When Shorts Attack
Board: RBS: BofI Holding
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For what it's worth, below is my response to select items in the article that I either did not understand or that I felt were just plain wrong.
First though, I have a confession to make. When I started to write my response to this article, I realized that I was reacting a bit too personally. BOFI is my largest position, and the company in my portfolio that I feel I understand the best. I found that I was reacting to the article as if I were defending myself, rather than critically analyzing what the author had to say.
Short "attacks" come in all shapes and sizes. Some are more well reasoned than others, and the well reasoned ones should be welcomed as a chance (or challenge) to take another look at the long thesis and see if anything was missed or has changed. Also, my role as ticker guide is to foster discussion of the company, not to defend it blindly. So if anything I write below smacks of me irrationally defending "my" company rather than critically analyzing the author's arguments, please call me on it. If BOFI is not the investment I think it is, my portfolio is in for a drubbing. And if I've crossed the line from objective observer to unabashed cheerleader without realizing it, I really need to hit the "reset" reset button.
With all of that said, below I present in bold selections from the the Seeking Alpha article and my responses. Thanks.
It's interesting, when we ask bank fund managers what stocks they are short. BOFI is often the first name they mention. From a valuation and risk perspective it's an obvious candidate. Trading at 5 times its book value and over 32 times the 2013 EPS, it's more than a bit rich for a mortgage driving California thrift. Here is how BOFI compares to some of its competitors and how we derive our $35 target:
According to Yahoo Finance, 6.5% of shares are short with a short ratio of 5.50. I’m not an expert on short selling, but 6.5% of shares short doesn’t seem like that big of a number to me. Notice that the article doesn’t actually include any numbers to backup its assertion that a bunch of fund managers are short.
Right after the above paragraph the article displays a list showing a bunch of other bank stocks and how BOFI’s price-to-book and trailing P/E are much higher than the listed companies. What the list does not present is the efficiency ratios of each company and each company’s book value growth. With a far superior efficiency ratio and by far the highest book value growth rate, perhaps BOFI deserves to be trading at higher price-to-book and P/E multiples than other banking stocks.
However, it's even more amazing that BOFI's numbers are driven by a depreciating - wasting away - non-agency mortgage asset. Basically the company made a timely decision and bought various duration mortgage assets at the bottom of the credit cycle at deep discounts to par. The earnings from these assets are waning. As these assets run-off, we expect net interest margin (NIM) to drop by 30bp next year. Without other lending opportunities, this may reduce EPS by $.10 this coming quarter and by $.40 over the course of calendar year 2014.
These numbers just don’t seem to work. What I think the author is saying is that at the bottom of the real estate cycle BOFI bought a bunch of mortgages at well below par value. Those loans are therefore “inflating” net interest income because these were super high yielding loans and net interest margin will decrease once these loans burn off and cannot be replaced. Well, the numbers tell a different story.
[See Post for Tables]
If what the author says is true, BOFI likely would have purchased these below-par value mortgage shortly after the real estate bottom, likely sometime in 2008 through 2010. By 2011, I think it was pretty obvious what jumbo loans were performing and which weren’t – and the nonperforming ones at that point were more likely to remain nonperforming. So if BOFI’s net interest margin is being artificially juiced by the purchase of these mortgages, I think we would have seen the impact between 2008 and 2010. I don’t think that would lead to a 130 basis point increase in net interest margin since 2011. That just doesn’t make sense to me.
If the author is saying BOFI’s net interest income is being juiced by mortgage backed bonds that BOFI purchased at a discount to par value, maybe there’s something there. BOFI does have $211 million of mortgage backed bonds, including $41 million of non-Agency real estate mortgage back securities (RMBS) - basically bonds backed by jumbo real estate mortgages (possibly what the author is referring to). These bonds are classified as either available-for-sale or held-to-maturity. BOFI had $41 million of net interest income during the last quarter, of which $6.3 million came from investments (which I believe – but am not 100% sure – where interest from these bonds is recorded). If the $6.3 million of interest income came from the $211 million securities portfolio, and the jumbo non-Agency RMBS bonds make up 19% of the total securities portfolio, what would happen if 19% of the securities interest income (about $1.2 million) disappeared?
