More Good Grades for First Marblehead

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Late last week, Motley Fool Hidden Gems selection First Marblehead (NYSE: FMD  ) released its second-quarter earnings. As this company is a bit of a lightning rod, I like to wait until I can get my hands on a transcript of the conference call and take a good look at things before reacting. This generally works out well, because the uncertainty and misunderstanding surrounding the company makes its shares volatile.

On its conference call, First Marblehead's management correctly pointed out that looking at just this quarter's results in comparison to last year isn't very useful, and that investors should instead look at the first half as a whole. This is because the company did one securitization in the first half of fiscal 2006 and has done two in the first half of fiscal 2007. The one securitization during the first half of last year occurred during the second quarter and was slightly larger than this year's second-quarter securitization, but the combined performance for the first six months more accurately shows the long-term growth of the business. For the first half, revenues increased 87% to $500.7 million, net income increased 110% to $222.2 million, and earnings per share increased 115% to $2.34 per diluted share.

That's a great performance for any company, but a look at First Marblehead isn't complete without considering its detractors' concerns. The big three concerns have been customer concentration, residuals, and cash flows, with the last two being tightly linked at the hip and impacted by a number of assumptions the company makes about prepayments, defaults, discount rates, interest rates, and recoveries.

While JP Morgan Chase (NYSE: JPM  ) and Bank of America remain important customers for First Marblehead, the company has largely put to bed any concerns about its customer diversification by adding KeyCorp (NYSE: KEY  ) , General Electric (NYSE: GE  ) , and others to its roster of customers during 2006. This quarter's announcement included the addition of E-Loan, Comerica, (NYSE: CMA) and US Bancorp (NYSE: USB) as new partners.

The issues of residual valuation and, in turn, cash flows are a bit stickier, though I do not believe they are as problematic as they have occasionally been made out to be. The first piece of evidence is in First Marblehead's ability to securitize some of its BBB-rated assets in the last two securitizations. The company's ability to continue increasing the cash on its balance sheet, not to mention repeatedly increasing its dividend (20% in each of the last two quarters), also provides evidence that keeping cash flowing into the coffers is less of a problem than commonly assumed.

The larger issue is the cash payments that are due to come in further in the future, which should grow in size as the company continues to grow the size of the loan pools it securitizes. Depending on how many of these loans prepay or default, the actual results could be quite different than what the company has estimated. In some cases, certain securitizations have shown higher prepayments or defaults than one might expect so early on. But all are still within the estimates set by First Marblehead, and the company clearly noted that these items will go in cycles and that the loans being securitized are long-term in nature (20 years), making a trend of a few months or quarters too difficult to interpret.

Management may need to make an adjustment, but given that the securitizations continue to perform well in the current environment, I'm optimistic that any adjustment wouldn't be large. In the long term, I'm far more optimistic about how the industry is shaping up, with the continued demand for private student loans to make up the shortfall in government-funded loans and the steadily increasing cost of education. As long as that dynamic stays in place, First Marblehead has the wind at its back.

Related Foolishness:

First Marblehead is a Motley Fool Hidden Gems recommendation. If you're interested in small-cap companies with great potential, take a free 30-day trial to Hidden Gems. The service is crushing the market, so there's never been a better time to try it. Just click here to start your trial.

Bank of America, JPMorgan Chase, and US Bancorp are Motley Fool Income Investor recommendations. E-Loan was acquired by Popular, another Income Investor selection.

At the time of publication, Nathan Parmelee owned shares in First Marblehead, but had no financial interest in any of the other companies mentioned. He was ranked 69th out of 21,218 CAPS investors. The Motley Fool has an ironclad disclosure policy.

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