Navigating the Challenges: First Internet Bancorp's Financial Journey

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As someone who closely follows the financial world, I've had my eye on First Internet Bancorp (NASDAQ: INBK), a bank with a unique history and some notable challenges. Established in 1999, right in the midst of the Internet bubble, this institution has seen its fair share of ups and downs. What's striking is that despite the years that have passed since its inception, its share price hasn't shown a consistent upward trajectory.

Now, let's delve into the nitty-gritty of what's happening with this bank, focusing on key areas of concern.

Loan Portfolio and Interest Margins

In the current economic climate, securing credit isn't as easy as it used to be. However, First Internet has been steadily expanding its loan portfolio, and it's quite diverse. On the surface, this seems promising, but there's a catch – loan yields aren't increasing as rapidly as they should.

The Federal Funds Rate has risen, making bank deposits more expensive. To avoid eroding their margins, banks have had to issue loans at higher interest rates. If the cost of deposits doesn't keep pace with the yield on loans, it's a recipe for reduced profitability.

This issue started in Q2 2022 and has continued, with the gap between loan yields and deposit costs getting thinner. This compression is affecting both net interest income and net interest margin. It's clear why this bank has struggled, and there doesn't seem to be an immediate turnaround in sight. The upcoming quarter's net interest margin is expected to be in the range of 1.50-1.55%, and even by Q4 2024, it may only reach 1.90-1.95%, still below the 2022 levels.

In the words of CFO Ken Lovik during a Q2 2023 conference call, "We still expect a little bit of compression on net interest margin and net interest income."

In essence, until the Federal Reserve reaches its terminal rate, this trend of net interest margin compression is likely to persist.

Deposits: A Weakness

While deposits are indeed growing, they represent one of the bank's weakest points. Their costs have been climbing rapidly. A bank with a competitive edge can typically keep deposit costs low, but this hasn't been the case here.

The cost of total interest-bearing deposits was already quite high in Q4 2022, but it reached a staggering 3.75% in Q2 2023. Even at around 2%, this figure would be considered high. According to a study by Deloitte, this trend might continue regardless of the Federal Funds Rate. Customers, used to substantial interest on their deposits after years of near-zero interest rates, are unlikely to accept lower returns. Competition in the banking sector is fierce, and cutting deposit interest rates significantly could result in losing a substantial chunk of deposits.

Even if the Federal Funds Rate were to drop, deposit costs are expected to remain elevated, at 1.70% in 2024 and 1.50% in 2025. Additionally, there's no guarantee that banks can issue loans at the current market rates. In essence, this scenario would further weaken banks, especially those like First Internet, which haven't been able to curtail the rise in deposit costs.

The silver lining here is that only a small percentage of deposits are uninsured. The real challenge lies in figuring out how to reduce deposit costs without hemorrhaging customers.

Shareholder Remuneration

First Internet rewards shareholders through dividends and share buybacks. The dividend per share has remained constant since 2014, which, while sustainable, might not be attractive to investors seeking dividend growth.

From my perspective, I question the need for a dividend at this point. If I were a shareholder, I'd prefer the company reinvest that money for growth. In other words, the dividend isn't likely to be the primary motivator for investors eyeing this bank.

On the other hand, the buyback program has been quite active. Shares outstanding have decreased by 16% since 2018. During Q2 2023, 203,000 common shares were repurchased at an average price of $13.52 per share. In total, $38.90 million shares have been repurchased since November 2021. This resulted in an increase in tangible book value per share to $39.85 at the end of the quarter, a nearly 4% rise from the previous year.

However, as the CFO has indicated, if the share price were to hover around $20-25 per share, the buyback activity might slow down. Buying back shares can impact equity and worsen capital requirements, which is something banks must tread carefully on.

Conclusion

First Internet is a bank grappling with profitability challenges primarily driven by the soaring cost of deposits. While loan yields are on an upward trajectory and expected to increase slightly in the coming quarters, this isn't enough to restore net interest margins to their historical levels.

Despite these difficulties, the Price/Tangible Book Value remains quite low at 0.49x, compared to a historical average of around 0.89x. During moments of extreme market panic, this ratio even sank to 0.25x, a level not seen since the 2008 financial crisis. At those levels, First Internet was certainly a steal, but hindsight is 20/20.

On paper, the bank still appears undervalued, but the recent rally has diminished the potential return on investment. In my opinion, at its current price, the bank is undervalued but no longer a screaming bargain. Given the elevated risk due to the squeezed net interest margin, I'd only consider investing if the price offers a substantial margin of safety. Unfortunately, that ship may have already sailed several months ago.

Interestingly, it appears that management shares this sentiment, as indicated by their reduced buyback activity as share prices rise. In any case, it's clear that navigating the challenges ahead will be crucial for First Internet to regain its footing in the banking sector.

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