Short Sellers Might Soon Get Squeezed Out Of BofI: Part 1

| About: BofI Holding, (BOFI)

Summary

These series of articles will emphasis the long case for BofI and refute short sellers thesis. We believe that the short sellers attack is based on inaccuracies and wrong assumptions.

We believe BofI’s share price is worth well over $40 and that short sellers attacks which resulted a drop in the share price created a tremendous opportunity in BofI’s stock.

Short sellers already attacked BofI two years ago based on multiple claims which we’ll discuss as background. These claims have been proven wrong by BofI’s results.

We believe BofI’s relationship with nonbank lenders such as OnDeck is legitimate and so small in terms of business size that BofI doesn't describe it. We’ll refute shorts sellers claims.

BofI is highly regulated and being visited by regulators at least one or two times a year by a professional team checking their practices. Wrong doing seems unlikely.

These series of articles will emphasis the long case for BofI (NASDAQ: BOFI) and refute the short sellers thesis. We believe that the short sellers attack is based on inaccuracies and wrong assumptions. Short sellers interest is obviously taking the stock down, but their claims are wrong. It is our believe BofI's share price is worth well over $40, but these short sellers attacks, based on misleading arguments, written with great skills in a manner of scare tactics to frighten small investors has resulted a drop in the share price and created a tremendous opportunity in BofI's shares.

The shorts have been using lack of knowledge of most investors in the small details of bank practices. Their articles combine some true facts with inaccuracies and out-of-context misrepresentations and very very wrong conclusions.

BofI as all banks is highly regulated and being visited by regulators at least one or two times a year by a professional team checking their practices. You have to be naive to think regulators are not thorough enough as these articles are published on the internet. There was no announcement of any investigation, probably because there is nothing to investigate as regulators know this bank top down.

Short sellers should turn directly to regulators with these claims (which they probably tried with no success). Regulators most probably have read all those articles and made the required checks. If any wrong doing was done by management, regulators would announce an investigation a long time ago.

We believe BofI's relationship with nonbank lenders such as OnDeck (NYSE:ONDK), Quick Bridge and others is a legitimate business relationship which is so small and immaterial in terms of business size, that BofI doesn't even describe it. Short sellers have been targeting this issue relentlessly with a few claims which we'll refute later in this article.

Since the shorts used multiple articles with lots of different arguments against BofI, it might take a number of articles to refute claim by claim. But rest assure, we will do just that! As we go through the details, we believe it will become clearer that this short attack is baseless and can be used by long investors for making a lot of money while short sellers might get squeezed out of BofI.

So, lets begin.

This article will first discuss the background of these short attacks to understand the techniques and motives of these (or other) short sellers. Later in this article, we will refute some of the latest short sellers claims:

Background: the 2014 short attack

About two years ago a number of short sellers have issued articles with short thesis on BofI. These articles claimed among others that BofI is: Overexposed to Interest-Rate Risk, Core NIM Could Decline by ~40%, Earnings Temporarily Inflated by Opportunistic Securities Purchases, Online Deposit Competition Getting Tougher, BOFI's Lending Niches Are Becoming More Competitive, Declines in Mortgage Refinancing Volume Will Depress Fee Income, Thin Loan-Loss Reserves Create Asymmetric Downside Risk, Stretched Valuation Already Discounts Rapid Growth and High Returns, 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, etc.

These very well written articles took the shares down pretty hard (more than 37%) for a few months from $26.39 on March 14th, 2014 ($105.55 before the split) to $16.42 on October 10th, 2014 ($65.67 before the split). But all these arguments brought in these articles were aiming to the business model of BofI and its valuation. The arguments were legitimate, but were proven wrong by the company's results. For example lets discuss some arguments made in an article published on April 8th, 2014:

