Description

BOFI Holding Inc. (BOFI) is a well capitalized internet-only thrift with a pristine balance sheet and sound assets that is trading at 80% of book value and less than 7x my projected EPS for fiscal 2009 (June).  Using my projected returns on equity and assets for BOFI, I would expect the stock to trade at about 2.3 time book value with the next 15 months, which equates to a share price of more than $20.00.  I expect the bank to benefit from the positively sloped yield curve and its ability to greatly increase net interest margin through the downward repricing of its deposit liabilities (CD’S) and swap out of low yielding (but safe) GNMA’s and FNMA’s for seasoned whole loans and AAA rated CMO’s from troubled financial institutions.  With the banking industry experiencing the “perfect storm”, many banks that looked sound in the good credit environment are beginning to struggle and fail.  There were very few banks that sidestepped the current credit crisis.  BOFI is one of them with a ratio of 0.09% non-performing loans to total loans. 

BOFI came public through Hambrecht in March of 2005 at $11.50 per share.  Once public, Hambrecht never picked up coverage and the bank still to this day has no sell-side analysts.  Management of the bank decided to use the proceeds of the IPO to purchase mainly GNMA’s and FNMA’s until the yield curve and risk adjusted credit returns improved.  As you may be aware, the yield curve remained relatively flat to downward sloped from the banks IPO until the 4^th quarter of 2007.  This led the bank to report very low EPS (earnings per share), ROA (return on assets) and ROE (return of equity) over its public life. 

The world has changed to BOFI’s favor in the last two quarters.  First, the spread between 3 month and 10 year Treasuries has gone from about 85 basis points (bps) on October 1, 2007 to over 200 bps today.  This is helping all lenders begin to repair their balance sheets by increasing net interest margin (cost of liabilities less yield on assets).  Second, the credit crisis has caused a re-pricing of risk for new and seasoned loans.  For new loans, banks are now more careful in their underwriting standards and pricing.  For seasoned loans and CMO’s (collateralized mortgage obligations), it is a buyers market.  There are so many banks that made bad loans needing to sell assets to stay well capitalized under Federal Reserve rules for banks, that quality loans are selling for historically high spreads over treasuries.  For example in the Indymac Bancorp (IMB) call, their management stressed that seasoned non-agency AAA CMO’s with low default rates were selling at an average of 93 cents on the dollar.  I have heard this pricing from a number of other sources as well.  This means that banks like BOFI can now increase yield on their assets by an additional 100 to 200 bps over where they were six months ago.  It is important to note that this increase in yield was accomplished without increasing the Bank’s interest rate risk.

Another positive effect of the decrease in short and mid-term interest rates is the decrease yields that BOFI needs to pay for time deposits (CD’s).  On the Company’s recent earnings call (May 6, 2008) it noted that 19% of its CD’s re-priced in the March quarter and 63% will re-price by the end of its next fiscal year in June 2009.  This will also result in an increase in net interest margin (NIM) over the next 15 months of approximately 100 bps.  In the chart below I show the Bank’s historical and projected NIM, ROA and ROE. 

Please note that the future interest rate spreads I used are conservative based on the facts made public in the earnings call last week. 

Another positive factor in looking at BOFI is the change in top management.  In October of 2007, the Company hired Greg Garrabrants to be CEO from Indymac Bancorp (IMB) where he led the business development group responsible for merger & acquisitions, joint ventures, and strategic alliances.  Prior to IMB, Garrabrants worked for Goldman Sachs as an investment banker and at McKinsey & Company focusing on financial institutions clients.  Garrabrants has spent the last 6 months analyzing the Bank’s strengths and weaknesses and has announced a number of improvements that will reduce expenses and improve NIM.  Please read the last two earnings transcripts for the details.

I have projected the ROA and ROE in the chart above based on the Bank’s current operating model.  The projected income statements are shown in the chart below and assume no growth in assets and only an increase in NIM with announced cost savings.

The upside to these numbers could come from the Bank’s announced intention to originate and sell qualified home loans to FNMA.  This would add gain on sale revenues to the model that I can’t quantify at this time.  The risks are straight forward, poor underwriting of future loans and a significant flattening of the yield curve.  I feel comfortable with both of these risks due to BOFI’s high underwriting standards and the state of the US credit markets.

Valuation

Historically banks that earn ROA’s of 1% and ROE’s of 10% trade in the public markets at significant premiums to book value.  Using a regression analysis based on historical bank acquisitions from the mid 1990’s till 2005, yields a value of 2.3x book value.  That would equate to a $20.00 per share based on Fiscal Year end 2009’s anticipated ROA and ROE and today’s book value of $8.67 per share.  I would expect BOFI’s stock price to migrate slowly from it current level to this price as investors recognize the soundness of the Bank and its earnings power.

Catalyst