Description

BOFI Holding Inc. (BOFI, $23.80 NASDAQ, “BOFI” or the “Bank”), an $8.7 billion thrift, is arguably the best run small bank in the United States.  BOFI is the oldest surviving pure play internet-only bank and has built a fast growing, profitable platform that will continue to generate well above average returns on equity and assets without taking undue risks.  BOFI trades at a discount to its peers despite having best in class returns and growth.  This is due to a short attack that was started nearly two years ago.  In this writeup I will lay out the case for why the shorts are incorrect, why BOFI’s business model is repeatable, and why the stock should move up 108% to $49.39 based on an average multiple of book value and earnings for fiscal year ending June 30, 2019.  Finally, there is currently a 46% short interest in BOFI’s stock and I believe that circumstances exist for a dramatic short squeeze to occur this year that could drive the stock up 50% or more.  To summarize my reasons for owning BOFI now:

1. BOFI is the best run bank in the US based on asset quality, returns on assets and equity and business prospects.

2. The short attack is wrongly theorized and should run out of steam soon leaving 46% of outstanding shares to be covered.

3. BOFI’s stock price should double over the next two years based on a continuation of its business strategy and growth.

History of BOFI and how the stock became inexpensive

BOFI was founded as an internet-only bank in San Diego, CA in 2002 with Gary Lewis Evans, the former president of LaJolla Bank, selected to run the bank.  BOFI avoided the mistakes of other internet-only banks that came before it, including Netbank (https://www.wsj.com/articles/SB119101077898343000 ), a $2.5 billion asset bank that failed in 2007.  BOFI dodged the credit mistakes of its predecessors due to its conservative credit quality focused board and management team.  

When I first discovered the Bank back in 2006, it was trading a 25% discount to book value since it was generating a low 0.48% return on assets and 4.57% return on equity.  These low returns were not due to poor lending habits, but the fact that the management and board viewed the home lending markets it participated in as being overheated.  BOFI was therefore mainly investing in mortgage backed bonds issued by GNMA and FNMA as it waited for the lending markets to become more rational.  In October 2007, the Bank hired Greg Garrabrants as Chief Executive Officer to replace Mr. Evans who stayed on as President until April 2010. Mr. Garrabrants joined the bank after having served as an investment banker at Goldman Sachs, a consultant at McKinsey and the head of business development at a large thrift.  

As we all know, the mortgage bubble burst in 2008 and many banks disappeared from our landscape.  For BOFI, 2008 was the inflection point it needed to redeploy its low yielding safe assets into higher yielding performing first home mortgages at large discounts to face value.  As the bank began to generate better returns and more cash flow, its culture of strong credit underwriting and well thought out business line extension has led it to become one of the best run banks in America.  This comment should not be taken lightly.  Over nearly the last 10 years under Mr. Garrabrants, the Bank has consistently generated top quartile ROA and ROE while growing assets at a mid-teens compound annual rate.  BOFI’s business model has significantly lower costs than traditional bricks and mortar competitors and the strong credit culture has allowed the Bank to have best in class loan quality.

This strong operating performance drove BOFI’s stock price from a low of about $0.75 per share in November 2008 to a high of about $35 per share in October 2015.  I originally wrote the stock up as a buy on May 18, 2008 at a price of $1.67 per share (adjusted for a 4 for 1 split in October 2015).  As a value investor I sold my position finally around $16 per share in 2010 and 2011 as BOFI became a growth stock and hit the upper limits of my valuation range.  

In October 2015 BOFI was sued by a fired disgruntled former internal auditor over allegations of wrongdoing.  This former employee has worked with his lawyer and short sellers to create an aura of impropriety that has driven the stock down to its current level of $23.78 per share.  I will talk below why these allegations are capricious and why BOFI is a value at current prices.

The Short attack on BOFI

The shorts began attacking BOFI based on its high valuation and “poor” lending standards back in December 2014 on seekingalpha.com (https://seekingalpha.com/article/2724995-bofi-holding-will-regulators-strike ) assuming that regulators would find problems with how BOFI underwrote the credit decisions on “Jumbo” home mortgages.  While I agreed at that time with the shorts about the valuation of the stock, I disagreed with their characterization of BOFI’s lending and underwriting standards.  For those unfamiliar with the term Jumbo mortgage see the section on single family lending below.