After the tax provision, the net income impact would be reduction of about $780,000. Divided by around 14 million shares that would reduce EPS for the quarter by $.056. Assuming the non-Agency RMBS securities generate a proportionally higher yield, maybe adjust up another penny or two. So you don’t quite get to the author’s $.10 in decreased EPS (I bet he forgot to include the tax provision adjustment), but maybe something close. However, this also assumes that these bonds burn off and management replaces them with nothing, which of course wouldn’t happen. While management may not be able find another pool of securities with the same yield, it would certainly find something with SOME yield. So I have a hard time seeing the impact being nearly as big as the author asserts.One of the reasons for the recent exponential shift in BOFI's price is the stored value card business. The street thinks that BOFI will be buying the H&R Block stored value portfolio that has been for sale for more than two years. Every bank that has looked at it has realized that they cannot make 12+% earnings multiple on the business. Management has hinted at this transaction forever, but what isn't mentioned is that if they get the transaction they would need to raise $200 million in capital to support this $6 billion block! In our opinion, this cannot get done at anything close to current share prices - no big bank funds would participate at 5x book value. The transaction would not be accretive for at least 2 years. We estimate it gets done at a maximum of $80 per share to attract the amount of funding needed to support the H&R Block business. To the best of our knowledge, none of the big bank funds own BOFI now, so why would they buy in at current prices?
I have no idea what this means. If I had to guess, he's talking about prepaid debit cards. In all of the conference calls I’ve listened to I do not recall ever hearing H&R Block mentioned or anything about an acquisition in the “stored value card business.” Management has said it wants to grow this product because it's very profitable. Prepaid debit cards provide BOFI with zero cost capital to lend.
Even if this is what the author is saying, it doesn't really make for a short thesis does it? The author is saying that Wall Street has bid up BOFI’s price because BOFI might make this acquisition, but then the author says that the acquisition would be a bad one. So the author is basically saying he disagrees with “Wall Street” - the acquisition would actually be really bad. Well, OK then.First, it's blatantly obvious to anyone who reads the 10-Q that the bank is betting your investment dollars on "Red". Red, being that interest rates stay down. Does the term Negative Gap Ratio mean anything to you? Well, go into your local bank and ask the CFO if they would run a triple digit negative gap ratio. Most banks keep this ratio as close to zero as possible. It's a measure of interest rate sensitivity. If a bank expects interest rates to stay low they may have a negative gap ratio of minus 5-10%. If a bank wants to be asset sensitive (expects rates to rise) they may keep a slightly positive gap ratio. For example, Banner lists a +13% cumulative gap ratio in its latest 10-Q. Umpqua lists the gap ratio at (-10%) in its 10-Q. But from BOFI's 10-Q, their cumulative gap is (-138%)!
So, for BOFI, a STEEP RISE (Fletch's emphasis) in interest rates will obliterate the earnings per share. Banks cannot adjust this overnight. It takes time to right size the balance sheet. BOFI responds to this risk by claiming that they will just keep interest rates low on their depositors for a longer period than other banks. This makes absolutely no sense. BOFI will need to raise rates the same or even more so than other banks. As an internet bank, it doesn't have loyal depositors. The bank has to pay .71% on checking accounts. In our opinion, depositors will move money at the drop of a hat to get a better rate at a competitor.
I had to look up the term Negative Gap Ratio because I had never heard of it. Running a negative gap ratio basically means you are not hedged very well against rising interest rates. If rates go up, you’re borrowing costs increase (i.e. interest rates you have to pay your checking account customers), but you cannot reprice the assets on your books (loans) so you will be subject to compressed spreads.
In this case, what the author says is factually correct, but still misleading. Per the most recent Form 10-Q, BOFI does in fact have a negative gap ratio of 130% - but only for assets and liabilities that mature and/or reprice sometime between now and 12/31/14. The gap ratio of BOFI’s total assets and liabilities is positive 11%, almost identical to Banner Bank’s 13% that the author states in more of an industry norm.
