Bank of Internet - a moat in not having a moat?

I've been pondering Bank of Internet a lot because it looks like a low cost producer in a commodity field.  I use the term "looks like" because there is nothing stopping other companies from replicating the same model and undercutting them, albeit having to absorb some starting costs as they hit critical mass.  What is interesting about Bank of Internet is that they are quite complex in their simplicity, as they have not followed down the money losing path of other internet banks and heck, its been a better performers than most banks in general.  The funny thing though is that everyone who has operating a similar business model, NetBank and ING Direct, have been real duds as far as business operations and investments go.  While just 3 examples don't make for a ground breaking study, NetBank, ING Direct and BofI, make for an interesting example of the benefits of meaningful inside ownership, the herd mentality, and the idea that mindlessly growing the business with no regard for the return generated for shareholders is a really (x10) dumb idea.

The benefit of high inside ownership with some exceptions is generally just seen as an alignment of incentives between management and shareholders.  It trickles down to the basic psychology of the managers.  If their stake is sizable enough they are going to act in the interest of making that stake worth more.  They're going to focus on shareholder value as opposed to more easily manipulated measures of performance, since they are very well rewarded for this.  Bank of Internet has inside ownership that is about 17% of the shares.  While they are likely competent as well, this is the reason their loans are written at ~55% of the value and they had a limited number of write downs and an unsuccessful foray into RV loans that never crippled the company.  They really powered through the worst of the financial panic and have been growing rapidly.  The bank is run as if management owns the company instead of just collecting a paycheck on easily manipulated metrics.  Oh, wait...they do.

Contrast this to NetBank and ING Direct.  According to the most recent proxy before they stopped filing, insiders at NetBank owned about 4% excluding options.  This might explain why the company dived head first into rolling up various companies that expanded the product offerings such as auto financing, selling insurance, and free standing ATMs.  While these are nice extensions for a brick and mortar bank, these all require addition capital and labor to execute on.  This erodes the key competitive advantage of an internet bank, as their low cost servicing allows them to offer super competitive interest rates.  Worse still, these acquisitions were made using debt, even though the company wasn't exactly a stellar profit maker.  From 1997-2005 its best year resulted in a a 1.85% ROA and a 12.25% ROE, which is mediocre.  Its second best year was very similar, but its third best year produced a 0.28% ROA and 2.45% ROE.  That is not good at all.  It's best year, measured in ROA and ROE, was 1998 when they generated a modest $6.6m in net interest income and $4.4m in net income.   All its expansion did nothing.  This is what I think would be referring to as value destruction.

This poor performance was a result of the herd mentality and a desire to grow the business for the sake of growing it that so often grip managers.  The idea that a bank had to offer all those services was, and still is, prevalent.  Everyone else is doing it.  While I could be confusing causation and correlation between a strategy of diversification and poor management, the two combined resulted in NetBanks deposits being sold to ING Direct in 2007.

ING Direct is a different beast than BofI is or NetBank was due to the sheer size.  BofI's management has remarked in conference calls that they don't consider themselves to be competing with ING Direct.  Their homepage does compare their rates to ING Direct though, but I think management is right to a degree.  BofI's value proposition is that it has super competitive interest rates on its products.  They aren't interested in being you insurance broker, or help you plan for retirement.  Judging from interest rates offered , ING Direct is far from a low cost provider and is run along the same lines as NetBank although since it had the backing of ING, it did not need to acquire a suite of companies to broaden its product offering.

There are is another thing that indicate that ING Direct is poorly run and not a real low cost producer despite lacking a brick and mortar presence.  From 2007-2009, $3 billion worth of Alt-A loans were written down in the ING Direct subsidiary of ING.  ING also had its own problems, but this indicates the a) management was poor and b) the net interest margin is earned was artificially inflated by poor asset quality and excessive risk taking.  Additionally, as part of its Dutch bailout, ING is in the process of divesting ING Direct.  This will likely not have the effect of installing a well aligned management since the companies being discussed as potential acquirers are as large as ING.

Judging from the divergent business models and the mishaps encountered by NetBank and ING Direct, it seems like BofI is cut from a different cloth.  BofI benefits from the culmination of several factors such as high inside ownership, a divergence from the herd mentality, and its simple focus.  It's focus on providing plain vanilla banking products appears to have ensured its survival through the financial crisis unscathed.  If my conclusion is correct that these are the key factors behind the differences, then the self restraint that BofI has exhibited is essentially a competitive advantage.  A disciplined management team is going to guide the company to success and intelligently allocate capital.  If BofI continues to be run in such a manner, it should see continued success.  Essentially, everyone else is not properly executing on the internet only model, which seems to only work when it focuses on being low cost as opposed to full service.  This could change though and I just don't have the skills to get comfortable with a bank.  Of course, there could be something I'm missing.  Food for thought.

Talk to Andrew about Bank of Internet

Bank of Internet - neither tech stock nor financial black box

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 (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, not mouthwatering 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 to NPLs 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 properly incentivized management and low cost business model.

Talk to Andrew about Bank of Internet