Description

First Internet Bancorp (Nasdaq: INBK) is an online bank whose share price has collapsed along with most banks since the start of the pandemic. The stock is an absolute bargain at 48% of book value, which seems to price in the worst-case scenario and provides a significant margin of safety. This is a situation where we can also identify multiple separate initiatives occurring at the company-level that will unlock shareholder value including improving profitability (management expects net interest margin to grow from today’s ~1.3% to ~2% over the next 12 months), and a liquid balance sheet that sets up management to repurchase shares as it has done in the past (having recently completed an accretive $10M buyback in Q3 2019 at about a 30% discount to book value). The bank’s conservative underwriting will also be demonstrated over the next year as it continues to experience much lower loan losses than its peers in the industry.

 Key Points of the investment thesis:

1)      INBK trades among the lowest price-to-book multiples of all regional banks in the US

2)      INBK has a skilled management team that has historically implemented capital allocation actions resulting in shareholder value gains, many of whom routinely buy stock in the open market and are big buyers at today’s price

3)      The branchless/online banking model keeps costs low and is a strength over the long-term for the bank, more so as the pandemic incentivizes customers to avoid physically visiting bank branches

4)      INBK’s stock should appreciate as the bank’s profitability trends higher as a result of 1) a large chunk of expensive deposits rolling off over the next 12 months and 2) fee and loan growth from the new SBA loan division

Business Overview

INBK operates a branchless bank that offers commercial, small business, consumer, and municipal banking products and services to its customers in the US through online channels.  There are numerous advantages that come with being a branchless bank, including a lack of geographic boundaries that traditional branch banks face, and hence INBK has a widely diverse mix of depositors from every state across the nation. INBK’s online account access services are augmented by their team of dedicated banking specialists. Additionally the bank does not own or operate any ATMs, but through network participation nearly any ATM worldwide can be used by the bank’s customers to withdraw cash, which is much more cost effective than building and maintaining its own ATM network.  The cost structure of a branchless bank is also advantageous compared to traditional banks that incur recurring expenses to maintain physical infrastructure in the normal course of business.

INBK’s internet-based, scalable banking platform has seen tremendous growth over the last five years, during which time book value per share grew by ~50% and their deposit base more than tripled. The bank also maintains strong asset quality metrics with relatively low levels of non-performing assets and charge-offs relative to peers.

Management Brings Skilled Operational Knowledge and Understands Capital Allocation

The founder/CEO/Chairman of the Board, David Becker, is an impressive owner-operator with a solid background as a serial tech entrepreneur. Mr. Becker founded INBK during the late 90’s tech boom and managed to grow the business over the next decade into a bank whose strong reserves and capital ratios enabled it to forego TARP funds from the government during the 2007-2008 financial crisis.

In recent years we’ve seen Becker and his management team demonstrate their ability to swiftly take advantage of the stock market’s emotional swings by raising capital when the stock trades at a premium to book value and repurchasing stock when it declines materially below book value. For instance in June 2018 INBK’s stock price traded at approximately $33/share, a premium to its last reported book value per share of ~27/share, prompting management to issue shares and raised ~$54M in net proceeds. By December 2018 the stock had fallen to ~$20/share which was significantly below the bank’s last reported book value per share of about $28/share, so management took the opportunity to implement a $10M share repurchase program. The full $10M repurchase authorization was completed by Q3 2019 at an average price of $20.70 per share – approximately a 30 percent discount to book value per share.

Insiders collectively own ~6 percent of the shares outstanding and when the stock price collapsed in March 2020, the CEO, COO, Corporate Secretary and two directors went into the open market to personally purchase meaningful amounts of stock.

Today’s Pessimistic Market Valuation Reflects A Doomsday Scenario

At its current price of $15.07 per share, INBK trades at a price-to-book multiple of 0.48x, which is a heavily discounted multiple compared to median and average P/B multiples of 0.92x and 0.98x respectively for a group of similar public peers in the US regional banking space*.

