Description
I recommend EDLG as a long. The stock price gives you a chance to buy a rapidly growing company at 84% of adjusted book, with a desirable business model in a growing industry, with minimal or no external financing needs. Furthermore, the downside risk is minimal.
Description:
EDLG is a leading marketer of consolidated loan products to students with $10,000 or more in outstanding student indebtedness. It is also an originator of federally guaranteed educational loans and offers student financial aid debt counseling, debt management, loan origination, loan servicing management, and secondary market loan acquisition services. EDLG is developing related business lines including its School as Lender Program and the marketing of PLUS loans to parents of students. Product Channels: Consolidation Loans, Traditional School Lender Lists, School as Originator, Direct Marketing Channel, Secondary Market Acquisition.
Assets are growing very rapidly (+124%,+19%,+28%,+19% sequential growth for the last 4 quarters). Interest income is ramping up. Management’s past track record is excellent. Their origination business (to be differentiated from the consolidation business) is growing too. The number of marketing partners is increasing. The growth numbers are not as interesting however, as the fact that this company is creating economic book value much more than its GAAP book value. Also, it is financing its business without any need for access to the capital markets.
Investment Thesis:
EDLG makes money by originating Federally Guaranteed Student Loans and holding them on the balance sheet. Under GAAP, the spread income earned on these loans every year must be recognized. However, assets have a net present value much greater than their book value and, if EDLG were an originate and sell company, they would book substantial profits. It is a wealth creation vehicle and book value should increase predictably for a long period of time.
There are 2 ways to assess its true economic value. Firstly, if the company were to sell its loans(some companies in this space do not hold loans), it would book much higher income. Student Loans have a 4 percent market premium because of the government guarantee and the minimal prepayment risk. The second way to look at it is to adjust the balance sheet to reflect economic book value.
1. A simple illustration of Originate&Hold vs. Originate&Sell
Consolidation Net Interest Margin Example
($100Million)
Buy and Hold
Interest Received from Student 4.64% - $4,640,000
Less:
Cost of Debt 2.48% - $2,480,000
Cost of Loan Servicing 0.281% $281,000
Amortization of DOE Fee 0.024% $ 24,000
Consolidation Loan Rebate Fee 1.05% $1,050,000
Loan Loss Reserve 0.087% 87,000
Net Interest Margin 0.718% 718,000
The prevailing market premium for the student loans is about 4%.
Selling these loans will show a $4,000,000 income.
Hypothetically, if EDLG were to sell its loans, its Income Satement for Year Ended Dec., 2002 would look like this:
Revenues
Gain on Sale of Student Loans (Consolidation) $53,962,150
Gain on Sale of Student Loans (SLX) $ 1,855,113
Other Income 18,925
Total Revenues 55,836,188
Operating Expenses
General & Administrative 9,101,454
Sales & Marketing 25,285,310
Total Operating Expenses 34,386,764
Net Income Before Tax 21,449,424
Income Taxes (assume 40%Fed and CA rates) 8,579,770
Net Income 12,869,654
Net Income per share $1.26
2. Creation of Balance Sheet Value
EDLG is creating book value as opposed to maximing taxable net income. Let’s do a simple exercise of adjusting for the economic book value. Let’s look at 6/30/2003’s Balance Sheet.
Using the 72 basis point net interest margin as the annuity payment for 18 years (the average holding period of the loans) and discounting at the Treasury Rate to its present value.
Assets: As of 6/30/03 GAAP Adjusted
Student loans 2,161,393,259 2,312,258,508
Cash and Investments 83,206,229 83,206,229
Other Current Assets 17,845,171 1,7845,171
Property,Plant,Equip 1,685,278 1,685,278
Other Assets 9,296,904 9,296,904
Total Assets 2,273,426,841 2,424,292,090
Liabilities and StockHolder’s Equity
Current Liabilities 13,202,641 13,202,641
Warehouse Loan Facility 310,093,855 310,093,855
Long-term Debt 1,978,068,249 1,978,068,249
Stockholder’s Equity (27,987,904) 27,987,904
PV in Excess of Debt 150,845,249
Total Liabilities and Stockholders Equity 2,273,426,841 2,424,292,090
This equates to an adjusted book value of 150.8M or about $13 per share of Book Value and $10 book value if you fully dilute the out-of-the-money options. Yesterday, the company announced that assets have grown to 2.7Billion. This equates to roughly $12 in book value per diluted share.
***This calculation does not even include the floor income that EDLG makes. The floor income is the additional income the company makes when interest rates go down. Interest rates are reset every July. In reality, the company has an additional 75 bps margin for some of their loans.
So, how does the company fund its operations?
EDLG finances its operations through a $1 billion credit line with Citibank and by borrowing against its future revenue stream. They can, from time to time, sell some of their loans as well.
