Summary

• BOFI’s recently announced, widely expected acquisition of H&R Block’s bank deposits boosts its earnings but does not address the long-term pressures that will drive down the company’s currently inflated profitability. At almost 4x book value, as we have previously argued, BOFI’s super-premium valuation remains unwarranted.

• At least five serious bidders besides BOFI vetted the H&R Block transaction, yet BOFI emerged as the winner despite a complete lack of cost synergies. We question how valuable an asset the H&R Block business can be when no one was willing to pay a single dollar for it.

• One of BOFI’s responsibilities under the new agreement is to serve as the issuing bank for H&R Block’s prepaid debit card. Looking at the two major issuing banks already operating in this space supports our concerns about BOFI’s high valuation and unsustainable earnings: they trade at half of BOFI’s price-to-tangible-book-value multiple, generate 35% lower net interest margins, and earn almost 50% lower returns on equity. In a highly competitive market in which BOFI has little experience, its returns should be weaker than those of the leading players. This peer comparison again highlights the fact that BOFI is over-earning and will suffer long-term deterioration in its NIM and ROE.

Said differently, BOFI has taken capital valued by the market at almost 4x book value and invested it into a business valued at less than 2x book value. This trade only makes sense if the original valuation was faulty and unsustainably high. Otherwise, management is actually destroying economic value.

• Meanwhile, recent earnings announcements confirm the dramatic decline in industry-wide mortgage originations and profits. Since BOFI generates the vast majority of its fee income and the bulk of its loan production in the single-family mortgage market, these trends underscore the near-term risks to BOFI’s earnings.

• For those seeking to bet on the growth in online-only banking, BOFI is no longer the only publicly traded vehicle. In the wake of last week’s IPO of Ally Financial, investors can acquire the leading online bank – posting far more rapid organic customer growth than BOFI on a >20x larger deposit base – at less than a quarter of BOFI’s relative valuation. BOFI again stands out as highly overvalued.
  

The H&R Block Transaction: Widely Shopped and Unlikely to Be a Bargain

It was no surprise when BofI Holding (BOFI) announced that it was assuming most of the deposits held by H&R Block (HRB); the acquisition had been heavily discussed by buy-side and sell-side analysts like. To be fair, one unexpected positive for the company was the absence of a capital raise: BOFI management indicated that it “expects no significant additions to regulatory capital will be required as a result of this transaction.” Rather than sell shares, BOFI is choosing to lever up its balance sheet and tie up capital that could have supported core business growth instead of M&A.

While the market and the sell side greeted the deal enthusiastically, the history of the sales process calls into question just how attractive a purchase this could be. HRB originally agreed to sell its bank deposits to Republic Bancorp (RBCAA) in July 2013. At that time, it said it had “talked to a lot of counterparties [and] received a lot of interest.” When the deal fell through in October because RBCAA failed to obtain the necessary regulatory approvals, HRB spoke more expansively about its due-diligence process and the set of alternative potential buyers (emphasis added):

So we, last fall, when we made the decision to move forward in this direction, engaged Goldman Sachs and First Annapolis and they’ve been working with us every step of the way. We ran a full process. So we talk to lots of interested parties. They called us; we called them….You then narrow it down to a smaller group of qualified people, have more detailed conversations. We then narrow that list down further to about six counterparties and had in-depth detailed diligence two-way type discussion before we narrow it down further and that sort of the end of that process, we ended up with Republic.

Later, media coverage in January indicated that HRB had again narrowed the universe of bidders down to six. Since BOFI has confirmed that it was one of the members of the original short list, there must have been at least five other serious bidders who examined the HRB transaction and decided either to pass or to bid lower than BOFI. But BOFI had no real edge in bidding for this asset: unlike RBCAA, it doesn’t have a history of offering tax-related financial products, and unlike a firm like The Bancorp (TBBK), it has little experience serving as the back office for a prepaid debit-card program. Yet BOFI still managed to win the transaction, suggesting that it was willing to be more aggressive than its competitors and accept worse economics.

Notwithstanding the competitive and drawn-out sales process, HRB’s deposits apparently never garnered a premium bid. Established deposit franchises typically sell at a premium to their liabilities – i.e. to obtain $100 million in deposits backed by $100 million in cash, a buyer must write a check for several million. For example, just last week Huntington Bancshares (HBAN) assumed $450 million in branch-based Michigan deposits from Bank of America (BAC) and paid a 3.5% deposit premium, or almost $16 million, for the privilege.

By contrast, RBCAA wouldn’t agree to pay any premium for HRB’s deposits, and BOFI isn’t paying a premium either. While the transaction isn’t costless – among other things, BOFI must put up capital to support the assets backing the acquired deposits – it surely says something about the quality and value of HRB’s deposit business that at least six parties closely examined it and none was willing to pay HRB anything for it. Potential buyers may have been unimpressed by the growth trajectory: in a rapidly expanding sector, HRB’s prepaid debit-card transaction volume grew only 3% in 2013, far slower than the 20%+ that BOFI shareholders expect from the company’s core business. Buyers may also have worried about the regulatory and operational risks of dealing with tax refunds and prepaid cards, both areas rife with fraud and money laundering. Whatever the reasons for buyers’ unwillingness to pay up, we doubt that there is much real value to be found in a transaction that was widely and repeatedly shopped yet failed to attract a meaningful bid.

