A “Short” Update on Bank of Internet

Disclaimer: I am short Bank of Internet. Supporting documents referenced in this article can be downloaded in zip format. Also, the title is just a joke related to short selling, this article is more than 140 characters.

Since I started writing reports on my favorite stock trades, the only one which has, so far, not worked in my favor is my bet against Bank of Internet.

My original thesis claimed Bank of Internet was an overvalued company whose stock price would decline for five reasons:

  • Excess profits were driven by a one-time opportunity in buying cheap mortgage-backed securities in the aftermath of the 2008 financial crisis that would not continue.
  • BOFI’s assets are structured to have a “negative interest rate gap” where a rise in interest rates could cause its depositor liabilities to become more expensive more quickly than its real estate investments could increase in value, thereby shrinking profits.
  • There was a real risk in its proposed acquisition of H&R Block Bank that the government would force BOFI to increase its spending on legal services and regulatory compliance software. The government cares about this deal is because the H&R Block Bank is involved in the “pre-paid card” business, a financial product used by terrorists for moving money/money-laundering.
  • The company is overvalued from a financial standpoint using either a discounted cash flow analysis or comparable price-to-earnings/price-to-book ratios versus competitors.
  • The top two executives (CEO and CFO) were involved in two previous financial companies which both collapsed and had to be saved by the government.

Shortly after I first wrote on the company in August, 2014, the stock dropped from $80 to $65 in two months. Since then it’s gone on an unhalting tear upward to $106.

BOFI Stock Chart Since First Blog Post

Why Did The Stock Dip Lower in October? The Regulators Delayed BOFI’s Acquisition of H&R Block Bank

On October 5, H&R Block announced that the Office of the Comptroller of the Currency was delaying the deal past the 2015 tax season, with an expiration date for the deal’s approval on April 30th, 2015. The deal was originally announced on April 10th, 2014.

The next day, H&R Block CEO William Cobb said on a conference call, “I am obviously extremely disappointed, and frankly I am surprised in this development.”

Then on February 17th, they announced another deal delay in an SEC filing, extending the deal talks again with a projected closing date of June 30th and a termination date of July 31st when the deal would be canceled.

June 30th passed without an SEC filing updating progress on the deal from either company involved. However, Bank of Internet did announce that its next annual earnings call would be on July 30th.

The BOFI CEO Responds to Investor Questions About the Deal with Wife-Beating Reference

During the second quarter conference call for the 2015 fiscal year, Julianna Balicka, an equity researcher for Keefe, Bruyette, and Woods, asked CEO Gregory Garrabrants about the government’s investigation into the H&R Block deal:

“On the H&R Block Bank transaction, to the extent that in reviewing the transaction and kind of based on — my comments are based on kind of how regulators have approached other bank acquisitions. To the extent that the regulators have asked you or H&R Block Bank to go back and fix ABC or change ABC with how you run your own bank and then they have to go back approve the ABC changes, and then they go to approve the deal, right? To the extent that, that happened with H&R Block Bank deal, have A, B and C that they’ve asked for already been completed?”

To which the CEO responded with an in-poor-taste joke (emphasis mine):

“That’s — I have to say, actually, I’m going to give you, like, the award for that. I think my dad had a good sense of humor, and he used to say, ‘If that’s a question’– When you get a question, like, ‘Have you stopped beating your wife?’ You always have to stop back and say, ‘Wait a minute. What was that — just question?’”

It’s Not Surprising To Hear These Comments from the CEO of a Company Without a Human Resources Department

My own research on the job review site Glassdoor revealed an interesting company secret: Bank of Internet does not have an HR department.

A search through its 330 employees on Linkedin found that the company has (at least of publicly available employees) an in-house recruiter, a payroll and benefits administrator, and a workforce operations administrator. Other than the workforce operations administrator, there doesn’t appear to be any human resources employees at Bank of Internet.

The nine Glassdoor reviews below all mention this issue:

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It’s not only the bad reviews or disgruntled employees. Even this positive, four-out-of-five-stars review of the company admits to no HR department:

H&R Block’s CEO is Not Happy About The Deal’s Progress

On June 9th, H&R Block had its latest quarterly earnings conference call. Its CEO Bill Cobb did not sound nearly enthused about the progress of the deal as his counterpart at Bofi.

“I’d like to comment on H&R Block Bank. Let me be clear. While we respect the work of the regulators, we are frustrated by this process and the length of time it is taking for the transaction to come to conclusion. We continue to work with BMI and our regulators, and believe that on its merits this transaction should be approved.”

Before going into further details from the call, I should explain upfront again why H&R Block is selling their banking division. Aside from the regulatory risks related to its prepaid card business I’ve explained before, H&R Block is primarily a tax preparation services business which also happens to run this bank business on the side. It wants to get out of the banking business for two primary, related reasons: First, it’s banking division is regulated by the OCC, and second, it’s required to maintain extra cash reserves to support its bank in case the bank runs into trouble and doesn’t want to risk depositors losing money. If H&R Block can sell its bank to another bank, then it can use its extra cash for other business expansion or share it with investors, and it won’t have to answer to as many government officials.

