The First Marblehead Corp (FMD)

TMFInvestorpoet (93.26) Submitted: 7/10/07 11:33 AM : Start Price: $37.26 FMD Score: -60.92

First Marblehead basically underwrites, securitizes, and services private student loans. However, they do very little of this directly with students. They partner with schools, banks, and other entities that deal directly with students and their parents. These clients then outsource the underwriting to First Marblehead. The loan is then originated by the client. Then, First Marblehead will purchase these loans (usually at quite a premium to par value), bundle them, and securitize them. First Marblehead then provides servicing for the life of the loan.

First Marblehead and the College Board and Congressional Research Services estimate that there is a huge funding gap that currently exists in the secondary education market between government grants, government loans, and scholarships; and the actual costs of higher education. They estimate that this gap has grown to $122 billion per year. Private student loans are growing to fill this gap. Private student loans currently total 16.5% of student aid, but this source of funding is growing at a 29.5% annual rate. As tuition costs continue to climb and government funding remains relatively static, the market opportunity for private student loans will continue to grow. First Marblehead is a leader in this industry with 20% market share, and this continues to grow.

The company has effectively three sources of revenue:
# Gains on Sales of Securitizations (Structural & Advisory Fees)
# Booking of Expected Interest Income from Subordinate Bond Classes (Residuals)
# Servicing and Administrative Fees

First Marblehead generates significant gains on their securitizations, some in excess of 10% of the amount securitized. They can generate these gains due to their track record and their access to the TERI database. First Marblehead has over 20 years of history on prepayment rates and default rates, the two biggest factors in modeling future cash flows for securitization. Because of this, they can achieve favorable treatment from rating agencies and investors purchasing the asset-backed securities that the they issue. In addition, the company can book some of the future cash flows of the subordinate bond classes that they hold upon securitization based on some assumptions. If these assumptions prove conservative, First Marblehead can anticipate an additional cash stream from these subordinate bonds in the future. The reverse is also true, if prepayment and default rates rise above the company’s models, they will have to report this miss as a loss.

When running simple valuations, it is obvious that there is some serious bad news priced into this stock. The company is a leader in an industry that is growing at almost 30%, but they are not priced this way at all.

I start my valuation with owner earnings of $4.04 per share based on my estimates above. The growth rates that I’m using are part of the table below. After running cash flows out five years, I use a 0.80 PEG ratio applied to the growth rate for my reversionary P/E. I discount all these cash flows back at 10%. Looking at this valuation, the 0.80 PEG ratio stands out as being very conservative, but we have yet to see a market P/E ratio that in any way reflects this company’s growth rate.

The market seems to be pricing First Marblehead as if they are going to lose 20% of their business next year and then grow at a rate of 11% for five years. I think the most reasonable and conservative valuation assumes a 14% 5-year growth rate with a reversionary P/E of 11.2. This results in a value of $71 per share.

Trading ranges are less important in this scenario because this company seems to be mispriced by the market. The P/E range has been from about 9x to 19x earnings. This suggests a range of $36 to $77 per share. Based on this analysis, the stock is trading at the approximate bottom of the historical P/E range.

Report this Post Replies: 6 | Reply