*21 bank peers used by Board in compensation analysis on basis of size (AX being the only exception to this, included due to similarity in business model), growth rates and other factors; peers includes: AX, SFBS, LBC, TSC, EBSB, FFWM, CNOB, MBIN, BMTC, PFBC, LOB, FSB, CCNE, STL, MCB, FRBK, CATC, BCBP, ALTA, BFST, WNEB

In a conservative scenario where INBK’s shares trade halfway closer to its peer group median and average multiples noted above, the shares would trade at roughly $22 to $23 per share for an upside of 46% to 52% over its last closing price. 

Why Mr. Market is Wrong About INBK

Given the uncertainty in the macro environment (pandemic business closures, spiking unemployment, record low interest rates, etc.) investors are increasingly pessimistic about the strength of bank balance sheets and their ability to generate adequate returns. These factors have weighed on INBK’s share price, but we would argue disproportionately so. When one “takes a look under the hood” we find that the underlying loan book is not nearly as bad as the share price implies and the bank’s profitability metrics will actually be rising in near term thanks to several internal initiatives currently underway (discussed below). 

First and foremost INBK has no direct exposure to airlines, cruise ships, oil and gas, multifamily, shopping malls, office buildings and other highly impacted industries during the pandemic. During COVID-related closures, division leaders reviewed the portfolios top to bottom individually by loan, their conclusion – that they’re in good shape and don’t anticipate loan losses to the extent that other banks have seen and remain in frequent communication with borrowers under deferral. Furthermore, third party stress testing on large parts of the portfolio indicate adequate loan loss reserves are already in place.

As with many banks during this time, INBK has offered its borrowers the option to defer payments during the pandemic and initially there were a significant number of borrowers that did. But as of July 17, 2020 there has been a meaningful reduction in loans on deferral from 21.9% of total loans in May 2020 down to 12.5% as of July 17, 2020. The majority of deferrals stem from its single tenant lease (STL) financing (~76% of total deferrals) and healthcare finance (~16% of total deferrals) loan portfolios.

The STL financing loan book consists of loans made to property owners of real estate subject to long-term lease arrangements with single tenant operators, who are primarily restaurants, quick service food chains, pharmacies and other retailers. About 28% of these loans were on deferral as of July 17, 2020, with about 85% of these deferrals stemming from restaurant properties. It’s important to remember that these loans are made to the property owners, not the operators and that the average LTV of ~55% provides an adequate margin of safety to INBK as a lender. Looking within the portfolio, some of the largest disclosed tenants include nationally recognized restaurants and pharmacies such as Red Lobster, Wendy’s, Burger King, Walgreens, and CVS, among others. As of their last earnings call (held in July 2020) management noted that they expect the vast majority of borrowers on deferral in this portfolio to resume making payments in August 2020. While the current environment is certainly a challenging one for the sectors in this portfolio and there may be some level of delinquencies, customers are returning and business is picking up as states continue to reopen. Given the low LTVs on these loans and the reopening of many of these businesses, the level of losses on this portfolio is unlikely to be anywhere as high as what the market price would imply.

The other major area of deferrals has been seen in the healthcare finance loan book. More than 90 percent of this portfolio is comprised of dentists whose loans are collateralized by business assets (including real estate in some instances) and all loans have personal guarantees. There were zero delinquencies or losses since inception until Q2 2020 when there was the first loss due to one borrower who had some unique circumstances (apparently he had a practice in California and when they didn’t let him reopen he panicked, shut down his business, took his family and left town). Generally speaking dentists are very good about making payments and are highly likely to resume making payments once pandemic closures ease and dentistry doors reopen. Management indicated on their Q1 2020 earnings call that the healthcare finance loan deferrals began largely as a result of dentists acting on the recommendation of the American Dental Association to limit their dentistry work to emergencies only in consideration of the pandemic. However this recommendation expired on April 30th and was not extended, therefore many dentistry practices are beginning to reopen for elective procedures with new safety guidelines in place. This positive development is reflected in INBK’s portfolio, as deferrals in the healthcare finance portfolio have declined from a nearly 80% of healthcare finance loans in mid-May to just 15% as of July 2020, with the majority of the remaining deferrals expected to roll off before this quarter’s end.

