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INBK - First Internet Bank


Tim Eriksen
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First Internet Bancorp is a bank holding company with assets of $1.9 billion as of December 31, 2016. The Company’s subsidiary, First Internet Bank, opened for business in 1999.  If you follow BOFI, INBK is at an earlier stage without all the questionable activity.  I presented on this at the Value Investing Congress in 2013.  As interest rates rise, many community banks are not going to be able to continue to pay nothing.  Internet banks such as INBK run a leaner operation allowing them to pay more on accounts.  Balance sheet is $1.9 billion with $0.4 billion in Securities and $1.25 billion in loans (67% commercial - mostly single tenant lease financing and 33% consumer - mostly residential mortgage with a bit of trailers and RVs).  Average yield on loans is 4.3%.  Securities is 2.5%.  Good loan quality.  NPA's under $6 million.

 

On the deposit side is mostly money markets and CDs since it is an internet bank.  Average cost of deposits are 1.28%. Does have $200 million of borrowed funds at 2.23%.  6.5 million shares outstanding at $31 per share.  EPS in most recent quarter was $0.65.  They did an equity offering in the quarter so it is not an accurate run rate.  When a bank does an equity offering it often takes a few quarters to fully invest. With their low cost structure (efficiency ratio of 59% and falling) their incremental margins are excellent. 

 

I used them for a mortgage for myself and my mother with no major difficulties. They quickly sold off both mortgages.

 

Catalysts: putting new equity to use means rising EPS.  Would benefit if corp tax rates are reduced.  Gently rising interest rates may increase net interest margin

Risks: Hey it's a bank.  Leverage can kill you if you make mistakes.  Rising rates may reduce loan originations 

 

 

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Internet banks such as INBK run a leaner operation allowing them to pay more on accounts. 

 

I'm not so sure this is a correct statement.  It might be more appropriate to say "Internet banks such as INBK have poor service and are perceived by depositors as riskier places to keep their life savings, as such, they have to pay more on accounts."

 

If you just compare efficiency ratio's, they appear efficient.  But compare the non-interest revenue of INBK to the non-interest revenue of WFC.  They have similar efficiency ratio's, but WFC pays for ~80% of its expenses with non-interest revenue whereas INBK pays for less than 60% of its expenses with non-interest revenue.  So the net cost per $ of deposits is much higher for INBK and they have to pay much higher deposit rates.  All the ancillary services that generate revenue cost money, so you're not comparing apples to apples by just looking at the efficiency ratio.

 

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I am not a bank expert , merely stating my view based on reading the 10Q. Current strategy according to 10q is to keep variable interest loans on the book and sell fixed loans for a fee. Plans to start holding a larger proportion of fixed loans when rates rise. As long as loan book growth exists and NIM doesn't compress, it looks cheap relative to growth. Loans past due also looks good. Efficiency ratio is around 60% so there exists a good chance of operating leverage.

 

CEO is a serial entrepreneur in the tech space having sold companies.

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Internet banks such as INBK run a leaner operation allowing them to pay more on accounts. 

 

I'm not so sure this is a correct statement.  It might be more appropriate to say "Internet banks such as INBK have poor service and are perceived by depositors as riskier places to keep their life savings, as such, they have to pay more on accounts."

 

If you just compare efficiency ratio's, they appear efficient.  But compare the non-interest revenue of INBK to the non-interest revenue of WFC.  They have similar efficiency ratio's, but WFC pays for ~80% of its expenses with non-interest revenue whereas INBK pays for less than 60% of its expenses with non-interest revenue.  So the net cost per $ of deposits is much higher for INBK and they have to pay much higher deposit rates.  All the ancillary services that generate revenue cost money, so you're not comparing apples to apples by just looking at the efficiency ratio.

Efficiency ratio for those who don't know is non-interest expense divided by net interest income plus non interest income.  So it captures what goes on in non-interest revenue.  Whether a bank earns its net revenue from interest rate spread or non-interest income doesn't matter in the calculation.  It is basically a cost per net dollar of revenue.  WFC is great on the non-interest revenue but not as good on net interest income. Most banks are the opposite.