As part of my previous research, I had met the team BOFI brought in from Thornburg Mortgage (“TM”) to originate and underwrite Jumbo mortgages.  Thornburg was one of the largest lenders to the Jumbo market until it failed during the housing crisis in 2009.  TM underwrote relatively low loan to value Jumbo loans in prime housing markets.  TM’s ultimate failure in 2008 was not caused by poor underwriting standards, but by the liquidity crisis for mortgage lenders that were not banks.  It had few non-performing mortgages even at the height of the crisis.  What caused this failure was TM’s inability to access the market for securitizing its newly originated loans.  BOFI’s availability of deposits eliminates this funding risk.  The Jumbo business for the Bank has continued TM’s strategy of making low loan to value mortgages in prime housing markets.  

BOFI has had a stellar record of having best in class net charge-offs / average total loans.  The chart below shows that BOFI’s charge-offs never approached 1% during the “Great Recession” and have been showing a net recovery in this fiscal year.  This year charge-offs are running negative, which means the Bank is making positive recoveries on bad loans.  The lack of charge-offs (defined as debt unlikely to ever be collected) over the last eight years indicates a strong underwriting culture at the Bank. (See chart below, Data from Bloomberg)

The second and more damaging short attack was started in an August 2015 article by the New York Times

(https://www.nytimes.com/2015/08/23/business/a-internet-mortgage-provider-reaps-the-rewards-of-lending-boldly.html ) based on information from a wrongful termination suit by Charles Matthew Erhart, a former entry level internal auditor, who claimed “whistleblower” protections.  The article implied that the Bank was violating federal banking laws over how it made loans to foreign nationals and Jumbo borrowers.  There was a statement by Erhart’s lawyer, Carol Gillam, that she had reported the Bank to the Office of the Controller of the Currency (“OCC”).  The lawsuit and the many subsequent short hit pieces on BOFI were mainly based on information that Erhart and Gillam fed to the shorts.  This was intended to up the pressure on BOFI to settle their lawsuit quickly and for significant money.  The list of supposed infractions was, according to short sellers, going to have the following implications:

1. Make regulators scuttle a deal BOFI had to buy H&R Block’s (“HRB”) deposit assets

2. Make regulators fine and stop the Bank from lending to foreigners to buy US homes

3. Cause the Bank to have large loan losses on poorly underwritten loans

4. Stop BOFI from making warehouse loans to other mortgage companies

It has been nearly three years since the short attacks began and BOFI has;

1. made two acquisitions (H&R Block’s deposit assets and Pacific Western Equipment) which were approved by the OCC

2. been through two full Fed audits with no material issues pointed out by regulators

3. completed two annual audits performed by BDO with a third expected in the next few weeks

4. improved asset quality and grown earnings.  

The short attack follows a strategy that attempts to get regulators to find trouble with a financial institution and therefore drive down the offender’s stock price.  This has worked well up in Canada, where Home Capital Group (“HCG”) was attacked for having a small number of brokers commit loan fraud.  The short sellers were able to get the Canadian Banking Regulator (the “OSC”) to investigate and subsequently fine the lender $30 million, which was immaterial to HCG’s business.  The bigger damage was that the short sellers caused a “run” on the institution by depositors who pulled out deposits and dried up HCG’s liquidity.  HCG was forced to raise very expensive money which saved the institution but hurt equity investors.  On June 21, 2017, it was announced that Warren Buffet will invest $400 million in the equity and provide a $2 billion line of credit through Berkshire Hathaway and the stock has recovered much of the drop caused by the attack.

Unfortunately for the shorts it has not and will not work with BOFI.  BOFI’s culture has been credit quality oriented since it was first started in the mid-2000’s.  Each business unit that receives capital goes through a rigorous proof of concept for a number of years before BOFI provides the equity for it to grow.  

For example, the shorts called the Warehouse Lending business a “rent a bank charter” operation that the OCC should close.  The implication was that the Bank was dealing with unscrupulous third-party finance operations that could only be in business by using BOFI’s charter.  In fact, this type of banking operation and lending area is common to large banks throughout the US like Wells Fargo and JP Morgan.  

The BOFI Warehouse Lending (see explanation in single family lending section below) business was started in 2012 by experienced lenders hired from another banking institution.  This lending function provides lines of credit to third-party mortgage companies (“TPMC”).  BOFI underwrites each loan as if it will retain the mortgage for itself.  The Warehouse line has strict loan to values on the pool of mortgages in it and requires the TPMC to have capital in BOFI to offset risk.  These loans typically leave the Warehouse within 30 days as they are sold by the TPMC. These types of lending relationships tend to be very profitable for banks as the fees and effective interest rates charged can run into the high single and low double digits based on the average outstanding balances.

The chart below details the growth of Warehouse lending into a business unit at BOFI.  What you can see is that while it has grown in absolute size, it still remains less than 10% of the Bank’s portfolio.

