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Summary

  • Extremely overvalued at 5 x Book Value.
  • Flawed business model with waning profits.
  • Potential capital raise at $80 per share or lower.
  • Aggressive reserving.
  • Enormous interest rate risk.

A favorite of the retail momentum investors, Bank of the Internet (BOFI) has been on a tear over the past couple of years, rising from $16 in early 2012 to over $100 today. But at almost 5x book value, we find the valuation excessive, and believe that the stock is due for a large correction. We don't think that the average investor understands the risks here. We find the business model flawed, and that a large generator of recent earnings growth is vanishing. We think the bank is taking an enormous amount of interest rate risk, much more so than a well-run bank would take on in our opinion. We question the quality of earnings given the recent reductions in reserves for non-performing assets (NPAs). We further believe that one of the reasons for the recent acceleration in the stock price, the potential for the acquiring the H&R Block stored value card deposits, would require a capital raise on the order of $200 million, which would mandate pricing at a 20% discount to the current stock price.

It's interesting, when we ask bank fund managers what stocks they are short. BOFI is often the first name they mention. From a valuation and risk perspective it's an obvious candidate. Trading at 5 times its book value and over 32 times the 2013 EPS, it's more than a bit rich for a mortgage driving California thrift. Here is how BOFI compares to some of its competitors and how we derive our $35 target:

P/BV

Trailing P/E

Bank of Internet

5.0

32

Wells Fargo (WFC)

1.6

12

Pacific Premier (NASDAQ:PPBI)

1.6

12

Banner (NASDAQ:BANR)

1.5

17

Wintrust (NASDAQ:WTFC)

1.2

18

Umpqua (NASDAQ:UMPQ)

1.2

22

Provident (NASDAQ:PROV)

1.0

13

Everbank (EVER)

1.6

19

However, it's even more amazing that BOFI's numbers are driven by a depreciating - wasting away - non-agency mortgage asset. Basically the company made a timely decision and bought various duration mortgage assets at the bottom of the credit cycle at deep discounts to par. The earnings from these assets are waning. As these assets run-off, we expect net interest margin (NIM) to drop by 30bp next year. Without other lending opportunities, this may reduce EPS by $.10 this coming quarter and by $.40 over the course of calendar year 2014.

One of the reasons for the recent exponential shift in BOFI's price is the stored value card business. The street thinks that BOFI will be buying the H&R Block stored value portfolio that has been for sale for more than two years. Every bank that has looked at it has realized that they cannot make 12+% earnings multiple on the business. Management has hinted at this transaction forever, but what isn't mentioned is that if they get the transaction they would need to raise $200 million in capital to support this $6 billion block! In our opinion, this cannot get done at anything close to current share prices - no big bank funds would participate at 5x book value. The transaction would not be accretive for at least 2 years. We estimate it gets done at a maximum of $80 per share to attract the amount of funding needed to support the H&R Block business. To the best of our knowledge, none of the big bank funds own BOFI now, so why would they buy in at current prices?

So, who owns Bank of The Internet now? In our opinion, long-term holders who don't want to take the gain, retail traders, and momentum funds who know not what they own, but just that it goes up. Typically stocks of this nature have dramatic moves at the slightest earnings miss, regulatory order, or negative mention in the press. As an example, this chart shows what happened right before last quarter's earnings announcement. A relatively benign Seeking Alpha article called into question the earnings fundamentals of the bank - and boom, the price dropped over 10% in one day.

(click to enlarge)

This article just scratched the surface of what is wrong with this bank. Let me start with the most egregious issues. First, it's blatantly obvious to anyone who reads the 10-Q that the bank is betting your investment dollars on "Red". Red, being that interest rates stay down. Does the term Negative Gap Ratio mean anything to you? Well, go into your local bank and ask the CFO if they would run a triple digit negative gap ratio. Most banks keep this ratio as close to zero as possible. It's a measure of interest rate sensitivity. If a bank expects interest rates to stay low they may have a negative gap ratio of minus 5-10%. If a bank wants to be asset sensitive (expects rates to rise) they may keep a slightly positive gap ratio. For example, Banner lists a +13% cumulative gap ratio in its latest 10-Q. Umpqua lists the gap ratio at (-10%) in its 10-Q. But from BOFI's 10-Q, their cumulative gap is (-138%)!