  1. Overexposed to Interest-Rate Risk - Shorts argued that BofI's business will suffer greatly from rate hikes as "its assets reprice much more slowly than its liabilities". Not only they have been wrong about rate hikes which comes much slower than they anticipated, but they were also wrong in their diagnosis, as described in the conference call a month later.
  2. Core NIM Could Decline by ~40% - Shorts claimed net interest margins is about to collapse. BofI's net interest margin was 3.89% in the quarter ended March 31st, 2014. This last quarter it was at 3.85%, hardly a decline at all. In fact, management said: "The net interest margin would have been 4.02% when excluding the average balances associated with lower yielding excess cash and the average balances and yield earned on the H&R Block related loan products during the quarter, which is consistent with our strong net interest margins reported in previous quarters," so instead of declining 40% net interest margins actually expanded.
  3. Earnings Temporarily Inflated by Opportunistic Securities Purchases - Shorts argued that BofI was benefiting from old positions it purchased a long time ago and therefore cannot repeat those numbers. The fact is, BofI's net income in the third quarter ending March 31st, 2014 were $14.6 million and now, 2 years later in the third quarter ending March 31st, 2016 net income was a record of $35.9 million an increase of 145.9% (way more than double the earnings in just 2 years).
  4. Online Deposit Competition Getting Tougher - Shorts argued that BofI cannot attract more deposits since its became harder in tougher competition. Again, BofI grew its deposits from 2.8 billion on March 31st, 2014 to more than 6 billion on March 31st, 2016, more than double, partly helped by H&R Block (NYSE:HRB) (which the shorts argued that regulators would not approve its purchase).
  5. BofI's Lending Niches Are Becoming More Competitive - Shorts keep arguing the environment will not only slow BofI's growth, but will also hurt its net interest margin and ROE. Wrong again as BofI's growth continues with full steam, net interest margin are great and ROE standout at 22.59%, well above BofI's long term target of 15%.

We could go on and on and refute claim by claim which have been proven terribly wrong over the last 2 years, but we don't want readers and investors to get bored over these older short attacks. So let's go now to the real interesting staff.

2015 short attack: basing a short attack on inaccurate and wrong arguments

When time passed by and the results have proven the shorts were wrong, the stock just ran the shorts over. But for some reason possibly because of the stock's sensitivity to these kind of articles (it did go down more than 37%! when these articles were published) the shorts understood this stock can easily be influenced (BofI uses the term manipulated) in the short term. Of course, its impossible to be sure whether these are the same group of shorts sellers or not, as they write anonymously (possibly fearing a lawsuit action against them by BofI).

Interestingly instead of changing their position after their arguments proved wrong, short sellers appear to have changed their arguments and probably keep their position (again, in case these are the same short sellers...). One would wonder if short sellers have targeted this stock regardless of what the truth is, simply because they can. That could explain the change in short sellers arguments over time. The current attack implies that BofI is involved with wrong doing while short sellers are possibly involved in lawsuits actions against the company hiding behind lawyers. As long as these actions and short thesis articles work in influencing the stock down, they will probably keep doing it. But hopefully, this is going to change.

We'll need a few articles to work through their arguments one by one, but rest assure, we will do just that! and we believe we can refute all of these shorts arguments.

So let's begin with some arguments found in an article called "BofI: Boiler Rooms, Bad Loans, And Off-Balance Sheet Maneuvers Underpin Poorly Understood Risks" which you can find here. In this article BofI is mentioned with "a network of boiler rooms and undisclosed lending relationships appears to have facilitated hundreds of millions worth of highly suspect, BofI-originated loans, that have flooded the courts with defaults". Short sellers indicate that "BofI's apparent financing of an undisclosed, off-balance sheet, Special Purpose Entity whose sole purpose appears to be to purchase BofI's own loan originations is examined." Arguments made in this article repeat themselves in different versions in more recent articles with updated numbers.

In particular short sellers indicate that BofI is growing its C&I loans by methods such as partnering with companies like OnDeck Capital and Quick Bridge. The article describes these methods as boiler rooms and implies that these methods are problematic, since BofI is using its federal banking charter to assist OnDeck and Quick Bridge in circumventing state banking laws that otherwise might prohibit the loans from being originated. The article also indicates in a negative way that BofI is using Off-Balance Sheet, Special Purpose Entity.

So what does all this mean? At first glance these claims look very convincing and scary, since most investors are not familiar with these kind of practices, but in fact, nor the relationships with these nonbank companies or the use of an SPE (Special Purpose Entity) is BofI's inventions at all. SPE's are used by the biggest banks in America such as JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and others as you can see in their 2015 annual reports here:

Source: JP Morgan 2015 Annual report page 77 Click to enlarge

Source: JPMorgan 2015 Annual report, page 77

Source: WFC 2015 Annual report page 182 Click to enlarge

Source: WFC 2015 Annual report page 182

JPMorgan describes an SPE's as: "the most common type of VIE" and adds that "SPEs are commonly use in securitization in order to isolate certain assets and distribute the cash flows from those assets to investors. SPEs are an important part of the financial markets, including the mortgage and asset-backed securities and commercial paper markets, as they provide market liquidity by facilitating investors access to specific portfolios of assets and risks."

Wells Fargo states that they "enter into various types of on and off-balance sheet transactions with SPEs, which are corporations, trusts or partnerships that are established for a limited purpose."

