- Given that BOFI operates in a commoditized industry with low barriers to entry against numerous competitors with almost identical offerings and business models, we think BOFI’s runway for profitable growth is challenged.
- Over the coming years, a combination of rising interest rates, combined with lower investment returns on MBS, are likely to significantly compress BOFI’s net interest margins.
- At 3.5x TBV and 20x earnings, BOFI trades at more than double its peers’ valuations. Based on our expectations for a long-term decline in profitability, we think a more appropriate valuation for the company is ~2.5x TBV or ~$50.
We are short shares of BofI Holding, Inc. (NASDAQ:BOFI), a bank holding company that owns several online-only banking brands, including Bank of Internet USA and Bank X.
At almost 3.5x tangible book value, BOFI is significantly overvalued, pricing in not only a long-term continuation of its rapid balance-sheet growth but also an extraordinarily strong net interest margin (NIM) and return on equity (ROE) in perpetuity. But BOFI's margins have been inflated in recent years by well-timed purchases of distressed securities, aggressive expansion in long-duration lending, and a drastic shift toward short-term deposits.
We think BOFI will go from posting industry-leading margins to falling well behind its peers - a logical outcome given its business model's inherent funding-cost disadvantage. As legacy securities roll off and interest rates rise, BOFI's funding costs should increase far faster than its asset yields, compressing its NIM by as much as 40% and crushing its ROE even more. With this rocky road ahead, investors who choose to pay 3.5x tangible book value for BOFI today are making a big bet on perfect execution and permanently low interest rates.
To be sure, BOFI has a strong track record. As a branchless bank, it has capitalized on its low cost structure to attract customers by offering better rates than competitors, achieving high deposit growth and a low efficiency ratio. The market has already rewarded its impressive operational performance: the stock has appreciated almost 1,200% over the past five years.
However, we believe the main driver of BOFI's recent earnings has been a large gamble on low interest rates and a once-in-a-lifetime opportunity in distressed MBS. It has managed to rapidly grow its profits in a mature and commoditized industry by chasing fickle, price-sensitive depositors and investing their funds in unusually long-dated assets. This strategy has given BOFI an enviable asset yield for the time being but has left it very exposed to rising interest rates. To retain its hot-money deposits in the future, BOFI will need to pay up, while still holding onto legacy assets earning below-market yields. Deposit growth could also become more difficult as big-bank customers feel more satisfied earning non-zero interest and online-only competitors replicate BOFI's value proposition.
At 3.5x TBV and 20x earnings, BOFI trades at more than double its peers' valuations. Based on our expectations for a long-term decline in profitability, we think a more appropriate valuation for the company is ~2.5x TBV or ~$50, which would represent a 32% decline from current levels.
I. Investment Highlights
- Overexposed to Interest-Rate Risk. BOFI has one of the largest negative interest-rate gaps among publicly traded banks. In other words, its assets reprice much more slowly than its liabilities. As rates increase, its funding will become dramatically more expensive, but its asset yields will stagnate. At a time when almost every high-profile bank has sacrificed short-term earnings to make its balance sheet "asset sensitive," with assets repricing faster than liabilities and thus positively levered to higher rates, BOFI has made the opposite bet, pumping up its earnings today at the cost of returns tomorrow.
- Core NIM Could Decline by ~40%. Rather than formulate our own idiosyncratic rate forecast, we look to the forward curve embedded in current market prices. On this basis, we expect short-term interest rates to rise by ~250bps over the next three years, while 10-year rates will rise by only ~100bps. Since BOFI's primary business is making long-dated jumbo mortgages and funding them with short-dated deposits, this implies that it will face 150bps of NIM pressure, pushing its margin down from ~4% to ~2.5% - more in line with its long-term history and that of other online-only banks. All else being equal, this normalized NIM would slash ROE from a standout 18% to a modest 8%. While the exact outcome will vary based on the path that interest rates take, a run-rate NIM of 2.5-3.0% would reduce ROE and net income by 40-60%.
- Earnings Temporarily Inflated by Opportunistic Securities Purchases. BOFI management, to its credit, recognized during the financial crisis that non-agency mortgage-backed securities were attractive investments. By putting almost a third of its balance sheet into these securities at low prices, it built up a store of future earnings that it has been gradually recognizing over time. As these assets continue to pay down, BOFI will have to reinvest at much lower yields, further depressing its NIM and reducing profitability. Moreover, in a post-Dodd-Frank regulatory environment, we question whether a bank of BOFI's current size would ever again be allowed to make such an extreme gamble with its depositors' money.
- Online Deposit Competition Getting Tougher. In the early days of internet banking, BOFI's offering was innovative and differentiated. Today, however, BOFI faces a wide range of serious competitors, from mega-depositories like Ally Financial to online-only players like EverBank. BOFI has a relatively price sensitive and fickle deposit base. With little brand recognition and deposit rates that are no longer ranking among the highest available, BOFI may struggle to sustain its torrid growth rate. Indeed, while BOFI has successfully increased its average account balance, we estimate that organic growth in the number of accounts has been negative for the past three consecutive quarters.