The three main short sellers were the anonymous Seeking Alpha contributors Aurelius, The Friendly Bear and Real Talk Investments.  My partner and I are former bankers and read each post carefully to see if there was any “meat” in the postings.  I would label them as scary to those who do not understand banking rules and practices.  Mainly they are written in a conspiratorial manner that the reader is supposed to reach the conclusion that the world is about to end for BOFI.  To sum up the reality of banking as an offset to the short hit pieces please note:

1. All banks use brokers to raise capital and pay them fees

2. All banks make related party loans and these are subject to Fed rules and are scrutinized by regulators

3. All large Jumbo mortgage lenders make loans to foreign nationals who do not have social security numbers and check these names against OFAC lists

4. All banks have made loans to people who either will be or have been convicted of a crime

5. Many third-party warehouse borrowers make risky loans and then sell them to the market in pools or as whole loans.  All warehouse lenders including Wells Fargo, JP Morgan, Etc. make these types of loans

6. Most national banks have offices in states like Delaware and Nevada to save on taxes.  BOFI has a functioning office in Nevada and conducts business there.

7. Supposed “whistleblowers” who have been fired sometimes are just in it for a settlement from their former employer.

For those who care to read each short article, I have included the bulk of them below.  

https://seekingalpha.com/article/3584756-sell-side-issued-favorable-reports-paid-millions-bofi-sell-market

https://seekingalpha.com/article/3620436-buyer-beware-odd-behavior-bofi

https://seekingalpha.com/article/3641526-buyer-beware-bofi-related-party-loans

https://seekingalpha.com/article/3652296-recent-bofi-court-filing-confirms-existence-undisclosed-subpoenas-nonpublic-government

https://seekingalpha.com/article/3672236-bofi-boiler-rooms-bad-loans-balance-sheet-maneuvers-underpin-poorly-understood-risks

https://seekingalpha.com/article/3695396-undisclosed-executive-history-may-final-blow-bofi

https://seekingalpha.com/article/3699616-bofi-risky-loans-undisclosed-balance-sheet-spes-found-disguised-within-mortgage-warehouse

https://seekingalpha.com/article/3699616-bofi-risky-loans-undisclosed-balance-sheet-spes-found-disguised-within-mortgage-warehouse

https://seekingalpha.com/article/3741946-bofi-confirmed-finance-undisclosed-balance-sheet-spe-transfers-bad-loans

https://seekingalpha.com/article/3792826-bofi-undisclosed-related-party-dealings-found-infect-audit-committee

https://seekingalpha.com/article/3825386-spes-managed-bofi-executives-directly-contradict-financial-reporting

https://seekingalpha.com/article/3859626-bofi-created-phantom-full-service-branch-nevada-desert

https://seekingalpha.com/pro/checkout/3973481?notice=pro

https://seekingalpha.com/article/3979230-inside-bofis-undisclosed-exposure-subprime-fintech-payday-loans

https://seekingalpha.com/article/3995038-court-filings-reveal-existence-undisclosed-second-alleged-bofi-whistleblower

https://seekingalpha.com/article/3995393-bofi-panama-papers-criminals-exotic-loans-high-risk-foreign-nationals

https://seekingalpha.com/article/4002704-bofi-will-fdic-stop-music

https://seekingalpha.com/article/4015081-barry-minkow-jason-galanis-just-thought-bofi-figured

https://seekingalpha.com/article/4024230-bofi-rally-set-unwind-fundamentals-point-material-headwinds-trump-election

BOFI comparison to bricks and mortar banks

I have been investing in banks since the mid-1980’s and have attended lots of bank investment conferences.  My impression of these events and the senior bank managers that attend them is that each bank is run by a white male in their 50’s or 60’s wearing a dark suit, white shirt, and red tie.  Each banker who presents their company talks about opening branches, taking deposit share, relationship lending and the regional market they compete in.  What I always notice is the uniformity and conformity of thought among these executives.  BOFI comes at banking from a refreshingly different perspective: that branch banking is dying and that customers can be best served by providing services over the internet.  This allows customers to earn more on their deposits, borrowers to get faster loan approvals and the Bank to earn better spreads on their business.

The lack of a branch network and its resulting costs creates a sustainable business advantage for BOFI and other internet only banks.  This slide taken from BOFI’s May 2017 presentation details the difference in core business margins between the Bank and other banks in the $1 - $10 billion size range.

This competitive advantage allows BOFI to capture market share from both small regional and national banks as it has continuously reinvested its profits in improving service and product offerings and growing its balance sheet through prudent lending in existing and new loan classes.

