BofI Holding: A Closer Look at This Online-Only Bank

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Industry Focus: Financials edition host Michael Douglass and Fool.com contributor Matt Frankel take a look at online-only bank BofI Holding (NASDAQ: BOFI), starting with an overview of the company's business model and competitive advantages. They also discuss how BofI got to its current state, and how it plans to continue to grow at a rapid pace.

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A full transcript follows the video.

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This video was recorded on Dec. 4, 2017.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Dec. 4, and we're doing a deep dive on BofI Holding, ticker symbol BOFI. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. Matt, welcome back!

Matt Frankel: It's always good to be here!

Douglass: Fantastic. So, we've been talking a lot about the news and personal finance and things like the Fed chair and tax plans and all this kind of stuff. We figured this time we would go ahead and do a hard pivot back to stocks, specifically one stock. In this case, it's the only bank stock that I personally own in my portfolio. A month or so ago, I referenced an article by Anand Chokkavelu about how to analyze bank stocks. And I said then that I use Anand's framework whenever I'm analyzing a bank stock, and that I view it as my banking Bible, and frankly that's true.

If you want to follow along using his article, drop me a note at industryfocus@fool.com. I'm happy to send along that article, because what we're going to do is kind of a three-part thing. First, we're going to run BofI through that framework, Anand's framework. Then, we're going to step back and talk a little bit about history and now, and then pivot to talking about the future. So think of this as a three-part episode. With that in mind, let's talk through Anand's framework.

The first part of that is, he asks the question, what does the bank actually do? First of all, generally speaking, banks work off the same underlying business model -- they borrow money at one rate, they lend it out at another higher rate, and they pocket the difference, also known as arbitrage. Let's start with the higher rate. That is loans. How does the bank lend money, Matt?

Frankel: They have historically been a mortgage lender. They focus mainly on jumbo loans, which are loans that are too much, too qualified to be purchased by Fannie Mae or Freddie Mac. I believe the cap is about $417,000 right now. So these are big mortgages, mostly focused in high-cost states. California is one. About a little over half, 54% of their portfolio, comes from these kinds of loans. And they also have multifamily loans, which are generally defined as buildings with two to four residences in them. Think small apartment buildings, duplexes, triplexes, things like that. About 18% comes from commercial and industrial loans, which are business loans. Then they have some other types of loans in their portfolio that make up the other 7%. So, primarily a mortgage lender, small portion of business loans, and that's about it for right now.

Douglass: Right. Again, Anand's framework is very good for talking about a snapshot in time, what happened in the most recent quarter. It struggles a little bit more with the historical perspective, which is why we'll turn to that.

The other thing to keep in mind is, BofI has about $8.6 billion in assets, about $7.5 billion of which are loans and leases net of losses. That's, 88% of their assets are loans. So, thinking about this from a general banking perspective, the higher the percentage of assets that are loans, the more traditional the bank is. So, BofI, by this measure, is a very traditional bank, at 88% of assets represented by loans. Consider, for example, Bank of America (NYSE: BAC), which has roughly 40% of its assets as loans and leases, just to give you a flavor of what this looks like. Of course, Bank of America and BofI are incredibly different companies. But they're both, at their core, banks. So that's why you can see that big difference.

So that's the talking about how the bank lends money. Let's flip over to how the bank takes in money, a.k.a. deposits.

Frankel: Speaking of what makes something a more traditional bank, if most of their liabilities are deposits, that's another measure of how traditional they are. BofI takes in mostly low-cost deposits. I say low-cost loosely, because they pay more than most traditional banks, which we'll get into a little bit later. But most of the way they take in money are consumer deposits. They used to be mostly CD-oriented. Over the past three or four years, they've switched to be a more traditional savings or checking account-oriented bank, which now make up the majority of their deposits. But the simple answer is, the bank makes their money by enticing consumers to deposit money with them.

Douglass: And it's interesting, because deposits are viewed as a liability. If you aren't familiar with banking, that sounds kind of strange. But the reality is, that's money that the bank is getting for some period of time, be it brief or long, and they're going to have to give that back. That's why it's a liability. As you point it out, Matt, it's usually very low or no interest rates, so it's a very cheap way for the bank to get cash to fund loans and therefore make that money, that arbitrage. If a bank can't attract deposits, it usually has to take on debt or some stock, both of which can really hurt shareholders when done at scale.

