Kerrisdale Capital Management, LLC
1212 Avenue of the Americas, 3rd Floor
New York, NY 10036
Tel: 212.792.7999
Fax: 212.531.6153

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Our Investments Blog typically profiles investments that we have made and explains our investment rationales.

Higher Rates Will Compress Margins for Bank Priced at 3.5x Book Value
Posted by Kerrisdale at 9:04 am
Disclosure: We are short shares of BOFI. Please click here to read full disclosures.

Our slide presentation explaining our short thesis on BofI Holding, Inc. is available here and our 35-page full report is available here.

We are short shares of BofI Holding, Inc. (BOFI), a bank holding company that owns several online-only banking brands, including Bank of Internet USA and Bank X. At almost 3.5x tangible book value, BOFI is significantly overvalued, pricing in not only a long-term continuation of its rapid balance-sheet growth but also an extraordinarily strong net interest margin (NIM) and return on equity (ROE) in perpetuity. But BOFI’s margins have been inflated in recent years by well-timed purchases of distressed securities, aggressive expansion in long-duration lending, and a drastic shift toward short-term deposits.

We think BOFI will go from posting industry-leading margins to falling well behind its peers – a logical outcome given its business model’s inherent funding-cost disadvantage. As legacy securities roll off and interest rates rise, BOFI’s funding costs should increase far faster than its asset yields, compressing its NIM by as much as 40% and crushing its ROE even more. With this rocky road ahead, investors who choose to pay 3.5x tangible book value for BOFI today are making a big bet on perfect execution and permanently low interest rates.

To be sure, BOFI has a strong track record. As a branchless bank, it has capitalized on its low cost structure to attract customers by offering better rates than competitors, achieving high deposit growth and a low efficiency ratio. The market has already rewarded its impressive operational performance: the stock has appreciated almost 1,200% over the past five years.

However, we believe the main driver of BOFI’s recent earnings has been a large gamble on low interest rates and a once-in-a-lifetime opportunity in distressed MBS. It has managed to rapidly grow its profits in a mature and commoditized industry by chasing fickle, price-sensitive depositors and investing their funds in unusually long-dated assets. This strategy has given BOFI an enviable asset yield for the time being but has left it very exposed to rising interest rates. To retain its hot-money deposits in the future, BOFI will need to pay up, while still holding onto legacy assets earning below-market yields. Deposit growth could also become more difficult as big-bank customers feel more satisfied earning non-zero interest and online-only competitors replicate BOFI’s value proposition.

At 3.5x TBV and 20x earnings, BOFI trades at more than double its peers’ valuations. Based on our expectations for a long-term decline in profitability, we think a more appropriate valuation for the company is ~2.5x TBV or ~$50, which would represent a 32% decline from current levels.

Investment Highlights

  • Overexposed to Interest-Rate RiskBOFI has one of the largest negative interest-rate gaps among publicly traded banks. In other words, its assets reprice much more slowly than its liabilities. As rates increase, its funding will become dramatically more expensive, but its asset yields will stagnate. At a time when almost every high-profile bank has sacrificed short-term earnings to make its balance sheet “asset sensitive,” with assets repricing faster than liabilities and thus positively levered to higher rates, BOFI has made the opposite bet, pumping up its earnings today at the cost of returns tomorrow.
  • Core NIM Could Decline by ~40%. Rather than formulate our own idiosyncratic rate forecast, we look to the forward curve embedded in current market prices. On this basis, we expect short-term interest rates to rise by ~250bps over the next three years, while 10-year rates will rise by only ~100bps. Since BOFI’s primary business is making long-dated jumbo mortgages and funding them with short-dated deposits, this implies that it will face 150bps of NIM pressure, pushing its margin down from ~4% to ~2.5% – more in line with its long-term history and that of other online-only banks. All else being equal, this normalized NIM would slash ROE from a standout 18% to a modest 8%. While the exact outcome will vary based on the path that interest rates take, a run-rate NIM of 2.5-3.0% would reduce ROE and net income by 40-60%.
  • Earnings Temporarily Inflated by Opportunistic Securities Purchases. BOFI management, to its credit, recognized during the financial crisis that non-agency mortgage-backed securities were attractive investments. By putting almost a third of its balance sheet into these securities at low prices, it built up a store of future earnings that it has been gradually recognizing over time. As these assets continue to pay down, BOFI will have to reinvest at much lower yields, further depressing its NIM and reducing profitability. Moreover, in a post-Dodd-Frank regulatory environment, we question whether a bank of BOFI’s current size would ever again be allowed to make such an extreme gamble with its depositors’ money.
  • Online Deposit Competition Getting Tougher. In the early days of internet banking, BOFI’s offering was innovative and differentiated. Today, however, BOFI faces a wide range of serious competitors, from mega-depositories like Ally Financial to online-only players like EverBank. BOFI has a relatively price sensitive and fickle deposit base.  With little brand recognition and deposit rates that are no longer ranking among the highest available, BOFI may struggle to sustain its torrid growth rate. Indeed, while BOFI has successfully increased its average account balance, we estimate that organic growth in the number of accounts has been negative for the past three consecutive quarters. 
  • BOFI’s Lending Niches Are Becoming More Competitive. Unlike typical banks’ more diversified loan books, BOFI’s portfolio, which has more than tripled since FY 2010, is heavily concentrated in just a few areas: jumbo single-family mortgages and multi-family mortgages. Both sectors experienced capital flight during the financial crisis, propping up returns for players like BOFI that were willing to pick up the slack. But in recent months competition has steadily ramped up and lenders have gotten more aggressive. As BOFI’s book turns over in this new environment, it will go from earning super-normal loan spreads to much more pedestrian returns, again putting pressure on its NIM and ROE. 
  • Declines in Mortgage Refinancing Volume Will Depress Fee Income. Without non-interest revenue sources like corporate treasury management, wealth management, or credit-card interchange, BOFI is heavily dependent on pure spread income. While fees have recently benefited from mortgage-banking gains on sale, rising interest rates have already sharply reduced mortgage originations, while competition has pushed down margins. BOFI thus faces major headwinds to future fee-income growth. 
  • Thin Loan-Loss Reserves Create Asymmetric Downside Risk. At just 0.54% of total loans, BOFI’s allowance for loan losses is strikingly modest. While BOFI today, like its competitors, boasts low delinquencies and charge-offs, its weak reserves position it poorly for any possible uptick in nonperforming loans. Given the inglorious history of fast-growing financial firms, shareholders should naturally be skeptical of any lender’s ability to maintain both 25% compounded loan growth and permanently pristine credit quality.
  • Stretched Valuation Already Discounts Rapid Growth and High Returns. By almost any metric, BOFI’s shares trade at an unusually high valuation. At 3.5x TBV and 20x earnings, BOFI likely needs to triple in size and maintain significantly above-average returns simply to justify its current share price, let alone drive upside. Indeed, according to BOFI’s own reported estimate, the NPV of its existing portfolio of assets and liabilities accounts for only a third of its current market capitalization.