 

I am not sure that is a fair statement to say poor service.  Of course an internet bank by design provides a lower level of service, but not necessarily poor service.  If I can take a picture of a check and deposit it I don't need an ATM or teller. If they reimburse ATM fees I can withdraw anywhere.  If they can attract deposits and grow paying 1.25% versus nothing I would suspect if rates rose 100 bps they would be in an even more attractive position.  To INBK customers, WFC is the one providing poor service by paying low rates.

 

WFC is probably not a fair comparison in terms of non-interest income.  Historically WFC has been one of the best.  Their cross selling has been impressive.  Their non-interest income does not necessarily come from depositors. MSRs, trust management, investment banking, loan origination, BOLI, etc. are mostly separate.  They are also a function of what a larger bank can do.  Outside of loan origination smaller banks tend not to do as well in the non-interest income area.               

 

Here is another way of looking at it.  To increase net income, INBK needs to grow deposits and lend the money, WFC has to grow deposits, make loans, and generate fees.  INBK's model is simpler which is why they are growing much faster.

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My concern would be how they are growing and the cost to maintain their past growth. INBK offers rates on CDs that are above or well-above the highest nationally advertised rate. Thus, INBK (or any firm without a large % of "core" deposits) faces interest rate risks on both halves of the B/S. Roughly 90% of INBK's long-term funding is through CDs and money market accounts. As an example of the two-sided risk, p.31 of 3Q 2016 10-Q shows average yield on assets was relatively flat while the cost of brokered deposits increased by 18 basis points. It seems like INBK earns above-average ROE due to their above-average interest rate risk assumed.

 

The single tenant book was just $85m in 2012 and $16m in 2008. It was $572m on 9/30/2016. The lion's share of their loan growth over the last decade is in this portfolio.

 

I think banks with high % of core deposits will see greater NIM expansion than those that rely on brokered deposits of any kind, if rate continue to rise. The current environment probably favors the INBK, all things equal.

 

https://www.depositaccounts.com/banks/first-internet-bank-of-in.html

 

http://www.gobaker.com/Websites/gobaker/Images/Articles/Article-2009-11-16b.pdf

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Internet banks such as INBK run a leaner operation allowing them to pay more on accounts. 

 

I'm not so sure this is a correct statement.  It might be more appropriate to say "Internet banks such as INBK have poor service and are perceived by depositors as riskier places to keep their life savings, as such, they have to pay more on accounts."

 

If you just compare efficiency ratio's, they appear efficient.  But compare the non-interest revenue of INBK to the non-interest revenue of WFC.  They have similar efficiency ratio's, but WFC pays for ~80% of its expenses with non-interest revenue whereas INBK pays for less than 60% of its expenses with non-interest revenue.  So the net cost per $ of deposits is much higher for INBK and they have to pay much higher deposit rates.  All the ancillary services that generate revenue cost money, so you're not comparing apples to apples by just looking at the efficiency ratio.

Efficiency ratio for those who don't know is non-interest expense divided by net interest income plus non interest income.  So it captures what goes on in non-interest revenue.  Whether a bank earns its net revenue from interest rate spread or non-interest income doesn't matter in the calculation.  It is basically a cost per net dollar of revenue.  WFC is great on the non-interest revenue but not as good on net interest income. Most banks are the opposite.

 

I am not sure that is a fair statement to say poor service.  Of course an internet bank by design provides a lower level of service, but not necessarily poor service.  If I can take a picture of a check and deposit it I don't need an ATM or teller. If they reimburse ATM fees I can withdraw anywhere.  If they can attract deposits and grow paying 1.25% versus nothing I would suspect if rates rose 100 bps they would be in an even more attractive position.  To INBK customers, WFC is the one providing poor service by paying low rates.

 

WFC is probably not a fair comparison in terms of non-interest income.  Historically WFC has been one of the best.  Their cross selling has been impressive.  Their non-interest income does not necessarily come from depositors. MSRs, trust management, investment banking, loan origination, BOLI, etc. are mostly separate.  They are also a function of what a larger bank can do.  Outside of loan origination smaller banks tend not to do as well in the non-interest income area.               