- BOFI's Lending Niches Are Becoming More Competitive. Unlike typical banks' more diversified loan books, BOFI's portfolio, which has more than tripled since FY 2010, is heavily concentrated in just a few areas: jumbo single-family mortgages and multi-family mortgages. Both sectors experienced capital flight during the financial crisis, propping up returns for players like BOFI that were willing to pick up the slack. But in recent months competition has steadily ramped up and lenders have gotten more aggressive. As BOFI's book turns over in this new environment, it will go from earning super-normal loan spreads to much more pedestrian returns, again putting pressure on its NIM and ROE.
- Declines in Mortgage Refinancing Volume Will Depress Fee Income. Without non-interest revenue sources like corporate treasury management, wealth management, or credit-card interchange, BOFI is heavily dependent on pure spread income. While fees have recently benefited from mortgage-banking gains on sale, rising interest rates have already sharply reduced mortgage originations, while competition has pushed down margins. BOFI thus faces major headwinds to future fee-income growth.
- Thin Loan-Loss Reserves Create Asymmetric Downside Risk. At just 0.54% of total loans, BOFI's allowance for loan losses is strikingly modest. While BOFI today, like its competitors, boasts low delinquencies and charge-offs, its weak reserves position it poorly for any possible uptick in nonperforming loans. Given the inglorious history of fast-growing financial firms, shareholders should naturally be skeptical of any lender's ability to maintain both 25% compounded loan growth and permanently pristine credit quality.
- Stretched Valuation Already Discounts Rapid Growth and High Returns. By almost any metric, BOFI's shares trade at an unusually high valuation. At 3.5x TBV and 20x earnings, BOFI likely needs to triple in size and maintain significantly above-average returns simply to justify its current share price, let alone drive upside. Indeed, according to BOFI's own reported estimate, the NPV of its existing portfolio of assets and liabilities accounts for only a third of its current market capitalization.
With so much growth already built into BOFI's valuation, shareholders need everything to go right just to eke out an adequate return. But in reality, as rates increase, BOFI's margins will revert to a more modest level that we estimate would justify a valuation of ~2.5x book value or $50 - still a sizable premium to peer levels yet 32% below the current price. If any credit problems emerge in the wake of BOFI's torrid loan growth, even that valuation will look extremely generous.
II. Company Background
Below is a snapshot of BOFI's financial and valuation metrics.
Multiples and Share Price Performance
BofI Holding Inc. is a bank holding company that operates a collection of internet-only banking brands, including Bank of Internet USA, Bank X, NetBank and UFB Direct. BOFI's strategy is simple: by eschewing physical locations, it can maintain significantly lower operating costs than its competitors. BOFI aims to use its lower cost structure to offer more attractive interest rates on deposits, thereby attracting more deposits than its brick-and-mortar banking competitors.
BOFI Has an Industry-Leading Efficiency Ratio
The strategy has been successful at attracting deposits, with BOFI achieving impressive growth in a mature and commoditized industry, though it has had to pay an average interest rate that is materially higher than most of its banking peers. Total deposits have grown from $420 million in 2006 to $2.4B in the latest reporting period (12/31/13).
Internet banks, like BOFI, attain their deposits at a higher cost than their brick-and-mortar peers.
Internet Banks Have Higher Funding Costs, and More Price-Sensitive Depositors
Source: FDIC Statistics on Depository Institutions, Bloomberg
From an asset deployment perspective, internet banks like BOFI suffer from some significant disadvantages. BOFI does not originate loans like traditional banks, which benefit from large staffs of branch managers and loan officers as well as close relationships with their borrowers. Rather, BOFI sources loans via branded websites like apartmentbank.com, as well as via relationships with affinity groups, wholesale channels and correspondent channels.
BOFI maintains a centralized loan solicitation and investment approach, using customer data sources, call centers and marketing efforts to solicit loan volume.
This unconventional approach has managed to achieve an asset portfolio that has generated a relatively attractive rate of return over the past few years. Management took advantage of their relatively smaller asset base to invest in opportunistic opportunities, such as buying distressed MBS at below par during the market downturn. These assets have earned investment yields of as high as 10%, helping boost BOFI's asset yields to industry leading levels.
BOFI Non-Agency Assets have Offset Declining Yield Environment
Source: Sterne Agee research, March 2014
Since BOFI effectively has no physical branch network, it generates little in the way of value-added fee-earning services. The vast majority of BOFI's non-interest income is in the form of income generated from selling originated mortgages, which, over the past few years, has been a very lucrative source of income due to heavy refinancing activity.
BOFI has Minimal Service-Based Non-Interest Income
Despite generating almost all of its income purely from borrowing higher-cost deposits and soliciting loans without a branch network, BOFI has achieved industry-leading earnings growth, profitability and return on equity for several years, while maintaining industry-leading underwriting performance.
Operating Metrics and Financial Highlights
We believe these results are unsustainable. Ultimately, BOFI is featuring among the highest NIMs in its history (~4%), and high ROEs for a bank (~17%), because of a very low interest rate environment, high nonrecurring asset yields, and a negative funding gap driven by longer-duration assets. Investors have assumed these results can continue for the long-term, valuing BOFI at P/TBV multiples nearing 4x and P/EPS multiples of 20x. We think NIMs are at risk of compressing, and the current sky-high valuation of the company is far too aggressive given the potential NIM pressures, slowing deposit growth and higher NPLs that the company may face.
