Bank of Internet: Neither Tech Stock Nor Financial Black Box but Probably a Good Investment

Feb. 7.11 | About: BofI Holding, (BOFI)

Banks are not the typical businesses that catch my fancy. Banking is a leveraged commodity business by definition. Many of them are currently still sorting through their balance sheets, face headwinds from regulation, are exposed to risk from derivatives and have not undertaken the steps to ensure future solvency. I also tend to shy away from internet or tech companies as well. This makes Bank of Internet

Bank of Internet (NASDAQ:BOFI) is in many ways different from the crowd. While it is inherently levered, it is in a low cost position due to a lack of brick and mortar branches. While normally perceived as a detriment to business, a lack of fee based income removes most regulatory risk. The balance sheet is straightforward with conservative underwriting standards and no derivative exposure.

The stock is currently trading at less than 8x TTM earnings, despite doubling earnings in the past year. The reasons for this are likely two-fold. First, around 40% of the loan portfolio is concentrated in California. Need I elaborate? Second, the earnings growth has resulted from the huge expansion in net interest margin, a result of the Feds monetary policy of helping banks repair their balance sheets with cheap capital. For this reason the market believes future earnings will be less than present earnings.

Seeing as how interest rates can either stay the same or go up from here on out, it is likely that future earnings will be lower or the same. Managements normalized target is 2%NIMs and an efficiency ratio of 35% or lower. On their current $1.5B in interest bearing assets, that’s revenue of $30m, leaving $12.5m of net income after expenses and taxes of 35% each. That leaves the company trading at 12x normalized earnings, notmouthwatering cheap.

Management states that their current plan other than maintaining an efficiency ratio of 35% or lower is to increase assets to more than $3b. Using similar assumptions as above that translates into earnings of $25.3m in however long it takes for assets to double. Looking at historical growth, it could taken anywhere from 3-5 years, although each dollar it earns now with widened NIMs decreases the time frame because a dollar earned can translate in an additional ~$12 of interest bearing loans at current leverage rates.

Additionally, out of necessity and a product of the business model, BofI offers higher interest rates on a lot of deposit products than other banks. Deposits are very sticky, which is why so much promotional offers from banks exist that seem odd to the layman. It always struck me as odd that a bank would give you $50 or $100 in your account if you signed up for an account and used it. Now it makes perfect sense, because deposits are unlikely to leave in most situations, and large incentives are needed. Due to this phenomenon,BofI has to offer higher interest rates if it has any hope of attracting deposits. It is able to cushion some of this expense through being a low cost operator.

I view the higher interest rates BofI is offering particularly important in an environment horrendous for people living on fixed income. Just looking at growth in interest bearing demand and savings from 2008-10, the balance grew from $76m to $447m even though the interest paid on those accounts dropped from 3.59% to 1.42%. Other banks are offering their customers that much less that such a decrease actually resulted in an increase in deposits.

It is important to get back from the future though. The currently loan portfolio requires scrutiny to examine if potential upside in the future growth of the company can be realized. As mentioned earlier, the company has a lot of exposure to California. Due to the simplicity of the bank overall, the breakout of their balance sheet is quite thorough and therefore easy to investigate.

The company is a plain vanilla bank. The bulk of the portfolio is in single and multi family. There was a poor expansion into RV loans, but that has been scaled back. Non-performing loans currently stand at 1.64%, although allowances toNPLs currently stands at 41%, indicating future charges to earnings in the vicinity of $15m. The weighted average loan to value stood at 52% in the most recent quarter. This is generally more conservative than most loans, which indicates realized losses on the portfolio will be lower relative to peers. Homeowners have more skin in the game through greater equity in the home, and the bank has less at risk.

The company also holds a portfolio of residential mortgage backed securities (RMBS) valued at $561m. Management purchased these in the height of the financial panic and the portfolio has fared well. The loans are either GSE backed or super senior first lien, meaning the real estate backing them would have to absolutely crumble for them to take a hit. Judging from the loan book that they have generated, this pool of securities is likely to be well chosen and conservative.

Directors and officers own 16.8% of the stock, so there is an alignment of incentives. Especially when dealing with a leveraged institution, it is good to see skin in the game to know nothing crazy will happen.

The bank currently trades at 1.2x tangible book value and 8x TTM earnings. On a more normalized basis , the company trades at approx 12x earnings. This seems fairly inexpensive for a growing business that has a properlyincentivized management and low cost business model.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.