Axos Financial (NYSE:AX) released its second-quarter fiscal 2019 results on Jan. 29, reporting 26.5% growth in earnings per share. But the company also created some confusion with its "adjusted" non-GAAP (generally accepted accounting principles) results, which it said improved 28.6% from $0.49 per share in fiscal 2018 to $0.63 in fiscal 2019. However, when Axos reported its adjusted earnings per share one year ago, it said its adjusted non-GAAP earnings were $0.61 per share, not the $0.49 per share it claimed this quarter.
So what gives? In short, a change in the way the company calculated adjusted earnings last year versus this year, which we will explain below.
What's more important is that Axos has seen expenses climb rapidly in recent quarters, with both interest expense and operating expenses outpacing earnings growth. Let's take a closer look at Axos' change to its adjusted earnings result for clarity's sake, as well as how operating and interest expenses are beginning to come down, even as its loan portfolio is getting bigger and more profitable.
1. Axos' GAAP gaffe
As mentioned above, Axos created a little bit of uncertainty when it reported different non-GAAP adjusted earnings for last year's second quarter than what it showed in last year's release. Needless to say, when a company said a year ago its non-GAAP earnings were $0.61 per share, and then this year it says last year's non-GAAP earnings were $0.49 per share, a lot of eyebrows are raised.
This is exactly where using non-GAAP earnings metrics can cause problems and confusion, because when a company reports a non-GAAP adjusted result, it is either adding in or excluding certain things required by GAAP accounting -- basic accounting rules all public companies must use when filing financial results.
So what changed? In short, Axos used a different formula to arrive at its adjusted earnings in last year's second quarter than it has normally used. In most recent quarters, the company has reported adjusted earnings as net income + acquisition-related expenses + excess FDIC expenses + income tax. It says by excluding these expenses, which can vary greatly from one quarter to the next because of timing issues (or which in some cases don't recur), investors can get a better picture of core earnings.
However, last year's second quarter was an aberration. Like essentially every bank, Axos took a paper loss related to the revaluation of tax assets on its book as a result of the new federal tax law. In Axos' case, it was approximately $8 million, or $0.12 per share, for a one-time, noncash adjustment that would be more than offset by the long-term benefit of the new, lower corporate tax rate.
Here's where it left investors confused.
When Axos reported its just-ended fiscal second quarter 2019, it went back to its prior formula and didn't adjust last year's one-off tax revaluation expense out. The end result was two different adjusted earnings numbers for last year's second quarter, and concern by some in the investor community that management was trying to pull a fast one on investors. Call it moving the goal posts if you like, but I don't think this was intended to deceive.
2. Reversing the higher-rate trend
Over the past couple of years, rising interest rates have hindered Axos' profit growth more than they have helped. This trend continued in the second quarter, with its net interest margin -- the weighted yield its interest-earning assets generate -- falling from 4% last year to 3.87%. Furthermore, the rate spread -- the difference between the average yield it earns and the rate it pays on deposits -- was 3.48%, down from 3.71% one year ago.
Higher rates on deposits are behind this. The average rate paid on interest-bearing liabilities (bank-speak for deposits and borrowings) jumped 61% from 1.41% to 2% year over year. This caused interest expense to surge 63% higher, while higher rates from its lending assets only increased 7%, from 5.12% to 5.48% year over year.
The good news is that deposit expenses are starting to fall. Axos closed on the Nationwide Bank deposits acquisition Nov. 17, and the benefits of that acquisition are more apparent when you look at the end-of-quarter numbers.
Time deposits -- primarily high-interest CDs -- have become a bigger source fund over the past year. In the first quarter, Axos averaged $1.7 billion in time deposit balances with an average 2.59% interest rate. At the end of the second quarter, the balance increased to $2.95 billion following the Nationwide closing, but the average interest rate fell to 2.3%. Furthermore, management has said even more high-interest time deposits will run off the books in future quarters.
Axos also ended the quarter with much less owed to the Federal Home Loans Bank (FHLB), which provides funds to mortgage lenders. It averaged $1.9 billion in debt owed to the FHLB in the quarter at a 2.33% average rate but cut that to $342 million by quarter-end.
Add in about $1 billion in non-interest-bearing deposits, and Axos ended the quarter with a weighted average interest rate on deposits of 1.74%, down from 1.82% at the end of the first quarter. A modest improvement, but it reverses the trend of steadily rising rates that it pays.
3. Another key metric got better
An important metric that measures Axos' ability to leverage its asset-light business model is efficiency ratio, the percentage of revenues it spends on non-interest expenses (bank-speak for operating expenses). Non-interest expense increased 25% from last year, more than $10 million higher, causing the efficiency ratio to worsen from 40.3% (lower is better) to 46.5% year over year.
A number of big initiatives have driven those expenses up rapidly over the past year, including Axos' investments in its Universal Digital Banking initiative and preparations for regulatory changes when it surpasses $10 billion in total assets. And while future spending growth will occur -- this is part-and-parcel for a growth business like Axos -- there was actually a modest $2 million decline in non-interest expense from the first quarter. This resulted in the efficiency ratio improving from 51.5% in the first quarter to 46.5% in Q2.
CEO Greg Garrabrants did caution investors on the earnings call that some recent acquisitions could hurt Axos' efficiency ratio while actually delivering better returns. "If [COR Clearing LLC] ends up growing well, it will grow in a way that will increase our [return on equity] but would decrease the overall holding company or increase the overall holding company's efficiency ratio."
While the lack of clarity on the change in its non-GAAP results caused unnecessary confusion, a deeper look at the numbers shows that Axos did indeed have a solid, if somewhat transitional, quarter. It continued to earn some of the best returns of any bank, while also driving down interest expenses and improving its operating efficiency. Furthermore, it has more acquisitions set to close in the near future, which should help improve returns and drive cost down even more.
Continued economic uncertainty has many investors concerned about the banking sector, but Garrabrants and his team have proven very skilled at allocating capital toward long-term growth while also navigating the normal cycles of the banking industry. Investors can probably expect more of the same.