Description

At $14, I believe that EDLG represents good value in a growing company, with an experienced and entrepreneurial management team.

Investors often complain of short-term management focus, and on forgoing sound economic decisions to produce short term gains in EPS. There are companies who do it the other way around, but they don’t always get credit for doing so. I believe that EDLG is just such a company. The current price is largely supported by the liquidation value of the balance sheet, without giving value to the franchise value that the management has built. New initiatives are adding to that value, but the story is obscured by the vagaries of GAAP accounting, and the expense burden of initiatives whose benefits will not be seen for another year or two. The value is only apparent by marking the balance sheet to market and looking at the growth that has been locked in by the expenditures that management has already made. Over the next 18 months, I believe that the stock should appreciate to the $20 range.

This idea was presented last year by scrooge833 when the stock was at $10, who covered many of the basic issues around the stock and its industry. Although the stock has risen over the last year to as high as $19, it has fallen back recently to the $13-$14 range.

Company Description:
I refer you to scrooge’s write-up and the company’s filings and those of Sallie Mae (SLM) for detailed background on EDLG and student loans, but in summary:
EDLG originates, holds and services federally guaranteed student loans (FFELP loans).
FFELP loans come in 3 types:
• Consolidation Loans - high balance, long life (up to 30 years), low spread loans -1.59% over CP, net of DOE rebate.
• Stafford Loans – low balance, shorter life (5-10 years post graduation), spread of 1.74% in school, 2.34% in repayment
• PLUS Loans – high balance loans, up to 10 years of loan life, with spreads of up to 3.1%, but only guaranteed to 2.64% by the government. These loans are guaranteed by the student’s parents.

For all three types of loans the federal government, in addition to taking almost all of the credit risk, takes all of the interest rate risk, too. The holders of the loans are guaranteed the borrower’s interest payment or a spread over the 3 month CP index. The net result of this is that loans can be securitized cash-positive.

Thesis
Most of the growth in EDLG’s balance sheet (and that of CFSI, a competitor) over the last couple of years has come from the recent boom in consolidation loan volumes. This has allowed the firm to rapidly accumulate over $4.2 billion in loans in about 3 years to the end of Q3. Consolidation loans are typically high balance, long life, low spread loans (net of all fees etc to the government). The boom in consolidation volumes has tailed off recently, leading to a falloff in EDLG’s new loan volumes.

EDLG’s current portfolio is about 95% consolidation, 4% Stafford and just over 1% plus loans. The profile of loans generated is changing though. At the start of 2003, it was over 90% consolidation, about 7% Stafford and 1.3% PLUS. Q304 it was 58% consolidation, 30% Stafford and 12% PLUS

Consolidation loan volumes are expected to stabilize at current levels. In addition, EDLG lost a marketing partner source of consolidation loans in Q2 of this year, with volumes reduced in Q3 as a result (the partner was bought by CFSI). EDLG recently bought its largest marketing partner, FinancialAid.com, and this, allied with the increase in internally generated loan volumes, puts EDLG in charge of its own future for originations. In addition, recent DOE rulings have opened up the FDLP (Federal direct lending, or “government as lender”) loan market to consolidation by EDLG and other private firms. Competitor CFSI has participated in this market in the past, but it is a potentially huge new opportunity for EDLG.

Where EDLG has an extra arrow in its quiver is that the firm has been targeting the PLUS and Stafford Loan market, with some success, though this has been masked by the falloff in Consolidation loan volumes. Consolidation loans are typically originated through direct to consumer marketing. Stafford Loans and PLUS loans are originated primarily through school preferred lender list channels. Getting on the list for a school requires establishing a relationship with the school’s loan officers, who effectively act as gatekeepers. The beauty of the school lender list business is the Master Promissory Note. This essentially means that if you get a student in the first year, you keep his or her loan business until he graduates. This leads to a “waterfall” of business for a lender entering a new school. If the lender originates $1 million of loans in year one, and the matriculation rate is 60%, then the following year, $1.6 million is locked in with a high probability. In fact, the number may be higher, since Stafford loan limits increase from freshman to sophomore to junior years (exact numbers depend on whether the student is dependent or independent). EDLG has increased Stafford volumes over 70% this year. Not all students are in four year colleges, and not all of those who are make it to senior year and graduate, but those who do can ultimately borrow over $20,000, from a freshman loan limit of $2,625. Right now, we see the full marketing costs to establish these relationships and the right to the “waterfall” of loans, but the P&L and balance sheet shows only the freshman loan volumes generated.

PLUS loans are especially interesting, because there is no limit to the balance that can be borrowed, and the loans have the highest spread over the index. In addition, servicing costs are lower (as a % of principal) for high balance loans, and PLUS tend to be high balance. EDLG has increased its volumes of PLUS loans by over 100% year over year each quarter this year.

