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Banking is a tough industry to be in right now. Low interest rates often translate into declining net interest income, and many banks like BAC are still dealing with the fallout of the financial crisis both in terms of loan write-offs and litigation. On top of these cyclical problems, banks big and small, commercial or investment-oriented are struggling with antiquated business models that do not fit will with modern economic realities. Large financial conglomerates like JPMorgan Chase (NYSE:JPM) and Citibank (NYSE:C) have not sufficiently moved away from their bloated pre-crisis cost structures that lavishly reward swashbuckling traders but discourage prudent stewardship of shareholder wealth. In fact, recent research suggests that these too-big-to-fail banks would be unprofitable if it weren't for the implicit government subsidy that lowered their borrowing costs [Wells Fargo (NYSE:WFC) is a partial exception]:

Smaller regional and community banks also tend to have high cost structures, although for different reasons. These banks often retain large workforces relative to their size and have large fixed costs devoted to maintaining physical bank branches. Such costs are even more of a burden during a period of subpar economic performance, deleveraging, and low interest rates.

Bank of Internet

Bank of Internet is different than many other banks because its unique business model avoids the high cost structures endemic in the industry. BofI Holding Inc. (NASDAQ:BOFI) is the holding company for BofI Federal Bank, which has nearly $2.9 Billion in assets, and operates though a single location in San Diego, California. Instead of the opaque, risk-laden business models of the big banks and branch-focused community banks, BOFI attracts depositors and borrowers through its website and independent loan officers that work from home. This approach has multiple competitive advantages, allowing BOFI to provide superior service at lower cost while also lowering overall business risk.

Superior Service to Depositors

Because of its low overhead, BOFI can offer higher interest rates in order to generate a loyal and growing deposit base. For example, its rewards checking account currently offers up to 1.25% interest. Additionally, recent changes in financial regulation now allow banks to pay interest on business checking accounts. This is bad news for community banks, which historically relied upon local businesses to provide a totally free deposit base, but good news for BOFI, which is aggressively marketing its 1.01% yielding business checking account product. BOFI also does not focus on nickel-and-diming its customers like more fee-driven business models such as PNC Financial (NYSE:PNC) (full disclosure: I am a very unsatisfied PNC customer, and will likely switch my account to BOFI in the near future), charging no overdraft fees or other "gotchas" that contribute to public disillusionment with the banking industry. Combined with its easy-to-use online interface and mobile apps, BOFI is poised to attract the tech-savvy, yield-starved, or dissatisfied-with-their-current-bank depositors. The proof is in the pudding:


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This achievement is extremely impressive: I am unaware of any other bank that has nearly quadrupled its deposit base in the last five years. As more of our lives are lived online and the iPhone generation begins to save, more people will become comfortable with the idea that a bank does not need to have an impressive marble building. As such, I expect the favorable shift in BOFI's funding mix and rapid deposit base growth to continue into the future.

A High-Quality Loan Origination Machine

BOFI generates loans through its website, referrals from other websites and third-party financial institutions. These loans are processed centrally in coordination with on-site independent loan brokers. Because BOFI can offer highly competitive interest rates and a hassle-free minimum-paperwork approval process, its origination pipeline is gushing with loan applications. Unlike some of the mid-2000s mortgage origination cowboys, BOFI's strategy focuses on selecting the highest-quality loan portfolio. According to the most recent quarterly report, about 56% of its current loan portfolio consists of single family (1-4 unit) mortgages, 35% of multifamily (5+ unit) mortgages, and the rest is a mix of home equity, commercial and RV loans.

This portfolio is the envy of the industry. In December 2012, the weighted average loan-to-value ratio of the real estate portfolio was 54%, while non-performing assets were only 0.95% of total, which is quite an accomplishment during an era of high delinquency rates and underwater borrowers. Unlike many other banks with conservative underwriting, however, the loan portfolio is also relatively insulated from interest rate risk because a high proportion of the loans have adjustable rates: in December 2012, only about 20% of the portfolio had maturities or interest rate resets five years or more into the future.

Because of its highly productive, high-quality loan pipeline, BOFI also does a brisk business selling loans to other banks having a harder time finding borrowers. In the quarter ending December 2012, revenue from mortgage banking was $5.6 million, compared to $3.0 million in December 2011, a $2.6 million increase. To add a little context to these numbers, total salaries, benefits, and stock-based compensation were $7.0 million and $5.0 million for the same quarters, respectively. This is the beauty of the business model: it is quite possible that within a few years, this little side business selling the loan pipeline overflow to others will pay for the entire company's workforce, occupancy costs ($477,000 last quarter) and advertising costs ($1.6 million last quarter). This would make the main loan portfolio pure shareholder gravy.

Business Performance

Now that I have described the basics of the business and what I see as its strengths, how well has BOFI performed overall? Management has set clear goals for itself in the 2012 Annual Report:

  1. Maintain an annualized return on average common stockholders' equity of 15% or better.
  2. Annually increase average interest-earning assets by 15% or more.
  3. Reduce the annualized efficiency ratio to a level of 35% or lower (efficiency ratio equals non-interest expense as a percent of net interest income + non-interest income, so the lower the better).

I really like these goals, because they are clear, ambitious, and achievable, and show simultaneous dedication to growth, cost-cutting, and profitability. Here's how BOFI has done in recent years:


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Not too shabby (sources: Efficiency ratio and asset growth from latest 10-K, ROE from Morningstar). The efficiency ratio is not quite there yet, although it is important to note that 40% already puts BOFI at the top of its industry, and that a 35% efficiency ratio would put it in first place.