III. Liabilities and Negative Rate Gap
Perhaps the primary risk to BOFI shareholders is the risk of rising interest rates. BOFI has one of the largest negative interest funding gaps in the banking sector. A negative funding gap refers to a balance sheet with higher rate-sensitive liabilities relative to rate-sensitive assets. For a bank with a negative funding gap over a given period, more rate-sensitive liabilities will reprice or mature than rate-sensitive assets -- for example, more deposits than loans. If interest rates are increasing over that period, the bank will likely suffer falling margins because the rise in its funding costs will outstrip any benefit to its asset yield. Over the past several years, BOFI has rapidly added a relatively price-sensitive and short-term-focused depositor base, while investing those deposits in longer-duration assets than most of its peers.
As a result, unlike most of its internet banking peers, or the banking industry in general, BOFI is uniquely positioned as a bank that has benefited immensely from declining interest rates. Over the past several years, BOFI has continued to reprice its deposit costs down lower (whereas many of its brick-and-mortar peers are already paying near-zero rates to their depositors), while retaining the higher yields on their long-duration asset book. This has greatly expanded BOFI's NIMs such that they now earn above the banking industry's average NIM (while internet banks generally earn below).
Even a modest increase in interest rates, which is largely expected at this point, will result in a relatively significant reduction in BOFI's earnings power due to the rapid increase in funding costs for its deposit base. Larger rate increases would put BOFI in a position where it could have capital shortfalls.
BOFI Has One of the Largest Negative Rate Gaps Amongst Online Banks
Source: Sterne Agee report, March 2014
A negative rate gap is particularly harmful for BOFI because their depositors are relatively price-sensitive, and less "sticky," than their brick-and-mortar peers. Depositors have flocked to Bank of Internet for the high interest rates, not for the large branch network, or the broad offering of ancillary services, that make brick-and-mortar banks' depositor bases stickier. Meanwhile, BOFI's assets are longer-term. So when rates rise, their cost of funding is going to ramp up, but the yield on their assets is going to take longer to rise, and therefore we should see pressured net interest margins.
IV. Price-Sensitive Deposit Base
In a mature and commoditized industry, how has BOFI managed to grow its deposit base so rapidly?
Unlike super regional banks such as Wells Fargo (NYSE:WFC), which have spent decades fostering an incredibly low-cost deposit base by providing considerable value-add services to their customers to become more "sticky," BOFI has largely attracted its deposit base by targeting a highly price-sensitive depositor base during a period of declining interest rates.
In a near-zero interest rate environment, BOFI's average ~1% interest rate on deposits is very attractive. The composition of BOFI's deposit base is more heavily weighted towards regular CDs (36% vs. industry peers at 19%) and jumbo CDs (19% vs. industry peers at 12%). This highly price-sensitive depositor base is both less sticky, and must be repriced more quickly (should rates decline) than the traditional retail savings and checking deposits that make up the vast majority of deposit financing for premium banking franchises. According to analysts, BOFI has had to pay, on average, 40% more than its peers in order to accumulate its deposits.
BOFI Has Attracted an Expensive and Price-Sensitive Depositor Base
Forward curve indicates continued NIM pressure
BOFI's negative interest rate gap is particularly profitable during a period of falling interest rates. As the bank's funding costs decline, it is investing its deposits in longer-duration, higher-yielding assets. However, when this steepening of the yield curve reverses, it can be particularly damaging to profitability since the bank's deposits will reprice relatively quickly, while longer-duration assets roll over more slowly.
The forward yield curve is currently flattening; for a bank with a large negative rate gap and long duration assets like BOFI, this implies a significant reduction in profitability.
Kerrisdale performed an illustrative analysis of what the flatter yield curve would imply for BOFI's profits given today's asset balances and approximate yields.
(click to enlarge)
Forward Curve is Not Looking Good for BOFI
V. BOFI's Deposit Growth to Decline
Total deposits have grown 20% to 40% annually over the past three years, driving much of the company's recent growth. We think that these rates will be difficult to sustain for a variety of reasons, including increased competition and headwinds from rising interest rates. As the company's deposit growth rate slows, its valuation should decline to more realistic levels.
Cautionary signs: BOFI's reduced competitiveness on Bankrate.com
Historically, Bank of Internet has provided some of the nation's highest interest rates on savings accounts and certificates of deposit, as can be seen by the industry monitor www.bankrate.com. Today, Bank of Internet is no longer a leading provider. For instance, here are the banks offering the highest 1-year certificates of deposit and savings accounts, as of March 31, 2014 according to bankrate.com.
Numerous Competitors Offer Higher Rates Than BOFI
As we can see, Bank of Internet is ranked approximately 20th in terms of providers of savings accounts and 1-year certificates of deposit. With respect to 1-year CDs, BOFI's rate is nearly half that of GE Capital's. Among savings accounts, BOFI's 0.55% interest rates are 20 basis points lower than the 0.95% rate offered by CIT and GE.
Here is a table showing how Bank of Internet ranked against peers in our review of bankrate.com for the most popular CDs and savings accounts.
(click to enlarge)
Competition From Online Banks Will Pressure NIMs and Deposit Growth
Across the board, the Bank of Internet's rates are substantially lower than the leaders in each product category. If BOFI continues to remain outside the top 10 for each product category, we would expect growth to markedly slow. New customers will likely gravitate to online accounts provided by competitors who are offering higher interest rates. Additionally, some of BOFI's own customers, who may have originally selected Bank of Internet because of its high rates, may migrate to competitors who are now offering better returns on their savings.
