Circle of Competence

First Marblehead released their earnings for their FY 08 3Q (their fiscal years run summer to summer) on Thursday. As I expected, the numbers were not pretty, but I actually saw some things I like in there, and their balance sheet remains viable. Read my original take on First Marblehead here.

Here’s the Deal

First, the actual earnings: the company lost $229mm on a GAAP basis, compared to a $71mm profit last year in the same quarter. Like I said, ugly. The TERI bankruptcy forced them to write down the value of their residuals to the tune of $315mm on a pre-tax basis. Service receivables (the residuals) on their balance sheet declined from $809mm to $467mm YoY, putting their book value at March 31, 2007 at around $700mm.

If you remember from my last article, the Goldman Sachs equity capital infusion is limited to 25% of FMD’s book value, so based on these numbers the investment is going to cap at $173mm. According to management, there is approx. $162mm in unrestricted cash on the balance sheet and the Goldman investment, when completed, should bring that number up to $300mm.

With those cash numbers in mind, management said on the earnings call that with their newly announced cost reductions should put operating costs at an annual run-rate of $100mm. Great, right? Well, before we get excited, remember that those are just operating expenses – this number does not include loan origination costs at their bank subsidiary, as I mentioned in the last article. In order for them to continue originating student loans, FMD will really need to find a new warehouse line. Their existing one is about tapped, and the Goldman line that was promised is no longer available.

Looking at the bare-bones economics, FMD should have some sort of future revenue stream available to it; student loan originations are insane for them right now:

“Overall loan facilitation volume for the quarter was $1.25 billion up 23% over last year. The volume was significant given the underwriting changes. On a year-to-date basis volume was $4.7 billion up 37% over prior year.”

The question remains: how will FMD continue to fund these loans in a way that is economically beneficial? Right now, it is obvious that their funding costs are too high to allow them to make any real money originating and holding the student loans at their subsidiary bank. That is, the “spread” between their funding costs on the loans and the coupon the loans pay isn’t so hot as of now. This is a common problem with student lenders in this environment; but luckily for Sallie Mae the government seems to be coming around to a solution for originators of federally backed loans. No help for FMD; they only originate and sell private loans with no government backing, so no matter what the government does or doesn’t do, FMD is in a mighty pickle.

FMD (and other lenders) used to be able to get around this funding problem; once their warehousing lines got full they could package up the loans and sell ‘em off to Wall Street for a hefty profit. Problem is, lots of that “profit” was merely accounting profit; the present value of expected future streams of cash that FMD hadn’t yet received. They were victims to assumption bias, and the level of cash earnings was much less than reported earnings.

Now, we can sit and debate their assumptions on prepayment rates, defaults, and the like but it’ll do us no good: obviously FMD made some wrong assumptions. With all of the write downs in the past few quarters, and the bankruptcy by TERI, there is no doubt that the assumptions they originally made were off. Whether it was because they didn’t expect this credit disruption, or they just flat out were too optimistic, FMD overbooked earnings in previous years. Wish I had seen it then.

What to do?

So, what’s still there? The company has $500mm in loans held for sale, $467mm in residuals, and $291mm in cash on the balance sheet. Book value is $700mm. With a market cap around $350mm at this time, price to book is a mere 0.5. While cheap on a quantitative basis, that number can be misleading: FMD will never show a higher market value unless they begin to generate serious cash earnings.

Management talked a lot on the earnings call about the future, but most of it was hopeful and theoretical. They “want” to generate cash flow near term. They “plan” to be profitable long term. They are “selling” new structures to their remaining partners (major ones are RBS and Chase) in hopes of a securitization in the future. All these things sound great; but in the end the proof will be in the pudding and there’s no chocolatey goodness yet, folks.

The company has enough cash to function for another year or so, it looks like, so I continue to hold my investment. I’ve come to terms with the fact that even if the company begins to recover in the next year or so, and the stock rises, I’ll still be deeply underwater. If I had a personal balance sheet, I’d be marking down my FMD “asset” due to permanent capital impairment. With that said, I still believe future intrinsic value is higher than the current market value, and management has some options to create value. At $3.50-$4.00/ share you basically are getting a cheap call on future improvement. If you could wrap your head around the economics of the business, an investment at these prices wouldn’t be the worst idea in the world, although there is probably more certain payoffs out there right now.

Other Stuff

In other news, I began reading the Einhorn book I mentioned here. So far it is fantastic; everything I expected and more. I’ll be sure to get a review up in the next week.

I’m also planning to write up another financial company that I currently own, a name I have much, much more confidence in than FMD or any of my past forays into the financial arena. This is a company that sells credit default swaps on corporate bonds, and holds them to maturity. I’ll explain why that line of business is in its sweet spot right now, and the company that can (and has been) taking advantage of it. To top it off, the stock is cheaper than dirt. Stay tuned.

Lastly, Berkshire weekend was last week, and there are some fantastic transcripts of both the meeting and the Wesco meeting (held by Charlie Munger) up at Reflections on Value Investing, so check ‘em out.

Disclosure: I hold a position in FMD