 

I'm aware of the efficiency ratio definition, but it's still not an apples to apples comparison.  A more apples to apples comparison is to say non-interest revenue less non-interest expenses over total deposits is the amount it costs (in expenses) a bank to maintain a $ of deposits.  If you look at it that way, it costs INBK 1.25 pennies + interest to maintain $1 of deposits, and it costs WFC 0.75 pennies + interest to maintain $1 of deposits.  Just a different way of looking at it that is more apples to apples.  So INBK spends 65% more to maintain a $1 of deposits, and then has to pay 1000% more in interest.

 

If you look at it your way, you are saying the margins are the same, but are ignoring the differences in capital intensity.  The capital requirements of the business will be greater per dollar of revenue for INBK than for WFC, since a larger % of WFCs revenue comes from non-interest sources, so $1 of deposits creates more revenue, all else equal, when non-interest revenue is included.

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Internet banks such as INBK run a leaner operation allowing them to pay more on accounts. 

 

I'm not so sure this is a correct statement.  It might be more appropriate to say "Internet banks such as INBK have poor service and are perceived by depositors as riskier places to keep their life savings, as such, they have to pay more on accounts."

 

If you just compare efficiency ratio's, they appear efficient.  But compare the non-interest revenue of INBK to the non-interest revenue of WFC.  They have similar efficiency ratio's, but WFC pays for ~80% of its expenses with non-interest revenue whereas INBK pays for less than 60% of its expenses with non-interest revenue.  So the net cost per $ of deposits is much higher for INBK and they have to pay much higher deposit rates.  All the ancillary services that generate revenue cost money, so you're not comparing apples to apples by just looking at the efficiency ratio.

Efficiency ratio for those who don't know is non-interest expense divided by net interest income plus non interest income.  So it captures what goes on in non-interest revenue.  Whether a bank earns its net revenue from interest rate spread or non-interest income doesn't matter in the calculation.  It is basically a cost per net dollar of revenue.  WFC is great on the non-interest revenue but not as good on net interest income. Most banks are the opposite.

 

I am not sure that is a fair statement to say poor service.  Of course an internet bank by design provides a lower level of service, but not necessarily poor service.  If I can take a picture of a check and deposit it I don't need an ATM or teller. If they reimburse ATM fees I can withdraw anywhere.  If they can attract deposits and grow paying 1.25% versus nothing I would suspect if rates rose 100 bps they would be in an even more attractive position.  To INBK customers, WFC is the one providing poor service by paying low rates.

 

WFC is probably not a fair comparison in terms of non-interest income.  Historically WFC has been one of the best.  Their cross selling has been impressive.  Their non-interest income does not necessarily come from depositors. MSRs, trust management, investment banking, loan origination, BOLI, etc. are mostly separate.  They are also a function of what a larger bank can do.  Outside of loan origination smaller banks tend not to do as well in the non-interest income area.               

 

I'm aware of the efficiency ratio definition, but it's still not an apples to apples comparison.  A more apples to apples comparison is to say non-interest revenue less non-interest expenses over total deposits is the amount it costs (in expenses) a bank to maintain a $ of deposits.  If you look at it that way, it costs INBK 1.25 pennies + interest to maintain $1 of deposits, and it costs WFC 0.75 pennies + interest to maintain $1 of deposits.  Just a different way of looking at it that is more apples to apples.  So INBK spends 65% more to maintain a $1 of deposits, and then has to pay 1000% more in interest.

 

If you look at it your way, you are saying the margins are the same, but are ignoring the differences in capital intensity.  The capital requirements of the business will be greater per dollar of revenue for INBK than for WFC, since a larger % of WFCs revenue comes from non-interest sources, so $1 of deposits creates more revenue, all else equal, when non-interest revenue is included.

I consider myself extremely competent in community bank stocks, but the above points are excellent. Thanks for sharing.  I knew the conclusion but didn't have as clear of a path to the conclusion.

 

In terms of interest rate disclosures, be careful with those. The bank can make them say whatever they want due to deposit assumptions. Think of it this way. The model has to capture not only contractual items (when do loans come due, what rate are they tied to)  but also behavioral (what will prepayments be. Will preference for fixed vs variable change?).  Deposits are even worse. For those core deposits, the only contract is the rate paid now. The bank has to guess how long that deposit will stay, when it will reprise, what account will it move to, and by how much will the cost rise.

