First Internet Bancorp: Credit Cleansing Sets Stage for Margin Recovery (NASDAQ:INBK) - INBK Stock Research Report

## Executive Summary / Key Takeaways * Balance Sheet Surgery: First Internet Bancorp's $837 million single-tenant lease loan sale to Blackstone (TICKER:BX) and complete exit from franchise lending represent aggressive portfolio cleansing that, while creating a $41.6 million Q3 loss, positions the bank for normalized earnings power by 2026. * Credit Cycle Peak: The $34.8 million Q3 provision and $21 million in net charge-offs—concentrated in SBA and franchise portfolios—appear to mark the apex of credit stress, with delinquencies falling to 35 basis points and management asserting they've "pulled forward" the worst losses, creating a cleaner slate for future periods. * Margin Inflection Intact: Despite credit noise, the bank delivered its eighth consecutive quarter of net interest margin expansion (2.04% Q3, up 42 bps year-over-year), with new loan originations pricing at 7.5% and deposit costs declining, supporting management's guidance for 2.4-2.5% NIM in Q4 and 2.70-2.80% in 2026. * Valuation Disconnect: Trading at 0.54x tangible book value ($39.88/share) and 1.75x sales, INBK trades at a substantial discount to digital banking peers like The Bancorp (TICKER:TBBK) (3.94x book) and Ally (TICKER:ALLY) (1.09x book), despite maintaining its SBA franchise and digital deposit moat. * Key Variable: The timing of credit cost normalization—if Q3 indeed marked peak provisioning, the bank's underlying pre-provision earnings power ($18.1 million Q3, up 50% quarter-over-quarter) could drive significant earnings leverage as the credit headwind abates. ## Setting the Scene: From Digital Pioneer to Credit Repair First Internet Bank of Indiana commenced operations in 1999 as the first state-chartered, FDIC-insured internet bank, establishing a pure digital model that remains its structural advantage. For 25 years, the bank operated without physical branches, gathering deposits nationwide through digital channels and building specialized lending franchises in commercial real estate, public finance, and—most notably—Small Business Administration (SBA) lending. The 2020 entry into SBA lending proved transformative, with originations reaching $1.8 billion by Q2 2025 and the bank climbing to become the seventh-largest SBA 7(a) lender nationally. The 2024 fiscal year represented a high-water mark, with net income and diluted earnings per share tripling compared to 2023, net interest income growing 17%, and SBA originations surging 45% to $540 million. This performance validated the bank's strategy of pairing low-cost digital deposits with specialized, high-margin lending. However, 2025 brought a stark reversal. Small business lending and franchise finance portfolios began showing stress in Q1, with $9.7 million in net charge-offs. By Q3, the bank took "decisive and aggressive action," recognizing a $34.8 million provision and $21 million in net charge-offs, while simultaneously announcing the strategic sale of $837 million in single-tenant lease loans to Blackstone (TICKER:BX). This pivot reflects both idiosyncratic and industry-wide pressures. SBA loan default rates across the industry are running 2.3 times higher in 2025 than in 2022, as small businesses face the lagged impact of inflation, labor cost increases, and higher interest rates on their cash flows. The bank's franchise finance portfolio, built through a 2021 partnership with ApplePie Capital, proved particularly vulnerable, leading management to cease originations entirely in January 2025. The credit issues are isolated—management emphasizes the remainder of the portfolio shows "sterling" quality—but the concentration in these two segments created a earnings cliff that forced dramatic action. ## Business Model and Strategic Repositioning First Internet Bancorp operates a three-pillar model: commercial lending (70% of loans), consumer lending (22%), and fintech partnerships that provide deposit funding and fee income. The commercial pillar divides into relationship-based lending (commercial and industrial, owner-occupied CRE) and specialized verticals (investor CRE, construction, public finance, healthcare, SBA, and franchise). The consumer pillar focuses on prime and super-prime borrowers, with residential mortgages, home equity lines, and other consumer loans originated nationwide through digital channels and financing partners. The SBA franchise represents the bank's crown jewel. Through the 7(a) program, INBK originates loans nationwide, sells the guaranteed portion into the secondary market at a premium, and retains the unguaranteed portion and servicing rights. This generates both interest income and material noninterest income from gain-on-sale. In the first nine months of 2025, the bank closed $460.4 million in SBA loans, generating $10.6 million in gain-on-sale revenue in Q3 alone. The pipeline remains robust at $260 million, and the bank ranks as the seventh-largest SBA 7(a) lender for the SBA's 2025 fiscal year. This national footprint, built over five years, provides a durable competitive moat that smaller regional banks cannot replicate and larger banks often avoid due to the specialized underwriting expertise required. The strategic repositioning in 2025 involved three critical moves. First, the bank sold $837 million of single-tenant lease financing loans to Blackstone (TICKER:BX) in Q3, with an additional $14.3 million sold post-quarter. This transaction incurred a $37.8 million pre-tax loss but accomplished three goals: it reduced interest rate risk by exiting a low-yielding portfolio (5% yields), strengthened capital ratios by shrinking risk-weighted assets faster than equity, and freed up capacity for higher-yielding originations. Management explicitly stated the sale would "enhance the interest rate risk