Banks are typically measured on how well they control costs through a measure called the “efficiency ratio”.  The efficiency ratio measures a bank’s costs as compared to its interest income.  The lower the number (costs/interest income) the better.  A bank with an efficiency ratio of below 40% is considered to be well run.  BOFI’s efficiency ratio of 34.4% as measured by Bloomberg is well below the median of 61.4% of comparably sized public banks.  Large banks like JP Morgan and Wells Fargo run at 57.6% and 58.5%, respectively.  This competitive discrepancy in BOFI’s favor has been growing despite the fact that the Bank has been investing heavily in developing both new technology and business segments.  As the BOFI matures and these investments begin to generate their rewards, this ratio should improve and widen its advantage.

BOFI’s deposits

BOFI obtains depositors and lending customers through digital marketing, affinity and distribution partners, direct-marketing and cross-selling.  On the digital marketing side the bank offers competitive checking accounts on numerous comparison sites like bankrate.com, nerdwallet.com and depositaccounts.com.  Its deposit base has shifted from largely being CD funded back when I first found the Bank back in 2006 to having 86% of it in savings, checking, and IRA accounts.  In fact, checking account growth has been 803% and savings account growth 238% since June 30, 2013 (See Chart below).  This is being driven by consumers and businesses acceptance of internet banking as a safe, easy and low-cost way of banking.  The shift away from higher cost CD’s has also benefitted BOFI’s net interest margin (for those unfamiliar with this term it is defined as NIM = ({investment income – interest expense}/ average earning assets) as deposits tend to be lower cost than CD’s since they can be demanded back by the depositor at any time.

BOFI’s deposit business is diversified across a number of branchless areas and is demonstrated in the chart below from its June 2017 presentation.

Deposit growth has also been strong on the business banking side as BOFI has grown its commercial and industrial (“C&I”) and warehouse lending businesses.  Business banking deposits have grown over 1,000% since the end of fiscal 2013.  These types of accounts generate significant fee income for the Bank and help keep funding costs low.  

BOFI’s customer base and deposit volume are well distributed throughout the United States as one would expect for an internet-only bank.  This helps to insulate BOFI’s deposit base from regional disruptions that can hurt banks in times of distress.  The map below from the May 2017 presentation highlights this fact.

 The 35% compound annual growth in deposits since 2011 has aided BOFI’s loan portfolio growth by generating fee income and low-cost funding.  The fee income from deposit relationships was 55% of total non-interest income in fiscal 2016.  Many regional banks rely more heavily on gains on sale of loans and investments and mortgage banking to drive fee income.  These streams are less reliable as fluctuations in interest rates and regional housing markets can heavily impact this revenue source.  Specifically, gain on sale income is considered by banking analysts to be the lowest quality earnings generator.

H&R Block transaction and relationship

One prime example of how BOFI benefits from its strong growth in deposits is its relationship with H&R Block post the Bank’s September 2015 acquisition of HRB’s $458 million in deposits. BOFI took over these deposits without paying HRB any money and agreed to a seven-year relationship with HRB.  These deposits have a weighted average cost of about 10 basis points and improve BOFI’s NIM due to their low cost.

The HRB BOFI partnership works as follows.  Temporary accounts are generated for HRB customers who have a tax refund for that tax year and are looking to defer their tax preparation fees.  This account is funded when the customer receives their state and/or federal tax refund.  BOFI earns a fixed fee paid by HRB for each of these accounts and has the use of the deposit for as long as the account has funds.  This causes some seasonality in BOFI’s earnings as fees and non-interest-bearing deposits peak in the March quarter.  The HRB relationship also generates unsecured lines of credit that are underwritten by BOFI and in which the Bank retains a 10% interest in after selling the 90% to HRB.  HRB also has the ability to sell other types of consumer loans to its customers for BOFI.

Banking service fees generated by the HRB relationship have become a growing part of BOFI’s non-interest income.  The HRB relationship generates fee income in three different ways.  The first product is the Emerald Prepaid Mastercard (“EPM”).  The Bank has oversight and control of the EPM program of a wholly owned subsidiary of HRB.  The noninterest-bearing deposits of the underlying customers generate automated clearing house (“ACH”) transaction fees each time the cards are utilized.  These ACH fees are included in this category.

he HRB BOFI partnership works as follows.  Temporary accounts are generated for HRB customers who have a tax refund for that tax year and are looking to defer their tax preparation fees.  This account is funded when the customer receives their state and/or federal tax refund.  BOFI earns a fixed fee paid by HRB for each of these accounts and has the use of the deposit for as long as the account has funds.  This causes some seasonality in BOFI’s earnings as fees and non-interest-bearing deposits peak in the March quarter.  The HRB relationship also generates unsecured lines of credit that are underwritten by BOFI and in which the Bank retains a 10% interest in after selling the 90% to HRB.  HRB also has the ability to sell other types of consumer loans to its customers for BOFI.