Mr. Cobb elaborated these points during the call: “We continue to expect to have approximately $1 billion of excess capital on the balance sheet when the bank deal closes. It is the desire of the board and management to use this capital and also incur some incremental net debt while maintaining an investment grade rating to return capital to shareholders. More details regarding the capital plan will be shared after the bank deal closes.”

When the question-and-answer session of the call started, the analysts continued to ask for further BOFI deal details.

Gil Luria of Wedbush Securities asked, “In your prepared remarks, you talked about the fact that the regulator hasn’t approved, or doesn’t seem to have any merits for not approving the bank sale. It sounds like you’re maybe implying that there’s other factors at hand here. And if that’s the case, and even if it’s not the case, and the regulator’s going to take an unknown period of time to approved this, doesn’t that make this the new normal? And if it is the new normal and even in consideration of everything that you talked in terms of volumes and unit accounting, how do you generate earnings growth on a sustainable basis going forward without a bank sale?”

Cobb responded,

“I don’t think we wanted to indicate anything other than there is no information at this time. And while we’re frustrated by the pace of the project, we don’t see any reason why this wouldn’t – transaction would not be approved on its merits.

Now, so there’s no signaling, there’s no, nothing of – and this seems to be taking a long. That is from our perspective, and probably many people would be with the same way. I’m not sure the regulator does. And for those of you who would deal with other banks and this whole industry, things are taking a long time in terms of any kind of deals that are being approved. I don’t want to speak for the regulators, but I don’t think they think this is – I think they feel they’re being thorough and complete as they approach this transaction.

So while it’s frustrating, while I would have thought we would have had an answer by now, there is nothing – and hopefully, we’ve gotten this through -there’s nothing to indicate that anything other than that this will move forward. However, the timing is something that is still in the hands of the regulators, and I think from their perspective, and again I can’t speak for them and I don’t think they’re going to speak about this, I think the timing is consistent with some of the ways they look at other deals.

Now, as for what the implications of that are – and again, I think every one of us also want to be very clear, we are not going to change our mind, if you will. We do not want to be regulated as a savings and loan holding company any further, and our intention is to exit holding – owning our own bank.”

Luria continued by asking, “Is there not a possibility for you to unwind the bank without having to sell it, and therefore not have to go through the same regulatory approval cycle? Is that not a possibility that you would have if this process was to keep going on or was to end with an unfavorable ruling?”

Chief Financial Officer Greg Macfarlane handled this question: “The important point number one is what Bill said, is we’re going to get out of this business…. We will get it figured out. It’s been frustrating, but we believe that the transaction we’ve entered into with BofI and talked about with all you many times is the way to go. As a hypothetical, in the event that doesn’t work out, what is the next backup? There is a way to separate the going-forward bank support that this company needs to continue to sell Tax Plus products, which we’re very committed to, and the actual formality involved with having a bank balance sheet. So effectively, we want to still be in the business of offering bank products, and we’ll need a partner bank to do that. So think of that as one transaction…. But really, just to finish up my response to your question, the plan that we have with BofI is the right plan we believe, on its merits, will be approved.”

Thomas Allen from Morgan Stanley tried to get a timeline for the deal closing out of Bill Cobb, who neutrally responded, “I’m out of the forecasting business. I think what we share and we continue to work very closely with BofI. We’re committed to them. I think they’re a terrific partner. We think the deal is going to be approved. But as for timing, we’ve been wrong a couple times on this. That’s why I’m out of the timing business.”

Why Is BOFI Even The Bank Getting H&R Block Bank? Because No One Else Really Wanted It

H&R Block has tried to sell its banking division before. In July 2013, it had an agreement to sell H&R Block Bank to Republic Bancorp. When the Republic Bancorp withdrew its offer that October, H&R Block stated:

“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.”

Kerrisdale Capital asked the important question: If there were actually multiple interested parties, how or why did Bank of Internet manage to outbid the others?

“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.”

What are those worse economics? The H&R Block Emerald Prepaid Card business and the bank’s deposits are not even growing.

In April 2014, Huntington Bank took over $450 million deposit accounts in Michigan from Bank of America and paid BofA $16 million, or 3.5% of the value of the accounts. In layman’s terms, a bank’s deposits are our money as individuals or business, and are actually liabilities for the bank who owe consumers that money if we ever want to withdraw it. One bank would acquire another bank’s deposits, despite deposits actually being liabilities, because it gives them a relationship with a customer to make money over the long term.

But in H&R Block Bank’s case, Bank of Internet is not paying H&R Block any significant amount beyond taking over the liabilities of the deposits.

In other words, BOFI somehow outbid other “interested parties” for H&R Block Bank with a bid of…nothing.

As summarized by Kerrisdale, “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.”