So, the two ratios to look at for this are deposits over liabilities and deposits over loans. The deposit-over-liabilities ratio is 93%, which means that almost all of BofI's liabilities are these low-cost deposits. And the deposit to loan ratio is 96%, meaning that they are almost entirely funding their loans through deposits, which is awesome. That means they're pocketing lots of juicy income.

The third component of this is, what money are they actually making, and how are they making it? Put a different way, you want to look again at that delta between what they're paying out for deposits, and as you noted, Matt, BofI deposits are primarily interest-bearing, so they are paying out money for them; and then, what they're getting from loans. That is encapsulated in net interest income.

Then, of course, is also non-interest income, which is whatever other money they're able to pocket. So net interest income for the most recent quarter was $79.6 million. Non-interest income was $13.3 million. So they generate almost all their income from loans, with the non-interest income primarily coming from mortgage banking income, and banking service fees.

So that was the first part of Anand's framework. The others go a little bit faster. Let's turn to part two: How expensive is the bank? And there are a couple of different ways to look at this.

Frankel: My favorite way is using the price-to-tangible book value metric. This basically tells you how expensive a bank is in relation to how many assets are on its balance sheet. BofI's currently 2.1 times tangible book value. This is relatively expensive in terms of banking, but to put it into perspective, it's the exact same as JPMorgan's right now, just slightly above Wells Fargo and not even that far above Bank of America. So BofI is not an expensive bank stock by any stretch. U.S. Bancorp, for example, is well above BofI's valuation.

The other way you can look at it is in more traditional terms of the P/E ratio. For BofI is actually about 12, which is very low, especially compared to the S&P right now. That's about half of the S&P right now, from the last 12 months. So don't think that just because this is a high-tech, fast-growing bank stock that it's going to be priced outrageously. It's really not.

Douglass: And hopping forward into the historical perspective a little bit, it has been priced, at least as banking people, we'd say, pretty outrageously in the past. There are some reasons the valuation has come down, which we'll come to later in the show.

Let's turn to part three, then. I promised they go a little bit faster, and they are. What is the bank's earnings power? BofI's price-to-tangible book value ratio is high-ish, let's say, and its price-to-earnings ratio is very low, which sounds a little bit weird. Return on equity, or ROE, bridges that gap. And BofI's is very good; it's 17.4% over the trailing 12 months. That highlights their ability to turn equity into earnings. For background, an ROE over 10 in banks is usually considered pretty good. So, 17.4% is stellar. 

Frankel: Yeah, definitely. Usually, 10 is considered to be the industry benchmark on that. But another thing to look at is the net interest margin, which is kind of a fancier way of saying the spread between the rate the bank is loaning money at and how much it's paying out in deposits. BofI's is about 3.77% right now. Which is about a full 1% ahead of most of the rest of the banking industry, thanks to its cost advantages, which we'll also get into in a second.

Douglass: Right. And I was just going to say, the cost advantage is really key here, because BofI is paying out on a lot of its deposits. And if you consider the fact that, chances are good whatever bank you bank with doesn't pay interest on your checking account and on your savings account, they're paying you very little as well, BofI is generally paying more, and that's because, in part, they can afford to. So they can attract really high-quality deposits.

That is, in part, as you noted, Matt, because of their low-cost structure. The efficiency ratio is really critical here. This ratio includes all of the non-interest expenses. That's real estate costs, marketing expense, salaries, etc., and divides them into revenue, so lower is better. Last quarter's efficiency ratio was 40.49%, which is fantastic. Anything below 50% is considered great. BofI's peer group, that is all savings banks with assets greater than $1 billion, has an efficiency ratio on average of 63% by comparison. So that really highlights the value of their online-only model, and the fact that they don't have physical branches that you can go to.

So, part four: what risk is the bank taking on to achieve those earnings? Frankly, all the rest of this is perfectly fine, but if the bank is taking on a great deal of risk to achieve what are really some pretty good numbers, then big problems are going to happen when the credit cycle turns. And the short answer here is, surprisingly little. The long answer, of course, requires a few numbers. One of the key things that we like to look at is assets over equity. This basically helps to see how highly leveraged the bank is. A bigger number is bad, because they're taking on a bunch of risk. A really small number can also be bad because it might be a sign that the bank isn't being sufficiently aggressive. BofI's right at 10, which means that the bank is theoretically about properly extended.