 

 

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I'm aware of the efficiency ratio definition, but it's still not an apples to apples comparison.  A more apples to apples comparison is to say non-interest revenue less non-interest expenses over total deposits is the amount it costs (in expenses) a bank to maintain a $ of deposits.  If you look at it that way, it costs INBK 1.25 pennies + interest to maintain $1 of deposits, and it costs WFC 0.75 pennies + interest to maintain $1 of deposits.  Just a different way of looking at it that is more apples to apples.  So INBK spends 65% more to maintain a $1 of deposits, and then has to pay 1000% more in interest.

 

If you look at it your way, you are saying the margins are the same, but are ignoring the differences in capital intensity.  The capital requirements of the business will be greater per dollar of revenue for INBK than for WFC, since a larger % of WFCs revenue comes from non-interest sources, so $1 of deposits creates more revenue, all else equal, when non-interest revenue is included.

 

You could say that a more apples to apples comparison is to say non-interest revenue less non-interest expenses over total deposits is the amount it costs (in expenses) a bank to maintain a $ of deposits. But would it be true?  You are implying yes, and I am saying it is not necessarily true and WFC is one of those cases.  If WFC buys MSRs, increases loan origination, buys a brokerage (unless deposits are held at the bank), etc. it does not involve deposits, thus skewing the results on a per $ of deposit basis.  I am not bashing WFC but I definitely prefer owning INBK.  Others may think differently that is fine.  Time will tell which will be better.   

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Wouldn't a way to meet in the middle is include deposit service charges and exclude other, non consumer related fees?  Almost every bank has a specific line for deposit fees, although this ignores the cross sell fees that may show up insurance, mortgage, etc.

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I'm aware of the efficiency ratio definition, but it's still not an apples to apples comparison.  A more apples to apples comparison is to say non-interest revenue less non-interest expenses over total deposits is the amount it costs (in expenses) a bank to maintain a $ of deposits.  If you look at it that way, it costs INBK 1.25 pennies + interest to maintain $1 of deposits, and it costs WFC 0.75 pennies + interest to maintain $1 of deposits.  Just a different way of looking at it that is more apples to apples.  So INBK spends 65% more to maintain a $1 of deposits, and then has to pay 1000% more in interest.

 

If you look at it your way, you are saying the margins are the same, but are ignoring the differences in capital intensity.  The capital requirements of the business will be greater per dollar of revenue for INBK than for WFC, since a larger % of WFCs revenue comes from non-interest sources, so $1 of deposits creates more revenue, all else equal, when non-interest revenue is included.

 

You could say that a more apples to apples comparison is to say non-interest revenue less non-interest expenses over total deposits is the amount it costs (in expenses) a bank to maintain a $ of deposits. But would it be true?  You are implying yes, and I am saying it is not necessarily true and WFC is one of those cases.  If WFC buys MSRs, increases loan origination, buys a brokerage (unless deposits are held at the bank), etc. it does not involve deposits, thus skewing the results on a per $ of deposit basis.  I am not bashing WFC but I definitely prefer owning INBK.  Others may think differently that is fine.  Time will tell which will be better. 

 

I agree with you, it skews the results on a per $ of deposits basis, as each $ of deposits doesn't individually come with X pennies of mortgage banking revenue, Y pennies of card fees, Z pennies of service charges, etc.  But, on average, they do at different rates for different banks with different expense structures.  I think comparing efficiency ratios of banks with very different operating activities (and revenue sources) and making conclusions on efficiency is more skewed.  The non-interest revenue side is more expense intensive then the deposit side.

 

Ultimately, the branches are customer acquisition tools both for deposits and loans.  I'm not so sure the reduction in branch costs for an internet only bank isn't more than offset by higher customer acquisition costs for deposits and loans.  INBK doesn't give you enough information to figure that out in the 10K.  WFC shows the yields on every type of loan, INBK just lumps it together as yield on loans, so you can't compare.  I suspect they have to offer lower rates on loans (and of course higher deposit rates) in order to get people to their site via Google.  Nobody is typing in firstinternetbancorp.com.  They manage to earn similar NIMs, but how do you know they aren't just picking up pennies in front of a steam roller?  Loans have much higher yields, and WFC (with much stickier liabilities) only lends 51% of its assets and INBK (with much less sticky liabilities) lends 77% of its assets.  Also, INBKs loan yields are 25bps higher than WFCs, which makes no sense unless they are taking more risk. 