profile, strengthen capital ratios, and optimize the interest-earning asset base," with an expected positive impact on net interest margin and return on average assets. Second, management ceased originating franchise finance loans in January 2025, acknowledging that market uncertainty and borrower-specific credit issues made the risk-reward unattractive. The franchise portfolio decreased 16% year-to-date to $450 million, with $5.3 million in Q3 charge-offs and nine loans moved to nonaccrual. While painful, this exit eliminates a volatile segment and allows management to refocus on core competencies. Third, the bank strategically moved over $700 million of fintech deposits off-balance sheet in Q3 to optimize balance sheet size following the loan sale. This maneuver provides tremendous flexibility—the deposits can be brought back on-balance sheet to fund growth or meet liquidity needs without the cost and friction of raising new funding. Fintech partnerships generated revenue up 14% quarter-over-quarter and 130% year-over-year, demonstrating the value of these relationships beyond low-cost funding. ## Technology and Operational Differentiation The bank's pure digital platform, operational since 1999, provides a structural cost advantage versus branch-based competitors. Without physical infrastructure, the bank can price deposits more competitively and invest in technology rather than real estate. This advantage manifests in the ability to gather deposits nationwide at lower cost and process loans with greater efficiency. In 2025, management invested in AI technology and loan-level predictive analytics for SBA processes, aiming to streamline document processing, gain insights from historical data, and refine credit standards. This investment matters because SBA lending is document-intensive and compliance-heavy; automation reduces processing time and error rates, improving customer experience and reducing operational risk. While not as flashy as consumer fintech apps, this back-office automation directly impacts unit economics and scalability. The fintech partnership strategy provides a technological moat in deposit gathering. By integrating with fintech platforms, the bank accesses sticky, low-cost deposits that are less rate-sensitive than traditional brokered deposits. The ability to move $700 million off-balance sheet in Q3 demonstrates the flexibility these partnerships provide—something traditional banks cannot replicate without significant technology investment. Management retains customer-facing servicing responsibilities for loans sold, maintaining customer relationships while optimizing capital allocation. ## Financial Performance as Evidence of Underlying Strength The Q3 2025 results appear disastrous at first glance: a net loss of $41.6 million, or $4.76 per diluted share, compared to net income of $17.9 million in the prior year period. However, this loss masks significant underlying strength. The $41.6 million net loss was primarily driven by a $37.8 million pre-tax loss from the STL loan sale and a $34.8 million provision for credit losses (which included $21 million in net charge-offs and was up from $3.4 million in Q3 2024). Excluding the loan sale loss, the adjusted net loss was $12.5 million, or $1.43 per share. More importantly, adjusted pre-tax pre-provision income totaled $18.1 million, up over 50% from Q2 2025 and almost 65% from Q3 2024. This metric isolates the bank's core earnings power before credit costs and one-time items, demonstrating that the underlying business is accelerating. The increase reflects strong revenue growth and positive operating leverage, validating the strategic pivot. Net interest income grew 40% year-over-year to $30.4 million (GAAP) or $31.5 million (fully taxable equivalent), driven by higher earning asset yields and lower deposit costs. The yield on average interest-earning assets rose to 5.68%, with new loan originations pricing at 7.5% during the quarter. Simultaneously, the cost of interest-bearing liabilities declined to 3.90% from 4.23% a year earlier, as the bank replaced higher-cost CDs with lower-cost fintech deposits and reduced Federal Home Loan Bank advances. This margin expansion is structural, not cyclical, reflecting the bank's ability to reprice its loan book and funding base. The loan portfolio, excluding the STL sale, grew $105 million in Q3, with commercial real estate and commercial and industrial loans showing particular strength. Construction loans declined 27% as projects converted to permanent financing, while investor commercial real estate loans surged 139% year-to-date to $644 million. This mix shift toward higher-yielding, relationship-based lending supports margin expansion and reduces reliance on transactional SBA gains. Credit costs dominated the narrative, but the trend appears to be turning. The $34.8 million provision included $21 million in net charge-offs, $5.8 million in specific reserves for franchise loans, and a significant increase in the allowance for credit losses for small business lending. Management more than doubled the ACL for small business lending due to updated CECL model inputs reflecting industry trends. However, total delinquencies fell to 35 basis points from 62 basis points in Q2, and franchise finance delinquencies dropped nearly 80% quarter-over-quarter. The pace of new delinquencies has slowed meaningfully, suggesting the aggressive actions are working. ## Outlook, Guidance, and Execution Risk Management provided detailed guidance that signals confidence in the turnaround. For Q4 2025, they expect loan balances to increase 4-6% (unannualized), fully taxable equivalent net interest margin to reach 2.4-2.5%, and net interest income to be $32.75-33.5 million. Noninterest income is projected at $10.5-11.5 million, assuming the government shutdown ends and SBA loan sales resume. Expenses are