Illustration: How EDLG generates operating cash:
Consolidation Loans Originated $100,000,000
Cash Borrowed on Warehouse Line $102,500,000
Less:
Principal balance of Loans ($100,000,000)
Government Fees(0.5%) ($500,000)
Cash available for Operating Expenses $2,000,000
Present Value of Loans is: $106,980,000
Fair Market Value of Loans Sold Today $104,000,000
** Cash Flow is met by excess borrowing against future revenue stream
Growth Opportunities for EDLG and Student Loans
Student loans have grown from $10B in supply in 2001 to a projected $41B in 2003, a CAGR growth of 60%. Bachelor’s degree recipients earn 80% more than those with only a high school diploma. Over a lifetime, this difference exceeds $1 million. About 29% of today’s jobs require some level of advanced education, but not a college degree – vocational program, associate’s degree in technical skills. Including parent loans, and consolidation loans, the size is expected to reach $240 billion by the end of 2003.
I could not get into more detail about student loans because it would take too long for this write-up. For a better overview on student loans, read the SEC filings of Sallie Mae. In summary, student loans are a desirable Asset Backed Security because:
-U.S. Department of Education reinsures FFELP loans, conveying an explicit federal guaranty. The government guarantees 98% of the loans, in case of default.
-Default rates have been declining since 1998, when Congress further restricted the discharge of most student loan debt in personal bankruptcy.
-Most student-loan ABSs are trip-A-rated floaters.
-The Special Allowance Payment (SAP) subsidy program, which benchmarks to three-months commercial paper rates, for federal government education loans mitigates interest rate risk for lenders and ABS investors.
-Students have a one-time option to convert all outstanding student indebtedness to a consolidation loan at a fixed interest rate up to 30 years. This means that EDLG’s loans have minimal prepayment risk. In fact, the average life of a loan is 18-20 years!
-FFELP student loans typically trade at a premium to face value owing to the 98% reinsurance guarantee, low prepayment rate and secondary market liquidity.
Loan Loss Reserve Calculations:
The company takes an appropriate, if not conservative, loan loss reserve estimate. Since 98 percent of the loans are guaranteed by the government, you take 2 percent multiplied by the national average (6%) to arrive at 0.12 percent. Student Loan default rates have dropped significantly and the fact that filing a bankruptcy does not erase student loans is another factor why default rates have improved significantly.
Management Track Record:
Management were former employees of American Express, which decided to exit the student loan business when it was getting rid of non-core operations. Robert de Rose, the CEO of EDLG, was the founder and former President and CEO of American Express Educational Loans.
Peer Valuation
The only other peers in the industry are Sallie Mae and Student Loan. I think that going forward, the consolidation business will start cannibalizing Sallie Mae’s loan portfolio. The same goes for Student Loan Corp. EDLG actually has none of this baggage. However, Sallie Mae trades at about 20-25% of assets, Student Loan trades at 10% of assets. Student Loan constantly trades at a discount because Citigroup owns 80 percent of STU and yet it still trades at twice the valuation of EDLG, which trades at 5% of assets, and EDLG’s assets are growing faster. I think STU will also be a decent investment, but I think EDLG will be better.
In summary, EDLG is in a lending business where default risk is minimized and 98 percent guaranteed by the government. There is no interest rate risk in its business. It is in a growing area. It has access to funding without diluting common equity. It is creating book value rapidly. It is run by very experienced managers who have excelled in this industry in the past. The loss reserves are conservative. So what are the potential risks?
Legislative
1. The number one risk is political and/or legislative risk. There are proposals for extending repayment terms, reasonable loan limit increases, etc. The most interesting proposal is to allow students to “reconsolidate” their loans. But most experts believe the chances of passing this proposal is minimal because it is fiscally unsupportable. There are potential headline risks that might unsettle the sector until the details are resolved in 2004. However, the federal programs are politically very popular, and its value in helping people raise their income levels is obviously clear. I certainly do not see any adverse proposals on the horizon that would hurt EDLG’s business. After all EDLG’s market share is still minimal and the market is for theirs to win, and for Sallie Mae and the other bigger players to lose.
Potential Questions
1. Options. There are 3 million options issued to management. Management indicated that they had to issue these options to attract the employees. These options vest over three years. Anyhow, in my computations for book value, I also used the fully diluted shares and I still get a book value of $10.00 based on Dec. 2002 statement. The assets have grown to 2.7Billion as of yesterday’s press release. A quick calcuation indicates book value is in the $12 range.
2. Insider Selling
There is an automatic regular selling of 1,000 shares by the CFO on every other day. I was assured that this is related to income taxes as a result of the CFO exercising options. The CEO has bought some shares in the open market. More importantly, management owns a sizable percentage of shares in EDLG.
3. Interest Rate Risk
As I explained above, the SAP subsidy program mitigates interest rate risk. Should rates go higher, the government subsidies the difference. Furthermore, EDLG, who faces exposure from fluctuations in the spreads between the company’s borrowing and lending rates, use interest rate swap agreements and other hedge instruments to manage interest rate risk.
Whichever way you model it, this company is a wealth vehicle which can easily grow its book value at 20 percent for several years. And it is available at a 20 percent discount to its present intrinsic value.
Catalyst
- Inevitably, people will realize the true economic vs. GAAP value of EDLG
- Wealth creation vehicle
- Unrecognized, underfollowed
- When company starts booking GAAP net income next year