Peer Metrics Point to Lower Returns and a Lower Valuation for BOFI

The key ongoing service that BOFI will provide to HRB is acting as the issuing bank for HRB’s prepaid debit-card program, Emerald Card. While this is a relatively new business for BOFI, there are two large, established, publicly traded competitors in the space: The Bancorp (TBBK), and Meta Financial Group (CASH). For example, the prepaid card that TurboTax offers as a way to receive a tax refund is issued by TBBK, while CASH backs Western Union (WU)’s card. Both companies trade at higher price-to-tangible-book multiples than one would expect based on their modest returns on equity, indicating the market’s faith in the ongoing growth of the prepaid debit sector. Even so, TBBK and CASH trade at massive discounts to BOFI, demonstrating just how overvalued BOFI is.

As we argued in our previous report, BOFI’s net interest margin is unsustainably high, temporarily inflated by well-timed securities purchases during the financial crisis along with an outsized bet on low interest rates. Examining CASH and TBBK, the major incumbents in BOFI’s target expansion market of prepaid-card issuance, supports this view: they earn substantially lower NIMs and, as a result, substantially lower ROEs than BOFI. Because prepaid card deposits are fast-moving, CASH and TBBK – unlike BOFI – opt not to expose themselves to major interest-rate risk and instead invest the deposits primarily in short-duration assets. The more BOFI seeks to mimic this business model, the more its NIM and ROE will come to look like these peers’, driving profitability down and calling into question its lofty valuation.

Economically, by investing its existing capital into a business like CASH and TBBK’s, BOFI is taking equity valued by the market at almost 4x its face amount and deploying it into an activity valued by the market at less than 2x. It strains credulity to suggest that BOFI can really generate twice as much value as its peers in this space despite these competitors’ strong, longstanding market positions. More likely, BOFI’s current valuation is simply too high and should, based on long-term fundamentals, move downward to be more in line with its peers’.

The Mortgage Market, a Key Revenue Driver for BOFI, Faces Plummeting Volumes and Heightened Competition

While BOFI shareholders have been focusing on the HRB transaction, other banks have begun to report their first-quarter earnings, dramatically confirming what we already expected: mortgage volumes are plunging, taking gain-on-sale revenue down with them. For the largest mortgage banks, Wells Fargo (WFC) and JPMorgan Chase (JPM), volumes have dropped a staggering 67% year-over-year, while revenues, driven by falling gain-on-sale margins, have deteriorated even more, down 80%.

For BOFI, these numbers are troubling because, on an LTM basis, mortgage gains have accounted for 60% of the firm’s non-interest income. Worse still, jumbo mortgage loans constitute 64% of BOFI’s pipeline of new loans (source: March 2014 investor presentation). In a dramatically declining market, BOFI will be hard-pressed to sustain the rapid loan growth that its investors have come to expect.

As other lenders look to replace lost volume, they are increasingly moving into the jumbo market, putting further pressure on loan yields. Another indication of this trend came last week when the Mortgage Bankers Association reported that “many lenders and investors are providing borrowers seeking higher loan amounts with a broader range of financing options by introducing new jumbo loan programs” (emphasis added). One factor that has propped up BOFI’s unsustainably high net interest margin has been a high yield on its loan portfolio, including its jumbo mortgage. As more and more players move into this niche, BOFI will experience narrower spreads and deteriorating profitability.

The Ally IPO Gives Investors a Much Cheaper Way to Play the Growth in Online Banking

For some BOFI shareholders, owning the stock is less an expression of their view on BOFI in particular than a bet on the overall growth in online retail banking. Almost every other publicly traded bank has some brick-and-mortar presence or material exposure to a different business line; BOFI was as close to a pure play as there was. We don’t doubt the long-term trend of the declining importance of physical bank branches (though we note that traditional banks have also benefited from this trend through lower operating costs and diminishing branch counts).

But in the wake of Ally Financial (ALLY)’s recent IPO, BOFI is no longer the only available pure play. Unlike BOFI, ALLY has a nationally recognized brand and, with over 1.5 million retail deposit accounts (source: ALLY IPO prospectus), substantial economies of scale. Despite its vastly greater size, ALLY is actually increasing its customer base more rapidly than BOFI: ALLY’s accounts increased by 24% in 2013, while, as we pointed out in our previous report, BOFI’s accounts, excluding the benefit of an acquisition, actually decreased over the same period.

ALLY certainly has its own challenges and undoubtedly a worse financial track record than BOFI. But this fast-growing, well-regarded online banking franchise (named “Best online bank” by Money out of a field of 15 competitors) trades for just 0.9x tangible book value – less than a quarter of BOFI’s multiple. While we respect the competence of BOFI’s management team, we find it difficult to believe that they merit quadruple the relative valuation of their leading competitor. BOFI’s stretched valuation creates asymmetric risk for shareholders: it already prices in flawless execution, high returns, and rapid growth. Those aiming to invest in the secular theme of online banking can do so dramatically more cheaply by buying ALLY than by buying BOFI.

Conclusion

By levering up to acquire HRB’s bank deposits, BOFI has increased its earnings power, but it has done little to alter the fundamental dynamic that should compress its valuation over time: it’s overearning because its NIM is unsustainably high. Close comparables, including TBBK, CASH, and ALLY, already earn substantially lower margins and trade at substantially lower multiples. The larger BOFI becomes, the harder it will be for it to find new niche markets to prop up its profits. Already, the major focus of its expansion efforts in the past several years – the single-family mortgage market – is coming under severe pressure, threatening near-term profits and growth. At nearly 4x book value, BOFI’s current valuation incorporates extremely rosy expectations, leaving shareholders at great risk of disappointment.