Competition from other online banks will pressure NIMs and growth
Banking is a commodity sector, since customers are indifferent to who provides their mortgage or pays interest on their money market account, as opposed to who provides their smartphone or sneakers. Online banking is especially a commodity. Whereas brick-and-mortar clients may prefer local banks with nearby branches and a robust ATM network, customers of online savings accounts are typically seeking the highest rates available, and are more likely to switch banks if their custodian can't match competitors' rates.
Additionally, the barriers to entry for online banking are low. A prospective entrant does not have to acquire real estate like a brick-and-mortar bank, but instead needs only to raise capital and acquire a banking license.
As a result, numerous new entrants are emerging to compete with Bank of Internet. A review of bankrate.com shows a large number of online banks that compete with Bank of Internet to offer the highest savings, money market and certificate of deposit rates to online customers. Like BOFI, these banks don't have brick-and-mortar branches to support or otherwise have access to lower cost of capital. Such firms include VirtualBank, AloStar Bank of Commerce, Discover Bank, EverBank (NYSE:EVER), GE Capital (NYSE:GE), Ally Bank, My e-BAnC by BAC Florida Bank and many others.
Broadly speaking, these competitors can be classified across a number of different verticals.
First, large national lenders such as Ally Bank and GE Capital have become strong competitors within online banking and currently offer among the highest rates for savings and money market accounts, as well as certificates of deposit. These large financial institutions have recognized the growth opportunities available within online banking, and have aggressively entered the market, offering both high rates to potential depositors as well as the security and assurance that comes with well-known brands. GE Capital, in particular, has become a dominant player, and its rates are listed among the top 5 in most savings account and certificates of deposit product categories.
Second, there are the online subsidiaries of foreign banks. Virtual Bank, for instance, is an online subsidiary of Banco de Sabadell (OTCPK:BNDSY), the fifth largest bank in Spain. "My e-BAnC" is the online subsidiary of BAC Florida, which is a subsidiary of Grupo Pellas, an industrial conglomerate based in Nicaragua. These banks benefit from the backing of large well-capitalized foreign banks, and can enter the U.S. market without having to acquire brick-and-mortar branches.
Third, numerous U.S. banks are launching or growing exclusively online banking divisions, essentially taking advantage of the low barriers to entry of online banking in order to grow their deposit base. GiantBank.com, for instance, is the internet banking division of Landmark Bancorp (NASDAQ:LARK), a small bank based out of Kansas. Doral Direct is the online division of Doral Bank (NYSE:DRL), a community bank based in Puerto Rico.
Fourth, there are increasing numbers of U.S.-based online banks entering or growing within the sector. These include EverBank Financial Corp, whose market cap is more than $2 billion, as well as smaller players like First Internet Bank of Indiana (NASDAQ:INBK).
We expect competition for online depositors to only grow over time. While Bank of Internet has established a longer track record of providing services to online customers, added competition will pressure BOFI to maintain high savings rates for customers, which will eat into the company's net interest margin. Alternatively, if BOFI wants to preserve its current net interest margin, it would be forced to sacrifice the rapid deposit growth rates that have fetched the company its high valuation multiples.
Headwinds from rising interest rate environment
The company's rapid deposit growth has been indirectly fueled by the lower interest rate environment. With interest rates at all-time lows, internet banks like BOFI can offer savings accounts with meaningful interest rates whereas brick-and-mortar banks like Bank of America (NYSE:BAC) and Wells Fargo are offering rates that are close to 0%. Many consumers want to be paid some sort of return for depositing their funds in savings accounts, and BOFI has been able to offer that benefit.
However, as interest rates rise, and traditional banks raise their rates to adjust to the new banking environment, BOFI's relative attractiveness for many consumers may decline, unless it's willing to boost rates to a greater degree.
Recent account growth has already begun to slow
In 2013, BOFI made a small acquisition, acquiring ~8,400 deposit accounts from Prudential Financial. When adjusting for this acquisition, BOFI's net account growth has actually been quite anemic recently, indicating that the bank's deposit growth has largely been a result of increasing account balances and customer wallet share.
(click to enlarge)
Adjusting for Recent Acquisition, BOFI Net Account Growth Has Been Anemic
Given that BOFI's depositor base is more weighted towards price-sensitive clients in a low interest rate environment (where BOFI's slightly higher deposit rates are relatively more attractive than brick-and-mortar offerings), BOFI is particularly at risk of rapidly losing deposits to competition.
VI. Assets: BOFI is Over-Earning on its Asset Portfolio
Despite a disadvantage in sourcing loans, BOFI has managed to actually increase its asset yield in a declining rate environment, while maintaining very high asset quality. How?
While BOFI's business model does provide a competitive advantage in terms of lower operating costs, BOFI has a competitive disadvantage on the asset side of its balance sheet. Whereas brick-and-mortar banks like Wells Fargo or SunTrust (NYSE:STI) can rely on longtime customer relationships to source loans that other lenders don't have access to, BOFI is either buying loans from borrowers who are actively shopping for the best pricing, or it is buying from wholesale and correspondent channels where BOFI has little informational advantage.
Typically, internet banks tend to earn asset yields that are at or slightly below their banking industry peers. However, over the past several years, BOFI has managed to achieve asset returns far above its peers. How?