As can be seen in these annual reports, both of JPM and WFC, describes an Off-Balance Sheet, Special Purpose Entity as a commonly used method.

So what does BofI really do?

In the last few years nonbank companies like OnDeck, Prosper Marketplace and others have emerged. These Companies also considered as FinTech companies, lend money to borrowers. As these companies sometimes find both an investor and a borrower and sometimes just a borrower, they often need a bank to originate the loan. OnDeck uses BofI and Celtic Bank. After the loan is originated with a fee to the bank (in our case, BofI), it is then sold back to the nonbank company.

While these methods looks a bit like bypassing regulation, there is nothing illegal about it. Lately some concerns have been made regarding these FinTech companies including OnDeck and others. Regulators are taking now a close look at these methods and may impose some restrictions in the future, but we believe it will have only a very minor effect on BofI.

The more ridiculous thing about this whole issue is that this business is not even very important for BofI and in fact (as mentioned by short sellers latest article) OnDeck Capital indicated in their annual report for 2015 that: "The agreement with BofI will expire and not be renewed in July 2016." Now, lets see what this means for BofI in terms of the size of this business. According to the short sellers article:

The loan amounts are also significant. OnDeck has stated that BOFI-originated loans amounted to 16% of it's $1.1 Billion in total 2014 loan originations. By extension, this means that BOFI's OnDeck related loan originations likely totaled around $185 Million during calendar year 2014. In OnDeck's most recent 10-Q, it disclosed that it purchased $103 Million in loans from it's bank partner in the first two calendar quarters of 2015. As a result, OnDeck likely has comprised roughly 15-25% of BOFI's C&I and specialty originations in recent quarters. This is a material amount and given the obvious risks, it's fair to question the sustainability of this income stream. The relationship with OnDeck, however, is not the only unique lending relationship that merits significant investor scrutiny.

(Article from November 10, 2015).

These arguments repeats themselves in a new article published about a week ago with more updated numbers.

So let's put this in order:

  1. These loans that BofI originates and sells back to the nonbank partner are not even on BofI's balance sheet, since BofI originates them and immediately sells them back to the nonbank partner.
  2. Since BofI doesn't earn interest on these loans (only for the few days it might hold them), this activity only generates fees and does not affect BofI's net interest income which grew 37.2% this quarter. It also does not affect the loans and deposits that are on BofI's balance sheet. Total assets grew 39.4%, Loan portfolio grew by $1,393.4 million or 30.0% compared to March 31st, 2015, and Deposits grew by $1,679.3 million, or 38.4% compared to March 31st, 2015.
    What does this mean? It means BofI grows fast regardless the nonbank activity.
  3. So if this nonbank lenders business is only generating fees it should be on the non-interest income. Since this quarter is not representative primarily due to seasonal H&R Block-branded products and service fee income, let's look at the full 2015 fiscal year ended 30/6/2015. In 2015 BofI had total $30.59 millions in non-interest income roughly 14% of total income (non-interest income + net interest income). Out of this $30.59 million, how much came from originating fees from nonbank lenders?
    If we eliminate the Mortgage banking income of $15.2 millions we are left with only two small clauses which are comprised of different like "other" thing.
  4. As it seems: this whole business of nonbank lenders (like OnDeck and Quick Bridge) that short sellers are not stopping to write about is so small, that BofI doesn't even have to put it in a clause of its own. It hides among other things in "Gain on sale - other" totaled $5.8 millions in full year 2015 and probably doesn't even makes the majority of this $5.8 million.

So even if we'll take the whole $5.8 million it would only be 4.1% of Income before income taxes in 2015, but in fact its even much less. So this business seems so small that BofI doesn't even describe it and yet short sellers are continuing with their relentless attacks. To our understanding, if BofI would shut down this business, the impact would be so small, most investors wouldn't even feel it.

And just for the fun of this: even if we'll take these numbers as short sellers present them, its roughly 4.2% of BofI's balance sheet for 2014 (Note that Ondeck fiscal year ends on 31/12/14 while BofI's fiscal year 2014 ends on 30/6/2014). BofI's total loans for fiscal 2014 were more than 3.5 Billion, an increase of more than $1.275 Billion from a year earlier. So even if we took out this whole $185 millions, BofI's loan portfolio would steal grow by about almost 1.1 Billion. Actually, even if we took all the C&I business out of BofI, it would still grow very nicely.

Did BofI do anything wrong with an SPE called WDI? Really?