Frankel: Sure. Another thing to look at is the percentage of non-performing assets, which is about 0.4% of the loan portfolio right now. That means people who are delinquent on their mortgage, businesses that haven't paid their loan in a couple of months, things like that. However, in BofI's case, their lifetime losses on mortgages are, I think, less than three basis points, which is 0.3%. That means that they're doing a great job of getting non-performing loans back to performing, and of evaluating credit risk in the first place. I mentioned earlier that their portfolio is primarily jumbo mortgages, which, by definition, because they're not eligible to be purchased by Fannie Mae or Freddie Mac, they're generally held to higher underwriting standards, meaning more than 20% down, high credit scores. So these, by definition, are lower-risk loans, before anything company-specific.

And the multifamily portfolio is even more impressive. The lifetime losses with that are less than one basis point, which is less than 0.1%, or virtually nothing. So the idea that they must be taking a lot of risk to achieve these returns is faulty logic.

Douglass: And one of the other things that really jumped out, this is a quote from BofI's CEO in their most recent quarter. He said, "We have not experienced losses in our C&I Lending Group since the exemption of the group." Think about that for a minute. How many bank CEOs can actually say that there is a part of their portfolio that is, let's say, more than three years old, where they haven't experienced any actual losses? It's incredible. The other thing to keep in mind is, even if a lender is appropriately conservative, one of the things they can do to game the system is decide how they're going to cover their non-performing loans. At a certain point, a lender has to write off the loan, and basically said, "We know we're not going to get this amount of money back."

Frankel: Sure. Banks put money in reserve to cover that. BofI has over 130% of their non-performing loans already covered in reserves, meaning that if all of those had to be written off, the reserves they already have in place would more than take care of it.

Douglass: Right, which is usually a sign, again, of a lender that is behaving appropriately conservatively. So that's the today snapshot. We're going to talk through what this all means and provide some historical perspective and things to look for going forward.

Let's talk historical perspective and background here a little bit. As you noted earlier, Matt, BofI is historically a residential lender, both single-family and multi-family. They really only started in business banking in 2011, and C&I lending in 2013. They're in the process of spinning up a consumer auto business now, which we'll talk about more on the going forward part of the episode. One thing that I want to highlight is, they've done a really good job of continuing to diversify their growth into new areas. That's one of the things that Anand's framework doesn't always give you, that historical perspective, so that's why it's important to start with those questions and then expand into other, broader ones that get highlighted as you're researching those initial ones.

Let's also talk about H&R Block (NYSE: HRB). This is something that doesn't really pop up in Anand's framework, but it's a really interesting and important part of BofI's business.

Frankel: Yeah, definitely. H&R Block and BofI, last year, for the 2017 tax year, entered into a partnership where BofI would start to provide refund anticipation loans for H&R Block's customers. You've seen the signs in the windows at the tax offices, "Get your refund now," things like that. For 2018, they've expanded their relationship where BofI is the exclusive provider of H&R Block's refund advance loans. The thing to know is, BofI doesn't make much money on this. They're interest-free loans. They charge no finance fees. The idea here is, this opens up, one, diversification, and two, cross-selling opportunities to recruit more BofI customers, hopefully, out of H&R Block's customers.

Douglass: It's a very interesting and frankly different model, and it's one that BofI has so far leveraged pretty successfully. Of course, we'll have to see how it pans out from here. Another thing that I want to highlight is the deposits side of things. Matt, you referenced this earlier, but I wanted to put some numbers to it. BofI used to be primarily time deposit based. Think a CD. About 50% of their deposits as of June 30, 2013, were timed deposits, things like CDs, and they had 2.1 billion deposits at the time. Fast-forward to the most recent quarter, they have $7.2 billion in deposits, so more than three times as much, and time deposits only make up 12% of their deposits, with checking other immediate demand accounts at 53%, savings accounts at 31%, and IRAs at 4%.

So that's the incredible growth, and they've really been able to achieve that by offering an attractive cost structure for consumers so that people can get higher yield savings accounts and things like that. So that has enabled that growth and diversification in loans that we were just talking about.

Another thing I want to highlight is, a few episodes ago, we talked about credit cycles and how they inevitably turn. Non-performing loans, frankly, are going to look good today. That's just part of the deal. BofI's are at 0.4%. Everyone's look good right now, because frankly, the economy is more or less humming along. The question, of course, is, what happens when the tide goes out?