This is directly from Banner Bank’s (BANR) most recent Form 10-Q: Certain shortcomings are inherent in gap analysis. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as ARM loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table.
It doesn’t sound like Banner thinks much of gap analysis anyway. So the author is correct about BOFI potential having some short-term exposure to a steep rise is interest rates for BOFI’s short-term assets and liabilities, but the total balance sheet appears to be hedged quite well. Additionally, for assets and liabilities that reprice anytime January 1, 2015 BOFI actually has a positive gap ratio of 67%. This means that if/when interest rates increase anytime in 2015 and beyond BOFI will GREATLY
benefit from the increase.
So if you’re worried about a massive interest rate spike in the next 9 months, yes, BOFI could take a short-term hit over the next two or three quarters. If you’re worried about gradual interest rate increases over the next two to five years, BOFI should be in a great position for that environment. So I don’t think the other is exactly wrong with this one, but I think greater context is required to fully understand the picture, and I’m quite comfortable with how BOFI is hedged (to whatever extent I can tell).In the past, BOFI has offered one of the highest interest rates on money market and CD deposits in the country. This is how it has been getting customers. Up until recently, if you wanted a high rate of return on your risk free assets, deposit your money at BOFI, (just don't go over the FDIC $250,000 limit if you want it to be risk free). For example, if you went to bankrate.com a couple of months ago and clicked on "Best CD rates" in the country, BOFI may have come out on top, sporting some of the best rates for a given CD or checking account. But if you go there now, BOFI doesn't even show up in the Top 10, and oftentimes not in the Top 20. BOFI has clearly backed off the market and this may affect deposit growth dramatically. For example, for a 5 Year CD, the current best rate in the country is 2.2% offered by GE Capital. If you scroll down the list, BOFI comes in 22nd place with 1.35%. BOFI Is clearly cutting back, probably because it realizes it has too much interest rate risk. If BOFI continues this strategy, then the high growth rates are a thing of the past, and BOFI's price multiple should come way down to reflect this. I really don't see how this strategy will work given the dynamics of an internet bank.
This one just makes me laugh and is a great example of the author either not understanding BOFI, or actively trying to mislead the reader. As we’ve discussed many times, CDs are not a great way to grow deposits because they do carry with them more interest rate risk as they can’t be repriced very easily. Over the last couple of years BOFI has been actively letting CD deposits run off because it DOES NOT WANT THEM. BOFI not being at or near the top of a list of highest interest rate CDs is management following through on its plan and is a good thing. CDs have been running off for several years, without being replaced, and deposit growth is still north of 20% annually. The data the author uses above is actually one of the primary reasons BOFI has been able to consistently widen its spreads! Competing on price -- interest rates, in this case -- can be a banker's downfall in a rising rate environment. BofI Holding (NASDAQ: BOFI) and Everbank (NYSE: EVER) do just that: They steal deposits from other banks by offering above-average rates on deposits. Because online banks compete on price, their deposits tend to be less "sticky." Customers choose an online bank based on returns, not features or advantages like branch networks. As of its last presentation, BofI Holding, which owns Bank of Internet USA, was primarily funded with higher-cost certificates of deposit. CDs made up 49.8% of its deposit mix, substantially more than other online and offline banks. Everbank, by contrast, sourced 23% of its deposits from CDs and other time deposits.
According to BOFI’s last 10-Q, it had $2.4 billion in deposits with $864 million of those in CDs, or 36%. I cannot figure out how the author comes up with 49.8%. Of the $864 million left, almost $400 million rolls of this year, meaning that going into 2015 and assuming another 20% growth in deposits this year (remember this have been rolling off for a few years and management has still grown deposits 20%+ annually), CDs will make up around 16% of BOFI's deposit base, even less than the 23% at Everbank the author uses as a comparable.
