional banks who are still offering student loans to their customers.    

I believe that the deal was completed in part because the company agreed to bring back its co-founder, Dan Meyers.  While Mr. Meyers is taking no salary he has secured for himself a significant number of out of the money options that are exercisable once certain profit targets are met.  

The options give Mr. Meyers the right to 3 groupings of 2M shares each with exercise prices of $6, $12 and $16.  While this will dilute future earnings and greatly expand Mr. Meyers stake in the company, it was money well spent by the board of directors.  In requesting Mr. Meyers to return, Goldman has ensured that a man who redefined the privately sponsored student loan market will be running its investment.  He is the perfect man and quite possibly the only man capable of leading the company through the current period.  

In looking towards the future of the company, I still believe that the company’s wholly owned bank subsidiary will be incredibly important to the company’s future.  While the bank is currently barred from boosting the number of student loans in its portfolio by the Office of Thrift Supervision [OTS], I believe that the company now has the capability to provide the bank with the additional capital that it needs to convince the OTS to lift its ban on the bank.  An increased capital base would make it easier for the company to expand its deposit base through the use of brokered deposits.  These deposits, which could be facilitated by Goldman, would then subsequently allow the company to expand its student loan portfolio. 

Another possibility would be for the company to go out and acquire a beaten up bank or bank(s) with higher quality commercial loans and a large deposit base that would be capable of supporting additional student loans.  Such a transaction would diversify the bank’s loan portfolio, which would appease regulators, while at the same time giving the bank the resources that they need to continue to support First Marblehead’s student loan activities. 

As the loans age, they should begin to repay principal and interest in mass and with the average rate on the company’s current student loan portfolio in excess of 8% the bank should be able to generate significant net interest margins.  Overtime the bank ought to be able to ladder their portfolio so that it has a yield typical of a prime mortgage portfolio.        

By my calculations, First Marblehead could drop down all of its short-term investments, worth about $100M and spend $100 million going out and acquiring a handful of smaller deposit based lending institutions out of New England.  These transactions would boost the banks capital base to over $300M and give it the ability to support $3B in deposits and several billion dollars in student loans.  While there are regulatory risks to such an action, I strongly believe that the company could appease regulators by keeping a third of their loan portfolio in highly rated commercial loans. 

If the company were to undertake such a plan it is my opinion that the company would be worth somewhere north of $1 billion dollars after accounting for the bank at 2 times book value, First Marblehead’s remaining cash and cash equivalents and what is left of the company’s residuals.  In addition, a fully leveraged bank of the size outlined above could potentially have annual earnings of 30-60M dollars.  When this is coupled with the profits that First Marblehead could potentially generate from a return of the securitization business it is clear that the company is significantly undervalued. 

If management were to build towards a depositary model, while still keeping its securitization capabilities I would not be surprised at all to see the company post earnings within five years that would approach 450-500M dollars on an annual basis.  Such a figure, with dilution included, would support a stock price in excess of $75 dollars a share. 

In times like these, when companies like First Marblehead are faced with the obsolescence of their business models, it makes perfect sense for management to embark on radical change.  In founding First Marblehead, Mr. Meyers created a completely new category in consumer lending.  I would hope that in leading the company’s revival efforts that he has the foresight to revolutionize the very market in which his company participates.  Companies like CapitalSource (NYSE:CSE) are already leading the efforts to create specialty lending focused banks and I see no reason why First Marblehead can’t jump to the forefront of this exciting new area of finance.  

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