Why I bought yet more First Marblehead

After the most recent First Marblehead release, the market gave me an offer I couldn't refuse. According to my calculations, the current liquidation or run-off value of the company is $9.80 a share. That number assumes shares will be diluted 20% according to the Goldman Sachs deal. Then I calculated a conservative guess of the company's value assuming it is able to return to some sort of stable business. I'm guessing the company is worth $38 or more if they are able to convert some of their loans on the balance sheet into earnings. Note that I'm not assuming they will get the same sort of securitization deals they received a year ago—just that they find buyers or financing to turn their loans into earnings at some point.

Personally, I think this whole crisis will blow over in a year or two and Marblehead and Sallie Mae will survive as a bunch of competitors will disappear. As survivors, their earnings power will dramatically increase and $38 will seem laughably cheap. But for the sake of argument, let's use that number. I also expect survival has a better than 90% chance, since Goldman Sachs has a stake in the company. But to prove the point, I'll assume the survival odds are 50%. My expected price, therefor, is $24 and my Kelly ratio is 39%. So I bought more shares at $14.95 to boost my First Marblehead position and reduce it's cost basis.

In my opinion, First Marblehead will be able to continue as a going concern whether or not it is able to securitize loans. Those loans will provide consistent, high-return cash flow to someone over the next few decades, so someone will buy them or finance Marblehead to keep them. It's not dissimilar from Microsoft shifting from selling shrink-wrap software to collecting service reviews. Either way they are selling something valuable and it's just a matter of how to collect profits. So this purchase is not a bet on the securitization market, but a bet on First Marblehead's business.

I think I understand the Goldman deal

After listening to the conference call and reading the press release and SEC documents, I think I understand the logic of First Marblehead's deal with Goldman Sachs. Recall that when I bought the company, it needed to securitize the loans it helped originate in order to make money. The banks that originally fund the loans only paid the cost of the loan processing in exchange for agreeing to securitize through First Marblehead. As a result, the business model was heavily backloaded and dependent on investors to buy asset-backed securities.

By the end of 2007, the market for all sorts of asset-backed securities had dried up to the point where First Marblehead was not able to sell the loans it helped originate. As a consequence, the banks originating the loans were able to start charging a penalty to Marblehead (a risk I did not fully understand). This left the company in a bind. It could stop originating loans until the market for them cleared up, losing ground to better capitalized companies. Or it could keep making loans hoping they could be sold before running out of capital. Neither choice was very palatable, though curtailing originations was clearly less risky.

Apparently, GS Capital Partners VI Fund, L.P. and First Marblehead "executed a confidentiality agreement, dated as of July 13, 2007", which means they had been considering some sort of deal for half a year. We can't know what the deal would have looked like at that point, but since the confidentiality agreement was signed by a "global, diversified fund dedicated to making privately negotiated equity investments" (according to its press release), we can be pretty sure it would have been a privately negotiated equity investments similar to the one that was finally agreed upon. Of course the terms would have been more favorable in July than they were in December.

It's possible First Marblehead saw the writing on the wall last summer and was ready to sell an equity share in order to get access to a warehouse facility like it got in December. That would open up options in the event secuitization stalled for a quarter or two. Alternatively, it might have facilitated keeping a portion of loans on the books for one reason or another. But there can be no doubt that what First Marblehead wanted, and what the Goldman Sachs fund could provide, was access to capital. So the plan was to begin shifting from the nearly capital-free business model to one that was more capital intensive.

I think the reason the Goldman deal did not go through during the summer is that it wouldn't have looked good to investors or to clients. Low capital requirements made the company a very attractive investment since cash flows could be diverted to dividends and buybacks. It also created an opportunities for First Marblehead's banking clients, who provided capital to originate the loans. So it would have been difficult to sell this deal in July when business looked pretty good.

By December, when it was clear the business was in trouble, the deal could be seen as a baleout, not a sellout. Whether or not it would have been better to just do the deal over the summer is water under the bridge—the real question is was it worth doing in the winter. And given the choice between stepping out of the student loan business or selling an equity share of the company to keep going, there is a strong case to be made for the later, especially if the plan was in the works already.

To make the case, let's look at First Marblehead's growth history:

Fiscal     2007    2006    2005    2004    2003    2002    2001    2000
Revenues  54.61%  34.83% 109.76% 118.11% 121.42% 511.06%  70.08%  72.38%
Earnings  57.37%  47.78% 112.12% 138.96% 157.58% 487.37%  

Now for the sake of argument, assume that without the deal, First Marblehead will lose money for a quarter or two (their Q2 and Q3), and then make enough in the final quarter to be flat on the year. Q1 revenue, which traditionally accounts for a third of the annual total, was up 24% and earnings were up almost 20% from the previous year, so this scenario seems possible. In 2009, we'll assume growth jumps back to 35%, so that earnings are up a total of 35% over two years. I made this scenario as aggressive as seemed reasonable, since it's the one I'm arguing against.