A month after Kerrisdale’s updated report, H&R Block’s own Annual Report (included in the downloadable folder) stated on page 35 (27 of the 10K SEC Filing): “Emerald Card fees decreased $5.2 million, or 5.0%, primarily due to lower transaction volumes resulting from a decrease of approximately 14% in prepaid debit cards issued.“

Even with an average yield of 34% (according to the the same filing’s line on “Emerald Advance on page 37), the HRB prepaid card business volume is decreasing, and BOFI is buying into it.

Aside from the HRB Deal, The “Negative Interest Rate Gap” and Rising Interest Rates Could Kill Profits

In my last report, I outlined the issues with the company’s focus on mortgage-backed securities, negative interest rate gap, and overvaluation compared to its peers.

The most worrisome of these issues to me is the negative interest rate gap, because it’s another area of its business where BOFI is both placing risky bets with its depositor’s money and regulators are not happy about it.

As a refresher, a bank’s “interest rate sensitivity” is a measurement of the effect interest rate changes (influenced the the Federal Reserve and/or the financial markets) have on the bank’s assets and liabilities. High interest on its assets means it makes more money, but high interest on liabilities means the bank has to pay its depositors higher rates on products like savings accounts. It’s the bank’s management’s job to delicately balance multiple factors: The interest rates it’s earning on its assets, how much it is paying out in liabilities, and the timespan over which it’s collecting money and paying back depositors.

On page 56 of Bank of Internet’s April 30, 2015 quarterly 10Q filing (also in the downloadable folder), the company reveals it has a -45.99% interest rate sensitivity gap, or approximately $2.5 billion in liabilities that will be repriced at potentially higher interest rates than its assets in the next six to 12 months (considering this was end of April, it’s now more like three to nine months).

BOFI explains on the same page: “In a rising interest rate environment, an institution with a positive gap would be in a better position than an institution with a negative gap to invest in higher yielding assets or to have its asset yields adjusted upward, which would cause the yield on its assets to increase at a faster pace than the cost of its interest-bearing liabilities.”

Rephrased, an institution like BOFI with a negative interest rate gap is in a worse position because the cost of interest on its liabilities will increase faster than the interest it earns on its profits.

Summarized, over the next three to nine months, if the Federal Reserve raises interest rates like it says it might, BOFI’s costs will substantially increase, shrinking its profits. Costs will rise because depositors, particularly those using online banks, can switch banks to whoever is offering the highest interest rate on savings accounts and CDs, so BOFI will be forced to increase its payments to depositors if it wants to keep them. But its assets, which are mostly mortgage loans, don’t increase their profitability as quickly.

Unfortunately for Bofi, Federal Reserve Chairwoman Janet Yellen said in a Congressional hearing earlier this week that she expects the Federal Reserve to increase interest rates this year.

This negative interest rate gap is also an area of interest to regulators. If interest rates rise, so does BOFI’s costs. And if costs rise enough, the bank may no longer be profitable and could eventually run the risk of bankruptcy. The government does not want to have to publicly deal with more bank failures.

The FDIC in October 2013 issued a four page guide/warning on managing interest rate sensitivity risk: “The FDIC is increasingly concerned that certain institutions may not be sufficiently prepared or positioned for sustained increases in, or volatility of, interest rates. For example, institutions with a decidedly liability-sensitive position could experience declines in net interest income and potential deposit run-off in a rising rate environment.”

Recently on June 30th this year, the OCC stated in a report: “The prolonged low interest rate environment continues to lay the foundation for future vulnerability. Banks that extend asset maturities to pick up yield could face significant earnings pressure and capital erosion depending on the severity and timing of interest rate moves.“

Related to the prepaid card business, the same report states: “Compliance risks remain high, as banks work to comply with new mortgage lending requirements and manage Bank Secrecy Act/Anti-Money Laundering risks.”

Could I Be Wrong? And if I Were, How Would I Know?

I ended my first report on Bank of Internet by listing the three ways I could be wrong about this pick. What I had failed to take into account the first time was that the regulators would postpone making a decision on the deal for over a year.

So I will state the criteria I personally use to judge whether this is a good pick.

I will continue to short Bank of Internet until the the H&R Block Bank acquisition deal has one of three outcomes: The deal is approved by regulators with no issues, the deal is approved by regulators on the condition that Bank of Internet spends a lot of money on regulatory compliance software and legal staff, or the deal is canceled because Bank of Internet is unwilling to spend the money on compliance or the government has issues with how Bank of Internet’s depositor money is being managed.

Any result beyond the first will be a very public signal that Bank of Internet will not live up to its own hype going forward, and I expect the stock price to drop to reflect that reality.

That’s the primary short term thesis upon which I am trading.

If the government does not act, then it could take a while before Bofi’s stock drops, and I would lose money while waiting. I’d be wrong regarding the government’s view of the H&RB Block deal.

Over the long term, Bank of Internet is still one of the most overvalued banks by fundamental financial valuation metrics with its profitability hinged on the Federal Reserve keeping interest rates low. If the regulators don’t take action against BOFI, its own risk-taking bankers will.