Axos Financial: When Quality Deserves A Premium (NYSE:AX)

Investment Thesis

Axos Financial (NYSE:AX) stood out as a major outperformer compared to the industry with double-digit earnings and book value growth for the fiscal fourth quarter of 2024. I am surprised by the balance of strong profitability with a balanced risk profile that Axos has, leading me to believe the shares deserve some premium valuation to the median sector. Given that the stock trades at a discount of 8.7x forward earnings, I believe there is more room for upside and rate shares as a buy.

Company Overview

Axos Financial is a “diversified financial services company with approximately $22.6 billion in assets and approximately $35.0 billion of assets under custody” according to the annual report. The company owns Axos Bank, Axos Clearing LLC, and Axos Invest as part of their holdings. Together, the three holdings signal Axos Financial’s diversified business model with a different kind of revenue sources.

Axos Bank “provides consumer and commercial banking products through its digital online and mobile banking platforms, low-cost distribution channels and affinity partners”. Like any other bank, they offer consumer and commercial banking services like deposits and lending to make the spread between their interest earning assets and liabilities.

Axos Clearing LLC is a “full-service clearing firm serving Independent Broker-Dealers and registered investment advisor” according to their website. As a custodian and clearing firm, they settle trades, process corporate actions, and provide overall recordkeeping services. They get paid for charging fees for their safekeeping services, typically based on assets under custody.

Axos Invest offers digital investment advisory services and managed portfolio for retail customers. They offer personalized, automated investments and “generate fee income from self-directed securities trading and margin lending and fee income from digital wealth management services to consumers”.

Overall the holding company is quite strong in my view due to its diversified businesses that have shown to be resilient during economically volatile times. According to Seeking Alpha, net interest income has grown from $477.6 million to $961.4 million for the past TTM, a very smooth ride up. This track record is quite impressive and shows the growth and profitability profile to be quite superior in relation to its peers.

Therefore, shares seem unreasonably cheap given the growth track record and the stunning return on average shareholder equity of 21.6% for the last twelve months ended June 30, 2024. I say the stock deserves a premium valuation, and rate shares as a buy because they trade at a modest discount to the overall sector. Going forward I expect continued outperformance based on management’s own guidance and historical credibility their track record gives them.

An Impressive Balancing Act

To me, it can be difficult to balance growth, risk and profitability all at once as usually banks have to make trade-offs between the three factors. In my opinion, if a bank wants more profitability, they tend to have to increase their risk appetite and lower their growth targets. In other words, pursuing profitability generally requires trade-offs that negatively impact other areas of the bank.

However, I am surprised that Axos Financial has a track record that has shown they can manage profitable growth without increasing the risk profile of their bank. The earnings call highlights,

Our strong returns contributed to the 26% year-over-year growth in our tangible book value per share.

Total non-performing loans dropped by $9 million linked quarter and non-performing loans and leases to loans fell by 6 basis points to 0.57%.

The diversity of our lending and deposit businesses allowed us to grow profitably in the three and 12 months ended June 30, 2024 as evidenced by our 18.8% and 21.6% return on average common shareholder activity respectively.

Compared to the sector median, the return on average common equity of 21.6% is almost double the median of 10%. Growth metrics are much higher than the sector, with revenue growth more than double the median according to Seeking Alpha’s growth rating. Investors can see this financial holding company has a one of a kind performance and deserves some premium because of their outperformance.

In my view, this outperformance can be largely explained by the quality of management at Axos Bank. Ultimately, banks perform a commodity-like service so it can be difficult to differentiate one service from another. What really drives outperformance in this sector in my eyes is management quality, so the track record of this bank demonstrates management’s competence in reading market trends, originating loans, and managing their deposit base.

On the risk side, I am also surprised to see strong capital adequacy ratios as well as excess liquidity, showing that management is also prudent risk managers as well. Capital to risk-weighted assets was 13.80% in June 30, 2024, and management says in the earnings call,

We carried higher excess liquidity with average interest bearing deposits of approximately $2.7 billion in the fourth quarter of 2024 compared to $2.2 billion in the third quarter of 2024.

In conclusion, an analysis of the bank shows that management is incredibly competent in balancing growth, risk, and profitability all at once. This impressive juggling act in a very competitive industry necessitates a premium valuation, which I do not see currently. Shares are thus undervalued and deserve a buy rating as I see no signs of the company’s performance slowing down.