So, for BOFI, a steep rise in interest rates will obliterate the earnings per share. Banks cannot adjust this overnight. It takes time to right size the balance sheet. BOFI responds to this risk by claiming that they will just keep interest rates low on their depositors for a longer period than other banks. This makes absolutely no sense. BOFI will need to raise rates the same or even more so than other banks. As an internet bank, it doesn't have loyal depositors. The bank has to pay .71% on checking accounts. In our opinion, depositors will move money at the drop of a hat to get a better rate at a competitor.

In the past, BOFI has offered one of the highest interest rates on money market and CD deposits in the country. This is how it has been getting customers. Up until recently, if you wanted a high rate of return on your risk free assets, deposit your money at BOFI, (just don't go over the FDIC $250,000 limit if you want it to be risk free). For example, if you went to bankrate.com a couple of months ago and clicked on "Best CD rates" in the country, BOFI may have come out on top, sporting some of the best rates for a given CD or checking account. But if you go there now, BOFI doesn't even show up in the Top 10, and oftentimes not in the Top 20. BOFI has clearly backed off the market and this may affect deposit growth dramatically. For example, for a 5 Year CD, the current best rate in the country is 2.2% offered by GE Capital. If you scroll down the list, BOFI comes in 22nd place with 1.35%. BOFI Is clearly cutting back, probably because it realizes it has too much interest rate risk. If BOFI continues this strategy, then the high growth rates are a thing of the past, and BOFI's price multiple should come way down to reflect this. I really don't see how this strategy will work given the dynamics of an internet bank. Here is a recent article discussing these dynamics when BOFI had market-leading rates:

From Samachar.com

Banks generally benefit from rising rates because they can charge more for loans while adding very little to how much they pay for deposits. Over time, a rising-rate environment leads to larger net interest margin -- the difference between interest paid and interest received. Some banks are better positioned than others to benefit from rising rates. Let's see how the industry stacks up.

Online Bankers Miss
Competing on price -- interest rates, in this case -- can be a banker's downfall in a rising rate environment. BofI Holding (NASDAQ: BOFI) and Everbank (NYSE: EVER) do just that: They steal deposits from other banks by offering above-average rates on deposits. Because online banks compete on price, their deposits tend to be less "sticky." Customers choose an online bank based on returns, not features or advantages like branch networks. As of its last presentation, BofI Holding, which owns Bank of Internet USA, was primarily funded with higher-cost certificates of deposit. CDs made up 49.8% of its deposit mix, substantially more than other online and offline banks. Everbank, by contrast, sourced 23% of its deposits from CDs and other time deposits.

Offline banks have much cheaper funding sources. Wells Fargo (NYSE: WFC) funds its balance sheet with very low-cost savings and checking account balances, which make up nearly $800 billion of its $1 trillion in deposits. It's "core deposits," or funding that it doesn't expect to vary greatly over time, makes up 94% of deposits, costing the bank 0.14% per year in the most recent quarter. Bank of America (NYSE: BAC) pays only 0.17% for its American deposit mix.

Bank

Savings and Checking Deposits as a Percentage of Total Deposits

Cost of All Deposits

Bank of America

83%

0.17%

Wells Fargo

80%

0.14%

Everbank

69%

0.76%

BofI Holding

50%

1.07%

Source: Latest 10-Qs and supplements.

Not surprisingly, high-interest internet banks rely more heavily on time deposits and CDs, which increase their funding costs.

