• BofI Holding, Inc. (NASDAQ:BOFI)’s recently announced, widely expected acquisition of H&R Block’s bank deposits boosts its earnings but does not address the long-term pressures that will drive down the company’s currently inflated profitability. At almost 4x book value, as we have previously argued, BOFI’s super-premium valuation remains unwarranted.
  • At least five serious bidders besides BOFI vetted the H&R Block transaction, yet BOFI emerged as the winner despite a complete lack of cost synergies. We question how valuable an asset the H & R Block Inc (NYSE:HRB) business can be when no one was willing to pay a single dollar for it.
  • One of BOFI’s responsibilities under the new agreement is to serve as the issuing bank for H&R Block’s prepaid debit card. Looking at the two major issuing banks already operating in this space supports our concerns about BOFI’s high valuation and unsustainable earnings: they trade at half of BOFI’s price-to-tangible-book-value multiple, generate 35% lower net interest margins, and earn almost 50% lower returns on equity. In a highly competitive market in which BOFI has little experience, its returns should be weaker than those of the leading players. This peer comparison again highlights the fact that BOFI is over-earning and will suffer long-term deterioration in its NIM and ROE.

Said differently, BOFI has taken capital valued by the market at almost 4x book value and invested it into a business valued at less than 2x book value. This trade only makes sense if the original valuation was faulty and unsustainably high. Otherwise, management is actually destroying economic value.

  • Meanwhile, recent earnings announcements confirm the dramatic decline in industry-wide mortgage originations and profits. Since BOFI generates the vast majority of its fee income and the bulk of its loan production in the single-family mortgage market, these trends underscore the near-term risks to BOFI’s earnings.
  • For those seeking to bet on the growth in online-only banking, BOFI is no longer the only publicly traded vehicle. In the wake of last week’s IPO of Ally Financial Inc (NYSE:ALLY), investors can acquire the leading online bank – posting far more rapid organic customer growth than BOFI on a >20x larger deposit base  – at less than a quarter of BOFI’s relative valuation. BOFI again stands out as highly overvalued.

The H&R Block Transaction: Widely Shopped and Unlikely to Be a Bargain

It was no surprise when BofI Holding, Inc. (NASDAQ:BOFI) announced that it was assuming most of the deposits held by H&R Block (HRB); the acquisition had been heavily discussed by buy-side and sell-side analysts like. To be fair, one unexpected positive for the company was the absence of a capital raise: BOFI management indicated that it “expects no significant additions to regulatory capital will be required as a result of this transaction.” Rather than sell shares, BOFI is choosing to lever up its balance sheet and tie up capital that could have supported core business growth instead of M&A.

While the market and the sell side greeted the deal enthusiastically, the history of the sales process calls into question just how attractive a purchase this could be. HRB originally agreed to sell its bank deposits to Republic Bancorp, Inc. KY (NASDAQ:RBCAA) in July 2013. At that time, it said it had “talked to a lot of counterparties [and] received a lot of interest.” When the deal fell through in October because RBCAA failed to obtain the necessary regulatory approvals, H & R Block Inc (NYSE:HRB) spoke more expansively about its due-diligence process and the set of alternative potential buyers (emphasis added):

So we, last fall, when we made the decision to move forward in this direction, engaged Goldman Sachs and First Annapolis and they’ve been working with us every step of the way. We ran a full process. So we talk to lots of interested parties. They called us; we called them….You then narrow it down to a smaller group of qualified people, have more detailed conversations. We then narrow that list down further to about six counterparties and had in-depth detailed diligence two-way type discussion before we narrow it down further and that sort of the end of that process, we ended up with Republic.

Later, media coverage in January indicated that HRB had again narrowed the universe of bidders down to six. Since BOFI has confirmed that it was one of the members of the original short list, there must have been at least five other serious bidders who examined the HRB transaction and decided either to pass or to bid lower than BOFI. But BOFI had no real edge in bidding for this asset: unlike RBCAA, it doesn’t have a history of offering tax-related financial products, and unlike a firm like Bancorp Inc (NASDAQ:TBBK), it has little experience serving as the back office for a prepaid debit-card program. Yet BOFI still managed to win the transaction, suggesting that it was willing to be more aggressive than its competitors and accept worse economics.

Notwithstanding the competitive and drawn-out sales process, H & R Block Inc (NYSE:HRB)’s deposits apparently never garnered a premium bid. Established deposit franchises typically sell at a premium to their liabilities – i.e. to obtain $100 million in deposits backed by $100 million in cash, a buyer must write a check for several million. For example, just last week Huntington Bancshares Incorporated (NASDAQ:HBAN) assumed $450 million in branch-based Michigan deposits from Bank of America Corp (NYSE:BAC) and paid a 3.5% deposit premium, or almost $16 million, for the privilege.

By contrast, RBCAA wouldn’t agree to pay any premium for H & R Block Inc (NYSE:HRB)’s deposits, and BofI Holding, Inc. (NASDAQ:BOFI) isn’t paying a premium either. While the transaction isn’t costless – among other things, BOFI must put up capital to support the assets backing the acquired deposits – it surely says something about the quality and value of HRB’s deposit business that at least six parties closely examined it and none was willing to pay HRB anything for it. Potential buyers may have been unimpressed by the growth trajectory: in a rapidly expanding sector, HRB’s prepaid debit-card transaction volume grew only 3% in 2013, far slower than the 20%+ that BOFI shareholders expect from the company’s core business. Buyers may also have worried about the regulatory and operational risks of dealing with tax refunds and prepaid cards, both areas rife with fraud and money laundering. Whatever the reasons for buyers’ unwillingness to pay up, we doubt that there is much real value to be found in a transaction that was widely and repeatedly shopped yet failed to attract a meaningful bid.

Peer Metrics Point to Lower Returns and a Lower Valuation for BOFI

The key ongoing service that BofI Holding, Inc. (NASDAQ:BOFI) will provide to HRB is acting as the issuing bank for HRB’s prepaid debit-card program, Emerald Card. While this is a relatively new business for BOFI, there are two large, established, publicly traded competitors in the space: The Bancorp (TBBK), and Meta Financial Group (CASH). For example, the prepaid card that TurboTax offers as a way to receive a tax refund is issued by TBBK, while CASH backs The Western Union Company (NYSE:WU)’s card. Both companies trade at higher price-to-tangible-book multiples than one would expect based on their modest

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