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Monday, June 14, 1999

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

A Value Investor's Look at Net.B@nk, Part 3

On Friday, I left off my look at Net.B@nk (Nasdaq: NTBK) by mentioning the company's net interest margin. Let me preface my comments by saying that I believe in the business model. Just as retailers have moved to lower margin, higher-turnover business models (the big-box retailing concept), I believe there will be successful online banks that generate lower net interest margins yet attain their return on capital goals with better asset turnover profiles and lower overhead expenses.

The goal is to deliver the most value to the customer and that's what Net.B@nk is pursuing. According to an Ernst & Young report cited in First Security Van Kasper's May 17, 1999 research note, 70% of U.S. financial institutions are undecided on their Internet pricing strategies and only one-quarter plan to offer lower prices over the Internet. If you're Net.B@nk, you probably couldn't ask for more indecision from your competitors.

If Net.B@nk can turn its assets faster than its peers and keep its overhead low, then the tighter net interest margin doesn't worry me as much as it might others. Net interest margin last quarter (annualized and not adjusted for tax equivalence) was 2.65%, which is well below the 3.2% to 5% net interest margin of large commercial and retail banking competitors and the 4.56% (taxable equivalent) mean net interest margin for 208 banks with mean average assets of $2.3 billion in the Fed's database (Q4 1998).

Like the hotel and airline industries, however, re-pricing of services can happen literally overnight in the banking industry. That does present some management challenges, especially if your customer base is made up of interest-rate sensitive customers who will expect to see rates on checkable deposits move with the market. I've included 40% of the company's residential mortgage loans and 50% of home equity lines in its bucket of assets with maturities of up to one year (even though they don't necessarily mature in one year, I would say this is a realistic assumption on repricing terms within that timeframe) and come up with a negative net interest rate sensitivity gap of -20.7% for the company.

According to research at SNL Securities (a specialty research company in Charlottesville, Virginia) 90% of 165 publicly-traded thrifts it tracks show a one-year net interest rate sensitivity gap of +/-20%. If we move more of the home equity lines into the category of assets repricing within one year, the gap would move closer to industry norms.

There's more to the interest-rate sensitivity of the company, however. With a negative one-year gap, one might expect falling interest rates to be beneficial to earnings. If customers name high interest rates as one of the prime attractions of doing business with the company, though, how much latitude does Net.B@nk have to lower deposit rates without hurting part of the value proposition they offer customers? You're also talking about a bank where 61% of interest-bearing funding maturing within one year is represented by CDs, some of which is undoubtedly not representative of loyal customers, but rather yield hunters.

This is why I've been so focused on service in nearly everything I've written about the company. I categorically reject final conclusions on the company that are based on "yield hunting" customers because a big part of the value proposition goes way beyond that. The way I look at it, if you're offering customers yields on deposits that are generally within the ballpark of market-based rates of interest, you've satisfied them. It beats with a pretty big stick what most banks are doing.

This has held up elsewhere. Why else are people signing up for Charles Schwab when it costs so much more? It's not just price; it's product and service. The reason why people return to shop at Amazon.com rather than chasing $0.50 or even $2.00 on a $19 selection elsewhere is due to Amazon.com's customer service. That encompasses everything from the customer interface to responsiveness of service personnel. If you want "sticky," it's not just the product category, it's how happy people are. The product isn't sticky; the total customer satisfaction result is where an analyst should be measuring "stickiness."

I've heard numerous comments from very satisfied customers who like Net.B@nk's service. That includes comments that service personnel got back to them promptly on questions, that deposits were posted quickly, and other raves about how much customers enjoy doing business with a company that is treating them as valued customers rather than as another source of fee income. If you're holding onto customers and revenues are able to get to scale, then your efficiency ratio goes down and your service organization is able to reach its intended scale. In general, you need a larger service base to get the ball rolling, and then those expenses come down as a percentage of revenues as the customer base matures and has less "newbie" sorts of questions.

