Why I bought First Marblehead

First Marblehead is an out-sourcer of private student loans. In order to understand why I believe Wall Street undervalues this company, it's important to understand what a difficult asset private student loans are to value:

1. Student loans are not backed by an asset that can be repossessed and sold as are mortgages and car loans.
2. Borrowers often have no income or even credit histories.
3. Student loans do not normally need to be repaid until after the student graduates and enters the workforce.
4. Loans do not normally carry a pre-payment penalty.
5. Loans may take 20 to 25 years to be repaid in full.
6. Private student loans are not backed by a government guarantee, but must compete (at least indirectly) with state and federal government-backed loans.
7. There is great variation in the ability and willingness of students to repay their loans upon graduation.
8. Student loans are highly regulated.
9. Securitization is required for the original lenders to transfer student loans to investors.

These "borrower-friendly" loans (as First Marblehead's CEO calls them) present many difficulties to lenders who would like to enter the market. The only way to be comfortable issuing these loans is to gather a few years (at least 10, I'd imagine) of experience and borrower data. That is exactly what First Marblehead offers. It's important to understand that the company doesn't originate or guarantee any loans, but provide outsourcing to lenders so that they can establish there own "private label" student loan programs.

Currently, First Mablehead provides these services at or near cost, and in exchange, the loan originators agree that if they sell the loans, they do it through First Marblehead. The process of selling loans to investors, called securitization, can be complicated and risky, but banks are generally eager to transfer loans to third parties so that the proceeds may be reinvested. Again, FMD has many years of experience. Once the loans are sold to investors, the originating banks are generally free of them altogether.

If you are observant, you'll notice that so far First Marblehead can't make any profit since it provides services to lenders at cost. When it structures a loan secutization, First Marblehead creates a trust where lenders deposit loans and divides the into tranches with different risks and returns. If the underlying loans are paid off as scheduled, the junior tranches will earn substantial returns on investment. If many of the loans go bad or are paid early, the junior tranches may earn less than expected or even lose principle. Setting up and administering these trusts is a difficult and complicated task, so First Marblehead is able to change substantial fees for these services.

The bulk of the fees are paid upfront by the trust. In the most recent securitization, First Marblehead claimed 13% of the trust balance upfront. It also receives ongoing fees (~1%) and residuals (~5%) of the trust. The later fees are estimates of the present value over the life of the trust, so if the loans default or get paid early, the result could be much worse. Residuals are the most junior tranche in the trust, so in theory, First Marblehead takes the greatest risk and earns the greatest return.

The beauty of the First Marblehead model is that it requires very little upfront and ongoing capital expenses. Most of its value to customers arises from its borrower database, the expertise of its employees, and the strong history of its securitizations. The market for private student loans is growing so quickly, there isn't any need to spend money to expand operations. In my opinion, this investment is a bit like buying Oracle a the start of the internet revolution. As the market increases, lenders are going to be more interested in taking advantage of the intellectual property First Marblehead already owns.

Based on explosive earnings growth, it wouldn't be too surprising to find that First Marblehead is priced to perfection. But my DCF model suggests that the shares are fairly priced even if earnings remain level for the next ten years. Part of the problem seems to be that current earnings are somewhat uncertain since a large portion are estimates of future cash flows from residuals and ongoing fees. The flip-side is that the estimates might under-value these future cash-flows. So far, the estimates seem to be on the conservative side.

One concern is the possibility that lenders will decide to hold onto loans rather than securitize them. If that happens, there's no profit for First Marblehead and the lenders might develop their own borrower databases. This (and many other) concerns are addressed by an excellent analysis from Tom Brown. (To be honest, I never would have found this company without reading his website.)