INBK / BOFI

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Hey Fools,

Cross post from the BOFI discussion boards…

I’ve been lurking on the Saul boards and found that some Fools owned INBK. As an investor in BOFI, I came across this presentation that looked good - http://www.firstinternetbancorp.com/Cache/1500099821.PDF?Y=&……

I don’t fancy myself as a banking analyst, so I reached out to one that I respect very much – Jordan Wathen. I was curious to get his opinion on INBK, so I wrote him an email.

Here was his response:

Hard pass.

I looked at this last when I lived in Indiana, decided to pass. I’ll give this 15 minutes and see what I can remember/come up with.

Worth noting that you should all those numbers on a per-share basis. You’ll see that growth, etc. is fiction. The bank is growing. Shareholder wealth isn’t.

More than half of deposits are time deposits (CDs). Deposit costs go up with loan rates as rates rise. Passes on the benefit to depositors.

Compensation structure is garbage. Executives comped for growing: 1) net income 2) net interest income 3) assets. They are also comped for minimizing nonperforming loans, ex-TDRs – LOL. None of the first three are on a per-share basis. Return on equity doesn’t even come into consideration. You can fudge NPAs (turn them into TDRs). Stupid basis for compensation. (Page 20 of DEF 14 https://www.sec.gov/Archives/edgar/data/1562463/000114420417…)

*Brian again. I had to look up TDR’s - stands for “Troubled Debt Restructuring.” I found this video series of the subject: https://www.fdic.gov/regulations/resources/director/technica……

*Back to Jordan now

Board is garbage. There isn’t a real banker on the board, nor anyone who I would describe as an accountant. Red flag. Red flag. Red flag. Very little combined credit experience on the board. No meaningful share owners, ex the CEO.

The CEO’s shares are used as collateral for a personal loan. People who leverage their stock holdings shouldn’t run banks. (in the proxy I linked) I actually use this as a filter for good shorts. It has signal.
A massive amount of its loans are all commercial real estate loans. I don’t like concentration.

*Brian again - Now comes that part that I found most interesting…

*Back to Jordan

But on to internet banks as a collective…

These internet banks are a fool’s game, IMO. That’s not to say you can’t make a ton of money with this stock. Maybe you can. I think it ends in tears, though, because of the above.

These online banks only look good because rates are low right now. That won’t go on forever. (bolding by Brian)

I pulled this data from the FFIEC. Figures are as a percentage of assets as of 12/31/2016:


                        INBK	All banks
Interest Expense	1.10%	0.39%
Non-Interest Expense	1.84%	2.89%
Total as % of assets	2.94%	3.28%

As it stands, INBK’s hurdle is basically 2.94% on all assets on its balance sheet. The average bank’s hurdle is 3.28%. INBK’s low operating costs (online bank) give it an edge, at least by all appearances.

But if rates move up 100 bps, INBK is going to have to raise the rates it pays depositors close to 100 bps. The average bank isn’t. People bank at INBK for one reason – it pays a lot on deposits. That isn’t true of the “average” bank. Convenience, etc., play a bigger role. (bolding added by Brian)

Imagine if in the future rates rise 100 bps. INBK eats it. The average bank passes on only 25 bps (guess)

INBK’s asset costs: 3.94%
All bank average: 3.53%

Not so brilliant business strategy now, is it?*

John Maxfield writes a lot about banking. He’s crazy about efficiency ratios. I share his enthusiasm for efficiency ratios, but really, I care about interest expense and operating expense as a percentage of assets more than anything.

Here’s how I look at it

I think I’d make a below-average credit analyst with the knowledge I have right now. The average credit analyst would destroy me on performance. But if the average credit analyst’s deposits cost his bank 3%, and my deposits only cost 1%, I can make A LOT of errors before his performance tops mine. I like my odds if I start with a 2% advantage.

Actually, I don’t even have to go out on a limb with a 2% advantage. I’ll stick my book in highly-rated corporate bonds and clip my ~3% coupons with virtually no losses. I like my chances against someone who has to earn 5%, after losses, to beat me.

That’s how I think about banks. I’ll take a banker with an IQ of 100 and asset costs of 1% over a banker with an IQ of 140 and asset costs of 3% any day of the week.