(click to enlarge)
BOFI's Asset Yields are Likely Not Sustainable
There are two broad explanations for why BOFI's asset yields have recently been well ahead of its peers, and why we believe they are not sustainable going forward:
- Large bet on distressed RMBS during the market recession
- Longer duration asset portfolio
- Loan niches where competition is heating up, specifically jumbo loans
BOFI is materially over-earning in its securities portfolio
Prior to the recession, BOFI earned yields on its assets that were at or slightly below conventional banks, which is typical for most online banks, since online banks have no sourcing relationships and thus must compete to acquire loans largely on the wholesale market.
However, during and after the recession, BOFI's management astutely deployed their capital into higher yielding securities such as distressed non-agency residential mortgage-backed securities (RMBS). While most banks were forced to de-leverage during the recession, BOFI was benefiting from rapid deposit growth during a period when several investment tranches became particularly attractive (RMBS, structured settlements), and many new loans had fantastic risk-adjusted profiles due to rapidly appreciating property values in following years.
BOFI's management invested heavily into these assets, resulting in rapidly expanding returns on assets despite a broad decline in market interest rates. As a result, BOFI's asset yields today actually exceed their banking peers, which is unconventional given the structural disadvantages for an online bank.
Despite Having No Loan Sourcing Advantage, BOFI Earns Yields Above Bank Industry
FDIC Statistics on Depository Institutions
BOFI's strong yield, however, may not stem from a sustainable competitive advantage but rather from a well-timed series of proprietary trades, the benefits of which will decay over time.
During the financial crisis, BOFI recognized that RMBS were undervalued and aggressively used depositors' money to build up what was, by the end of FY2009, a $458 million portfolio, amounting to a whopping 35% of total assets. (In fact, up until the past few years, BOFI had no meaningful track record as a portfolio lender, concentrating instead on buying up securities and originating loans for sale.)
(click to enlarge)
Why is BOFI's Asset Yield High? Nonrecurring Bets on MBS!
As a result of its astute call on RMBS, BOFI's recent financial performance has seen an abnormally high yield on its securities portfolio. In the fourth quarter, BOFI reported on average yield of 4.7%, far outpacing its mid-sized bank peer group, which ran at only 2.2%. Given the size of BOFI's portfolio, this 250bp delta between BOFI's securities yield and its peers' yield inflated EPS by ~$0.51 - an 18% benefit relative to what BOFI would have earned had it achieved only its peer group's yield.
(click to enlarge)
BOFI's Earnings if in Line with Peers
Roughly 45% of the company's securities book, equivalent to 15% of earning assets, is in non-agency RMBS with a high yield of ~5%. These securities are expected to decline by 15%-20% annually and could lead to a ~175 basis point decline in the overall securities yield. This would translate to a 25bps decline in the net interest margin over the next few years. Irrespective of how quickly or gradually interest rates rise, we expect to see a decline in the securities yield as these higher rate non-agency RMBS assets pay down.
Comparison to EverBank
We also compared BOFI's earnings yields to those of another online bank, EverBank. EverBank, like BOFI, faces the same structural disadvantage as it pertains to deploying assets, yet BOFI earns a higher return on its assets (~5.0%) relative to EverBank (~4.4%). Both EverBank and BOFI pay significantly more than conventional brick-and-mortar banks for their deposits, both paying ~1%. However, BOFI's NIM of ~4.0% is significantly higher than EverBank, which is ~3.4%. The main reason for the gap is the larger returns BOFI earns on its assets, particularly its securities portfolio.
(click to enlarge)
Compared to EverBank, it is Clear that BOFI is Over-Earning on its Assets
Not only does BOFI's securities portfolio feature a higher yield than EverBank's, but BOFI also earns more than EverBank on its loan portfolio. As discussed further in this report, this is due to an intentional, and quite risky, decision by BOFI management to chase yield by investing in longer-dated assets.
BOFI's loan growth has been narrowly focused, and competition is heating up
Over the past several years, BOFI has achieved remarkably fast loan growth: from the end of its fiscal year 2008 to the last reported quarter, the balance of loans held for investment increased at a 31% CAGR, far outpacing the overall market.
Rather than diversifying its lending across many sectors, BOFI has made an extremely concentrated bet on housing: since FY08, single-family mortgages, warehouse loans (i.e. loans to mortgage lenders), and multi-family mortgages have contributed 94% of BOFI's total loan growth. Single-family mortgages alone have ballooned by a factor of almost 9x. Meanwhile, non-housing-related lending, which previously constituted almost a quarter of BOFI's loan book, has steadily diminished in relative importance.
BOFI's Loan Growth Has Been Concentrated in Housing
Within single-family mortgages, BOFI has focused particularly on jumbo loans - those with balances exceeding the Fannie Mae/Freddie Mac size limits - typically acquired on a wholesale basis via mortgage brokers. In the wake of the financial crisis, jumbo mortgage spreads became unusually wide, and BOFI capitalized on this dislocation by piling into the asset class. Since then, however, the market has swung far in the opposite direction. On March 20th, the Financial Times highlighted this trend in an article entitled "Jumbo loans the new battleground for US banks" (emphasis added):
Competition between the banks has helped push the difference between rates on "jumbo" mortgages and those on smaller home loans to one of the lowest levels ever recorded…
…Redwood Trust, one of the few companies that has been selling private-label MBS, told investors earlier this year that "we do see large money center banks through their retail lending platforms being very aggressive in the jumbo lending space."
