First Marblehead

[tucker]

First Marblehead Corp (FMD)
Recent Price: $52.69
Revenue: $564mil
Market Cap: $3.32bil
EPS: $3.68
Shares Outstanding: 63mil
P/E: 14.32
Avg. Volume: 937,556
Dividend: $0.48
Book Value: $9.14
Yield: 0.94%


First Marblehead Corp is not itself a lender, but the company facilitates educational loans. The largest part of First Marblehead’s revenue comes from fees it charges to lenders, especially nonprofit TERI (The Educational Resources Institute), for helping those lenders manage their loan portfolios. However securitization of loans, essentially selling loan portfolios to private investors, has become increasingly important for First Marblehead over the past three years.

In addition to those mentioned in the Standard & Poors report that RainFrog partners received by email, there are a few important issues to consider with FMD. First, analyst enthusiasm for the company has waned over the past month, and analysts are now slightly bearish on the stock. The fundamentals of the company haven’t changed, and much of the sentiment change appears to be a valuation issue. The stock has risen from a low of $43.61 on August 2nd to a high of $54.89 on August 24th, a gain of more than 25% in less than 3 weeks. Although the attached S&P report maintains a 12-month price target of $59, the consensus target $50.75 is lower than the current trading price.

Another important factor with regard to First Marblehead is the company’s securitization schedule. Securitizations are huge events for First Marblehead and result in large profits. In the past the company has facilitated only two to four securitizations per year. The number and size of the securitizations the company will facilitate in the coming year will be an important determinant in earnings and thus in share price. Last year the company announced its securitization schedule on September 15th, and most investors expect a similar announcement in mid-September of this year. If this announcement looks favorable, the stock price could get a nice boost. However, if it doesn’t, the price could fall. This may create a potential for above average short-term gains in the stock, but also adds an element of volatility.

Finally, S&P mentions the potential reform of the US Higher Education Act (HEA) as a potential source of uncertainty for FMD. At this point, reform of educational finance in the US is probably a question of when rather than if. Recently lawmakers on both sides of the aisle have complained that the federal government’s subsidized loan programs are more expensive than government direct loans. Essentially, it costs taxpayers more to guarantee profits for educational lenders than it would cost for the government to simply make the same loans itself. As a result, there has been an increasing number of calls to end or reform the subsidized student loan programs. Currently the subsidized loan industry has powerful allies both on Capitol Hill and in the White House, but if public opinion continues to run in the direction it has been something will almost certainly have to be done in the next few years. This could turn out to be either good or bad for FMD. First Marblehead facilitates private rather than subsidized loans, and a check on subsidized loan programs could mean higher demand for private loans. On the other hand, an increase in federal direct loan programs could mean less business for the company.

Educational finance reform could create an interesting ethical dilemma for First Marblehead. On the one hand, private loans may be better for taxpayers than subsidized loans, and this is an incentive for ethical investors to support the private student loan industry. On the other hand, it would almost certainly serve both students and taxpayers best if the federal direct loan program were expanded, and this might cut into First Marblehead’s market. In this respect First Marblehead’s financial interests may not be perfectly aligned with those of students and taxpayers. To date, First Marblehead has concerned itself with its business and seems to have stayed clear of the politics that help define that business. If RainFrog invests in FMD, we will need to watch carefully to make sure this doesn’t change.

My pricing estimate for FMD is very close to that of S&P. The consensus 5-year growth estimate for the company is 20%, but I have discounted that to 16.5% to match the generally lower estimates for short-term growth over the next two years. Moreover, I use a conservative forward P/E of 11.5, which is on the low end of the range for near-competitors SLM and Student Loan Corp. Given this and the current dividend yield, a fair price could be close to $58.83.

[tucker]

RainFrog has held First Marblehead since September of 2006. In January of 2007, the stock touched an all-time (post-split) high of $57.56. Since then, the price has crumbled. While most financials suffered in 2007 first under rising interest rates and then in the growing subprime mortgage crisis, First Marblehead has suffered more than most. On January 5th, 2008, the stock closed at $13.41, more than 75% off of its record high a year before.

The pressures that have driven First Marblehead’s fall are certainly real. However, there is some question as to whether the market’s reaction to these factors may have been overblown. If so, RainFrog may wish to consider adding to its holdings at the current price. I have briefly summarized some of the major issues and challenges facing First Marblehead below so partners can begin to weight the risks and rewards associated with the stock.

The student loan industry started 2007 under pressure from an investigation by the New York Attorney General’s office. Several major lenders, most notably SLM Corp (Sallie Mae), were discovered to have unfairly obtained preferential treatment from colleges and universities at the expense of the students they claimed to be serving. While it was and remains unclear which or how many lenders may have been involved, the investigation pushed the entire industry into a downtrend. Although it had not yet been named in the investigation, First Marblehead followed its peers, shedding nearly 20% of its value by April 15th.

First Marblehead was subpoenaed by the New York Attorney General’s office on August 22nd. The company has cooperated with the investigation and to date has not been implicated in any wrongdoing. However, even if First Marblehead was not involved in the abuses that seemed to have plagued the student loan industry, the repercussions of the investigation can be expected to have a material effect on the company. Over the past year both state and federal agencies have tightened their regulation of the student loan industry. First Marblehead expects that increased compliance costs will weigh on future earnings, although neither the company nor independent analysts have attempted to quantify the effect. Moreover, if recent or future legislation changes the landscape of the student loan industry First Marblehead’s competitive position may be altered, and it is difficult to predict if, how much, or even the direction in which changes in the industry will affect earnings.