Investing in financials is different than investing in any other type of company. You aren’t looking for the upside. That takes care of itself. Eliminate the downside. That’s how you find good financials, IMO.

Footnote: INBK’s operating expenses are lower in the first 6 months of 2016 as a percentage of assets. Likely has to do with timing on compensation, audit, public filing costs, etc., but I didn’t do any digging into that. Might just be a function of rapid asset growth. Dunno. Didn’t go down that rabbit hole, tbh.

P.S. Virtually everything I said about INBK goes for BOFI, too. I wouldn’t touch either stock with a 100 foot pole.

P.P.S. I’ve considered writing up many of these thoughts – about internet banks, not INBK in particular – before. I think I started that post 100x. Might be worth revisiting. This helped me think it through again.

*Brian from now on

I honestly hadn’t thought about this before. I’ve always assumed that BOFI’s efficiency ratio would allow it to price products aggressively and still earn strong returns. However, I must admit that Jordan has an excellent point – people bank with BOFI because of the high rates. Throughout my entire history investing in BOFI the company has operated in an environment where interest rates are basically zero. By offering 1% checking they stand out from other banks, which makes them look like an attractive alternative. As rates rise, will their rates (and hence their costs) rise in lock-step? I’m not sure, but I could see it happening. If so, there amazing growth numbers (which is why I’m invested in them in the first place) could start to disappear.

Now, their relationships with Costco & H&R Block could help to keep new customers coming in even if they don’t move rates up in lock-step with interest rates. However, this is a risk that I hadn’t considered before (could just mean I’m not paying enough attention).

I’m not giving up on BOFI, but I must admit that my enthusiasm for the stock has been knocked back a bit…

Hats off to Jordan for his eye-opening email.

Brian

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Very interesting. For what it is worth I use an internet bank that isn’t public, USAA. I use them for their low fee structure and convenience. I hate having to go into banks and wait in line. I never had my money their because i could get a 0.6% apr on my savings instead of a 0.2%

Another point I am not sure that I totally understand. Lets say INBK offers a 1% high yield (remember before the financial crisis, 4-5%) rates go up 0.25%, Why wouldn’t INBK just raise their rate to 1.25% just like the other banks? They will still have a higher yield. Maybe I am misunderstanding.

As for the rest of the points, interesting.

thanks for the cross post

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I replied over on the HG board, but I figured I would post it here as well:

One very key difference, glossed over by your friend (or perhaps not noticed, since this has happened since he last looked at these two companies), is that BOFI has moved significantly away from CDs to the much stickier demand deposits (checking and savings accounts). Thus, they no longer compete by offering the highest yield on CDs… that market is notoriously fickle as customers shop ruthlessly for yield. Going forward, their deposit base will increasingly be dominated by demand deposits, differentiating them from INBK, and making benefits like convenience, low fees, and low fixed costs their real drivers of growth.

Tiptree, Fool One guide, long BOFI

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This is great post.
Thanks to your friend for insight and to you for sharing Brian.

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Hi ethan1234,

The point is that if rates rise 0.25%, that INBK (and other online only banks like BOFI) will be forced to raise their rates by that same 0.25% if they want to continue to attract new customers. The reason is that interest rates are the primary tool that they use to bring people in. However, big banks like WFC, BAC, C, and regional banks won’t have to raise their rates in lockstep because customers choose them for reasons other than interest rates (convenience, ATM network…etc).

Thus, the huge advantage that the internet only banks have over the big boys right now – super low costs structure because they don’t have to maintain a branch network – will start to get erroded as rates rise because their all in costs (interest expense + non-interest expenses) could grow and eventually exceed the big banks.

If that happens, then BOFI wouldn’t be nearly as profitable from a loan as, say, WFC, if it was made at the same interest rate. That’s one reason why he is a “hard pass” on both INBK/BOFI.

Now, BOFI in particular might still be able to keep growing because of its Costco/H&R block relationships…but this is just a risk that I personally didn’t think about before.

Truth be told, I’m personally much more cautious on BOFI/INBK that I was just a few days ago.

Brian

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