The author then says that BOFI can’t compete because other banks like Everbank, Wells Fargo, and Bank of America pay their depositors lower interest rates than BOFI has to. What he fails to mention is that because BOFI is so much more profitable with a much stronger efficiency ratio, BOFI can pay the higher interest rates to its account holders and still have a higher net interest margin than these other banks!BOFI's issues aren't just limited to its liabilities. BOFI's assets, and its reserves, raise some questions as well. The Bank makes non-conforming jumbo loans across the country. These loans are typically made to investors based on 1099 income or K1 income (AKA the Alt-A non-conforming investor that World Savings made negative amortization loans to for 30 years) While there is an after-market for these loans, it's not traditional. When the stock market sells off, these loans based not on investors' salaries but instead on stock market gains and illiquid assets may become delinquent. There is the potential that in the future these Non-QM Mortgages (Non-Qualifying Mortgages) will be put back to the bank. Other banks we have interviewed have told us they stopped making these loans as of the end of 2013.
BOFI does make non-conforming “jumbo” loans, and a lot of them are in Southern California. I believe “jumbo” loans are loans above $417,000. I have relatives who live both in the LA and San Diego area, and I don’t know how most people down there would be able to buy a house without needing a “jumbo” mortgage. Heck, most people in Portland these days need a “jumbo” mortgage to buy anything in the city.
And having a K-1 for your income isn’t a bad thing. For example, a partner in a law firm or a business owner likely receives most of his or her income via a K-1 as a business owner. It is not a stretch to think that some of the people in Southern California buying more expensive homes may be business owners, partners in firms, etc. That doesn’t mean they are somehow bad credits. And BOFI doesn’t make “no doc” loans, which the author also implies. Just a lot of bad information in this paragraph.Over the past several quarters, BOFI has reduced its reserves for Non-Performing Loans (NPAs) to 58 bp! In our opinion, this is extremely low. We wonder why they are so aggressive. Could it be that they wanted to juice earnings so as to beat the expectations in each quarter? Why do most brick-and-mortar banks, who arguably have better knowledge of their credits and therefore better underwriting, reserve for NPAs at roughly 180bp when BOFI has only 58bp? In the future, BOFI's earnings can't be "improved" much further from reductions in NPAs as they have in the past. Further, if even a small number of their credits go south, BOFI doesn't have the reserve to cover them, so earnings will get hit and BOFI will need to build the reserve up for expected future claims. At 58bp there is very little margin for error.
Not much to say here. Either you believe management or you don’t. In the INBK report a posted yesterday I think the same number for those guys was .9% or something. The author wonders why brick and mortar banks have higher reserves for non-performing loans. Um, how about because a lot of those banks are still holding mortgages that were made prior to the 2007 and 2008 real estate correction, while BOFI didn’t really start ramping up its loan portfolio until a few years ago. Perhaps that's a reason why BOFI doesn't need the same percentage loan loss reserve of say, Bank of America with its purchase of Countrywide Financial and that loan portfolio, or Wells Fargo with its purchase of Wachovia and that loan portfolio, or JPMorgan Chase with its purchase of Washington Mutual and that loan portfolio. Just a guess.When you look at the large owners of BOFI, you will find very few bank funds. I am not surprised at all, but this should be a clear red flag to any retail investor who is long the stock.
This is speculation on my part, but don’t most mutual funds have minimum market cap requirements for the companies in which they can invest? If you run a $5 billion mutual fund and you’re looking at BOFI last year with a market cap of $700 million, you simply can’t invest in BOFI. To take any kind of a meaningful position you’d have to buy a 10% ownership stake, and that just isn’t going to happen. So my guess is that most bank funds simply couldn’t invest in BOFI because it was so small, and they probably don’t want to invest today at 4x and 5x book value. I don’t think that’s a red flag though, like the author would have you believe.
The remaining comments in the article are mostly subjective and speculative without any data to back them up, and therefore no data for me to analyze. But I think you get the point by now. I bought some more today, so we'll see how that goes.
If you got this far, thanks for reading!
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