 

Also, even if internet banking was more efficient, why would INBK have any competitive advantage in internet banking with only $1 billion in deposits?  Seems like a business that should earn its cost of capital over time and be worth book value.  Just my 2 cents.

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Loans have much higher yields, and WFC (with much stickier liabilities) only lends 51% of its assets and INBK (with much less sticky liabilities) lends 77% of its assets.  Also, INBKs loan yields are 25bps higher than WFCs, which makes no sense unless they are taking more risk. 

 

Also, even if internet banking was more efficient, why would INBK have any competitive advantage in internet banking with only $1 billion in deposits?  Seems like a business that should earn its cost of capital over time and be worth book value.  Just my 2 cents.

I have to disagree with your comparisons here. There are fundamentally different aspects of comparing a large bank like WFC to a smaller lender. Much of what you point out above would be witnessed if you compare any small bank to any large bank and it is not unique to INBK. For example, loan yields are almost always lower at big banks. This is due to the more competitive market for their borrowers (large multinational corporations, remember the yields are dollar weighted) and different lending types.  For these sort of comparisons, it really isn't apples to apples to compare yields and structures.

 

Compared to similar sized banks, their loan yields are 40bps below the average. They are often in the bottom 20th percentile of the distribution. The fact they have loan yields so similar to WFC is concerning, because it means their growth requires significant price discounting.  May also mean they can't price their assets as quickly up if rates rise

 

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Loans have much higher yields, and WFC (with much stickier liabilities) only lends 51% of its assets and INBK (with much less sticky liabilities) lends 77% of its assets.  Also, INBKs loan yields are 25bps higher than WFCs, which makes no sense unless they are taking more risk. 

 

Also, even if internet banking was more efficient, why would INBK have any competitive advantage in internet banking with only $1 billion in deposits?  Seems like a business that should earn its cost of capital over time and be worth book value.  Just my 2 cents.

I have to disagree with your comparisons here. There are fundamentally different aspects of comparing a large bank like WFC to a smaller lender. Much of what you point out above would be witnessed if you compare any small bank to any large bank and it is not unique to INBK. For example, loan yields are almost always lower at big banks. This is due to the more competitive market for their borrowers (large multinational corporations, remember the yields are dollar weighted) and different lending types.  For these sort of comparisons, it really isn't apples to apples to compare yields and structures.

 

Compared to similar sized banks, their loan yields are 40bps below the average. They are often in the bottom 20th percentile of the distribution. The fact they have loan yields so similar to WFC is concerning, because it means their growth requires significant price discounting.  May also mean they can't price their assets as quickly up if rates rise

 

That may be true for your typical small local community bank where you have customer relationships and people come in and only ask you for a loan and don't shop around, but because INBK is an Internet bank (totally different than your average small bank), it's borrowers are all by definition searching for the cheapest option or they wouldn't ever find INBK.  How can you say with confidence that INBK is able to lend in less competitive markets than WFC?

 

Most of their loans are single tenant buildings, that's not a competitive space?

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Good points, but I think you are not appreciating the scale of difference. My statement is more probabilistic in nature. It's more likely it's less competitive and there would need to be evidence to suggest that it isn't.  Of course single tenant buildings will be competitive. But a $1 mil.  building will be less competitive than a $10 mil building and less than a $100 mil. building.  As the size increases, the financial impact on people in the industry increases and they pursue them more aggressively. And then credit risk tends to decline as loans are larger, because it's larger borrowers with better financial statements and disclosures and normally less concentrated operations.  Of course there are many counter examples, these are just very reliable rules of thumb after being inside lots of banks and seeing how they talk about their loan competition. Some banks (like ZION) focus on these less competitive smaller loans. Others like Wells Fargo likely have a large percentage of their loans as SNCs.  Just a different world, Wells Fargo is routinely making loans the size of INBK

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