I expect the efficiency ratio to come down more in the next few years as the funding mix continues to switch from long-term debt to lower-cost deposits and the mortgage origination business takes off. In terms of ROE and asset growth, the company is meeting its goals and just needs to keep chugging along.

Here's the performance of the overall business from another perspective (source: Morningstar):


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After a rocky start in the first half of the 2000s, it looks like the company has finally hit its stride and has entered a period of rapid growth.

Valuation

I think that BOFI is a great business that is poised for long-term growth and success. Its unique model means that it has among the lowest cost structures in the industry while also offering higher quality product. Nothing in life is guaranteed, but I think that BOFI's superior position within a troubled industry resembles the early days of Southwest Airlines (NYSE:LUV) and Nucor (NYSE:NUE). Like these other shareholder success stories, BOFI is challenging the ossified, bureaucratic models of an economic sector not currently known for enlightened, forward-looking management.

However, identifying great businesses is only half the battle in investing. Is BOFI reasonably priced? As of this writing, the last price was $35.02. This gives BOFI a P/E ttm of 14.0 (diluted EPS of $2.50), a P/B of 2.1 and a market cap of $450 million. When I do valuations, I like to work backwards from the market price in order to get a sense of what the market thinks the future holds, and then see if I disagree. Using a discount rate of 11%, the market expects BOFI to grow at a 5% rate for five years and then stabilize at 3% going forward (DCF value of $34.99). So here's what the market thinks will happen compared to what has already happened:


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Earnings are notoriously difficult to predict, and people who pretend to have a crystal ball are lying to themselves. This is even more so for small cap companies that are still getting established. However, I feel confident that growth in the secondary mortgage business and changes in the funding mix will help BOFI at least maintain current levels of profitability along with 15%+ top line growth for a long time. This is because there is a significant growth runway: at $2.9 Billion in assets, BOFI has about 0.12% the assets of JPM or 0.13% of BAC. There's plenty of room to get a bigger slice of the banking pie, particularly if you can provide a superior product and dissatisfaction with banks is at an all-time high. 10% EPS growth for the next five years and 5% thereafter yields a DCF valuation of $53.98, more than 50% premium over the current price. However, I believe that quantitative, medium-term projections only provide a partial view of current value, because BOFI is dramatically disrupting the banking industry and its competitive advantage is here to stay. In my opinion, there is a very real chance that in the next decade, BOFI will be a 10-bagger.

Risks to Watch

There is no such thing as a perfect investment. As such, I've tried to come up with a bear case against BOFI, or at least possible problems that bulls should look out for. One possible concern is that established banks will increasingly focus on online banking and loan origination, competing with BOFI on its own turf. I'm not too worried about this because BOFI's low cost structure will allow it to outlast the competition. There is the possibility that another equally successful pure play Internet bank could come along, but I think there is enough space here for multiple winners.

A more serious risk is the issue of leverage and shareholder dilution. This is a perennial problem for banks whose assets and deposits (liabilities) are growing quickly, because retaining earnings is not enough to provide an adequate equity capital base. For example, the average ttm leverage ratio is 13.12 (source: Morningstar), which is a bit high for my taste. BOFI has addressed this problem by issuing additional common stock as well as convertible preferred stock. The most recent example of the latter was $18.6 million in October 2012 that yielded 6.0% and was convertible at a price of $30.50. For a company that regularly has a ROE of 15%+, such arrangements are very accretive to common stock holders. In the longer run, however, ownership gets diluted and previous shareholders only enjoy a portion of subsequent balance sheet growth. Such a dilution contributed to the EPS dip in 2011, although 2010 also had abnormally high net income due to one-time gains on securities held. I'm not too worried about this though: while the float increased from 5 million shares in 2003 to 12 million in 2012, net earnings grew from $2 million to $35 million. The BOFI net income pie is growing much faster than the additional slices that dilution requires, although investors should keep an eye on this in the future.

Another issue is about $192 million of non-agency held-to-maturity mortgage-backed securities and $70 million of the same available-for-sale, about 10% of balance sheet assets. These are the sorts of toxic assets associated with the financial crisis, although BOFI acquired many of them at a discount after the credit crunch. In the latest annual statement, this class of securities yielded a collective 8.92%, which either speaks to their riskiness, management's investment savvy, or both. On page 20 of the latest 10-Q, there was $2 million in net unrealized gains in non-agency held-to-maturity MBS securities, and $7 million for the available-for-sale securities. This suggests to me that management knows what it is doing. However, management's willingness to devote a non-trivial portion of the balance sheet to dicey MBS assets does pose additional risk, and investors should carefully watch for developments in this area in future filings.

In conclusion, I believe that BOFI's low cost structure and superior service will lead to a long period of outperformance. I'm not the first person to come to this conclusion: in the last year, the stock is up nearly 125%. While the contrarian in me suggests caution in the face of such dramatic price action, I think that the long-term bull case is still sound. Just like LUV decades ago, BOFI offers the possibility of significant long-term capital appreciation because it is the rare well-run company in an industry famous for ticking off customers and lighting shareholder capital on fire. Its small market cap means that this stock is largely ignored by Wall Street and still below the radar for many institutional investors, so patient, small-scale retail investors can still get in on the ground floor. I hold BOFI stock in both IRA and taxable accounts, and plan on doing so until the valuation gets too out of hand or the fundamentals deteriorate.

Source: BofI Holdings: A Potential 10-Bagger