The second product is a tax refund transfer.  Similar to the EPM, the Bank provides oversight and control of this program offered by HRB to its tax preparation customers.  BOFI opens a temporary bank account for each HRB customer who is receiving a tax refund and elects to defer payment of his or her tax preparation fees.  After the IRS or state tax authority transfers the refund to the account it is closed and BOFI earns a fixed fee from HRB.  These fees are primarily generated in the March 31st quarter.

The third product are IRA accounts opened by HRB for its customers.  The Bank provides IRA custodial services and earns nominal fee from account closures and transfers.  These three products generate approximately $30 million in annual fees to the Bank and expose the 13.6 million people a year who do their taxes through HRB with BOFI.  This should help to drive both deposit and lending relationships for years to come.

In fiscal 2016 BOFI generated approximately $29.3 million in banking service fee income from the HRB relationship.  BOFI has estimated that the HRB relationship will add between $31 million and $34 million in annual revenue.  Needless to say, this is a very profitable relationship for BOFI.  The benefits of this deal are shown in this slide below from an August 2015 presentation:

BOFI’s lending business

BOFI has primarily been a lender against housing related real estate.  At March 31, 2017, 78% of BOFI’s portfolio was guaranteed by single and multi-family housing first liens.  The remainder of the portfolio is in 12% Commercial and Industrial (“C&I”), 4% C&I single family lender finance, 2% factoring and 4% other.  BOFI’s lending profile has been conservative since its inception in 2000.  BOFI focuses on lending to borrowers at low loan to value ratios which creates a nice cushion against future loan losses.  This has resulted in best in class asset performance over the Bank’s life.  A demonstration of this point is BOFI’s loan to value ratio against its real estate lending portfolio from its June 2005 and 2016 10-K’s (see table below).

This table highlights that BOFI’s stunning growth over the last 12 years has not come at the cost of becoming an aggressive real estate lender (Sorry shorts).  Also, the stated loan to value ratio does not take into account appreciation of real estate post loan closing and probably understates the conservative nature of BOFI’s lending portfolio.

BOFI has five silos of lending.  They are single family mortgage, commercial real estate, C&I, small business and consumer.  They are detailed in the slide below from the May 2017 presentation.

In this write-up, I will discuss the first three lending areas.  Small business and consumer are still currently immaterial business units and will not add value to this discussion.

Single Family Lending

BOFI originates and underwrites single family mortgages across the US according to its lending guidelines.  In the Gain-on-sale Mortgage Banking business it sells loans that either conform to FNMA and GNMA rules or are non-conforming Jumbo loans.  It sells these loans to the government agencies if they are conforming or to other banks or financial institutions if they are non-conforming.  There is interest income generated while the loan is being held for sale, but this is primarily a fee income business.  

In the Warehouse Lending business BOFI underwrites single family loans for third-party mortgage companies.  These loans move into a warehouse loan facility and are then removed when the TPMC sells them, usually in less than 45 days.  BOFI requires the TPMC to have enough asset value in the account to protect BOFI from defaults.  It would be highly unusual for a loan to default while it is in the facility since it stays in for a short duration.  From this facility, BOFI earns fees and interest based on its total size and outstanding borrowings.  Traditionally, banks like BOFI lend into warehouse facilities to profit from lending areas that federal regulators may prefer that bank to have minimal exposure.  Examples of this type of lending are sub-prime auto loans, sub-prime home mortgage loans and others.  Warehouse lending is a common and profitable area for large banks and is practiced by Wells Fargo, JP Morgan Chase and many others.

BOFI’s Jumbo Lending business originates and underwrites mortgages above $417,000 in most parts of the US and above $625,500 in high cost markets like New York City, Los Angeles and San Francisco according to US regulatory rules.  The market for Jumbo lending is highly fragmented and is a specialty lending business.  According to the Wall Street Journal, the top six US retail banks controlled less than 25% of the Jumbo single family loan market in 2015 (https://www.wsj.com/articles/banks-keep-making-more-jumbo-mortgage-loans-1467649522?mg=prod/accounts-wsj ).  Many high net worth borrowers have complicated financial situations and tax returns due to the types of businesses they own and operate.  This makes underwriting a Jumbo loan a more laborious and credit intensive process than most small banks feel comfortable with.  Jumbo mortgages carry interest rates that are typically 25 to 50 basis points higher than conforming mortgages.  BOFI competes not only on the interest rates it charges, but also on its ability to close on a complex loan underwriting on time and with the rate quoted.  