The online banks have a tremendous advantage in a low-rate environment, when the difference between rates is a huge selling point for low-cost operators. Bank of Internet's 0.71% APY high-interest checking accounts look like an exceptional deal when rates are low. But will the promise of 0.71% on checking accounts be just as attractive if short-term rates run to 1%?

Think about it this way: Wells Fargo pays up to .01% on checking account balances. Bank of Internet offers 0.71%. If rates rise by 1%, Wells Fargo will offer as much as 1.1% on deposits, whereas Bank of Internet might offer 1.71%. Some 61 basis points isn't as compelling when the baseline is 1.1% interest on checking accounts.

But even that scenario may be too friendly to online banks. The fact of the matter is, traditional bank customers aren't fleeing from large operators like Wells Fargo. If rates go up, they have no real need to push rates higher -- their customers don't use Wells Fargo because it offers the best rates.

For BofI Holding and Everbank, rising rates will undoubtedly require that they step up their interest rates in line with increases in short- and long-term rates. [emphasis added] That could pressure their net interest margin while big, national operators like Wells Fargo and Bank of America use their trillions of dollars in low-cost deposits to make much more profitable loans.

BOFI's issues aren't just limited to its liabilities. BOFI's assets, and its reserves, raise some questions as well. The Bank makes non-conforming jumbo loans across the country. These loans are typically made to investors based on 1099 income or K1 income (AKA the Alt-A non-conforming investor that World Savings made negative amortization loans to for 30 years) While there is an after-market for these loans, it's not traditional. When the stock market sells off, these loans based not on investors' salaries but instead on stock market gains and illiquid assets may become delinquent. There is the potential that in the future these Non-QM Mortgages (Non-Qualifying Mortgages) will be put back to the bank. Other banks we have interviewed have told us they stopped making these loans as of the end of 2013.

The NPAs:

Over the past several quarters, BOFI has reduced its reserves for Non-Performing Loans (NPAs) to 58 bp! In our opinion, this is extremely low. We wonder why they are so aggressive. Could it be that they wanted to juice earnings so as to beat the expectations in each quarter? Why do most brick-and-mortar banks, who arguably have better knowledge of their credits and therefore better underwriting, reserve for NPAs at roughly 180bp when BOFI has only 58bp? In the future, BOFI's earnings can't be "improved" much further from reductions in NPAs as they have in the past. Further, if even a small number of their credits go south, BOFI doesn't have the reserve to cover them, so earnings will get hit and BOFI will need to build the reserve up for expected future claims. At 58bp there is very little margin for error.

When you look at the large owners of BOFI, you will find very few bank funds. I am not surprised at all, but this should be a clear red flag to any retail investor who is long the stock. Here are the large owners from Yahoo Finance:

Top Institutional Holders

Holder

Shares

% Out

Value*

Reported

Renaissance Technologies, LLC

744,500

5.27

58,391,135

Dec 31, 2013

BlackRock Fund Advisors

683,137

4.84

53,578,434

Dec 31, 2013

Dimensional Fund Advisors LP

509,143

3.61

39,932,085

Dec 31, 2013

Gilder, Gagnon, Howe & Co.

451,758

3.20

35,431,379

Dec 31, 2013

Vanguard Group, Inc. (The)

