Tuesday, December 12, 2006

The bear case on First MarbleHead (FMD)

We've identified FMD as one of the most expensive stocks in the financial services sector, based on the implied ROE as suggested by the current price/book valuation of 7.3, the reported smoothed ROE, and the predictability (or lack of) in the earnings stream going forward. As usual, obtaining excess returns is feasible over a relatively short period of time, but by and large, there are no real barriers to entries in FMD's student loan advisory and securitization business model. And we would expect this to be recognized by market participants over the next few years. And even if we assume above average ROE's through 2008/2009, the stock would still appear to be 30% overvalued under current ideal interest rate conditions (i.e mid-, intermediate and long term rates below 5%) and economic conditions. Under less favorable conditions (say yield curve shifts upwards 50 basis points), another 20% to 25% could be clipped off the price/book valuation. For now, we assume the degradation in the ROE will be a more gradual process, with the returns falling from the 2004-2006 avaergae of approximately 45% to the mid to high twenties by 2008/2009 (versus 30% for consensus), and the price/book to closer to 3 times book.
How does Wall Street's view differ? To be honest, few are raging bulls (except for Think Equity Partners). But the others (Goldman, FBR, and JPM, Bear Stearns, UBS) though not bullish, can't seem to get a grip around why they the stock is so awfully expensive, and have limped in with neutral or hold ratings, despite expectations of a decline in the ROE to 30% by 2008. But they provide no explanation as to what the current valuation implies in terms of expectations of future earnings, returns on capital, margins, or for that matter the whole business model. This is a flat out sell, the sooner the better. Trading momentum stocks is one thing, buying on the basis of discounted earnings and cash flow is another. As a veteran watcher of financial stocks, this implosion of this stock is a "When" not "if". For those who may have been burned already by the run up, rest assured that it has less to do with company specifics, and more to do with demand for financial stocks; That firepower seems to show no signs of letting up, so a long short pair trade (say long FRE short FMD) may be the best way to play this thing until technically the stock finally breaks.


e_alexander said...

You say few analysts are raging bulls, however, you missed one of the biggest bulls, Tom Brown (I get that he has talking his book, but his reasons for owning the stock are well written and sensible, unlike your thin points that are tough to back up).

But how about this comment from a Bankstocks.com article recently published by Tom Brown, "Banks are willing to pay Marblehead all these fees, by the way, because private student loans can be ridiculously hazardous to underwrite. It’s not hard to imagine why, either. The borrower is usually a college undergraduate, with no income, no assets, and not much in the way of a credit history. Further, by the terms of the loans he doesn’t need to begin repayment until after he’s graduated, which may be up to five years in the future. The loans themselves carry very long terms (like, 20 years), but aren’t backed by collateral.

If you think the risk of default can be high in a situation like this, you’re right. But Marblehead, just about alone in the industry, knows how to make money at it. The secret to its success: a proprietary database that contains 20 years’ worth of payment histories of student borrowers. Understanding past student borrowers’ behavior allows the company to profitably underwrite would-be borrowers now."

I agree with him on these points and they seem to displace your "there are really no barriers to entry" argument.

I am going with over 25 years of investment experience, and have done so since 12/15/05 (Long FMD).

mytime2025 said...

Just how short are you on this stock? Your blog on FMD sounds like it was written by a short hedge fund.

Messenger said...

There are huge barriers to entry, if not, why havent FMD clones been popping up left and right, or why arent large loan originators doing it themselves? Places like JPM and BAC are very sophisticated financial services firms, and yet even they havent bothered to create a captive FMD.

Here's the problem. If for example, JPM decides they're going to do this in-house, who's going to do business with them? Do you think BAC or KEY is going to sign up with a competitor as opposed to FMD? Nope...not unless the pricing offered by JPM was substantially better, in which case, what's the point of JPM doing this at all? So these banks would have to calculate the economics just on the loans that they themselves would securitize and nothing else. All the sudden, getting 400-500 risk-free points from FMD doesnt look so bad. It's a rather neat catch 22.

Alas, I expect someone to try it. And when they do, FMD will get clobbered on the news. One science experiment to follow for now is UNCL...we'll see how well they do with all this (so far, not so good). COF shoulda just bought FMD before they started buying all these banks.

Btw, I would argue that it's already trading around 3x book, given the overly conservative valuation of the securitization equity. But why the reliance on book multiple to value this company at all? They're a service provider! Time will tell.

607swest said...

Re: few bulls on Wall St. Of 11 analysts covering FMD, 5 rate it a buy, and the 5 with the best StarMine rankings (accuracy of coverage) are 4 buys and 1 outperform. Perhaps you were referring to the kind of bull you're dishing out?

Jordan said...

Past comment writers, as well as myself, may benefit from a furthur (in depth) explanation of your comments...

I have a very low cost basis on FMD and would appreciate your comments.


Glen W Peterson said...

Using ones many years experience as a "market watcher" brings to mind, first, a tip-off of a week argument (I have nothing else, so I"ll use that)and secondly begs the review of the old mantra, "Some people gain wisdom from experience and others simply have the same experience over and over and over again." Such is certainly the case with respect to this gentle poster. To discuss FMD in the context of either ROE or book value is simply a specious argument. EPS multiples and sales growth are what drives the sector. I might add that the macro's related to student loan growth, cost of tuition, matriculation and percentage of DTC loan sales in the market leave plenty of room for upside, regardless of margin compression related to increased volume. The prepayments argument is bankrupt. Only fools would refinance a 20 year loan to a 30 year loan with a variable rate. The costs always outweigh the benefit, and no one has come out with a fixed rate product, because it simply doesn't make sense.

As to "no barriers to entry" I say, ignorance is bliss. FMD has a TERI developed database with 20 years of data on this specific niche sector. No one else does. Many have tried, few have succeeded where unsecured, private student loans and their underwriting is concerned. JPM has resigned through 2010. I think BOA will do the same. BOA has already resigned for it's GATE LOANS. Frankly, I'm amazed at how analysts continue to cleave to their completely broken models of evaluating FMD. They continue to be hooked by GOS accounting, having been burned in the past by many a sham operation. Although, admittedly, the are beginning to see the light, at least at Bear Stearns and JPM, who have recently acknowledged that FMD could simply monetize all of it's residuals if it wanted to. It chooses not to, presumably, because it thinks they will end up being a better long term investment, than short term gain. Who am I to argue.


Anonymous said...

A lot of time is spent on the alpha versus beta debate but little consideration is given to another equally important but often ignored greek letter - rho or the sensitivity to changes in interest rates. Some San Diego business investors fund strategies have negative rho, that is depend on interest rates staying low. Ironically pension funds have positive rho as rising rates permit them to use a higher number to discount future liabilities. That can be a pyrrhic victory because on the asset side of the balance sheet their portfolios of stocks and bonds tend to fall in such times. It therefore makes sense for investors to diversify with OTHER strategies that tend to perform well in a RISING interest rate environment.