One part of the equation that is still to come at Net.B@nk is the noninterest rate spread revenues. Loan origination, brokerage, insurance, bill payment, credit cards, and commercial loans are all available or in the business plan for Net.B@nk. These are all vital revenue sources that must be developed for the company to succeed, in my opinion. With a lower net interest margin, you have two other places to make up the earnings: noninterest expenses as a percentage of assets and noninterest income as a percentage of assets.

To adjust for substantial uninvested capital at the company, I've expressed noninterest expenses as a percentage of average earning assets and compared that to the large incumbent banks. Depending on the sort of bank you're looking at, the company is working at a 2-7 percentage point advantage to the big banks here. But it's also working at a 3-6 percentage point disadvantage in the category of noninterest income as a percentage of average earning assets because it has foresworn much, if not all, of the deposit account fees that the big banks love so much. This is another area where investors should measure success, not just in growth.

Any analysis that focuses on customer growth, deposit growth, and asset growth without an accompanying consideration of a banking company's CAMELS (capital adequacy, asset quality, management and administration, earnings, liquidity, sensitivity to market risk) characteristics is an incomplete and poorly-constructed one. You can't just walk into a situation like this and treat it like Amazon.com and focus on the growth numbers without looking at the specifics of this sort of company.

Analyzing a bank isn't rocket science, but if you can't define "net charge-offs," "Basle accord," or assess other banking exigencies, then you're playing with matches in a barn. Maybe I'm a curmudgeon, but the failures of a few big S&Ls in my hometown of Buffalo, New York were a good illustration that growth has to be looked at carefully and that there are no truly new eras in banking. You can't just slap an "e-commerce" analyst on the banking sector and say "go at it." That's not just my comment on sell-siders, either. It applies to individual investors, as well.

So the value of the stock boils down to a couple of things. Naturally, the value of any financial asset is the net present value of the cash flows to investors it can generate. Slapping a multiple on book value and saying that's good enough isn't the way to go about it. The multiple to book value that shakes out of a discounted cash flow analysis is the result of a proper valuation, not an attempt at valuation itself. Having been influenced by Ben Graham, I don't feel uncomfortable whatsoever in expressing my belief that the company is worth anywhere from $22 15/16 to $53 13/16. That is to say that I can come up with a number of scenarios in which capital buildouts, return on capital, share buybacks, varying discount rates and the cost of capital, and the timing of these variables all affect the present value to an investor.

Since this entire exercise has grown out of my analyzing the company for a portfolio I run, I will say that I discount cash flows to equity at 15%, which is my personal hurdle rate. Intrinsic value is a necessarily variable data point that depends on one's individual return needs. In assessing the company going forward, I will look at a number of developments (in no particular order):

1. Asset quality, especially with regard to the amount of home equity loans and unsecured loans the company chooses to generate (I'm not a big fan of the current level of reserves).
2. Development of noninterest rate spread lines of business.
3. Management of net interest margin in variable interest rate environments.
4. Customer churn.
5. The ability of the company to service and retain the customer.
6. The willingness of further customers to overcome the lack of an owned ATM network, especially in light of the consolidation of banks in key regions, which means that customers of the incumbent banks won't have to do business with a foreign ATM.
7. Control of core overhead expenses.
8. Liquidity -- You don't crank up this sort of bank to a 5% leverage ratio, in my opinion.
9. Capital intensiveness -- I would like to see some less capital intensive agent-relationship business lines rather than all principal-relationship lines. Asset turns must speed up -- this will also have to come from the noninterest income line.

In conclusion, I think that readers should realize I'm looking at this company as a prospective investor and not as someone looking to spin a story either way. I don't consider myself to be a journalist or a writer. I consider myself to be a securities analyst that tries to assess investment opportunities. Securities analysis is neither an objective nor totally subjective pursuit. It's a mixture of those two things.

I've seen some pretty whack theories on the message boards as to why I've said this or that about the company. The goal here is not to spin -- it's to be right. Along with that, I personally like a margin of safety. I don't engage in single-point, single-probability analyses. Rather, I try to develop a spectrum of probabilities and a multi-point valuation of a company. Within that context, I hope you'll find the foregoing analysis helpful.

Also see Part 1 and Part 2 of this series.

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