We believe that the best is yet to come in lender-list Stafford and PLUS originations:
• The company has invested heavily in marketing programs to drive these volumes, and not all of the benefits have been seen so far. Only part of the disbursement for this student year has shown up in the Q3 numbers.
• The firm has yet to reap the full benefit of the lender lists at the schools where it was added to this year (588, up from 511 in Q1, and “over 400” at the end of 2003). It typically takes at least a year to become established within a school, and a large part of that process is the relationship with the school loan officer.
• The full effect of the waterfall described above for those relationships already established will not show through for another four years
• PLUS loans in particular have not been as widely marketed as Stafford and Consolidation, and compete favorably with private loans for the excess cost of tuition.
• The firm has been testing out several new marketing channels this year and expects to optimize and improve its performance in loan originations next year.

EDLG’s management team have done this before at American Express, where they targeted the PLUS market successfully. We have spoken with loan officers at a few prominent schools and they gave glowing reviews of EDLG’s team, service and reputation.

In addition, management has begun the buildout of its own student loan servicing platform. They hired experienced personnel and have licensed existing software – there is minimal execution risk. Right now, the firm is bearing the cost of the buildout without the benefits. EDLG has the right to bring the servicing of most of its existing portfolio back in-house, and claims that it will be able to break even on servicing at about $5 billion of loans or so. At the current rate of originations, I estimate that the firm will reach that volume about the end of 2005. EDLG anticipates transferring its portfolio in 05/06. In addition to cost savings on loan servicing, benefits to the company include:
• Potential profits from third party servicing
• Marketing benefits. Many schools seek to deal with lenders who make, hold and service their loans, and EDLG will now fulfill those needs.

Accounting & other issues:

EDLG is a tough beast to value using EPS. The reason is that until recently most loans were originated by marketing partners, who were paid a fee, which was expensed. The company financed its loans via a warehouse line, and then securitized the loans when the balance was large enough. EDLG treats its securitizations as on-balance sheet financings, therefore recognizing no gain on sale, despite the fact that company is able to extract cash from the securitizations, and is self-funding. The net result is that when originations are large relative to the current portfolio, value is created, but earnings and book value are depressed. Having just purchased their largest marketing partner, FinancialAid.com, this accounting should be less of an issue going forward.

Floor Income: As noted above, in times of falling interest rates, EDLG (and other student lenders) benefit from “Floor Income” which goes away as rates rise again. Some bears have promoted this as an Achilles heel for the company. I would say that the firm has always treated it as a windfall, and while it will have some benefit from floor income over the next couple of quarters, we fully expect it to go away in the near term and it is not an essential part of the story.

Funding costs: EDLG’s costs of borrowing have been falling as the firm has become better recognized in the Student Loan securitization markets, and its deals are done at a small (and shrinking) spread to Sallie Mae’s. In addition, the firm’s warehouse line, which is a more expensive source of funding than securitizations, is becoming a smaller percentage of the outstanding borrowings over time, which will also reduce borrowing costs and increase spread.

Loan mix: The firm is originating more PLUS and Stafford loans, which will increase its average spread earned. In addition, the Stafford Loans that EDLG has retained will go into repayment, which will cause the spread over CP on those loans to increase from 1.74% to 2.34%.

Loan sales: EDLG is required to sell its loans generated at certain schools to Sallie Mae. They have been getting fairly low premiums on those loans (relative to market prices). We think that the company will be able to increase the premium received on those loans in 2005.


Valuation:

To simplify, I look at the company as follows:
• No benefit from the buildout of the loan servicing platform (no third party business, servicing cost as a % of loans stays the same as currently, another net $5 million spent on buildout).
• I have left out the FinancialAid.com acquisition, though I expect it to be accretive.
• Consolidation volumes under $700 million in 2005, then stable as a percentage of overall consolidation volumes as projected by the DOE.
• We assume that a quick decline in marketing penetration in the school lender list program. Our estimate of EDLG’s freshman Stafford and PLUS loan growth is over 30% currently. We project this falls quickly to be in line with overall DOE projected FFELP volumes by 2007.
• No new marketing partners
• Assume that the firm still has $12 million of NOL asset remaining
• Company sells 50% of its Stafford and PLUS originations (we believe that the number may be less).