CRE Loans Are Well-Managed

Given some of the concerns about CRE, I noticed most of Axos Financial’s CRE loans were in multifamily. After reviewing management’s loan book in CRE, I believe they are incredibly prudent in managing risk with the weighted average LTV ratio being 40%, which is super impressively low. Even in the event of default, I do not think investors should worry as the chance of a permanent impairment loss is quite low with such strong LTV ratios.

Furthermore, management has been reducing their exposure to some of the CRE sector, perhaps in preparation for a potential future recession. According to the transcript,

Ending balances for our multifamily term loans and commercial real estate specialty loans declined by approximately $122 million and $31 million respectively in the fourth quarter. We continue to reduce our auto, consumer and select real estate backed loans to tactically manage our interest rate and credit risk.

Multifamily in particular seems attractive given that regular homes are unaffordable for most Americans. With limited options for housing, multifamily seems to be the most popular choice as it is cheaper to afford so the likelihood of default in this sector to me is unlikely. According to Fannie Mae,

At a national level, rental demand remained positive for much of 2023, due to stronger-than-expected job growth, smaller-but-continued wage increases, elevated interest rates, and an overall shortage of housing, especially for-sale housing, keeping many renters-by-choice renting – for now.

Thus, the multifamily focus in Axos Bank’s CRE loan book seems to be well managed with strong LTV ratios and a focus on high-performing properties. Investors should view the assets on the balance sheet positively and expect continued performance which should contribute to overall profitability and growth for Axos Financial.

Valuation – $90 Fair Value

I believe given the track record of outperformance and high management quality, the stock deserves a premium valuation to the median sector. I will assume that book value and earnings grow together in tandem at around 15% annually. I feel 15% is a good conservative number given that historically many of these metrics used to compound at over 20%. Furthermore, it roughly matches Seeking Alpha’s FWD EPS GAAP growth projection of 13.56%, which is around 15%.

By 2026, I think EPS can reach $8.00 assuming my 15% EPS annual growth rate holds true (FY 2024 EPS was $6.74. Assuming 15% EPS growth, EPS will be $8+ by 2026). Apply a premium earnings multiple of 11.5x gets me $90 fair value, rounded down. A 11.5x P/E multiple is a premium to the 5Y average of 9.87x, and is actually around the sector median of 11.34x according to Seeking Alpha.

Anyway an investor slices it, the stock is remarkably cheap and holds a lot of value due to its strong growth and profitability profile. Management was smart to buy back their stock at $48, as it represents a significant discount to my estimated fair value of $90. Ultimately, a long-term compounder like Axos Financial is a good target for buy and hold as long as it continues to compound investor’s capital at a high rate.

Risks

Banks face liquidity risk, interest rate risk, and credit risk so investors need to be careful about the overall economy which may affect some of these challenges. There is talk about a potential recession in the United States, which could slow down loan originations and negatively affect loan performance. Furthermore, a drop in interest rates can make NIM go down as it becomes harder to earn a profitable net interest spread.

Past outperformance is no guarantee of future outperformance. A lot of my thesis does assume that the past extrapolates forward, but there is no guarantee that this will happen. If the future performance slows down due to external challenges or management changes, the stock no longer deserves a premium and would invalidate my thesis.

Short-sellers have shown a different picture, highlighting “that a former Axos credit review officer detailed the practice of loan ‘evergreening’, or providing loans to non-performing or doubtful borrowers to avoid recognizing problems, per litigation records”. Hindenburg claims that there are big CRE loan problems, and that the premium valuation is unwarranted. Interviews with former employees show that Axos has allegedly allocated capital dangerously, and a potential subsequent meltdown may lead to permanent losses, according to Hindenburg.

After reviewing the 8-K on June 4, 2024, I am surprised by the detailed rebuttal and dismantling of the short report from management. I remain convinced and believe management’s integrity and understanding of their own business is likely trustworthy, but the risk posed by short sellers should be well considered by investors.

It remains yet to be seen whether Hindenburg is correct, but investors should note that this short report does present an opposing thesis to mine. In my view, the market has already priced in the short seller’s thesis but investors may want to size their position carefully in case the shorts happen to be right.

Buy Axos Financial

I choose to trust management and their integrity and competence, however it may be worth sizing the position carefully in case the shorts are right. I personally view the bank and financial holding company as very profitable with a strong growth track record that will likely continue. However, if future news comes out that proves Hindenburg has more credibility and weight to their argument, I am willing to change my mind on this stock. For now though, I rate shares as a buy and choose to trust Axos Financial’s management.