422,154

2.99

33,109,538

Dec 31, 2013

FMR, LLC

382,100

2.71

29,968,103

Dec 31, 2013

Pembroke Management, LTD

365,600

2.59

28,674,008

Dec 31, 2013

Weatherbie Capital, LLC

353,265

2.50

27,706,573

Dec 31, 2013

Shaker Investments LLC/OH

324,577

2.30

25,456,574

Dec 31, 2013

State Street Corporation

236,097

1.67

18,517,087

Dec 31, 2013

Top Mutual Fund Holders

Holder

Shares

% Out

Value*

Reported

Fidelity Low-Priced Stock Fund

350,000

2.48

21,147,000

Oct 31, 2013

iShares Core S&P Smallcap ETF

253,956

1.80

21,014,859

Jan 31, 2014

iShares Russell 2000 Index Fund

190,931

1.35

15,799,540

Jan 31, 2014

Vanguard Total Stock Market Index Fund

174,050

1.23

13,650,741

Dec 31, 2013

Powershares Exgh Traded Fd Tr II-DWA Small Cap Momentum Port

113,777

0.81

9,415,046

Jan 31, 2014

iShares S&P Small Cap 600 Growth Index Fund

104,594

0.74

8,655,153

Jan 31, 2014

Vanguard Extended Market Index Fund

96,976

0.69

6,285,014

Sep 30, 2013

DFA U.S. Micro Cap Series

91,936

0.65

5,554,773

Oct 31, 2013

iShares Russell 2000 Growth Index Fund

90,739

0.64

7,508,652

Jan 31, 2014

DFA U.S. Small Cap Series

86,700

0.61

5,238,414

Oct 31, 2013


Imperial was also a Southern California bank that made non-relationship loans that filed for bankruptcy several years back. Andrew J. Micheletti is currently the Executive Vice President and Chief Financial Officer of BOFI. He was formerly the Controller for Imperial Savings. These holders are not bank funds. These are quant shops, index funds, and momentum firms. There is no Wellington, Harvest, Stilwell, Jacobs Asset, EFJ Alternative Asset. The large intelligent value driven financial services managers have sold a long time ago. We asked one bank fund manager whose fund manages over $400M what he thought of BOFI (He has requested to remain anonymous).

It's like Imperial Savings Industries all over again. They don't make relationship loans instead their loans are made on an internal algorithm that the guys from Long Term Capital may understand, but no one else gets.

The financial services fund manager went on to say that:

As a banker, you need to know who your loans are being made to. This bank (Bank of the Internet), when the credit cycle turns may never see these assets paid back. There will be a catalyst, either a regulatory order, a turn in interest rates or a change in credit. Something or someone will tell us that the emperor wears no clothes

There are numerous complaints on Bank of the Internet. I guess running an internet bank the customer service leaves a lot to be desired. We found it interesting that the CEO of the bank chose to respond to the online complaints. Here are a few of the more colorful examples.

Awful bank making too many serious mistakes and underpaying the interests

I wonder if the other customers have gotten similar experience with the SAF Branch. They make far too many serious mistakes, and are very slow in correcting them (if they eventually decide to do so). You should double check and calculate your interest payment to make sure they are not underpaid. Mine has been underpaid for about half. They also haven't been keeping their promise.

Incompetent employees

Definitely not a place if you are looking for real advise on financial matters. Representative do not have the knowledge beyond the basics. Experience, knowledge, and customer service does not seem to be high on the list when hiring candidates. It seems that personality is the only trait HR looks for when hiring individuals. However, pure personality does not take you far enough. Definitely do not recommend BOI.

Purely Awful

Attempted to open a rewards checking account. Went through the standard online application and was told I would receive back confirmation in 4-5 hours. After no word back in two days I called and was told I needed to mail my drivers license (note not a copy of my license) to an address in San Diego. After some very unhelpful back and forth with an offshore customer service rep I gave up. Total let down, avoid!

The Worst Customer Service and Sketchy Technology

While the interest rates may be marginally higher & fees and charges marginally lower, the stellar customer service I had 10 years ago is gone. Now, every complaint submitted automatically gets a "resolved" & I have to resubmit multiple times -- some have still not been addressed. My issues include:

- my account was accessed by someone from Intuit as I received an email with Intuit.com. I did not authorize any non-bank personnel to do anything to my account at the time. When I reported it, I was told they were "fixing the issue with text messages" (see below) but the issue isn't fixed

- they've brought in more 3rd parties that receive my data (e.g. the service that prepares the statements for them) - clearly they don't care about my privacy

- I snapped a clear deposit photo 4x today with my Galaxy 3, following their advice, but it wasn't accepted

Terrible Customer Service and Lack of Basic Finance Knowledge Beyond the Most Basic

So far they have duplicated a deposit, not allowed pop money, and not delivered my check to a payee but offered to charge $35 to stop payment and send it again. My suggestion is to find a different online bank. Now they have rejected mobile deposits because they do not understand the word beneficiary. A supervisor finally overruled after multiple notes and phone calls and allowed the deposits, but they forgot to do one. They are the worst banking customer service group I have ever worked with. Also, if you do a mobile deposit, make sure you check that it goes in because they rejected mine with no email notification whatsoever. They claimed the system was broken but only after I asked.

