Bank Of Internet: A Diamond In The Rough, Part II

| About: BofI Holding, (BOFI)

First, apologies for the delay in getting this up, had some administrative hurdles that got in the way.

Anyway...Back in March, I first wrote about a stock that we thought had great upside potential, Bank of Internet Holdings (NASDAQ:BOFI). I think its worth mentioning, since I published that article, BOFI is up ~30%, while the S&P 500 is flattish, the Nasdaq index is down ~2%, the Financial Sector SPDR (NYSEARCA:XLF) is down ~6%, the Bank SPDR (NYSEARCA:KBE) is down 9%, and the ABA NASDAQ Community Bank Index (ABQI) -- to which BOFI was recently added -- is down 4.5%!

Whether our posts, tweets, and discussions with investors had anything to do with BOFI's absolute and relative return over this time period is up for debate, you simply can't ignore the company's results and the stock's performance.

Today, I want to update you on our views bringing in Q1 (BOFI's Q3) results and some work we've done on BOFI's closest -- albeit far from perfect -- public competitor, Everbank (NYSE:EVER).

Since I'm a skeptic -- first and foremost -- my inclination is that the market is valuing BOFI correctly, and there must be some clear risks and problem areas that explain BOFI's valuation relative to its peer group (although that is quite hard to define given its unique business model). Let's take a look:

BOFI's Tier 1 Risk-Based Capital Ratio has varied over the past few years, and at the end of the most recent quarter was 13.47% versus 13.04% for all FDIC-insured institutions and 15.33% for banks with $1-$10 billion in assets. While the recent number is slightly out of line with its peer group (by assets), this doesn't seem to be too much of an issue as the bank is still well above the minimum capital adequacy limits and he Q1 number is up 28bps from the previous quarter.

With the Total Risk-Based Capital Ratio, BOFI is below the averages for FDIC-insured banks of all sizes and the Raymond James West Coast group (see below), however its ratio is still significantly above that required by regulations. For a bank to be "well capitalized" -- the highest rating -- it must have a >= 10.0% Total Risk-Based Capital Ratio, >= 6% Tier 1 Risk-Based Capital Ratio (and >=5% leverage ratio). We think it's impressive that BOFI has been able to not just maintain but exceed these ratios while showing such strong loan growth performance, 24.6% CAGR from 6/2007 through 12/2011 and +43% over the last 12 months. Additionally, BOFI, despite having the vast majority of its loans in California, has experienced, and continues to experience relatively low levels of non-performing assets and charge-offs relative to banks with similar geographic exposure:

If we take a look at 14 metrics of valuation and risk, BOFI outperforms this group in 9/14 (with one push since it could be argued either way), and in those 9, its outperformance is much higher in magnitude than its underperformance in the categories where it does so.

Numbers in green are where we think (or know) BOFI is doing better/presents a better opportunity than its "peers" while numbers in red are ones where the opposite is the case. Loan loss reserves/non performing loans is in black since one could argue BOFI doesn't need to reserve as much given its two other better credit quality metrics OR that its under-reserving and subjecting itself to unnecessary risk, so we'll call that one a push to be fair.

What we see is that BOFI delivers higher return on assets and equity, has a lower P/E (but higher P/TBV), and seems significantly less risky than its peer group:

Additionally, and perhaps more importantly, we believe all are not only explainable but of little concern, at least in the intermediate term. For example, NIM (net interest margin):

Since BOFI is branchless, in order to attract business, it generally offers slightly higher interest rates on deposits and attractive rates on loans, so its not exactly surprising its NIM is lower than its peers in the RJ group, although as this chart shows, NIM has been improving substantially and is now close to in-line with its peer groups. We expect as the firm becomes larger, more widely known, and the shift to online banking accelerates, this trend should continue.

Additionally, due to its branchless business model, BOFI's efficiency ratio is substantially lower (better) than any of its peers, and almost half that of EVER, so in a sense, BOFI can "afford" to offer attractive rates on deposits and loans due to its lower non-interest expense (although this is certainly something to keep an eye on for sure).

By now, I think it's pretty clear that many of the "flags" raised by critics that we could identify are, as I previously mentioned, both explainable and of little if any concern to investors (again, in the intermediate term).

I think there may still be some room to run in this stock, given its performance. Look at the Return on average assets trend and level, for example:

The same is also true of return on average common equity, which is well above both the mean & median #'s for West Coast banks and similar to EVER's, although the latter's is far more volatile:

The only real area of concern I see here is that BOFI purchased a not-insignificant amount of mortgage securities at very attractive prices when markets were depressed. As these roll off (mature) and/or if BOFI has to recognize any currently unrealized losses on these securities, the company will have to replace these attractive-yielding assets with new originations (and/or purchases) with similarly attractive terms. This shouldn't (key word) be too much of a concern for the intermediate term, after which point the interest rate and general macroeconomic environment should (let's hope!) look at least slightly better than it does today. Even so, most of the non-agency RMBS on the balance sheet doesn't come due (and isn't forecast to be pre-payed) for the next few years, so again, the situation isn't dire (unless you go by a nickname like "Dr. Doom" or something) Even if you're bearish there, though, BOFI shouldn't fare any worse than other banks who'll face the same headwinds. That said, it could be very hard to keep up the growth if those assets can't be replaced with similarly-yielding ones.

Now, one could argue that BOFI is fairly valued on a P/TBV basis, both relative to banks in the Raymond James peer group and EVER, but considering its loan growth (while its peer group is largely facing headwinds in that department) solid risk management, and impressive outperformance in most categories relative to its peers, I think its easier to make the argument that the stock price could still go up.

These are the imputed P/E and P/TBV values for the stock at different levels from its current price, LTM EPS, and mrq TBV. Depending on your views on where the market and stock are heading, fair value, etc, it looks like there's still some upside potential even after its solid past returns.

Admittedly, those of you concerned about the P/TBV might see less upside, even though there's a long list of riskier, lower growth banks that trade at ~2x P/TBV despite those factors (why, I have no idea!).

Ultimately, the upside opportunity depends on management's continued ability to execute, maintain discipline, deliver continued solid growth, and fight off competition from the bigger banks who are finally sort-of starting to get the whole online banking idea. The bigger (especially the biggest) banks, by definition, will have trouble growing at rates like BOFI, and face greater regulatory and management issues, just to name two limiting factors. I'd certainly keep an eye on the run-off of the non-agency MBS since those will likely be pretty difficult to replace, but I like an underdog, though, a veritable David v. Goliath story, and with BOFI, that could be exactly what we're watching.

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

Additional disclosure: Stone Street Advisors' company policy is to keep the bespoke, paid research and analysis we do for clients confidential. However in certain circumstances - and only with a client's explicit permission - we may share some or all of that research publicly. The above (the analysis/article) contains some of the research we performed for/with a client and from whom we received compensation for so doing. The client who paid for this research has a long position in BOFI and stands to gain if BOFI markedly increases in price. In addition, following publication of this article, our client may continue to hold, add or reduce its position. The opinions presented herein are those of Stone Street Advisors LLC. Neither Stone Street Advisors LLC nor any of its members has a position in BOFI, nor do we have any plans to initiate one. The information and opinion presented in this article is presented as-is, and does not constitute any offer or solicitation. Stone Street Advisors LLC makes no representation as to the accuracy or completeness of the information contained herein and has no duty to update the information and opinion in the article. The content presented is not investment advice, nor is Stone Street Advisors LLC a Registered Investment Advisor.