2023-06-27 13:00:00 ET
Summary
- Axos Financial is undervalued but has high-risk loans, above-average deposit costs, and a declining net interest spread.
- The bank's loan portfolio is heavily weighted towards the risky CRE specialty segment, and its loan-to-deposit ratio remains high.
- Axos does not issue dividends, which may make it unattractive to some investors.
Axos Financial, Inc. ( AX ) was incorporated in 1999 and is headquartered in Las Vegas, Nevada. Its market capitalization is about $2 billion and overall it is a traditional bank in its operations. In fact, net loans, cash and equivalents are 93 percent of total assets; investment portfolio exposure is very small. For this reason, Axos, unlike many banks, does not have a comprehensive income in the deep red. In addition, the fact that it does not issue dividends has enabled a rapid increase in retained earnings.
In any case, as well as the entire banking sector, Axos has been under downward pressure in recent months due to the failures of some large U.S. banks, and its price per share seems to have reached important technical support. Will it restart from this support or continue to fall?
In this article, I will try to answer this question through the analysis of three critical factors for Axos' future.
1st Factor: Quality of Deposits
The quality of deposits is the main issue for a bank since these funds are the basis of the banking business. If customers do not deposit money, the bank does not have the funds to grant financing to another customer.
In the case of Axos Financial, deposits are increasing over time, which is by no means a given after what happened in March with the failure of SVB.
As we can see from this table, there has been a rather large increase in total deposits: in June 2022 they were $13.94 billion; in March 2023 they were $16.73 billion.
At first glance this may seem like a positive result, and in part it is, but the increase in the cost of deposits is a game changer. Interest bearing demand and savings are the main source of funding for Axos and in 9 months they cost 258 basis points more. This is far too high an increase. Certainly, the Fed Funds Rate has increased a lot in the last year, but Axos has shown very bad deposit beta.
The composition of deposits has totally changed, and the ones that suffered the most were non-interest bearing deposits, which are the most important ones for a bank. In 9 months, they have decreased by $1.86 billion and now represent only 19% of total deposits; previously they were 36%. In short, an increase in deposits is not always a positive signal; it depends on how their composition has changed.
It is difficult to assume that the cost of deposits could rise much further, since it is already much higher than the average for regional banks, 1.56 percent . In any case, I would not rule it out completely.
Should the Fed raise the Fed Funds Rate to 6-7 percent, the consequences could be devastating for Axos' deposits; this is an unlikely but not impossible scenario.
If, on the other hand, the Fed Funds Rate has almost peaked, at that point it is hard to believe that the cost of deposits could rise much more than the current level. At most, two more 25 basis point hikes are expected by the end of 2023, which means little room for increase. The latter represents the most likely scenario.
2nd Factor: Size and Performance of the Loan Portfolio
Since liabilities cost more, the yield on assets also adjusted accordingly, otherwise, the net interest spread would have narrowed too much.
Loans represent the vast majority of total assets and achieved an average yield of 7.07 percent compared to 4.79 percent last year. This is an important improvement, but one must always keep in mind that there are no free meals in finance, and such a high return corresponds to higher risk.
In particular, the focus is directed mainly at the CRE specialty segment, which accounts for about 31 percent of the loan portfolio. Analysts often tend to monitor this segment more closely as it is considered rather risky and subject to business cycle trends. In any case, there do not seem to be any signs of weakness at the moment and CEO Greg Garrabrants also reiterated this in the last conference call :
So what's interesting about it is that the housing market just in generally including what you see on the condo sales side, even in places like New York, Miami, all these places, they've essentially held in or actually gotten better in some respects. So right now, the single family or condo sort of issues that people thought might arise so far have been a big bust. Now, again, when you're at 40% loan to values on those things, it doesn't really matter that much if you get some decline in value. But we're not seeing it. It's not there. And in fact, if it's a good product and it's well placed, it's New York. It's flying off the shelves, actually.
Indeed, with a weighted avg. LTV of 42 percent even a reduction in property values would not affect Axos' soundness much more, but we cannot know the magnitude of a bearish real estate market in advance. Of course, banks are more capitalized and conscientious than in 2008, but it is better not to take anything for granted.
Also, the current Loan to Deposit ratio of 94 percent should not be overlooked. There has been an improvement over the previous three months where it was 101%, but it still remains high. The fact that Axos is reducing this ratio by raising money at a high cost puts this improvement on a whole other perspective. In short, the bank may be able to make new loans at high interest rates, but it should not unbalance itself too much as it is unable to reduce the Loan to Deposit ratio without adversely affecting the net interest spread.
3rd Factor: Prevalence of Variable and Hybrid Rate
The last factor I want to discuss is the rate composition of the loan portfolio. We can see that fixed rate accounts for only 7 percent of the entire portfolio, while 83 percent of fixed and hybrid rates will be repriced within 5 years.
So, in light of this data, I personally remain quite doubtful of how the bank is positioning itself in the current macroeconomic environment. As discussed earlier, the Fed Funds Rate's upside room is quite limited according to expectations, which makes the floating and hybrid rates less attractive than a fixed rate at current levels.
Based on the current composition of rates, when the Fed Funds Rate is reduced, since only a minority of loans are fixed rate, inevitably the yield on loans would be reduced going to affect both the net interest spread and the net interest margin.
In short, I personally do not fully support positioning myself toward further rate increases. At this stage, I would rather invest in banks that are locking in new fixed-rate loans than the other way around. By the way, in five years the majority of fixed and hybrid rates will be repriced, barring unforeseen events, at lower rates.
In all this, it is necessary that, with the reduction in the Fed Funds Rate, the cost of deposits should also follow this trend, otherwise the bank would end up with a still high cost of liabilities and a worsened yield on loans.
Valuation and Final Thoughts
If we based the valuation of Axos on valuation multiples alone, the stock would be correctly valued, as it has ratings between B and C.
In any case, the multiples method does not help us to understand how much the fair value of Axos is. I will use two different approaches to calculate it: one based on EPS and another on P/B. The data source I will consider will be Seeking Alpha.
- The average P/E for the last 5 years is 11.43x; multiplying this figure by the expected FY 2023 EPS of $5.15 (Street estimates), the fair value is $58.86 per share.
- The average Price/Book Value over the past 5 years is 1.70x; multiplying this figure by the current Book Value per share of $31.07, the fair value is $52.81 per share.
In short, in either case, Axos would be undervalued since it is now trading at about $36 per share, but I would like to make a point.
The fact that Axos is undervalued does not mean that this bank should be bought as soon as possible, in fact, that is not what I will do. Since March 2023, almost all banks have collapsed and are undervalued relative to their past multiples, so you have to be careful which one you choose to invest in. On paper, almost all of them are undervalued relative to historical Book Value, so theoretically we would have to invest in hundreds of banks if we were only following this metric. There must be other factors that drive us to buy a bank, such as cost of deposits, net interest margin, and competitive advantage.
In the case of Axos, we are talking about a bank whose loans have a high yield (hence high risk), a cost of deposits above the industry average, and a declining net interest spread. In short, it may be undervalued relative to book value, but remember that things are often cheap for a reason. Personally, I prefer to invest in undervalued banks without these problems just reported. That said, the fact that Axos is undervalued on paper leads me not to enter a sell rating.
Finally, I conclude by reminding readers that this bank does not issue a dividend, which makes it unattractive to many investors. The fact that it does not issue it is not a problem in itself, it simply may not be attractive to the investment standards of some individuals. Sometimes not issuing the dividend could be an advantage; I suggest you read my article on Metropolitan Bank if you are interested in the subject.
For further details see:
Axos Financial: 3 Factors To Monitor In Coming Months