(click to enlarge)
BOFI's largest segment of loans, Jumbo loans, are facing declining yields
This piece is only the latest in a series of reports underlining the recent intensity of jumbo competition:
- "Wealthy Americans benefit from banks hunting jumbo mortgages" (Boston Globe, July 2013)
- "Lenders get the munchies for jumbo loans" (Bankrate.com, December 2013)
- "Hurdles shrink for jumbo loan shoppers" (CNNMoney, February 2014)
In the words of veteran mortgage-market journalist Guy Cecala, "It's a good time to be a jumbo borrower." By the same token, it's a bad time to be a jumbo lender. As a small player relying on brokers and other third parties to generate loans, BOFI lacks the customer relationships that give big-bank competitors a modicum of pricing power; thus it has no choice but to match lower rates if it wants to retain, let alone grow, its market share. BOFI's big bet on jumbo lending, which began as an opportunistic allocation of capital to a disrupted sector, has now become an outsized dependence on an increasingly competitive niche market dominated by the largest banks. In the face of this competition, BOFI's hopes of sustaining super-normal returns will diminish.
The multi-family mortgage market, BOFI's second largest area of focus, has also witnessed increased competition and deteriorating lender economics. New York Community Bancorp (NYSE:NYCB), one of the largest bank players in this space, said on its fourth-quarter earnings call in January, in response to a question about "pricing and the competitive environment in multi-family," "I think there's no question that the marketplace is highly competitive." Freddie Mac (OTCQB:FMCC), which securitizes multifamily as well as single-family loans, opened its discussion of the outlook for the sector in 2014 in the report "Preparing for a Year of Competition in the Multifamily Market":
We know the year is going to be challenging for you as well as us. The consensus is that Treasury yields and competition will likely increase through 2014. We are prepared for elevated competition from conduits on proceeds, life insurance companies on price and banks on floating-rate transactions. Our challenge is to stay relevant with this level of competition.
Journalists have also noticed the recent ramp-up in competition. As the Commercial Observer reported in March ("Multifamily Lenders Scramble for Business"):
[M]ore banks have entered the fray-sometimes even resulting in bidding wars-and borrowers are being courted. Lenders have a bouquet of attractive terms they are willing to provide, including higher LTVs and fewer or no administrative fees, sources told Mortgage Observer.
…"The multifamily market has always been competitive, but it has become much more competitive the last two years as more lenders enter the business," said Dan Harris, the chief lending officer at Dime Savings Bank of Williamsburgh, an active multifamily lender. "While many lenders offer similar rates, terms and loan amounts, secondary issues like prepayment fees, interest-only periods, step-ups and long-term rate locks have become [the areas] where lenders differentiate themselves to win the business."…
In today's environment, based upon the loan to value and debt service coverage, certain lenders are charging interest only for as long as five years, offering fixed rates for loans with terms as long as ten years. LTV ratios, meanwhile, are as high as 80 percent, at times. … Other terms to sweeten the deal include reduced legal fees-as low as $2,500 per property-and no appraisal or environmental fees on certain deals.
Traditional banks offering a wide range of products can ride out frothiness in individual lending markets without facing a great deal of pressure on overall returns. But by allocating its portfolio so heavily to single-family jumbo and multi-family mortgages, BOFI has held itself hostage to the competitive dynamics in these sectors, which continue to become less favorable.
Asset size is an anchor to investments returns
When the Bank of Internet was smaller, it made sense that management was able to source attractive loans wholesale that generated a reasonable return while exhibiting strong credit quality. However, as the bank grows, sourcing larger volumes of loans and assets will become increasingly more difficult for the bank, as it begins to compete for larger loan pools with other market participants.
The result may be slower asset growth, higher non-performing assets, or lower-yielding assets, or a combination of all three. These developments would call into question the company's industry-high valuation multiples of 3.5x P/TBV and 20x forward P/E multiples.
VII. Assets: BOFI's Asset Duration is a Systemic Risk
BOFI's asset duration is longer than its peers -- this is a mismatch with their deposit base
Online banks like BOFI tend to attract more price-sensitive depositors that are less "sticky" than those of conventional brick-and-mortar banks. Thus, online banks should presumably match their less stable liabilities with shorter-duration assets to take into account their riskier asset / liability mismatch.
However, instead, BOFI has a particularly long-duration asset portfolio when compared to its peers. Why do this? To get higher yielding assets!
BOFI's decision over the past few years to maintain a longer duration loan book made sense, because interest rates declined and the bank was able to benefit from higher-yielding assets. But going forward, interest rates are more likely to increase. So BOFI will face one of two choices. It can either reduce the maturity of its assets, in order to be able to reprice its assets to match its rising deposit rates. That will result in a lower asset yield. Or it can maintain its longer maturities, and then if interest rates do rise, it won't be able to reprice its assets, resulting in compressed NIMs. Either BOFI's asset yields will decline as the company tries to reduce its interest rate risk, or the bank decides to take on substantial interest rate risk.
