Amidst a torrent of recent promotional press releases, Bank Of The Internet (NASDAQ:BOFI) has curiously omitted a major announcement. BOFI, the "branchless" internet wonder-bank, has opened its first physical branch location. BOFI is, in fact, no longer branchless! Mysteriously, however, the existence of this new branch has not been disclosed in the company's SEC filings or investor relations materials. Instead, its existence only recently emerged on the FDIC's website:
The FDIC reports that last August, BOFI opened a purported "full service brick and mortar" branch in the Nevada desert. A significant development, why would BOFI keep the existence of its first branch a secret from investors? With the bank's promoters having compared BOFI to the Tesla Motors (NASDAQ:TSLA) or Amazon (NASDAQ:AMZN) of the banking industry, I initially thought that this "branch" was a prototype in the spirit of Apple's (NASDAQ:AAPL) foray into retail stores (below). Perhaps the new branch is part of a dynamic effort to reinvent traditional banking?
Wanting to take a tour, we decided to visit BOFI's first brick & mortar branch to see its potentially revolutionary branch banking concept for ourselves. Expecting to be awed, we instead found... well, anything but a full service federal branch.
The Phantom Desert Branch
BOFI's "full service branch" is located on the 8th floor of 200 S. Virginia Street in Reno, Nevada. Getting off the elevator, customers are greeted by a Regus "virtual office" location offering shared and tightly compacted housing for dozens of small businesses. Walking up to the communal reception area and thinking there must be a mistake, we asked where the BOFI Federal Bank branch was. While the receptionist was not aware of a bank branch, she did indicate that there was a BOFI representative officing there.
After a brief wait, an individual who would only introduce herself as "Kim" emerged. Kim indicated that she did work for BOFI Federal Bank but declined to provide any additional information. She stated she didn't have a business card, would not offer her last name, and appeared to be quite nervous. This may be for good reason.
It appears that Kim is the only BOFI employee at this supposed Federal "full service" branch. The branch is registered with regulators as consisting of "Suite 813," which is the microscopic office highlighted below:
Believed to command around 75 square feet, BOFI's brick & mortar branch is the size of a glorified closet. The office itself looks similar to this sample photo from the location (minus the window view).
To our eyes, BOFI's Nevada location is an obvious front that is far from the "full service," "federal branch" that BOFI has even asserted (in a public 2014 document sent to the OCC prior to its opening) serves "the community" of Reno.
All investors are encouraged to take advantage of cheap airfare and evaluate the legitimacy of this "branch" for themselves. The question, of course, is why BOFI would even need to set up a phantom full service federal branch in the Nevada desert? (Hint: It has to do with regulators, millions in profits, and over $400 Million in highly controversial loan production last quarter)
Refund Transfers, Regulatory Problems, and H&R Block
BOFI's Nevada "federal branch" was created on August 31, 2015 which is the exact day that BOFI's long pending acquisition of H&R Block's (NYSE:HRB) bank closed. The timing is not an accident. Soon afterwards, BOFI began providing three, often interlocking, H&R Block related products:
These products have already become loudly trumpeted contributors to BOFI's financial results. Last quarter, for example, BOFI's loan production was boosted by a full $413 million in Emerald Advance line of credit originations. Going forward, BOFI has also reiterated its guidance that:
We continue to expect that on an annual basis three initial products in the H&R Block program management agreement will generate $31 million to $34 million of annual revenue and approximately $13 million to $16 million of after-tax net income
While certainly representing a boost to (short term) reported profits, BOFI has plowed headfirst into a space that contains significant risk and underpins a fundamental investor misunderstanding. BOFI (in my opinion) "won" the H&R Block deal only because no one else was willing to take on the risks that H&R Block was looking to shed - this is, in part, why H&R Block actually paid to get rid of its bank.
Citron Research has already authored a report on BOFI, warning about the pervasive risks of BOFI's expansion (through the H&R Block deal) into the prepaid card arena. As one of only several major industry players, The Bancorp (NASDAQ:TBBK) is a prime example of the regulatory perils of this space. Despite having a compliance department substantially larger than BOFI, TBBK shareholders have experienced near total losses since it was hit with a June 2014 Cease And Desist Order and a December 2015 amended consent order:
These risks have been forgotten by many investors due to the combination of the H&R Block deal's lengthy closure and the enormous promotional impact of constant sell-side gong-beating and hype. Also poorly recognized is the fact that the H&R Block deal has brought BOFI into the highly controversial tax refund transfer space. Believed by consumer advocates to be an extremely predatory product, this area has been a perennial focus of regulators. Refund advance loans (RALs) were mostly eradicated when the largest banks pulled out after a series of government actions, including a specific FDIC ban.