BOFI focuses its Jumbo lending in the high cost markets since it believes that the number of transactions in those markets makes valuing the underlying assets less subjective than a one of a kind house in a smaller market.  That means that it has concentrations in Los Angeles, San Francisco, San Diego, Silicon Valley, New York City, Phoenix and Florida’s Gold Coast.  Unlike a regional bank lender who is required to lend in its region, BOFI is free to concentrate its lending where it sees the best risk adjusted returns.   As you can see from the chart below from BOFI’s 2016 10-K, these markets make up about 85% of total and 87% of single family mortgage loans.

Multifamily lending / commercial real estate

BOFI is an active lender into the multifamily mortgage market and these loans made up 27% of the Bank’s mortgage loans at June 30, 2016.  As can be seen from the chart above, BOFI focuses on California when making these types of loans.  The Bank has been actively lending in to these markets since inception and is able to satisfy its Community Reinvestment Act obligations by this focus.  The Bank generates both fees and interest income over the life of each loan and often requires the borrower to keep some form of deposit relationship.  The fees are generated by pre-payment penalties and deposit account charges.  The Bank sells some of the loans it originates, which creates additional mortgage banking income.

BOFI maintains a conservative loan to value ratio in this segment as with all its businesses with LTV’s for last fiscal year of 55% weighted average and 54% Median.  This is an unusually low LTV when looking at a book of multifamily loans which many banks originate at around 80% LTV.  BOFI achieves this through its ability to build relationships with apartment owners by closing loans quickly without changing rates and conditions.   Multifamily is one of the safest asset classes as it is secured first lien lending to an income producing property with low turnover of rents.  

Commercial and industrial lending

The $868 million C&I loan book is comprised of equipment leases and other types of commercial loans. BOFI began C&I lending in 2010 with a focus on financing businesses engaged in the origination of niche mortgage products secured by residential or commercial real estate.  This business, known as lender finance was discussed in the single-family section above.  The Bank has expanded this practice to include leveraged lending for selected industries, project-based real estate secured lending and other asset-backed financing.  The C&I book was approximately 16% of assets at March 31, 2017.  The 4% single family lender finance warehouse lending business was discussed above, so I will focus the remainder in this section.  

Equipment leasing

The Pacific Western (“PW”) leasing business was purchased by BOFI in March of 2016, which added a $140 million book of performing equipment leases and 25 employees.  The Bank paid a 2.5% premium for these leases which yield 7% annually.   PW focuses on lending to small to medium sized companies for the purchase of capital equipment vital to the operation of the business.  The leases are secured by the assets being leased and are underwritten based on the businesses’ cash flow and balance sheet.  Commercial and industrial loans outside of the leasing area are originated by a commission based lending sales force based out of the corporate offices.  These business loans are underwritten based on cash flow.  

This non- real estate backed book of business has had no non-performing loans over the last four quarters.  This is partially due to the way BOFI purchased Pacific Western assets, which were cherry-picked to avoid troubled industries and economic areas.  The main reason for the lack of troubled assets is the strong underwriting of leases and a benign US economic environment.  The same conditions for the leasing business are driving the rest of the C&I book.  Strong underwriting has led to having no non-performing assets.

Factoring

The last C&I lending business is Specialty Finance Factoring, which is about 2% of BOFI loans outstanding.  This area lends money to borrowers who grant a security interest in receivables from state lotteries and structured settlement annuity payments.  This type of secured lending effectively discounts these receivables at a rate that is related to the strength of the credit of the borrower’s source of payment.  The credit risk for these payments are state lotteries and insurance companies.  Despite the strong credit nature of the receivables, this area generates a yield above that of mortgages.  At March 31, 2017, BOFI had no non-performing factoring loans.  This has also been true for the last two years of financials.  

Large balance commercial / specialty real estate

Secured commercial real estate loans totaled $155 million at March 31, 2017 and are just over 2% of loans outstanding.  These loans are underwritten to the Bank’s conservative lending standards with 42% at a LTV less than 50%, 23% at between a 51% and 60% LTV, 29% at between a 61% and 70% LTV and 6% at between a 71% and 80% LTV.  At March 31, 2017, the Bank had no non-performing loans in this business sector.  A year earlier this figure was $254,000 against a $121,492,000 portfolio or 20 basis points.

Investment income

Investment income is generated by banks investments in fixed income securities.  Typically, these investments are in mortgage-backed, municipal and corporate bonds.  Banks keep these investments as a means of having available liquidity through the ability to sell these tradable investments quickly as required by the OCC should there be an emergency.  As these investments are interest rate sensitive, the decrease in interest rates over the long term has allowed banks to generate gains on the sales of these securities.  

BOFI has been able to deemphasize its investment portfolio over the last decade as it has built up its lending franchise.  Back in the 2007 and 2008 time-frame, investment income made up between about 33% and 50% of all interest income earned by the Bank.  For the March 31, 2017 quarter, investment income was about 7% of interest income.  This has benefitted the Bank’s net interest margin as investment securities tend to yield less than BOFI’s loans.

