First Marblehead Corp.
Conference Call Notes: "White Hot"

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By Puck50
October 29, 2007

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On the CC, management finally provided insight into the general level of profitability of FM's proprietary brand loans.

To begin with, it is necessary to comprehend the emerging dynamic of FM's marketing spend related to its own in-house lending program. FM's marketing spend is divided into two categories for GAAP accounting purposes: that in support of loans originated by clients and that in support of FM's in-house lending program. Marketing spend related to client loan programs is expensed at the time (in the reporting period) that revenue accruing from that expenditure is received; so for GAAP accounting purposes this expense and the revenue it generates occur simultaneously and are matched in time even though in reality the market expenditure precedes the revenue it begets. In the case of FM's proprietary lending program, however, both marketing spend and revenue associated with that expense are recorded in the reporting periods in which they occur, with expense inevitably preceding revenue. Management's characterization of this dynamic is that marketing expense for FM's proprietary lending program recorded in one quarter drives revenue in the subsequent quarter.

During the first quarter of fiscal '08, FM recorded $8.5 million in marketing expense for its in-house lending program. Revenue derived from this expense will accrue during the subsequent quarter and even continue to impact quarters farther out as well. Thus, for FM's own lending business, a simple way to consider marketing expense is that it precedes revenues generated by that expense by a quarter, or one reporting period, which is to say that there is a one quarter offset in time between the two whereas no such offset exists for marketing spend related to client lending programs. Ultimately what this means is that seasonality for revenues and marketing expenses is out of phase, and attempts to model FM's business need to take this fact into account.

As for the profitability of FM's proprietary loan program, management has provided the following insights:

FM's in-house brand loans comprised 10% of the loan volume securitized during the Q but 21% of FM's revenue.

Dollar balance of in-house brand loans securitized: $200 million.

Revenue received, also referred to as "marketing fee," from securitizing in-house brand loans: $20 million.

Thus the securitization margin for FM's in-house brand loans is 10%.

Management also observed that it is necessary to subtract the marketing expense incurred to generate in-house brand loans from the marketing fee received from their securitization, or sale, in order to calculate the net, or true, level of profitability of the in-house brand loans, and management did not provide specific guidance about the marketing expense allocated to the in-house brand loans securitized in Sept.. Management's statements about the marketing expense dynamic imply that the marketing expense related to the in-house brand loans securitized in Sept. would have been incurred during the preceding quarter, or the April-June time frame. Management also advised that the level of this expense was small enough that it was "easily absorbed" by other accounts and therefore not broken out and presented discretely, as the $8.5 million expense of FY1Q has been. The only thing that can be inferred is that the FY4Q07 marketing expense supporting 1Q revenues was considerably smaller than $8.5 million.

Revenues that FM receives from securitizing its in-house loans is not reported as securitization revenue and thus is not reflected in the securitization margins that FM reports. Revenue from securitizing proprietary brand loans is recorded on the "Administrative and other fees" line of the income statement; although securitization revenue may not necessarily be all that is reported on this line item. For instance, the number for this revenue line in 1Q is $21.76 million, and management stated that revenues from securitizing in-house brand loans for the Q was approximately $20 million. It could be that most if not all of the revenue reported on this line is securitization revenue--I don't know at this point. As a consequence, FM's reported securitization economics--both revenues from and profitability margins of--are now being understated and increasingly so.

In the case of FM's 1Q securitization economics, if the reported securitization margin were to be adjusted to reflect revenues from FM's in-house brand loans, it follows that for every additional $2 million in revenues net of marketing expense, the securitization margin would be 10 BPS higher. As it is, the reported securitization margin turned out to be 15.7%, higher than the originally anticipated 15%. (The change in the discount rate caused part of FM's residual interests to be valued lower but the other part to be valued higher.) FM's gross revenue from securitizing in-house brand loans was $20 million. If this full number were added to the revenue amount used to calculate the reported securitization margin, the margin would be 1% higher, or 16.7%. Because marketing expense must be subtracted in order to get a number that accurately reflects FM's true securitization profitability, the adjusted number would necessarily be lower. If FM had spent, say, $4 million in marketing expense during the prior Q, the adjusted margin would be 80 BPS higher, or 16.5%. Because the prior Q's marketing expense hasn't been reported with any degree of precision, the true adjusted securitization margin isn't calculable, but I guess that this number is probably pretty close if not a tad low. This exercise does provide insight into the general degree to which FM's reported securitization economics have begun to understate reality.

Other gleanings from the CC:

Market share for fiscal '07 was 23%, up from 20% in fiscal '06.

Revenue from BofA and JPM increased 15%; revenue from all other clients increased 95%!

Tax refund of $37 million received.

Management has suspended the share repurchase program (wisely in my opinion) to fortify FM's balance in response to uncertain business conditions causing the cash balance to swell by 62% from the prior Q to $380 million--and FM is going to get another slug of cash from the next securitization in about a month. With no share repurchase activity, I expect that the dividend will continue to rise.

The ABS markets have been showing signs of improvement since the last securitization.

Prepayment rates have declined for "every single pool" of securitized loans.

As a long time bank and thrift investor, it amuses me to look at FM's balance sheet now and see "Deposit" and "Loans held for sale" lines.

FM's proprietary loan business is growing fast. As evidence, at Sept. 30, FM reported approx. $200 million of loans held for sale. These loans essentially represent FM's Sept. loan production, as they were all originated after the cut off date for the Sept securitization, which was August 31. Sept. loan production thus approximated the entire balance of loans that FM originated during June, July, and August and securitized in September, loans which represented FM's entire loan production during the peak season. That Sept loan production equaled production for the preceding three months and that those three months spanned the seasonal peak for the student loan industry implies that FM's lending business is growing at a 300%, 400%, or 500% rate--whatever the rate, it is mind-boggling. Additionally, advertising spend took a leap up during 1Q, which according to management, will begin bearing fruit in the current quarter. There is no doubt: this company is white hot.