The next major bombshell to strike First Marblehead came on April 16th, when Sallie Mae announced that they had accepted a buyout offer from an investor group led by J.C. Flowers and Company. While a takeover usually causes all stocks in the industry to rise, the issue here was not the buyout but rather the members of the Flowers group. Under the proposed buyout, both J. P. Morgan Chase and Bank of America would take 24.9% shares of the privatized Sallie Mae. J. P. Morgan Chase and Bank of America are First Marblehead’s two largest clients, accounting for 29% and 15% of revenues in fiscal 2007. Many investors feared that the two companies would move some or all their student loan business from First Marblehead to Sallie Mae. FMD dropped 22% on the announcement.

The Sallie Mae buyout has since fallen through. The Flowers group argues that new legislation represents a material change in the industry and nullifies the buyout contract. Sallie Mae is suing for $900 million in termination fees, but Sallie Mae’s most recent earnings report seems to confirm the buyers’ argument and Sallie Mae will likely have to settle for less or possibly nothing at all. Moreover, Sallie Mae’s financial strength has suffered in the current lending climate, and the company has announced that it will slow lending in the coming quarter. This may indicate that First Marblehead will experience less rather than more competition in the near future. On the other hand, the market response to the attempted buyout underscores the fact that there are few barriers to entry into the student loan industry. While the immediate threat may be gone, it now seems that First Marblehead may be unable to maintain the near monopoly on private source student loan securitizations that they currently enjoy.

In the past First Marblehead’s main advantage has been its relationship with The Education Resources Institute (TERI), the non-profit organization that insures private student loans. As well as providing services to TERI, First Marblehead has benefited from exclusive access to TERI’s long-term data base on student loan default rates. This has allowed First Marblehead to more accurately assess the value of securitizations for its clients. However, other lenders have been developing their own data bases, and the information advantage may not be permanent. Moreover, on October 26th, FitchRatings downgraded TERI’s insurer financial strength from A+ to A and changed their outlook on the organization to negative. So far Fitch has maintained its ratings of First Marblehead’s TERI-backed securitizations, but reduced investor confidence in TERI’s backing is likely to reduce the value of future securitizations.

Finally, although First Marblehead has no direct exposure to the subprime mortgage crisis that has hammered other financials, the crisis has had an indirect effect on the company’s business. Families that are unable to make their mortgage payments will likely be unable to make student loan payments as well. While student loans are not dischargable in bankruptcy, that doesn’t mean those loans will be paid, and certainly doesn’t mean that they will be paid in a timely fashion. The number of loans in default in First Marblehead’s securitization has increased significantly this year, and investors fear that the worst is yet to come. A rising default rate will make it increasingly difficult for First Marblehead to make further securitizations. In fact, First Marblehead has announced that it will not make any securitizations in the first quarter of 2008, and analysts think it is unlikely that the company will be able to place a securitization before the September of 2009. Since the company draws 84% of revenues from securitizations, this almost certainly means a loss for the first three quarters and for fiscal 2008. The company has suspended dividend payments for the foreseeable future in order to conserve cash in the upcoming year.

For all of the reasons above, First Marblehead stock was soundly punished in 2006. However, recent positive news has at least temporarily lifted the stock from its low of $11.01. On December 21st, First Marblehead announced that the company would receive a cash infusion from Goldman Sachs. Under the agreement, Goldman Sachs will buy up to a 16.7% stake in the company for up to $260 million, and will offer a loan of up to $1 billion. The infusion may allow First Marblehead to self-fund its student loans until the market for securitizations improves, and thereby to avoid penalty payments of up to $50 million to its loan clients. Moreover, it has been suggested by some analysts that the increased capital may allow First Marlbehead to emerge from the current lending crisis as a stronger competitor in the student loan field.

Goldman Sachs will acquire its first 5.3 million shares of First Marblehead at $11.24, and up to 13.4 million more shares at $15. This suggests that both first Marblehead management and Goldman Sachs believe that the fair value of the shares falls somewhere in this range. The agreement prevents Goldman Sachs from selling the shares before June of 2009, which indicates that Goldman Sachs is willing to bet that shares will appreciate considerably in the 18 months following the cash infusion. Indeed, the market seems to have agreed, pushing shares up more than 66% to close at $18.70 on the day the Goldman Sachs deal was announced. Shares have since retreated to $13.41, which may represent a new buying opportunity.

There are reasons beyond the above to be concerned about First Marblehead. Rising interest rates or an increase in alternative sources for educational funding could negatively affect the company’s future performance. However, if we assume that the student loan industry will recover, it seems likely that the biggest questions to consider will be how much the landscape of the industry changes and how much new competition emerges from the current crisis. The possibility that First Marblehead will not survive in the new market is real. On the other hand, if the market returns to its something similar to its former state, a fair current value for First Marblehead might be in the low $30s, more than twice its current price. Moreover, First Marblehead shown itself to be an able competitor in the student loan industry, and it is possible that the company will emerge with a larger share of a market currently valued at $85 billion annually.

There is no doubt that First Marblhead is a high-risk investment, but at the current price the potential rewards may justify the risk. First Marblehead currently represents 1.28% of the RainFrog Growth Portfolio. Partners may wish to consider if, how much, and at what price the partnership should increase this position.