Non-interest income

BOFI derives non-interest income from gains on sales of securities and credit products, pre-payment fee income from commercial and multi-family mortgages, mortgage banking income and banking service fees.  

Gains on sales of securities has been a source of income for all banks over the last thirty years as interest rates fell to all-time low levels.  For BOFI this has been an irregular and largely insignificant income contributor.  2016 was the only year since 2010 where it made up more than 4% of pretax income.  

Pre-payment fee income is a double-edged sword.  It is caused by a borrower’s early payment of a loan with contractual penalties.  It generates income for the period, but the Bank loses its long-term stream of interest on the loan.  This churn of an account means that BOFI needs originate new loans greater than this loss plus the normal amortization of its portfolio.  If interest rates stay stable or begin to rise, this negligible area of revenue will be offset by increased interest income.

Mortgage banking income is generated by the sale of single and multi-family mortgages to government entities, banks, hedge funds, insurance companies and Investment banks.  BOFI sells all its conforming mortgages to government entities like GNMA and FMNA.  BOFI’s Jumbo and multi-family mortgages not being held on the balance sheet are purchased by other buyers to be held to maturity or to be packaged and sold to structured credit products.  Mortgage banking income peaked in 2013 at $23 million and has generated between $10 million and $16 million in all the other years since 2012.  

Another potential source of fee income and relationships is the Bank’s creation of a Universal Digital Bank (“UDB”).  BOFI is beginning to build relationships with financial technology (“Fintech”) companies that want to use its platform.  While still in its early stages, the UDB will allow BOFI to become one of the first online consumer banking platforms to allow open access to all banking products and services regardless of the provider.  This is potentially a very large opportunity which will grow deposits and fees in the future, though it is not definable at the current moment.  The slide showing this is below.

Credit quality

As a bank stock investor and former banker, I have always focused credit quality to measure the strength of a bank’s management skill and control.  As I mentioned earlier, the shorts have argued that the OCC was going to step in and punish BOFI for poor compliance oversight and credit issues.  After two and soon to be three annual audits by BDO, numerous regulatory filings and two OCC approved transactions, I believe that investors can comfortably ignore these accusations.  BOFI has had best in class loan quality when compared to banks between $1 billion and $10 billion in asset size.  The slide below from the Bank’s June 2017 presentation highlights this.

Banks start to have loans in non-accrual status when they reach 60 days or more past due.  BOFI is in strong credit position in these troubled loans due to the underwriting standards and controls mentioned above.  This causes the net charge-offs to run significantly below its peers.  The table below from the March 2017 quarter shows the loans that are past due.

BOFI has a table that reports its loan quality the way that the OCC categorizes the riskiness of loans.  This includes loans that are not adversely classified (Pass and Special Mention) and adversely classified loans (Substandard, Doubtful, and Loss).  The definition for Substandard loans “are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged”.  The following link highlights these definitions. (https://www.fdic.gov/regulations/resources/director/college/ny/materials/2012-loans.pdf )  BOFI has zero doubtful or loss loans and only 0.5% that are classified as substandard.  The substandard loans shown in the table below have only $496,000 that is not secured by a real estate lien, which is less than 1 basis point.  

From the credit statistics show above it is easy to see why regulators have not agreed with the shorts arguments.

Interest rate risk

All banks are required to show how a 200 basis point move in interest rates will effect net interest income.  BOFI generates few long term fixed rate loans and typically relies making on adjustable rate loans.  There would be some lag if the rate shock happened all at once, however bank deposits have shown little resistance to significantly lagging Fed rate increases.  There was a Wall Street Journal article linked here that discusses this fact (https://www.wsj.com/articles/want-a-higher-interest-rate-on-your-bank-account-tough-luck-1499851801).  In BOFI’s March 2017 10-Q it shows that a 200 basis point increase would be very advantageous to the Bank.  If rates were to fall 200 basis points it would be hurtful, though I am not sure how this could happen with rates so low.

Net interest margin and returns on equity and assets

BOFI has generated an annual net interest margin (“NIM”) of 3.95%, 3.92% and 3.91% in 2014, 2015 and 2016, respectively.  The Bank is on track to have a NIM of over 3.90% in fiscal 2017.  The Bank targets a NIM range of between 380 and 400 basis points for its business.  BOFI’s NIM has benefitted from its access to low cost deposits, the run-off of higher cost CD’s and reverse repo’s, and its focus on lending areas that generate higher rates of interest.  When comparing BOFI’s NIM to a group of public banks with similar market capitalizations, the Bank generates on average about 30 basis points more of NIM.  