expected to be $26-27 million, reflecting continued investment in technology and personnel. For full-year 2026, management models noninterest income of $41.5-44.5 million, down from prior expectations due to heightened credit standards reducing SBA origination volumes. Noninterest expense is estimated at $106-109 million, and they are comfortable with analyst estimates for net interest income and provision for credit losses. The bank is targeting a full-year net interest margin of 2.70-2.80% in 2026, which would represent a 66-76 basis point improvement from Q3 2025 levels. The guidance assumes a flat rate environment, consistent with prior quarters. However, management notes the bank is slightly liability-sensitive, meaning rate cuts would actually benefit net interest income. A 25 basis point rate cut would add approximately $1.4 million to annual net interest income, providing upside if the Fed eases policy. Execution risk centers on three factors. First, the SBA business must navigate industry-wide credit stress while maintaining origination volumes. Management has implemented AI-driven underwriting enhancements and tightened credit standards, which may reduce volume but improve quality. Second, the franchise finance exit must be managed to minimize further losses; the portfolio has already declined 10% year-to-date. Third, deposit costs must continue falling as higher-rate CDs mature and are replaced with lower-cost fintech deposits. ## Risks and Asymmetries The primary risk is that Q3 did not mark the peak of credit costs. SBA loan default rates remain elevated at 2.3 times 2022 levels, and macroeconomic headwinds for small businesses could worsen. If inflation persists or the Fed reverses course and raises rates, borrower stress could increase beyond management's updated CECL model assumptions. The government shutdown poses a near-term risk to SBA loan sales and noninterest income, though management expects resolution. Deposit beta risk remains. While the bank has successfully moved $700 million off-balance sheet and reduced deposit costs, competition for deposits could intensify if market rates rise or if larger banks like Ally (TICKER:ALLY) or SoFi (TICKER:SOFI) increase their savings account yields. The uninsured deposit ratio increased to 33% (27% adjusted), though the bank maintains robust liquidity with $2.9 billion in available funding sources representing 216% of adjusted uninsured deposits. On the upside, credit normalization could occur faster than expected. If Q3's aggressive provisioning and charge-offs have indeed "pulled forward" the worst losses, provision expense could drop dramatically in 2026, revealing the underlying earnings power of the SBA franchise and digital banking model. The loan sale, while painful, has de-risked the balance sheet and improved capital ratios, positioning the bank for growth when conditions improve. ## Valuation Context At $21.69 per share, First Internet Bancorp trades at 0.54 times tangible book value of $39.88 and 1.75 times trailing twelve-month sales of $333.4 million. This valuation stands in stark contrast to digital banking peers. The Bancorp (TICKER:TBBK) trades at 3.94 times book value, while Ally (TICKER:ALLY) trades at 1.09 times book. Even after accounting for INBK's recent losses and smaller scale, the discount appears excessive. \ The bank's market capitalization of $189 million compares to an enterprise value of -$244 million, reflecting net cash and investments exceeding market value. This negative enterprise value suggests the market is assigning no value to the lending franchise, viewing it as a liability rather than an asset. However, the SBA business alone generated $10.6 million in gain-on-sale revenue in Q3, and the core pre-provision earnings power of $18.1 million quarterly implies an annual run rate of $72 million. Historical valuation is challenging given the recent credit losses, but the bank traded at over 1.0 times book in 2024 when earnings were strong. The path to value creation involves three steps: demonstrating credit costs have peaked, returning to consistent profitability, and growing book value through retained earnings. Management's guidance for 2026 NIM of 2.70-2.80% suggests net interest income could approach $130 million, providing substantial earnings power if credit costs normalize. ## Conclusion First Internet Bancorp's 2025 transformation represents a classic case of short-term pain for long-term gain. The aggressive credit actions and strategic loan sale have created a clean balance sheet and refocused the bank on its core competencies: SBA lending, digital deposit gathering, and relationship-based commercial real estate lending. While the Q3 loss is severe, the underlying pre-provision earnings power is accelerating, and margin expansion remains on track. The investment thesis hinges on whether management has correctly called the peak of credit stress. Evidence suggests they have: delinquencies are falling, the franchise portfolio is winding down, and the SBA business continues to generate strong gain-on-sale revenue. Trading at a 46% discount to tangible book value, the market is pricing in continued credit deterioration and ignoring the earnings power of a normalized bank. For investors willing to look through the credit noise, INBK offers asymmetric upside. If credit costs normalize in 2026 as management expects, the combination of NIM expansion, controlled expenses, and a refocused loan portfolio could drive earnings well above current expectations. The digital banking moat and SBA franchise remain intact, providing a durable competitive position. The key variables to monitor are delinquency trends in the SBA portfolio, the pace of franchise loan runoff, and deposit cost trends. If these metrics stabilize, the valuation discount should close as the bank returns to consistent profitability.