Now lets go back to the SPE theme. Short sellers also indicate that BofI is using and funding an SPE called WDI. What was the nature of this? Well, it seems that BofI while working with Quick Bridge on a legitimate correspondence lending like it does with OnDeck, it also gave Quick Bridge a loan as indicated by the short sellers article pointing to this link. This is also legitimate. As indicated in the conference call on January 28th 2016 In special cases in order to protect a loan, BofI sets up an SPE. While not mentioning it specifically in the conference call, it seems management was referring to this quick bridge loan. So how does a responsible bank protects itself from an unlikely event that Quick Bridge defaults on a loan? It sets up an SPE (WDI) in which quick bridge puts a collateral pull of loans and if quick bridge doesn't pay back the loan, BofI can access that collateral.

In other words BofI uses this SPE to isolate certain assets, exactly as stated in the JPMorgan annual report. The loan itself is reported on BofI's balance sheet. The SPE protects BofI from fighting with other creditors should quick bridge gets into a financial problem.

Note: All information for this article was derived from publicly available information. The article makes no representations or judgments as to BofI's compliance with any applicable laws. Investors are encouraged to conduct their own due diligence into these factors. The information set forth in this article does not constitute a recommendation to buy or sell any security including BofI.

Can a bank really grow this fast?

As an industry, banks usually don't grow very fast, as fast growth might indicate poor underwriting. While this is true for most banks, we believe BofI has some advantages going for it. As this article is already very long we look forward to discuss this issue along with many more important issues in our next articles.

Valuation

If for one minute we'll ignore all this short sellers background noise, how much does BofI really worth? Well, we believe BofI is worth well above $40 a share, but we are going to leave this for another article.

We will tell you this much: previous to the last series of short sellers attack (around October 2015) BofI already traded at about $36. Since then, the business accelerated its growth. On 29/10/2015 the company reported net income of $25.5 million (for the first quarter ended September 30th, 2015). Six months later on April 2016 the company reported net income of $35.9 million (for the third quarter ended March 31st, 2016). Even though this is not all organic growth and there may also be some seasonality, its hard not to be impressed from the results. BofI is an innovative and fast growing company and in the last few months, not only that it hasn't slowed down, it even accelerated its growth so far in 2016.

Conclusion:

As we go through the arguments of short sellers attacks, we easily refute them one by one as we did in this article, starting with previous attacks of 2014, which have proven ridiculously wrong by the results of the last 2 years, continuing through some of the arguments made in the current attack over these "Boiler Room" articles who in our view, inaccurately presents the legitimacy and practices of how BofI operates with nonbank lenders, SPEs and the risks that it takes.

As readers and investors fear the highly skilled short sellers arguments, it seems that this short sellers attack is based on inaccuracies and wrong conclusions aimed at unprofessional investors who don't have the time or patient to deep into the details.

Its important to understand that a federal bank like BofI is highly regulated and being visited by regulators at least one or two times a year by professional teams, checking their practices. Short sellers have been kicking their doors for a long time and until now, there is not even an announcement of an investigation, probably because regulators have already looked at all those issues a hundred times and didn't see any problem. You have to be naive to think regulators are not thorough enough as these articles are published on the internet and a bank stock has crashed. There was no announcement of any investigation, probably because there is nothing to investigate as regulators know this bank top down.

We believe BofI's share price is worth well over $40 and that short sellers attacks which resulted a drop in the share price created a tremendous opportunity in BofI's stock. We also believe that short sellers might soon get squeezed out of BofI.

Rest assure, this article is just the beginning. We intend to continue solving case by case, argument by argument and explain why these short sellers are wrong. And yes, we are long BofI!

We know we have a lot of work, but its fun already :)

Disclaimer:

Note: All information for this article was derived from publicly available information. The article makes no representations or judgments as to BofI's compliance with any applicable laws. Investors are encouraged to conduct their own due diligence into these factors. The information set forth in this article does not constitute a recommendation to buy or sell any security including BofI.

Disclosure: I am/we are long BOFI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Disclosure: I am/we are long BOFI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am/we are long BOFI. All information for this article was derived from publicly available information. Investors are encouraged to conduct their own due diligence into these factors. 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," "refute," "intend,", "wrong," "indicate," "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 change his/her position at any point in time without providing notice. The author encourages all readers to do their own due diligence. The author of this article is a portfolio and fund manager. At the time of publication, funds and accounts managed by the author were long BofI Holding (BOFI). Such funds and accounts may buy and sell securities of BOFI (and other companies mentioned in this article), including changing to short positions in BOFI, both before and after the publication of this article and without giving further notice to any party. 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.