With so much growth already built into BOFI’s valuation, shareholders need everything to go right just to eke out an adequate return. But in reality, as rates increase, BOFI’s margins will revert to a more modest level that we estimate would justify a valuation of ~2.5x book value or $50 – still a sizable premium to peer levels yet 32% below the current price. If any credit problems emerge in the wake of BOFI’s torrid loan growth, even that valuation will look extremely generous.

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Dominant Franchise in a Lucrative Niche Has 75% Upside
Posted by Kerrisdale at 10:02 am
Disclosure: We are long shares of JGW. Please click here to read full disclosures.

Our 42-page report explaining our long thesis for JGWPT Holdings (JGW) is available here.

We are long shares of JGWPT Holdings (NYSE:JGW), which, via its J.G. Wentworth and Peachtree brands, is the number-one player in an attractive consumer-finance market niche. JGW provides liquidity to personal-injury plaintiffs, lottery winners, and others who are entitled to long-term payment streams but have near-term financial needs. Despite its 60-70% market share, attractive organic growth rate, and ability to compound capital through acquisitions and platform expansion, JGW trades at a consensus P/E ratio of 7x, an EV/EBITDA multiple of 8x, and at nearly half of our estimate of intrinsic value…

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A History of Missed Deadlines, Aggressive Cash Burn, and Vague Supply Agreements Suggest a 75% Overvaluation
Posted by Kerrisdale at 9:12 am
Disclosure: We are short shares of UNIS. Please click here to read full disclosures.

We believe that shares of Unilife (UNIS) are more than 75% overvalued as investors have once again over-reacted to deal announcements heavy on lofty potentials but light on detail. In a sequence reminiscent of the 2003 and 2009 episodic pops in Unilife’s price, shares climbed by over 50% following the announcement of a new supply agreement with Hikma. The stock appreciated a further 17% on December 3rd after Unilife reported a nebulous supply arrangement with Novartis. While the Novartis arrangement offers nothing in guaranteed revenue, the Hikma agreement promises $5m of upfront cash. Unilife is also eligible for a $15m payment in 2014, assuming certain milestones are met, and another $20m from Hikma in 2015. At a discount rate of 10%, the present value of these payments is just $35m. This is just one-sixth of the $210m market capitalization gain Unilife has realized in the days following the announcement…

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Irrigating the Emerging Markets With A Modest Valuation
Posted by Kerrisdale at 11:10 am
Disclosure: We are long shares of LNN. Please click here to read full disclosures.

Our 35-page report explaining our long thesis for Lindsay Corp. (LNN) is available here.

We are long shares of Lindsay Corporation (NYSE:LNN), a global irrigation business headquartered in Omaha, Nebraska. Lindsay owns a world-renowned brand name (Zimmatic), sells into an under-penetrated market and benefits from the secular trends of increasing global food scarcity and rising protein consumption. Given this long-term growth opportunity, a robust capital efficiency profile (ROIC of 25%+), and the stock trading at 13.7x net-cash P/E on trough FY 2014E earnings, we believe shares trade at a 50% discount to our conservative estimate of intrinsic value…

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September 24th Merger Vote Combined with Shareholder Activism Should Unlock Value
Posted by Kerrisdale at 5:09 am
Disclosure: We are long shares of PMO.DE. Please click here to read full disclosures.

Our 19-page report explaining our long thesis for Prime Office REIT-AG (PMO.DE) is available here.

Prime Office REIT-AG (PMO.DE or “Prime”) is an undervalued German REIT with several near-term catalysts that could unlock its true intrinsic value. With a current share price of just €2.98, Prime Office trades at a high 55.1% discount to book value (“NAV” or “net asset value”) and a 22.4% discount to gross asset value (“GAV”), more than double that of comparable German commercial real estate companies. Prime Office is a busted IPO from June 2011 that owns twelve multi-story office properties in Tier-1 German cities including Munich, Stuttgart, and Frankfurt. These hard-to-replicate, well-equipped buildings house high credit quality tenants like Medtronic, Daimler-Benz, and Deutsche Telekom…

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Kerrisdale Capital Management, LLC
1212 Avenue of the Americas, 3rd Floor
New York, NY 10036
Tel: 212.792.7999
Fax: 212.531.6153