The market is undeniably forward-looking -- but how far the market looks into the future is certainly up for debate. Today's case in point: Hidden Gems selection First Marblehead (NYSE:FMD). The company reported strong results and sounded optimistic when discussing its future on the conference call, but analysts remained keenly focused on several areas of potential weakness.
The quarter was great, but since we have the annual earnings numbers, I'll focus there for earnings. For the year, revenue was up 35%, earnings increased 48%, and earnings per share increased 54% to $3.68, versus last year's $2.39. The $1.29 improvement in earnings includes $0.18 per share in tax benefits related to how the company accounts for the Massachusetts state taxes on its trusts. These changes appear permanent, and the company pegs its effective future tax rate at 40% instead of the 42% seen in the last few years. The company also reported a 51% increase in loans available for securitization.
Many analysts have predicted that First Marblehead's margins will fall, because of the new deals it signed with Bank of America (NYSE:BAC) and JPMorgan Chase (NYSE:JPM) in the last few months. Eventually, margins will likely fall as the business gains volume, but they haven't yet. And the entire industry's growth looks strong enough to let First Marblehead absorb these declines and keep earnings and cash flows moving upwards. Still, those margins are worth watching
The quarter did have its flaws. Prepayments were up slightly on the loans that the company securitizes, and as such, First Marblehead had to reduce the value of its residuals (cash the company expects to collect in the future). The residuals, and how much cash the company will eventually see from them, are the biggest gripe bearish analysts have about the company. I don't have the space to fully elaborate on that concern here, other than to say that prepayments, defaults, discount-rate assumptions, and interest rates all have an effect on residuals. The company stated that it expects prepayments will be lumpy, that it will adjust its residuals as necessary, and that it believes its 7% estimate of prepayments over the life of the loans is conservative.
Quickly glancing at the company's 10-K for a refresher, and comparing it with the 10-K for Sallie Mae (NYSE:SLM), shows that the 7% estimate is in line with what both companies have seen in the last couple of years across their entire portfolios. I'll admit that I have a little more to look into here, but I'm not immediately alarmed.
Another item of concern is the company's cash balances, which decreased year over year despite the strong income-statement performance. The company correctly explained that $66 million of the drop was due to share repurchases, and that changes in prepaid assets (taxes and expenses) also affected the cash balances. A closer look at the company's cash flow through the first nine months confirms their statements. Given the prepaid assets (like additional increases in residuals) and some level of capital expenditures in the just-reported quarter, a flat cash balance since last quarter makes sense.
The prepayments are certainly something to keep an eye on, but there are positive factors as well. The company continued to diversify its client base, adding KeyCorp (NYSE:KEY), General Electric's (NYSE:GE) consumer finance division, and Monster Worldwide (NASDAQ:MNST) during the latter part of the year. First Marblehead also reduced the proportion of revenue it receives from its three largest clients from 65% in 2005 to 52% in 2006. That's good to see, considering that its three largest clients continue to grow as well.
Despite all the positives at First Marblehead, it's true that cash flow will trail net income, but I think the valuation more than accounts for this. The residuals may not perform as expected, though I believe they will; either way, I doubt the market will fully embrace First Marblehead until the company starts to meet its residual estimates. With its first wave of incoming residuals still a while off, expect volatility in First Marblehead's stock until they arrive.
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At the time of publication, Nathan Parmelee owned shares in First Marblehead, but had no financial interest in any of the other companies mentioned. JPMorgan Chase and Bank of America are Motley Fool Income Investor selections. The Motley Fool has an ironclad disclosure policy.