The company's stock price has had a perfect momentum manager's chart for the last three years, but over the last three months it has been parabolic. Let's delve into why that is. Over the last 3 months there have been over 10 positive articles written on the name. The Motley Fool, Authors on Seeking Alpha, IBD have more than foamed at the mouth. We believe that the Motley Fool did a six article piece on the company (does it really take 6 articles to pump a simple bank stock). One, maybe two, but not six. Obviously, it was someone's intention to drive the stock price up! Here is a sampling:

The Best Bank for the Next Decade

Two Banks Others Should Idolize

Everything you need to know about BOFI Earnings

Will BOFI Continue to Surge Higher?

BOFI to Present at Three Investor Conferences in March

Is BOFI a Great Growth Stock?

Are On-line Banks a Good Place for Emergency Funds?

The Critical Thing You are Overlooking at these Banks

However, some of the comments from these articles called into question the bullish thesis. Here is one that hits home:

I think you guys are really missing the regulatory point here. Other banks are not doing this because they are not allowed to do it. From a theoretical standpoint, funding oneself with brokered deposits and CDs that pay higher than market interest rates, and then growing at a breakneck pace is not good for the overall risk of the market. Can you imagine what would happen if every other bank tried to do this? Credit quality would go into the toilet overnight. Technologically and feasibly, every other bank could run this business model overnight. BOFI is operating in a regulatory loophole essentially, and while that can continue as long as things go well, it is unrealistic to think that the government will let them grow to be a systemically important bank (which a $20b bank would be) with only one branch.

What's more amazing is that this company started from nothing. This was a small bank lender making a bunch of RV loans, with other hairball assets. The company made an amazing bet on non-agency assets at the bottom of the credit cycle, offered very high interest rates and gave out Non Qualifying mortgages (in our opinion) like crack to addicts on street corners.

In fiscal 2013, which ended June 30, the company pocketed $22.9 million in mortgage banking fees, a nearly 500% increase since 2011. This goosed EPS growth, which increased by a more modest but still impressive 55% during the same period. Put another way, as mortgage banking income increased by $18.2 million in the last two years, income before taxes increased by $34 million. Clearly, mortgage banking has been an important part of the company's recent growth story. A 35% decline in total originations across the industry versus the first half of the year along with continued headwinds in 2014 will make it difficult for the company to repeat this performance.

Other issues consist of regulatory risk as they reach into the structured settlements business which they mostly keep on balance sheet. We believe that their regulator (the OCC) may at some point have issues with life settlements business. There is a reason most conservative banks don't touch loans in this sector.

While the earnings growth numbers may have been jacked up by high deposit rates and non-traditional lending models have been high, it seems the building blocks of this institution might not be solid. There is a reason why successful banks grow slowly. Each loan is looked at as a long-term relationship. A customer is not an algorithm and while it is easy to rapidly increase assets through this model, the non-performing loans always tick up when credit turns. However, in this case there is the potential of a double whammy. If credit turns, the bank has problems; if interest rates go up, the bank has big problems; if regulators have an issue with the aggressive growth, the bank has huge problems. I think that at 5 times book and 32 times earnings, an investment in Bank of The Internet does not justify the risk.

Source: BofI Holding: A Bank Model Fraught With Peril, 65% Downside Based On 1.6 X Book Value

Additional disclosure: We are short BOFI.