BOFI's Loan Portfolio Maturity is an Outlier
Regulators are worried about banks like BOFI
As the prospect of higher interest rates has become more real, bank regulators have increasingly drawn attention to the need for careful management of rate risk. In the Office of the Comptroller of the Currency's latest Semiannual Risk Perspective, released in December, the agency points out that the "retention rate of post-crisis core deposit growth rate remains uncertain":
Bankers need to analyze core deposits carefully because they are potentially more sensitive to rising interest rates than historical relationships would suggest. These deposits flowed quickly into the U.S. banking system and are at risk of rising more rapidly in cost or moving out of the banking system.
The FDIC has likewise recently stressed the dangers facing liability-sensitive banks like BOFI:
The FDIC is increasingly concerned that certain institutions may not be sufficiently prepared or positioned for sustained increases in, or volatility of, interest rates. For example, institutions with a decidedly liability-sensitive position could experience declines in net interest income and potential deposit run-off in a rising rate environment… Boards of directors and management are strongly encouraged to analyze on- and off-balance sheet exposure to interest rate volatility and take action as necessary to mitigate potential financial risk.
VIII. Non-Recurring Mortgage Gains
Declining mortgage origination will lead to lower-interest income
A substantial portion of the company's historical profit has been driven by non-interest income from the company's mortgage origination business. BOFI originates single family mortgages through its multiple national branded websites, relationships with large affinity groups and a call center which uses a variety of internet, third-party and other leads.
While it retains some of these loans, it also sells some to other customers, generating a gain on sale on the transaction. While this was a growth driver for BOFI over the past several years, the sharp slowdown in originations are likely to cause a headwind to the company's growth over the next few years. In the aggregate, BOFI sold $1.1bn of mortgages in FY 2013, compared to $665m in FY 2012 and $217m in FY 2011.
BOFI generated $23m of mortgage gain on sale in FY 2013 and $17m in FY 2012. That compares to overall operating income of $68m in FY 2013, and $50m in FY 2012. In other words, mortgage gain on sale accounted for 34% of the company's EBIT in both FY 2013 and FY 2012.
(click to enlarge)
BOFI Has Minimal Service-Based Non-Interest Income
Unfortunately, the Federal Reserve's tapering has led to rising long-term rates, which has led to a sharp slowdown in mortgage originations. For the first half of 2014, according to the Mortgage Bankers Association, mortgage originations are slated to decline 53% year over year, which will likely cause a decline in the company's mortgage gain-on-sale business.
Given that the mortgage origination business has been a strong contributor of historical profits, its certain decline calls into question the company's lofty 3.5x P/TBV and 20x 2014 P/E multiples.
IX. Potentially Under-Reserved on NPAs
BOFI's level of reserves raises questions as well. A large percentage of the bank's mortgage book is comprised of non-conforming jumbo loans. This can be seen, for example, from the company's March 2014 investor presentation, where the company shows that 76% of its single family loan production in the second half of last year was in the jumbo segment.
While LTVs are low, jumbo loans are not necessarily bullet-proof assets. Certain jumbo borrowers may derive much of their income via 1099s or K-1s, and a reversal of fortune as well as a broader recession could lead to delinquencies. In addition, BOFI's loan growth has been dramatic over the past few years, and historically, it's often difficult for banks to incur rapid loan growth without relaxing underwriting standards. We wouldn't be surprised if BOFI's historically strong credit quality deteriorates due to the pressures that come with expanding its balance sheet quickly to meet incoming deposits.
Yet despite potential risks, over the past several quarters BOFI has reduced its allowance for loan losses to 0.54% of its total gross loans, an unusually small amount, and that percentage has declined in each of the past two quarters.
In our opinion, BOFI's reserves for losses are at atypically low levels. Most other banks maintain much higher allowances for loan losses. Below we present a comparison of comparable banks and their allowances for loan losses as a percentage of total gross loans.
(click to enlarge)
BOFI's NPLs Leave Investors with Very Asymmetric Risk to the Downside
As we can see, BOFI's NPA reserves are materially lower than its peers.' We believe that lower provisions have helped inflate historical financials, but with reserves at industry lows, the company's ability to rely on abnormally small provisions for loan losses to generate EPS growth is going to deteriorate.
Furthermore, if even a small number of the company's loans go sour, BOFI may have insufficient reserves to cover them, which would result in a hit to earnings. It would also force BOFI to be more conservative in future provisioning, which would create headwinds for its growth prospects.
At the current 54 basis points of allowances for loan losses, BOFI has given itself little margin for error. The company's current market valuation multiple is simply too high given the potential tail risks that its inadequate reserves present.
X. Valuation Appears to Discount an Unrealistic Scenario
Below is a comparison of BOFI's valuation multiples relative to its peers. As we can, see BOFI's multiples are materially higher than its peers on both a P/E and P/TBV basis.
(click to enlarge)
BOFI P/TBV vs. Banking Universe
(click to enlarge)
BOFI P/EPS vs. Banking Universe
BOFI's P/TBV valuation multiple is well higher than other traditional banks like Wells Fargo or US Bancorp, in many cases being more than double the multiples of these well-run banks with decades of operational outperformance. But BOFI also has one of the highest valuation multiples amongst the nation's fastest growing banks, such as banks fueling deposit growth from prepaid cards or in particularly high-growth regions.
With respect to internet banks, which feature some of the disadvantages previously discussed in the report, BOFI's valuation is a very conspicuous outlier. The market appears to penalize other online banks' high-cost liabilities and lack of competitive advantage when it comes to sourcing assets, but disregards these same concerns when valuing BOFI.
