Description

Axos Financial (“AX”, formerly known as Bank of Internet) is a very attractively valued low-cost operator and compounder that is likely to generate at least ~15% CAGRs from current share price levels for many years to come. I think AX can achieve this from organic growth alone, excluding multiple rerating or accretive M&A, and over a longer period of time I think AX can be again a 10-bagger as it has been for past investors. AX has been written up several times, once by david101 and twice by mitc567. My intention is to refresh and complement their theses from an GARP angle. 

Attractive Valuation

First and foremost, AX is attractively valued at ~1.2x BV and ~1.3x TBV (excluding CECL adjustment), 8x FY2020 earnings and 9.5x FY 2020 pro forma earnings (after tax, June year-end) for the termination of the Program Management Agreement with H&R Block. In all fairness, almost all banks currently trade cheaply due to “lower for longer” interest rates and various macro concerns around the economy. Several good banks have been pitched on VIC recently, but I think for unconstrained investors (or orphans and widows), AX offers a great risk-reward balance because management are both fantastic operators and capital allocators as evidenced by their industry leading RoE of 15% and efficiency ratio of 30-40%, which leads me to the crux of my thesis.

Asset Quality: a conservative and profitable lending business

General disclaimer that past performance is no guarantee for future performance aside, AX has nothing but a rock solid loan book, and mitc567’s 2017 writeup provides ample analysis and historical evidence for AX’s exemplary underwriting performance throughout the GFC, which david101 anticipated in his 2007 writeup. To sum up their excellent work and predictions from 2007/2008: AX’s net charge-off ratio peaked FY2010 at 0.7% of its total loans when its NPL ratio to total loans stood at 1.5%. AX’s book mostly consists of mortgages at 55-60% LTV and based on what I understand, they underwrite very conservatively using 2-3 different valuations on top of the transaction price and generally avoiding refis. 

One addendum has been that since 2015, AX has greatly expanded its Commercial & Industrial loan book, which hasn’t clocked up material losses given they seem to have first-out pieces with good collateral and supportive PE sponsors. But maybe it’s too early to tell. In terms of overall problematic exposure, in the C&I space, exposure to troubled industries (mainly restaurants, some indirect oil-and-gas and airlines exposures) make up 2.5% of overall loans, with troubled real estate exposures comprising 2.5% to hotels and 1.4% to mixed-use real estate but overall non-performing assets at the end of June 2020 was apparently at 82bps, but we will have to wait for the 10k for more detail.

Liability Structure: using technology to lower cost of deposits

Putting aside the fintech craze, branchless / internet-only banks have historically had to pay up in order to attract deposits, but AX’s management has been extremely thoughtful and creative in building up or laying down the infrastructure to attract low- or no-cost deposits to fund its lending business. One example has been the Nationwide deposit acquisition, where AX is now providing the IT and call center support for Nationwide’s banking customers in exchange for using their deposits, another one has been the acquisition of Epiq, a software provider to Chapter 7 liquidators, where AX intends to consolidate the deposits onto its own balance sheet. 

Now, I don’t want to speculate whether internet-only banks are just a fad and a physical branch network will still be the key to stable and low-cost deposits in 10-20 years’ time. Regardless, I think AX’s software infrastructure definitely enables AX to achieve and maintain a very high efficiency ratio, even during the past few years when they hired more developers to consolidate various software components onto their own Universal Digital Bank (“UDB”) platform.  Most legacy banks are a collection of disparate software systems, which are even harder to change and unify due to their sprawling physical branch network. In my mind, the Nationwide deal neatly demonstrates how a superior technology platform will allow AX to find ways to get low-cost deposits even though AX has now crossed the $10bn asset threshold and won’t be able to pursue prepaid card business models like TBBK or CASH due to the Durbin Amendment. 