Frankel: When recessions hit, banks have higher non-performing loans. People have a tougher time covering their bills, and this trickles into the bank's balance sheets. Just to give you some perspective, some banks were approaching double digits back in 2008-10 timeframe. Bank of America's credit card portfolio was over 10% at its peak. BofI only got to about 1.5% of its total loans at the end of 2010, were non-performing, not even charge-offs. So, this is an amazingly low ratio considering what was going on at the time. And will another 2008-09 style housing crisis happen? Probably not to that extent. But if it does, BofI should be well covered.

Douglass: Certainly, if their historical credit lending standards continue to hold true. Finally, it's worth noting, and we foreshadowed that this was coming a little bit. There's a reason why BofI has gotten cheaper over the last four years, and that has in large part been because of some allegations against the company.

Frankel: Yeah. Without going into too much detail about this, basically there were some accusations involving money laundering through the bank's channels. The New York Post, I believe, ran a story claiming this. The bank has repeatedly denied it. No wrongdoing has really ever been found. But there are still a high percentage of its shares that have been sold short, which is the reason why BofI's not trading at as high of a valuation as it was a couple of years ago.

Douglass: Right. So that's something to keep in mind. Again, nothing has been proven of the allegations. I am a shareholder and a very happy one, but there may still be more to the story that we don't know everything about. So that's just your usual standard cautionary commentary there.

Let's talk about moving forward with the bank briefly. We've only got a few minutes left. The bank has a number of opportunities it's trying to execute on right now. We mentioned auto lending. They're also getting into the personal-loan game. You've probably seen Marcus by Goldman Sachs ads on Facebook. At least I have. They're certainly pushing into that. And that's all, when you think about all of what they're doing, it feeds into this universal digital initiative that they're working toward.

Frankel: Yeah, this is kind of their initiative where they want to be a one-stop digital bank for anybody's banking needs. They want to make the most user-friendly interface among digital banks, offer any lending and deposit product you could ever want, and be more open to third-party partnerships like the H&R Block partnership I mentioned earlier.

Douglass: Yeah. That means, among other things, they're doing a lot of other investment in tech right now. Actually, that 40-and-some-change efficiency ratio we talked about is higher than it's been historically in part because they are making so many of those investments right now. Of course, you still have an enormous cost advantage.

Two other things going forward that are worth highlighting -- the first one is interest rates. The Fed has increased interest rates by 0.75% in the last year. BofI has only increased their average interest rate, checking and savings deposits rates, by 0.29%. So that difference is an arbitrage advantage, and that's one of the reasons why, when we talk about rising interest rates benefiting banks, this is why, it's things like this. The banks are able to raise how much they are paying out for deposits in savings accounts at a lower rate than the Fed is increasing overall interest rates, which then enables them to pocket the difference.

Frankel: Yeah. It's also worth pointing out that the 0.29% is actually more than most banks have increased in the same amount of time. My Wells Fargo savings account still pays out something like 0.02% or something like that.

Douglass: [laughs] Right.

Frankel: So it sounds like the bank is being a little greedy by getting 0.75% more on their loans, and only paying out less than half of that in additional interest on deposits. But it's really a lot more generous than the industry standard. BofI's rates were a lot higher to begin with, too, so this makes some of the more appealing interest rates in banking look even more so.

Douglass: Yes. And this for me highlights the really key thing to think about with BofI, and it's the primary reason that I'm a shareholder, which is this inherent advantage, which is its low-cost structure. Low-cost structure is everything in my mind if management is good, because that means you're going to be able to continue attracting deposits, because you're able to pay out more for them.

You're also, on the flip side, on the loan side, you're able to get the most creditworthy folks with the really high FICO scores because you're able to offer them a slightly lower loan rate than anybody else, and you're able to do that on both ends because of your non-interest expenses -- so, things like, in this case, physical plant, are so much lower than anybody else has, such that you are able to take those hits on both sides of the loan/deposit part of the business, but still maintain profitability and core conservative underwriting standards, because you don't need to chase yield. If your cost is lower than everybody else's, you can give more back on both sides to attract the best consumers.

For me, this is a huge advantage that BofI has. And, again, it's why it's the only bank that I personally own. 

Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at industryfocus@fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening, and Fool on!

Matthew Frankel owns shares of Bank of America. Michael Douglass owns shares of BofI Holding and Facebook. The Motley Fool owns shares of and recommends BofI Holding and Facebook. The Motley Fool has a disclosure policy.