In late October, Bank of the Internet (NASDAQ:BOFI) reported its third quarter earnings, and the results were solid.
|Income Metrics||Q1 2018 Growth (YOY)|
|Earnings per Share||11.1%|
|Book Value per Share||19.2%|
Even though these are solid numbers, one metric that may concern investors is the company's lower (though still stellar) return on equity. Return on equity is often touted as one of the top indicators of bank performance, as it measures how efficiently a bank is turning its capital into profits. For the third quarter, BOFI's return on equity came in at 15.24%, lower than the 16.54% mark the bank acheived in the year-ago quarter.
However, a deeper look reveals more to the story. In fact, for long-term investors, I think this is one time where a lower ROE could be taken as a good thing. Here's why.
Let's remind ourselves what return on equity indicates -- net income divided by equity capital. Since the numerator is net income, let's examine that first:
As you can see, net income increased only 12.1%, which is good, but slower than the 12.9% growth the company acheived in fiscal year 2017 and the 44.2% income growth in fiscal 2016.
While that indicates a significant slowdown, a closer look paints a better picture. Interest income -- the bank's core profit engine -- grew faster at 15.4%. The shortfall in overall net income was due to a 9.4% decline in non-interest income. Non-interest income comes mostly from selling assets to other institutions, and the bank chose to keep more assets on the books this quarter, so the decline seems like a discretionary choice. Since the company had zero chargeoffs on its loans last quarter, that seems smart.
Second, lower net income growth could mean competition is creeping in on the bank's core franchises. A closer look shows this also isn't the case: Return on assets increased, as did net interest margin (interest income divided by average interest-earning assets), as did the interest rate spread (the difference between what the bank earns on its loans versus the yield it pays to depositors):
|Yield Metrics||Q1 2018||Q1 2017|
|Return on Average Assets||1.54%||1.53%|
|Net Interest Margin||3.87%||3.78%|
|Interest Rate Spread||3.62%||3.61%|
Finally, the company's efficiency ratio, which measures non-interest expenses to revenue, came in higher, at 40.49%, compared to 38.9% a year ago. This could mean that the company is having to spend more just to service existing growth.
That also does not seem to be the case, as the company is incubating "subscale" businesses such as consumer unsecured and auto lending, making investments toward its Universal Digital Bank initiative, and is preparing for regulatory requirements of reaching $10 billion in assets. The bank currently has $8.6 billion in assets, so these investments are preparing for assets to grow at least 16% in short order.
So, the slightly higher efficiency ratio (which is still lower that just about every other bank) points toward new growth initiatives, not expenses creeping into existing franchises.
Now that we have looked at the numerator, let's look at the denominator -- equity.
Banks fund most of their loans via deposits and other short-term borrowing, which are liabilities; however, a bank doesn't borrow 100% of its funding, but retains a minority portion of equity, preferred equity, and retained earnings. The bigger the equity capital ratio, the "safer" the bank is. That's why banks are required to hold higher amounts of equity as part of post-financial crisis regulations.
A quick look at BOFI's Tier 1 capital ratio shows the bank steadily increasing its capital ratios over the past year:
|Capital Ratios||Setptember 2017||June 2017||September 2016|
|Equity to Assets||10.10%||9.81%||9.19%|
|Tier 1 Capital to Adjusted Average Assets||9.95%||9.60%||9.20%|
|Tier 1 Capital to Risk-Weighted Assets||14.70%||14.25%||14.01%|
Of note, Tier 1 equity to risk-weighted assets grew to 14.7% -- over twice the minimum ratio required of banks by the Basel III Accord by 2019.
If that means that the company is running out of places to lend, it may be a problem. However, management did not think the market for BOFI's core franchises was limited, attributing lower growth to management's "attention dilution" on the new growth initiatives.
Of course, even if BOFI's profitable niches are slowing, having conservative capital ratios isn't a bad thing. The company could use the extra capital to make opportunistic acquisitions, or institute a share repurchase program. With the stock trading under 13 times earnings, that wouldn't be a bad idea.
Summing it up
While a bank's return on equity is probably the most important metric in determining its quality, the metric still needs to be viewed in context. While ROE, assessed over a number of years, can be quite telling, ROE in any particular quarter or year only gives a snapshot. With so many moving parts and being in the late stages of a bull market, I don't think Bank of the Internet's lower return on equity should concern investors. The company's interest spread is growing, management is incubating new growth seeds, and the bank has plenty of dry powder on hand in case of a downturn. That's a pretty good combination.