As an additional data point, we compare BOFI to other banks on a chart comparing P/TBV to Return on Tangible Common Equity. Again, BOFI is an outlier, trading at a materially higher multiple relative to its peers.
BOFI vs. High Growth and High Profitability Peers
Another approach to demonstrating how BOFI is overvalued is to use reverse integration - backing into a set of assumptions that would justify BOFI's current valuation. Below, we lay out projections that attempt to do that:
What Assumptions Would Justify BOFI's Current Valuation?
As we can see from the above chart, one set of circumstances that could justify BOFI's current valuation includes the following:
- Tripling of its deposit base: assuming BOFI can increase its deposit base from $2.4B to $7.5B, while US GDP is expected to grow only modestly
- Asset growth to $11 billion from less than $3 billion
- Maintain 3.5% NIM: BOFI has one of the largest negative interest rate gaps in the US banking industry; we illustrate a scenario where the bank is able to deploy nearly $11 billion at ever rising investment returns to offset its rising borrowing costs
- Efficiency ratio of 35%: in line with management's long-term goal
- Non-interest income grows in line: mortgage refinancing gains continue to grow despite a rising rate environment
- Permanently low NPLs: BOFI's underwriting team manages to deploy $11B in capital yet maintain only 50bps in provisions
We believe the scenario above is not realistic, and incredibly difficult to achieve.
We think a more reasonable valuation for BOFI is approximately $50.00 per share, or ~2.5x TBV and ~15x EPS.
- Deposits continue growing, but at a slower pace, approximately doubling to $5B
- Net interest margin compresses to 3.0% long term, modestly lower than the banking industry overall
Illustration of a More Reasonable Valuation
BOFI is currently one of the highest-valued publicly-traded banks in the US. The Company's shares trade for approximately 20x EPS and 3.5x TBV because investors have mistaken BOFI as a bank with a competitive cost advantage and a long runway of growth.
Given that BOFI operates in a commoditized industry with low barriers to entry against numerous competitors with almost identical offerings and business models, we think BOFI's runway for profitable growth is not nearly as healthy as investors think it is.
Over the coming years, a combination of rising interest rates, combined with lower investment returns on MBS, are likely to significantly compress BOFI's net interest margins (bringing them in line with banking peers). They will also significantly dampen refinancing activity, hurting BOFI's mortgage gain-on-sale business, while also slowing BOFI's deposit growth.
- Borrowing costs will rise faster than income growth: BOFI's deposit base is more heavily catered towards price-sensitive depositors. While most banks benefit from rising interest rates because their deposit rates may not rise as quickly as loan rates, BOFI will likely be forced to pay higher interest rates to retain their funding, whereas its assets are likely to roll over into higher rates more slowly.
- Deposit growth will likely slow: Furthermore, the speed at which BOFI collects its deposits will likely be impacted. Online banking is becoming increasingly competitive, and financial stalwarts such as GE Capital or Ally Bank are increasingly topping bankrate.com in terms of the highest-yielding savings rates and certificates of deposit. As new customers, and perhaps some current BOFI customers, gravitate towards competitors offering higher yields, BOFI's deposit growth could come under pressure. Additionally, in a period where interest rates are near zero, many clients may choose to forego the convenience of a local branch network in order to earn some interest income from BOFI. However, as rates increase, the relative benefit of BOFI's service declines precipitously (there is a more significant relative difference between offering 1% rates when your competitors offer near 0%, and offering 4% when your competitors offer 3%).
- Asset returns and loan losses mean reversion: We don't think there is much leverage for BOFI to generate incremental income from its assets. BOFI's assets are already generating abnormally high returns and BOFI has provisioned a razor thin level for loan losses. Part of this may be due to managerial skill and BOFI's small size - BOFI has been nimble enough to pick pockets with particularly high risk-adjusted returns without sacrificing loan losses (MBS, structured settlements, others). However, as BOFI's loan book grows, BOFI's asset returns and loss provisions are likely to come closer to industry norms, greatly diminishing their earnings power. We think the risk to the downside for BOFI's asset returns is significant.
By almost any valuation metric, BOFI's shares trade at an unjustified premium to its peers. We attribute this to the market's mistaken assumption that BOFI has a true competitive advantage, and that the rapid profit growth achieved during the past five years, during a period of declining interest rates, will continue during the next five years, during a period of rising interest rates.
We believe BOFI's earnings are artificially inflated by a variety of factors which will reverse in coming years, and that investors are wholly mispricing numerous significant and likely risks that will bring the valuation towards a more reasonable level. BOFI's business model can be easily replicated - the reason it has not been is that brick-and-mortar banks have realized that the marginal benefit of lower funding costs is offset by the marginal cost of higher funding. As interest rates rise, BOFI shareholders will realize this as well.
We believe a more appropriate valuation metric for BOFI shares is approximately 2.5x TBV, which still gives credit to the management team's growth record and investment skill. Nonetheless, this would represent a significant downside of 32% for existing equity holders.
Additional disclosure: Read our full disclaimer at kerrisdalecap.com/legal-disclaimer-3. This is not a recommendation to buy or sell any investment. We may transact in the securities of BOFI at any time subsequent to publication. Please read our full disclosures at the end of our report.