BofI Holding Inc (NASDAQ:BOFI) has made for a remarkable investment over the past decade. Its stock price is up an incredible 2,140% since the start of 2008, a remarkable 17-fold better total return than the S&P 500 over the same period of time. Over that period it has grown its assets almost 860% and increased earnings per share almost 2,600%.
But what about the future? Can BofI sustain its past success, or has the best money already been made? After all, the big banks have also invested in online banking, building better, more user-friendly apps and making it easier for people to engage in a banking relationship without ever entering a branch. From where I'm sitting, I expect BofI will continue to grow at an above-average rate for years to come, taking deposits and market share. It may not be able to grow assets and earnings by the same incredible rates it did over the prior decade, but it won't have to continue delivering market-crushing results for investors.
And the biggest reason why isn't because it's an online bank, but because BofI has great leadership with a solid track record of high returns and minimal losses. That indicates it does very well at the most important thing in banking: Managing risk.
How the branchless model is helping BofI
Because of its branchless model, BofI spends a much smaller portion of its revenues on operating expenses -- called non-interest expense on the income statement -- than traditional banks with retail branches. The simplest way to see how the branchless model benefits BofI is by its efficiency ratio, which measures the portion of revenues required to cover operating expenses. BofI sported a 32.4% efficiency ratio last quarter, which works out to about twice as good as the average retail bank with efficiency ratios in the 60% to 70% range (meaning they spend about twice as much on operating expenses).
Sure, there's an argument that rising interest rates will hurt online banks more than traditional retail banks, as they usually pay higher rates on deposits. One of my colleagues went so far as to take the position that traditional banks will maintain a competitive advantage from their retail branches, giving them cheaper access to capital. The problem with this argument is that it ignores the raw numbers, which show that noninterest expenses are a far-bigger cost for banks than interest expense.
For instance, Bank of America (NYSE:BAC) spent $13.9 billion on non-interest expense in the first quarter versus $3.99 billion on interest expense, or 3.5 times more on operating expenses than interest expense. BofI, spent $45.4 million on non-interest expense, and $28.2 million in interest expense, or 1.6 times more on operating expenses.
Yes, Bank of America -- like most big banks -- does pay paltry rates to depositors, helping keep its interest expenses lower. But the cost of operating retail branches sucks up a substantial amount of capital each quarter, and any advantage they provide in terms of access to cheaper deposits is shrinking. If that weren't the case, they wouldn't be closing branches at such a quick rate: Since peaking at over 6,000, Bank of America has 4,400 branches now. Wells Fargo also had more than 6,000 branches at its peak, but aims to cut that number to 5,000 or fewer within two years.
Leveraging lower expenses to invest in growth
While big retail bank operators are spending time and resources to close branches and cut operating expenses, BofI is ramping its spending higher. Last quarter, non-interest expense increased 28% and has increased 22% over the past nine months. It's part of the company's strategy to expand, and a continuation of a multi-year trend of increased operations investment to drive asset growth, while its big-bank competitors have been more focused on cost-containment.
In recent years, BofI has entered into an agreement with H&R Block to provide tax-return loans and other products to its customers, acquired the business equipment leasing business from Pacific Capital Bancorp, and brought in key executives to grow its auto and commercial and industrial -- C&I -- lending.
It's starting to pay off. In two years, BofI has grown its auto loan book from $20 million to almost $200 million, while its C&I portfolio has increased 37% in less than two years, from $992 million to $1.36 billion since June 2017. For comparison, BofI's residential real estate loan portfolio increased by $243 million over the same period, to $5.77 billion.
Residential lending still makes up the majority of BofI's loan book, and that's likely to remain the case for the long-term. But over the past three quarters, commercial and industrial lending has increased from 13% to almost 17% of the loan portfolio. While commercial lending can be higher-risk than residential real estate lending, it can also be very profitable. With a solid record of risk management under CEO Greg Garrabrants, my expectation is that BofI's ability to invest in expanding these new business lines should continue to drive earnings higher for many years to come.
BofI's "other" competitive advantage is its real strength
It's not just low operating expenses that give BofI an advantage: It's excellent management. Garrabrants has proven to be very good at the two most important jobs of a bank CEO: Managing risk and allocating capital. Here's how its returns have compared to the big banks over the past decade under his leadership:
Yes, low interest rates have helped drive its returns, but investors shouldn't discount the value of great management, particularly with a business like banking.
In addition to generating solid returns, Garrabrants has also spearheaded efforts to grow BofI's brand recognition and improve its online and mobile banking experience. These tools are the modern-day bank branch, and should continue to drive growth across BofI's business lines for years to come.
Ten years out
A decade from now, there will almost certainly be fewer retail bank branches open than there are today, as more and more people transition to online and mobile banking. As this occurs, many banks will benefit from lower operating costs, and the big advantage BofI has in this regard probably won't be as large. But it will -- hopefully -- still have a top-notch CEO and a strong culture of low-risk, high-return lending, and many years of investing in expanding its offerings as well as the way customers interface with it.
If these things prove out over the next 10 years, I expect BofI will have continued to make for a market-beating investment, and will have transitioned from today's sub-$10 billion in assets, to far greater in size and profits.