Strategic Direction: still a bank

AX continues to use its software development capabilities in a thoughtful manner to broaden its product offerings and creating value, e.g. by working on an online brokerage platform that will offer free share trading to its customers. Again, AX ultimately intends to harvest excess cash to use as low-cost deposits for their banking business, however, their COR Clearing and WiseBanyan acquisition have largely paved the way for this. You may be able to see where we are going here, namely the question of whether AX should be viewed (and valued) as a fintech company. The answer so far is a not-so-obvious no, because despite possessing a competitive software infrastructure including capabilities to further develop it, they are currently not in the business of licensing their software capabilities unless it allows AX to do banking-related things like the Nationwide deal. 

I’ve asked AX directly whether they’d consider licensing their software altogether to become a “real” fintech company, but they see their own software as a competitive advantage that they want to keep to themselves for now in order to compete against other banks. However, they have thought about it and (so far) decided not to make the necessary investments into personnel for implementation and customer support necessary to become a “real” software company. It is funny, and the irony isn’t lost on management that they are growing very quickly for a bank but a bit too slow to get the tech investors interested, but overall, that suits me fine for being able to build a larger position in this over time.

Key Risks

Jumbo Loan Exposure

AX has been particularly active in the jumbo mortgage space, largely in California, and this exposure is probably more cyclical than the bulk of the mortgage space. As a result of its jumbo loan exposure, AX has a bigger mix of business owners and also greater exposure to the tech industry, although today, probably no one is very worried about the latter. It’s unclear to me if working-from-home will lead to a sustained exodus away from California resulting in a permanent stepdown in residential real estate prices, but obviously rolling brownouts are not supportive of Californian house prices in general.

Low Rates 

It will be so much more obvious to seasoned financials investors why higher interest rates are generally supportive for bank profitability that I will touch upon it in passing, not because I disagree, but because I don’t have any intelligent views on where rates should be or will be in the future. Generally speaking, lower rates will result in lower profitability for AX. 

Credit Risk, generically

As alluded to in the Asset Quality section above, judging by past performance and recent asset performance figures, there are no reasons to worry, but when investing in a bank, this is clearly always a risk. Also, AX had the OCC come in to investigate allegations by a whistleblower regarding certain loans made which mitc567 chronicled well and ultimately resulted in no actions whatsoever.

Liquidity Risk

AX has a lot of untapped FHLB capacity plus cash on hand that I’m generally not worried. 

Capital Position & CECL Impact

Given their 11.2% CET1 (RWA-basis at the holding level) and 11.9% CET1 (RWA-basis at the bank level), there probably shouldn’t be any major concerns in any case. The overall hit from CECL has been guided to $35-55mn so a 62bps maximum hit to RWA-based capital ratios if taken upfront, which is not the end of the world, let alone when phased in over 5 years. Even to get to $55mn, management used an extremely conservative assumptions as using Moody’s worst-case assumptions, AX would have to lower existing provisions, but instead, AX assumed that house prices would drop by 30-40% as it did during the GFC and stay there in order to come up with their CECL adjustment. Excessively conservative in my opinion but I don’t mind.

Disclaimers

The author and affiliates may or may not have material positions in issuers and securities mentioned in this note and will not be obligated to give notice of any changes in their views or positioning. You agree to hold the author harmless and to waive the right to any legal action against the author in relation to this note. The views expressed here reflect the author’s personal views about the issuers and securities and do not constitute investment advice. The author makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information. This note is for information purposes only and should not be construed as either projections or predictions. Before making any investment decision, you should seek independent investment, legal, tax, accounting or other professional advice as appropriate, none of which is offered to you by the author in this note. The author accepts no duty of care to you in relation to investments. Past performance cannot be relied on as a guide to future performance. You should not assume that the performance of any specific investment or investment strategy will be profitable or equal to corresponding past performance levels. Any investment or investment strategy can be impacted by numerous factors, including market and economic conditions, and may result in a loss to investors. As with any investment, there can be no assurance that any investment objectives or strategies will be achieved or that an investor will not lose a portion or all of its investment.

Catalyst

Nothing that I would consider to be a hard catalyst