Investors in Axos Financial (NYSE:AX) (formerly Bank of the Internet) have gotten used to the online bank's huge profitability in recent years. However, in 2018 those margins have gotten squeezed. Deposit rates are rising with interest rates, and the company is also heavily investing in its future at the same time.
Still, Axos posted a very good 15.01% return on equity last quarter, despite maintaining very healthy capital ratios. Another bit of good news -- the company has finally completed a long-term technology investment in a proprietary platform it calls the Universal Digital Bank.
The Universal Digital Bank is Axos's effort to separate itself from newer online-only competitors and legacy banks that are becoming more digitally savvy. The UDB investment, in combination with the name change to Axos and several bolt-on acquisitions, have made 2018 a transformative year for Axos.
A modern banking experience
On the recent earnings call, CEO Greg Garrabrants said that "banking will distribute itself such as vertical software providers linked to banking services."
In plain English, Garrabrants is talking about providing various banking products from Axos and its partners through a single software system that Axos controls. With that data all under the company's own platform, Garrabrants hopes to create an automated platform that uses data for mass customization. This is not unlike how large internet stocks such as Netflix (NASDAQ: NFLX) or Facebook (NASDAQ: FB) collect personal data, then present you with shows you might like or highly relevant ads.
This may sound like something any company can do, but the UDB appears to have taken a lot of time and effort for Axos. This is for a couple reasons: One, the company developed the entire software stack in-house on its own, instead of outsourcing to another tech company. Two, Axos itself has been built on a patchwork of highly profitable niche businesses over the years, both organically and via acquisitions. Still, many of these companies or divisions had their own siloed systems, which must now be integrated under the new Axos UDB system.
The integration of the company's entire product portfolio will not only increase cross-selling opportunities to consumer and business customers, but should also have a second, perhaps more important effect.
Lowering the cost of funds
The Universal Digital Bank will be instrumental in Axos's attempt to gain a competitive advantage against its other online-only competition, such as Ally Financial (NYSE:ALLY) and Marcus by Goldman Sachs Group (NYSE:GS). Online-only banks typically entice customer deposits with higher rates (since they don't have the cost of branches), but as rates go up, competition for low-cost deposits appears to be heating up as well.
That affected Axos's net interest spread last quarter. The interest rate spread is the difference between what a bank earns on assets and what it pays on liabilities. That figure declined to 3.39% last quarter, down from 3.62% last year. Garrabrants and company now hope the superior customer experience of the UDB will allow Axos to retain depositors even if competitors offer higher rates. According to Garrabrants,
... many others are kind of going ... 'I'm going to put up higher rates' and those sorts of things. So we're looking at certainly changing the competitive landscape there. That's been going incredibly well. It's obviously an incredibly ambitious initiative. It's been costly. It's required a lot of IT resources, but it's been very successful.
2019 looks better
Even without the UDB, interest spreads should expand for Axos next year. This year, the company purchased Nationwide Bank's deposits, WiseBanyan (a robo-advisory service), COR Clearing (a clearinghouse with access to broker-dealers), and Epiq (bankruptcy trustee business). The Nationwide acquisition will transfer $2.5 billion in low-cost deposits, and WiseBanyan, COR Clearing, and Epiq are all fee-based financial businesses that bring lower-cost deposits with them as well.
These new deposits, along with the Universal Digital Bank rollout, should help Axos obtain and retain lower-cost deposits going forward compared with 2018. While it's difficult to say how much improvement there will be, I think 2019 will shape up to be much better than 2018 for Axos, at least in terms of profit margins.