2023-06-08 13:00:00 ET
Summary
- First Internet bank is currently undervalued but faces challenges due to rising deposit costs and a struggling loan portfolio.
- Management remains confident in the bank's future, with CEO David Becker and other insiders buying shares, and the bank continuing its buyback program.
- I remain cautious about investing in First Internet Bank because of the current challenges and the potential for further negative surprises, but I will keep the bank in my watch list.
First Internet Bancorp ( INBK ) is a very small bank that capitalizes only $123 million and was created in 1999. It is headquartered in Fishers, Indiana, and has assets worth only $4.72 billion. In short, we are talking about a bank that is not very relevant in the financial markets, but still has managed to overcome several crises since its inception.
After the bankruptcy of SVB, a negative period began for the entire banking sector, and First Internet is no exception being 75% far from its all-time high. But how justified is such a huge slump?
Currently First Internet has an LTM Price / Tangible Book Value per Share of only 0.35x, while the average over the past 17 years has been 0.90x. Multiplying the latter figure by the current Tangible Book Value per Share of $39.43, First Internet's fair value comes out to be $35.48; significantly higher than the current price per share of $13.85. In short, it is clear that we are facing a strong undervaluation on paper, but sometimes companies are cheap for a reason.
Financial markets tend to look to the future and not the present, so it is evident that the market expects this bank to deteriorate sharply in the following months. In this article, based on the latest quarterly report , I will show you my two main concerns about First Internet's current situation and whether or not I will eventually invest in it.
First problem: deposits are too expensive
The raw material of any bank is deposits, since with the liquidity from them it is possible to invest in assets whose return is ideally greater than the cost incurred to obtain that liquidity. So, for a bank to improve, it not only needs growing deposits, but also that their cost is not excessive. In the case of First Internet, the first condition is met while the second is not.
As we can see from this image, total deposits have increased from $3.44 billion in Q4 2022 to $3.75 billion in April 20. In practice, the banking crisis that erupted in Q1 2023 did not affect the total amount of deposits of this bank. This is positive, however, looking at the increasing cost the bank has to bear for deposits, the picture of the situation gets much worse. In just 3 months, total interest-bearing deposits went from a cost of 2.45% to 3.24%, a definitely worrying increase.
Money market rates remain high, and in my opinion we are unlikely to see a contraction in costs in the coming months. Moreover, it cannot be ruled out that the Fed may continue to raise rates, which would make the scenario even worse. Since the Fed has repeatedly said it will not reduce rates in 2023, I expect that at best the cost of deposits will be at least as high as it is today.
As for the aspect related to a possible bank run, it is unlikely to happen since only 26% of total deposits are uninsured. In any case, should all uninsured deposits disappear, the unused liquidity and borrowing capacity of $931.7 million would cover 109% of them.
Overall, deposits have improved in total amount and are mainly insured, however, the problem is that their cost is rising dangerously. Apparently, since the bank does not have significant bargaining power, it has to offer deposits at high rates in order to get new customers and new liquidity, which makes bank funding significantly more complex. According to CFO Ken Lovik, this condition will persist until the Fed stops raising rates, at which point the cost of deposits will stabilize and quickly return to a low level when interest rates are cut.
It is likely that if the Fed surprisingly raises rates for another 2-3 meetings, the bank could be in serious trouble; therefore, the hope is that the Fed Funds Rate will remain stable.
Second problem: net interest margin in trouble
As we have seen, the cost of deposits has become a problem, and it does not help that loan yields are not increasing at the same rate.
As can be seen from this image, it is evident that since Q1 2022 there has been a convergence between the yield on loans and the cost of deposits. The deterioration is visible from quarter to quarter, and what concerns me most is that this trend is not slowing down, on the contrary. The impact on the GAAP net interest margin has been significant, in fact it has gone from 2.69% in Q1 2022 to 1.76% in Q1 2023.
According to the company's guidance , the net interest margin is also expected to decline for Q2 2023, albeit not at the same rate as the previous two quarters, and is expected to rise from Q3 onward. In short, there is still pain, but we can see light at the end of the tunnel.
Personally, given the data seen so far, I would venture a prediction and I believe that in Q2 2023 we will have worsening guidance. Money market rates are unlikely to change in the coming months, and the incentive from depositors to move cash to a T-Bill yielding above 5% is high. The bank is likely to be forced once again to raise the interest rate offered on its deposits.
Moreover, the yield on loans is not growing fast enough to offset this imbalance. Ken Lovik himself stated during the conference call that he expects a flat earning-asset base or slightly increasing because of the prudent choice to hold more liquidity at this time.
In short, I think there is little room for improvement for assets in the coming months but a large room for deterioration for the cost of deposits. The market has already discounted a struggling Q2, but it has probably also discounted that from Q3 onward there will be a rebound. If this does not reflect the reality of the facts, I doubt the market will take it well.
Management's confidence is surprising
After discussing the main issues that are plaguing this bank, in this paragraph I would like to light a glimmer of hope.
In the long run, tangible book value per share with the exception of the last few quarters has always experienced an upward trend. This figure is crucial since the price per share of any bank is derived from it. Moreover, since it represents shareholders' equity and must meet minimum capital requirements imposed by the Basel committee, it is the most important factor in assessing the health of a bank. In the case of First Internet, the minimum capital requirements are all met and even by a wide margin. So, for the time being, the bank remains sound.
Anyway, what surprised me the most is that management believes strongly in First Internet, so much that they will do everything they can to buy as many of their own shares as possible. The only limitation is set by the minimum capital requirements that the bank must necessarily meet; therefore, they will make sure that the buyback will not hurt the current financial position too much.
At the beginning of the year $25 million was allocated for the buyback, and another $19 million remains to be deployed. For this quarter, the buyback will proceed, and only when the price per share goes up will there be an eventual slowdown. The long-time CEO David Becker strongly believes that First Internet is undervalued, to the point of stating that at the current price it is ludicrous not to do buybacks since it is the absolute best way to allocate capital.
But there is more, here are David Becker's words regarding the current historical period:
We're still rock-solid on the capital requirement. So we view it as kind of business as usual. We've been through these cycles, as Ken stated, several times over the last 20 years, and we survived them all and we come out stronger on the other side, and we're going to do that again.
Basically, management is serious and strongly believes that $13 per share is too little for First Internet. However, unlike other banks that follow the same narrative, in this case words are also matched by actions. Making buybacks in the current difficult environment where it is necessary to keep liquidity high is a risk, but it does not concern management. And apparently it doesn't concern their portfolio either.
Insiders have been buying for months and no one is selling. David Becker has bought 10,000 shares since March, which adds credibility to his words.
Overall, the results of the latest quarterly reports have been disappointing, mainly due to the rising cost of deposits and the loan portfolio struggling to improve. The tangible book value per share has stopped growing, and as a result, the price per share has plummeted.
In any case, CEO David Becker strongly believes that First Internet will recover as it has in the past and currently at $13 per share is a golden opportunity. In fact, both the bank itself and insiders are buying as much as they can.
Personally, as an outsider who can only evaluate the bank based on public information, I rate the riskiness of this investment excessive for my degree of risk aversion. The problems are tangible, and I doubt that anything will change in the coming months; in fact, I believe there may be unpleasant surprises. However, I do not feel I can permanently exclude this bank from my watch list as it is evident that on paper it is extremely undervalued. Moreover, management's confidence in both words and actions leads me to believe that they may know something more than the market.
In short, I await new data since in case of a further collapse I may invest a very small part of my portfolio in First Internet.
For further details see:
First Internet Bancorp: Highly Undervalued But There Is A Reason