Thursday, June 15, 2006

First Marblehead's Insiders Unload Stock

Boston-based First Marblehead (FMD) is one of the most complex companies we've ever encountered. First Marblehead focuses on the private student loan market, swapping its loan-processing services in return for the right to securitize clients' student loans.

The firm ostensibly makes money by securitizing student loans for its customers, who outsource their processing and administrative duties to the small cap company. After securitizing the loans, FMD captures the spread between the dollar value of the securities and the dollar value of the loans backing those securities. First Marblehead keeps a small percentage of the difference, generating EBITDA in the process.

FMD's business model gets more complicated, so we'll spare you the details. A few things you should know, though:

1. FMD faces stiff competition from giants like Sallie Mae (SLM) and Student Loan (STU), whose size and business model transparency we find more attractive. Sallie Mae, which coughed up $3B in revenues last year, recently made a terrific acquisition, we think, in buying 529 planner Upromise. This deal should enable the firm to capture and capitalize on families aiming to both save + borrow for their kid's college education. Equally, it bestows SLM with a competive advantage other firms would love to have: your name all over McDonald's bags (Upromise's logo is part of every Happy Meal you buy).

2. Second, FMD's customer list is highly concentrated. Last time we checked, JP Morgan was responsible for 30% of FMD's sales. Bank of America is also a big client. Although FMD has slowly de-concentrated its revenue sources over the last 3 years, we still deem the risk/reward mildly unattractive; valuation of 5.8 x sales does not help the bull case.

3. FMD's revenue recognition policy screams for attention, as well, since the company books the present value of any future cash flows as revenue -- if loans underperform, the stock could fall out of bed. While this is common to all loan players, investors should augment whatever discount rate (WACC) they're using to value FMD shares because FMD has less experience, employees, and cash flow generation.

4. In addition, 2 major insiders quit last year after it was discovered that they were swapping gifts in order to land contract deals. They've brought in new management, but it looks like they're all overpaid given the whacking FMD's stock price took in the last 6 months. Lest we forget, insiders have been unloading the stock like madmen; Board Director Stephen Anbinder pulled in a million just 2 days ago, which comes after the million he raked in on May 25th; VP of Capital Markets John Hupalo has also developed an allergy to the stock.

5. As if that wasn't enough: While many analysts may have a hard time figuring out exactly how FMD makes money, they should have no difficulty determining how FMD's friends and family pay the bills. The amount forked over was not eye-popping, but news like this forces us to reconsider management's priorities. From FMD's latest 10-K:
At March 31, 2006, the Company had invested approximately $98,064 of cash and cash equivalents in a money market fund. The investment adviser for this fund is Milestone Capital Management, LLC (MCM), an institutional money management firm. In addition, approximately $24,955 of cash equivalents was invested by MCM on behalf of the Company under an investment management agreement. MCM receives a fee for services it performs under this agreement. MCM is a wholly owned subsidiary of Milestone Group Partners. Members of the immediate family of one of the Company's directors own approximately 65% of Milestone Group Partners.
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