This better margin coupled with lower operating costs and stronger asset quality means that BOFI generates returns on equity and assets well above its peers.  This also allows the Bank to grow its assets at a double-digit rate without the need for outside equity capital.  Banks that consistently generate a return on assets above 1% and return on equity above 10% are considered to be well run.  BOFI has done this every year since fiscal 2010!  I have generated a table (shown below) from Bloomberg with banks around BOFI’s size.  The table demonstrates that BOFI trades at a discount to its peers despite having statistics that indicate the Bank is a better run institution.  I will discuss this in more detail in the valuation section of the write-up.

Valuation

Investors value public banks based on earnings, asset quality and business prospects.  The two most accepted valuation metrics are price to book value and price to earnings ratio.  The commonly used measures of bank profitability are return on assets (“ROA”) and return on equity (“ROE).  I ran a Bloomberg screen, shown above, using all banks with market capitalizations of between $800 million and $2.6 billion.  These banks on average generated a ROA of 1.03% and a ROE of 11.53% and trade at a P/E ratio of 20.71 and a price to tangible book value (“PTBV”) of 2.27.  BOFI trades a P/E ratio of 12.81 and a PTBV of 2.08 despite having a ROA of 1.61% and a ROE of 18.24%.  This discrepancy cannot be explained by asset quality issues, since BOFI has lower non-performing assets and net charge-offs than its peers.  I believe this discount is related to the continued short attack on the Bank.  

BOFI is due to announce its annual numbers for in fiscal year ending June 30, 2017 on July 27th.  I believe that this third annual report post the start of the short attack should begin to deflate the shorts passion for BOFI.  Currently, 46% of BOFI’s stock is short totaling 25.3 million shares.  The Bank’s stock trades about 1.02 million shares per day.  This translates into about 25 days of trading volume needed to cover the shorts’ position.  

If we valued BOFI today at its peers’ average trading multiples the stock would be at $28.44 per share based on PTBV or at $42.09 based on P/E ratio.  Therefore, I believe short term upside based on last quarters trailing numbers is between 19% and 76%.

As a value investor, I do not invest for the short term.  If we look out two years and continue to grow assets at about 15% per annum and assume that NIM stays in the low in end of the Bank’s guidance of between 380 and 400 basis points without a material worsening of credit performance, then investors’ expected returns for BOFI go up markedly.  I am modeling a tangible book value of $18.40 and a latest twelve months EPS of $2.76 for June 30, 2019.  Using current peer multiples that translates into price targets of $41.71 and $57.07 for the PTBV and P/E multiple, respectively.  This represents potential appreciation of 75% and 139%.  Using the midpoint of $49.39, BOFI has 108% upside.  

Regression Analysis Valuation

Since we have a large sample of peer banks to consider as comps, I looked to see how closely ROE, ROA correlated to a multiple of book and P/E. Surprisingly, there is very little correlation between these performance metrics and P/E; almost all the banks in the sample trade at around 20x irrespective of performance. However, when I regress the peer banks price to book against ROE and ROA I get a nice, tight, positively sloped line (especially for ROE).  This is exactly what you would expect: banks with higher returns on equity and assets trade at higher multiple of book. Using BOFI’s ROE and ROA to determine where it should trade today based on these multiples yields a PTBV of 3.08 and 2.99, respectively.  This would imply that BOFI’s stock should currently trade at between $37.49 and $38.67 per share (based on latest twelve months March 31,2017 numbers) for current upside of between 57% and 62%. The regression analysis and scatter grams are show below.

Conclusion

I believe BOFI is a mispriced bank stock due to a long-term short attack that should run out of steam over the next few months.  The stock offers both short-term and long-term upside due to the following factors:

1. BOFI is one of the most efficient run banks in the US as measured by its efficiency ratio.

2. BOFI generates top tier ROE and ROA amongst US banks.

3. BOFI’s asset quality is strong and should remain so over the investment period.

4. Bank customers are moving quickly away from bricks and mortar to internet banking transactions.

5. BOFI can continue to grow at a double digit annual rate without the need to raise dilutive equity capital.

I think a long-term investor should target a stock price of $49.39 per share for July 31, 2019 based on trading at the midpoint of peer multiples.  If BOFI is able to succeed with its universal digital bank offering, then this could be a conservative estimate of share price.  Also, as BOFI is an early mover in internet banking, it could become a takeover target for a mid-sized bank looking to expand its digital footprint. If this were to occur I believe my target price could be achieved more quickly.

Catalyst

1. Short covering

2. Continued strong earnings performance and resulting multiple expansion

3. Takeover by a larger bank