The remainder of the loan portfolio is in much better shape with minimal loan deferrals, as >90% of all deferred loans come from the two loan books discussed above.

Other than underestimating the strength of INBK’s loan portfolio, the other aspect of INBK’s business model that the market has overreacted to is the recent declines seen in the bank’s net interest margin (NIM), an important profitability metric for banks. Over nearly 3 years, INBK’s NIM on a GAAP basis has declined on a quarterly basis from 2.35% (Q4 2017) down to 1.37% (Q2 2020) as a result of declining interest rates, expensive certificates of deposits, and elevated cash balances. The declining NIM has no doubt been a significant red flag for investors and has roughly coincided with the sustained decline in the bank’s stock price.

Management has been working to boost NIM primarily by lowering deposit costs and has successfully lowered the monthly rate paid on interest-bearing deposits from ~2.30% in January 2020 down to 1.80% by the end of June 2020. Over the next 12 months approximately $1B in CDs (roughly half of the CD amount outstanding) with a weighted average cost of 2.18% will mature and be replaced by lower cost deposits currently in the range of 1.00-1.05%. In total, management expects to generate about $17-$20M in savings in 2021 from lowering the cost of deposits, which will put strong upward pressure on NIM and overall profitability.

In addition, INBK’s new SBA platform is being built out nationwide and will provided a route to increasing noninterest income through SBA gain of sale and loan servicing revenue, further bolstering the bank’s profitability. The SBA platform will also retain higher yielding loan balances and fuel small business deposit growth at INBK. The SBA platform is still a small part of the business today, but is growing rapidly and should become a large opportunity for INBK in the coming years. At the beginning of the year the SBA loan pipeline was about $10M, by July 2020 it had grown 10x to $100M. Management expects to generate SBA loan originations of $200M-$225M in 2021.

INBK’s NIM bottomed in May and has recovered since then, ending June in the mid-to-high 1.50% range. Management expects that the initiatives currently underway set INBK on a path to achieving a NIM of about 2.00% within the next 4 quarters. With INBK’s NIM closer to its peers, the stock should re-rate higher to a valuation level more in line with its peers.

Catalysts

The primary catalyst we see is INBK reporting increasing NIM over the next few quarters, ultimately achieving Management’s 2% target within the next 12 months.

Another catalyst will occur as COVID-induced negativity eases in the real economy and the market. Given that INBK has elevated its cash holdings due to the uncertainty introduced by the pandemic, once this uncertainty dissipates management would be in a good position to execute accretive share repurchases as it has done in the near past when its shares were undervalued by the market.

Another catalyst may come from reversion to the mean – keep in mind that right now INBK’s shares trade at the low end of P/B ranges relative to a) its own prior history of trading and b) nearly every regional banking peer in the US. At half of book value, the stock market is pricing in much more losses in INBK’s loan portfolio than is likely to occur from the pandemic.

Risks 

The major risk to INBK and all banks right now stems from the unknown economic ramifications of the pandemic down the road.

Conclusion

This is a bank with a low-cost business model relative to traditional banks, a loan portfolio that is stronger than it looks, and a pathway to elevated profitability from today – these factors have been overly discounted in today’s environment of investor fear concerning banks. Given INBK’s history of successful growth and its outlook for profitability, we disagree with the negative overreaction embedded in the current market price and see strong upside over the mid-to-long term. 

Catalyst

Improving net interest margin over the next 12 months as high-cost deposits roll off and SBA platform grows

Better than expected loan performance in the near-to-mid term

Future share repurchases when near-term uncertainty subsides

Reversion to the mean