In January 2010, we wrote an introductory article introducing our long thesis on Bank of Internet (NASDAQ:BOFI). It has been nearly two years since that article, and it's time to provide an update on what continues to be one of our favorite long ideas.
By and large our thesis remains intact, and the high-level arguments that we highlighted in our original post continue to be the main points supporting our long thesis today.
Nevertheless, given that two years have passed, it makes sense to provide an update.
The Big Picture
Before we get to the numbers, it's important to explain some of the distinguishing aspects of BOFI's business model. Bank of Internet is an internet bank, and the only publicly traded internet bank in the United States as far as we know. As such, it has no direct comparables and the nuances of its unique approach to banking have received scant equity research coverage.
Internet banks are banks of extremes, as in some of their metrics are industry-leading while others are potentially industry-lagging.
On the positive side, internet banks feature:
- Industry-leading efficiency ratios, because they don't operate physical branch locations. BOFI has one branch and its loan officers, sales team, and management are primarily based out of its San Diego headquarters
- Industry-leading deposit growth, because they aren't reliant on branch locations to gain customers, but rather benefit from consumers' increasing shift to the internet to fulfill their banking needs
- A more rational underwriting policy, because credit officers are located in a single, central location and are not pressured to make loans to local customers at the branch level
On the negative side, internet banks feature:
- The potential for industry-lagging net interest margins, because internet banks gain customers by offering high savings interest rates
- Industry-lagging non-interest income, because internet banks have historically had limited business customers and have found it difficult to offer ancillary banking services like trust services, investment management fees, etc.
As we can see, when compared to traditional brick-and-mortar banks, internet banks have some positive traits and some negative ones. Yet when all the pros and cons of the internet bank operating model are combined, the end result is actually a sound business that can achieve attractive returns on equity and earnings growth as long as it's run by a management team that diligently monitors credit quality.
Strong Operating Momentum
As far as banks go, Bank of Internet's financial statements are among the most straightforward that you'll come across, partly because the company maintained robust credit quality during the credit crunch.
Non-performing loans to total loans have been 0.72%, 1.48% and 0.45% in fiscal years 2011, 2010 and 2009, respectively. Their loan book is primarily comprised of single family mortgages (39% as of 6/30/11) and multifamily mortgages (48% as of 6/30/11), which together comprise more than 85% of their total loans. LTVs are low, with a weighted average LTV of 54% for both single family and multifamily mortgages, as of 6/30/11. More qualitatively, we believe that BOFI has historically had better credit quality than other banks like Citigroup (NYSE:C) or Bank of America (NYSE:BAC) for the simple reasons that its underwriting team operates out of one central location and is run by a small core of conservative loan officers. Banks are capital allocators, and as any investor can appreciate, a lean "investment team" operating out of one location will often make better underwriting decisions than when multiple credit officers are trying to communicate between different locations.
Deposit growth has been rapid, growing 40% last year and 50% in 2010. Net interest margins have held steady, at 3.7% in FY 2011, 3.8% in FY 2010 and 3.0% in FY 2009. The result of high deposit growth, steady NIMs, and strong credit quality has been healthy growth in both earnings and tangible book value. Below are the relevant metrics:
The Company grew through the credit crunch unfazed, and has continued to grow tangible book value at a 10%+ annual rate. Yet, as we'll see, BOFI continues to trade at an irrationally low valuation.
At yesterday's closing price of $16.40, BOFI trades at a cheap multiple regardless of what valuation metric one uses. The stock trades at 1.1x Tangible Book Value. Based on 9/30/2011 LTM EPS, the stock trades at 8x P/E. If we were to assume a normalized P/E multiple of 14x, the stock would be worth $29. If we were to assume a TBV multiple of 1.75x, we would see a stock price worth $25. These prices imply 50%+ upside from current levels.
Based on what we have seen from BOFI CEO Greg Garrabrants, we think he has done a commendable job growing the business and launching intelligent business initiatives to increase the company's earnings. Garrabrants is a former senior vice president of IndyMac who took over the CEO role in 2007. He is also a guy with a respectable pedigree, having worked at both McKinsey and Goldman Sachs, and received both an MBA and JD from Northwestern, not to mention a bachelor's degree in engineering and a CFA. Building that sort of a resume requires smarts and hard work, and from speaking with Garrabrants, we get the sense that he is someone who has a vision for BOFI and is willing to work hard to achieve it. A sample video of Garrabrants is available here.
Garrabrants inherited an underwriting team with a strong track record when he joined BOFI; the bank navigated through the credit crunch atypically well because its former CEO, Gary Evans, had been quite conservative in the years leading up to 2007 and 2008 (his conservatism actually contributed to Evans' resignation, even though his disciplined underwriting ultimately proved to be prescient). Although Evans has since left the firm, Garrabrants has insisted that he has strived to maintain the disciplined underwriting culture that Evans had upheld. Thus far, we have seen little sign that BOFI's credit culture has deteriorated.
At the core, BOFI is a relatively simple story. The bank has historically had commendable loan underwriting, and its current asset portfolio appears conservative and straightforward. As an internet bank, BOFI benefits from healthy deposit growth and a differentiated business model that can continue to grow market share over the foreseeable future. Its management team appears competent, and recent operating history has demonstrated that they have been able to execute well for shareholders.
Last but not least, its valuation is attractively cheap.
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