EDLG can be valued in 3 ways:

• Marking the balance sheet to market. This is a bit tricky, since the value of a loan depends on the balance, the school it came from, and a couple of other variables, but it does give a reasonable indication of value. In addition, secondary market prices don’t necessarily reflect the value to a holder (the buyer expects to make a profit). However, talking with secondary market participants, consolidation loans go for 4%-5% premiums, Staffords for 2%-2.5%, PLUS for about 3%. Using 2.25% for Stafford and PLUS, and 4.5% for consolidation loans, and giving about $0.50 per share of value for the tax assets, I estimate that Dec 04 value of the balance sheet will be $11. At a $14 stock price, you are getting the franchise, the built-in waterfall and the presence on all those lender lists for $3. I ran an estimate of the value that would be realized by shutting down marketing and new originations and obtained a similar result. Using this valuation method and projecting out future balance sheet growth and discounting back at 10% gives me a $20 value.

• EPS multiples. As described above, EDLG’s EPS are a poor way to value the company while it is in growth mode. The greater the level of originations, the higher the marketing partner fees, the lower the earnings, though the greater the economic value created. EDLG could increase earnings by selling a greater proportion of its loans (as CFSI does), though this would reduce long term value. In addition, the expenses for the buildout of the loan servicing platform could be avoided, but we believe that servicing will create value. On top of all that, we don’t have the full economics of the FinancialAid.com business platform (though based on conversations with industry participants, the price paid appears to have been attractive). Published estimates are 0.78 for 2005. For what it’s worth I estimate that EDLG will do over $1 of earnings in 2006 once the servicing platform is built out, rising to over $2 in 2010. However, for the reasons outlined above, I place little weight on EPS, and clearly, anyone’s projections for any firm in 2010 are to be taken with a pinch of salt. For what it's worth, SLM trades at about 20x 2005 EPS. CFSI on the other hand trades at 13x 2005 and 11x 2006E. I don't think either firm is a great comp, but that would point you to a value of $11-$16

• DCF. This requires running the model out a few years to see the full effect of the waterfall and the investments in the lender list programs, and the investment in the servicing platform today. We assumed that growth would only run above inflation until 2010 and arrived at a value of $20, but as with any DCF you can derive any number numbers from $13 to $25 by varying assumptions on Stafford/PLUS originations, gain on sale percentages, overhead growth, etc. The key thing is that I believe that there is limited downside and decent upside in the range of outcomes.


Risks:
I know that there is a significant short interest in the company (Herb Greenberg for one has been writing on it, and the last conference call featured a few attempts to sling mud). There are definitely some issues to bear in mind, here are a few:

1. Consolidation Loan volumes: The single lender rule states that if one firm holds all of a borrower’s loans, then that firm has right of first refusal on consolidating those loans. Naturally, Sallie Mae is a fan of this rule. It may turn out that although the Consolidation Loan market stabilizes, most of the volume in the future is subject to this rule, leaving the rest of the market to fight over a much smaller pie than the overall size of the market would imply. The offset to this is the potential for FDLP consolidation
2. Increased competition. It is not uncommon for lenders to offer borrowers discounts for direct debit, and for reaching a certain number of payments on time. Ultimately, that may reduce the economics (of consolidation loans in particular).
3. Unknown economics of the FinancialAid.com purchase. We believe, based on our due diligence, that the deal will turn out to be an excellent one for EDLG, but clearly we have yet to see the full P&L impact, and we have modeled no economic benefit from the deal.
4. Very volatile stock, with often low trading volumes. A lot of the volatility comes from a focus on quarterly EPS. I wouldn’t say that EPS are meaningless, but it’s not the primary thing to look at for this company.
5. Re-authorization risk. With John Kerry out of the picture, a lot of the political risk has gone (hence the jump in SLM stock) but there are things that could happen to hurt the market
a. Reduce the guarantee limit from 98% to 96%
b. Reduce guaranteed spreads
c. Make consolidation loans variable rate
The first two rules would hurt EDLG by reducing the value of the student loans that they generate. The third will have little impact, since the firm has little floor income now, and the main attraction for consolidators in the future would be reduced payments, not locking in interest rates. Possible benefits would include elimination of the single lender rule, and allowing re-consolidation, which would open up a huge section of loans that EDLG cannot currently go after.

In summary, we believe that this is a company which has invested wisely in a platform which will create value for shareholders for many years to come. This is not an event-driven investment. It will take a couple of years for that value to become fully evident for the reasons outlined above, and for GAAP to catch up and reflect the value created. Over that time, value should continue to compound, and patient investors who accumulate positions in the $13-$14 range should be well rewarded. Our estimate of risk/reward is downside to about $12, with upside north of $20.

Catalyst

• The maturity of the waterfall over the next four years
• Increased penetration of school lender lists
• Increased spread, net of floor income, through lower borrowing costs and increased percentage of Stafford and PLUS loans
• Rollout of the Servicing platform, reducing costs