In turn and as a key player in the space, refund transfers have been a source of constant regulatory issues for H&R Block. In 2010, HSBC (NYSE:HSBC), H&R Block's refund transfer lending partner at the time, decided to flee the RALs because of the risks. Fighting back, H&R Block actually filed a suit against HSBC in an effort to force the bank to finance RALs during the tax season.
The fact that HSBC would jump a long-term contract in order to avoid making loans illustrates the "untouchable" nature of this category for many banks. The lawsuit was quickly dropped after a specific OCC action terminated the contract by specifically ordering HSBC to stop all RAL lending. After HSBC left, H&R Block began offering modified refund transfer products through its in-house bank (which BOFI has now acquired). This soon resulted in a large class action lawsuit, which claimed that H&R Block violated California consumer and lending laws by charging "predatory interest rates and fees" and "aggressively marketing these predatory products to the working poor and minority clients." Having now acquired H&R Block's bank, BOFI has jumped directly into this fray.
Regulatory scrutiny of refund transfers has continued in recent years. With technical modifications, RALs currently live on in new disguises: Refund Advance Checks (RACs) and tax-oriented personal lines of credit - both of which are now key BOFI products. In addition to the CFPB, one of the most aggressive regulatory offices in this category has been the California Attorney General. H&R Block itself has already been the subject of a previous California action, which resulted in a 2009 settlement. Ominously, while the H&R Block/BOFI deal was still pending, the California Attorney general began to again kick the tires on H&R Block's refund transfer products, which became the subject of an "official inquiry." Notably, in its SEC disclosure, H&R Block warned of the "material adverse impact" of any regulatory limitations:
Since BOFI (which now provides the products) is headquartered in California, the California Attorney General's reported interest in this area obviously may have important implications for its ability to offer refund transfer products. This brings us back to the purpose of installing a phantom federal branch in the Nevada Desert.
The Value Of A Phantom Branch
Written into the document, the publicly filed BOFI/H&R Block program management agreement specifically calls for BOFI's creation of a Nevada Branch:
Importantly, the agreement clearly states that BOFI "will issue and book the Financial Products at the Nevada Branch." Indicating that this provision has been put into action and that the products are now being issued in Nevada, BOFI's Emerald product disclosures (here, here) claim that Nevada law applies. By implication, BOFI's H&R block related credit products are likely being "booked" through BOFI's phantom Nevada "branch." This means that "Kim" has been quite busy. Her 75 square foot office likely was singularly credited with the origination of $413 million worth of Emerald Advance loan production last quarter alone (making her perhaps the most productive bank employee in the country!). While I applaud her efficiency, the major issue is that Kim's office is an obvious phantom (in my opinion) that is far from the Reno community's federal full service brick & mortar branch that BOFI has claimed.
The legitimacy of the "branch" is critical because its creation was so important that it was even designated as a specific closing condition (page 31) of the H&R Block contract. Nevada, unlike California, completely lacks a usury limit in addition to other consumer protections. So, does BOFI believe that issuing and booking these products through its "full service branch" in Nevada exempts it from California regulatory restrictions that would otherwise apply? One thing is known; the agreement clearly states that the Nevada Branch is "necessary for [BOFI] to export Nevada interest rates (and rely upon Nevada usury rates) on the Emerald Advance and other credit products." Appearing to have been booking hundreds of millions of dollars of loans through a phantom branch in the desert, BOFI's ability to "export" Nevada law may be tested, especially if the California Attorney General's reported "inquiry" is ongoing.
As a result, I believe the legitimacy of BOFI's entire H&R Block product offering could be at risk and potentially subject to a sudden halt. BOFI's investors have pinned their hopes to these products, which are widely viewed as major risk-free growth drivers (representing $13-$16 Million in guided annual net income). With expectations being so high, any disruption to the H&R Block business would likely have a major impact on BOFI's earnings and stock price. The investment risks, in my opinion, remain beyond elevated.
Note: All information in this article was derived from publicly available information. Investors are encouraged to conduct their own due diligence into these factors.
Disclosure: I am/we are short BOFI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Additional disclosure: I am/we are short BOFI and have no present position in HRB. All information for this article was derived from publicly available information. Investors are encouraged to conduct their own due diligence into these factors. Additional disclosure: This article represents the opinion of the author as of the date of this article. The information set forth in this article does not constitute a recommendation to buy or sell any security. This article represents the opinion of the author as of the date of this article. This article contains certain "forward-looking statements," which may be identified by the use of such words as "believe," "expect," "anticipate," "should," "planned," "estimated," "potential," "outlook," "forecast," "plan" and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This article is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this article and undertakes no duty to update its contents. The author may also cover his/her short position at any point in time without providing notice. The author encourages all readers to do their own due diligence.