With the deal, we can assume loan volume growth will be close to the 35% we saw in 2006 because there's no evidence student borrowing is slowing down. Q2 will still be a losing quarter and depending on how the accounting works Q3 might be too. But when the market for ABS opens, First Marblehead will have a lot of inventory saved up. We don't know exactly when securitization might start up again, but let's suppose it takes through the end of 2009 to work through the backlog. Two years of 35% growth works out to about 82% total growth compared to 35% without the deal.

Presumably, the securitizations will be less profitable with the deal, because warehousing the loans racks up interest charges. And of course, you have to factor in the 20% share of the company First Marblehead needed to give up. Obviously, there are risks added as well. But its hard to argue against diluting shares 20% over two years to get 47% better growth over the same period.

2007 Year in review

On the last day of 2007, my IRA ended the year down 13.3%, which was the first down year I've had and substantially worse than my benchmarks, the S&P 500 and Berkshire Hathaway. These things happen and especially with an ultra-concentrated portfolio. Here are my core positions:

Stock               2007 Return
-----               -----------
Alberto-Culver      20.83%
Berkshire Hathaway  29.19%
Canon              -17.74%
First Marblehead   -87.43%
Oracle              34.23%
Sally Beauty        16.03%
Select Comfort     -57.70%

Select Comfort has been the biggest disappointment of my short investment career. I certainly misjudged the business though I still think my initial purchase was a good decision. I now believe my follow-on purchase last year was a mistake, because I did not recognize the danger of air mattresses becoming a commodity. Select Comfort is built from the ground up to be a specialty bedding company, so if it ever needs to compete on price, quality and service alone, it must be revalued. That said, I think the current price is actually less than what the company would be worth as a commodity manufacturer. So any future turn-around comes as a free option at prices less than about $7 a share. As I mentioned when I made my third purchase, I plan to aggressively sell covered call options until the future becomes more clear.

First Marblehead has always looked stunningly cheap to me. Incredibly, the price has dropped to just over book value because of worsening conditions in the student loan paper market. Basically the market assumed for a while that the company would just close up shop. Since the supply (or from the perspective of students, the demand) of private student loans is growing at breakneck speed, walking away from the business would be crazy. Instead, First Marblehead has entered into an agreement with Goldman Sachs that will allow it to hold the loans it currently sells off in exchange for nearly 17% of the company's equity. I haven't had time to dig into the details of the deal yet, but it does seem like First Marblehead simultaneously removed short-term risk, reshaped its business model, and bought a powerful ally with a vested interest in its success. Buying more shares is a definite possibility, though I don't like the message sent by the dividend cut.

Canon became cheaper in part because of a delayed entry into the TV business due to patent problems. In the meantime, the company's core camera and printer products have sold well and profitably, and it is working on other entries into the display business. The dividend for 2007 was raised another 10% without seriously eating into cash flows. Canon's dividend is important because it is a signal from management that the business is doing well and it provides me with another reason to keep holding. Based solely on the dividend, Canon is trading below its fair value.

Outside of these three stocks, my investments performed quite well. Unfortunately, my losers made up a larger portion of the portfolio than the winners did. Options and arbitrage transactions worked extremely well for me on the whole, but I'd have to dramatically increase my trading activity to come close to making up for any one of the losing positions. On the other hand, my returns would undeniably be worse without these small, short-term, trading successes. Along the same lines, Alberto-Culver helped, but is a portion of my portfolio too tiny to profitably sell. Its performance barely matters.

Sally Beauty meets my current expectations. Everything seems quiet at the moment, but that will change as the company pays down debt and the restrictions on insider sales expire over the next year or so. I'm contemplating increasing my exposure in what amounts to a publicly-traded, private-equity investment (if you can imagine).

I'm in the process of wishing Oracle, my first and most successful investment, a fond farewell. On an annualized basis, my return on shares sold in 2007 has been over 20%. I've decided to end this investment because I believe the company is trading at a fair value. For the last few months it seems that Larry Ellison agrees with me as he has been exercising options for and selling a million shares a day. He has plenty of shares left to keep his financial future firmly tied to the company he founded, but I'm guessing he is more excited about other investments such as NetSuite. I'll keep my eye on the price in case it falls below its fair value again, however.

Berkshire Hathaway remains the anchor of my portfolio for the foreseeable future. This year will almost certainly be the moment when the company can finally use its dry powder. There are certainly plenty of quality assets available for pennies on the dollar due to "lack of liquidity" (i.e., over-leveraged entities that can no longer refinance). No doubt we will see some buys in the months to come.

Perhaps I'm foolish, but I feel fairly optimistic about 2008. Besides Select Comfort, the portfolio has improved financially and the businesses are stronger than ever. I have no urgency to sell until the future becomes clear, so the market price isn't all that important in the short run. Further, lower prices for stocks in general ought to present me with better opportunities for future purchases.