Description

First Bancorp Puerto Rico (ticker: “FBP”) is a $12.2B asset bank, headquartered in San Juan, PR and with operations in PR, the Virgin Islands and Florida.  FBP is the second largest bank in Puerto Rico, its better known competitor Popular (ticker: “BPOP”) is the largest. As of 9/30/18, FBP had $9.4b in total assets in PR, $6.6b total PR loans (18% market share), and $5.8b in core deposits (11% market share).  The company also has a strong and valuable presence in Florida ($1.7b of loans or 20% of its loan book), and a smaller presence in the Virgin Islands (6% of total loans, 30% deposit market share).

BPOP is the larger presence on the island in terms of loans ($18b of loans, 48% market share) and deposits ($32b, 60% market share).  There are a few other important competitors on the island which are subsidiaries of much larger institutions…these are Banco Santander ($3.6b of loans/10% market share, $4.2b deposits/8% market share) and Scotiabank ($2.8b of loans/7% market share, $3.1b deposits/6% market share).  These banks are in my opinion “stranded”, in other words they are subscale, not growing, and haven’t historically fared that well (PR has been mired in a recession for ten years). Also, given their tiny size relative to their corporate parents, they are more or less irrelevant to the larger parent companies.  This is important, because given the lack of success and subscale nature of the operations, I believe both parents might be willing to put the operations up for sale. FBP is in a prime position to consolidate one or both of these assets for three reasons: 1) FBP has a substantial excess capital position (a 20% Tier 1 Common ratio vs most banks operating ~10%), 2) BPOP cannot acquire deposits as its market share is already too high and thus a deal would be deemed anticompetitive, 3) OFG (the third largest PR bank with $4.2b loans/12% market share and $4.6b deposits/9% market share) is under a consent order that precludes them from doing M&A and they have stated that organic growth is their focus.  Given FBP’s substantial excess capital position and a large branch overlap (50-70% of branches within 1 mile of either Santander or Scotia), an acquisition could be done in cash (i.e. with no equity issuance) and with a large amount of cost reduction, making it massively accretive (50%+) and highly beneficial to the stock.

Ex the macro environment, the PR banking market is structurally sound largely due to the consolidated nature of the banking market described above (3 large players).  This manifests itself in a few ways, namely structurally higher asset yields due to a lack of competitive borrowing options and a lower rate of change upward on deposit costs relative the upward migration of the Fed Funds rate (i.e lower deposit betas).   As evidence of that FBP’s NIM is 4.73% which is ~ 100 bps higher then mainland peers. In addition, core deposit costs are up only marginally at FBP over the past couple years vs much higher deposits betas at mainland banks during this latest Fed hike cycle.  As a result of some of these strong attributes, originally the PR banks traded at healthy multiples….but the financial crisis hit them very hard and the island has now been mired in a recession for the past 10+ years.

It’s important to note that FBP is a much different bank then it was immediately post crisis.  Here is the snapshot from the latest investor deck that illustrates the changes:

As you can see, NPAs are down significantly, capital is up significantly, deposit composition is much improved.  In addition, the loan book composition is drastically different today (higher risk construction loans for example are now non-existent, etc) and the book is very well “seasoned” i.e. far through the loss curves at this point given the lack of much growth over the past several years.  Despite all that, the recovery has been long as PR has never fully recovered (the economy has lagged the mainland recovery, unemployment has been structurally higher, population has seen some level of outmigration, and the PR fiscal situation has been problematic). As a result, the PR bank stocks for the better part of the last decade have traded at discounts.  Currently FBP trades at only ~ 1x TBV vs mainland peer average of 1.7x (a too heavy discount in my opinion).

The real opportunity came in the September of 2017 when Hurricane Maria hit the island hard (it was the most powerful storm to hit PR in nearly a century).  Category 4 winds and floods left millions of Puerto Rican citizens without electricity, food, or water. The entire island lost electricity and parts of the infrastructure that was already underinvested was destroyed.  The immediate fears for the banks were a) loss of revenue and increases in expenses related to Maria damage, b) the future impact on credit losses, c) longer term effects from slower economic activity, d) a substantial spike in economic value added population outmigration (white collar professionals, doctors, lawyers, etc).  One particular shortseller proposed that the dollar losses would so high that it would crush the banks reserves/capital, put an already weak economy into a deeper more/prolonged recession, and lead to a huge brain drain which would cripple the economy. As a result of the fear, FBP and BPOP sold off hard (down roughly 20-25% for two months post hurricane).  What the market in hindsight missed initially on the sell off was a) the level of homeowners and business interruption insurance present in the portfolio, b) the fact that most of the severe damage was in the more rural center parts of the island (an area without much lending exposure), c) the positive effects that post hurricane stimulus (insurance proceeds and federal aid) could have.  As the company’s started reporting earnings over the past year, they only took moderate initial reserves for credit losses, dismissed the notion of large outmigration as evidenced by their own employee counts (BPOP is a large employer on the island), saw a quicker than expected return of electricity, store openings, and cell phone service. This led to a recovery in the stocks, although BPOP for example is still only back to its pre-hurricane levels.

What’s emerged over the past year leading to where we are today is that the net effect of the stimulus measures have been and will be meaningfully beneficial.  Consider the following:

• The net amount of the stimulus of ~$80b equates to ~100% of PR GNP….as this will be released mostly over the next 4-5 years that’s an enormous 20% boost per year.

• The PR banks are currently seeing credit statistics (delinquencies and NPA migration) that are better than they were versus pre hurricane levels.

• More investment is coming to the island, with sales of repossessed assets exceeding appraised values.  This will facilitate NPA disposals. In addition, the island was recently designated an “opportunity zone” which should further bolster outside investment (investors can roll capital gains and invest tax free).

• The unemployment rate is at multi-decade lows –

• GNP forecasts have been revised upwards such that PR is now expected to grow faster than the US mainland for the next couple of years.  Total PR GNP growth through 2023 is expected to be +1.6%/year (including the -8% in 2017), which is far better than the -1.8% average annual GNP drop from 2008-2017.  

• Deposit growth at the banks has ramped as stimulus proceeds come in, bolstering AEAs and NII -

• New auto sales are up substantially Y/Y –

• Retail sale are up 16% YOY in 2018 versus pre storm levels to $23B

• Per BPOP management...”cement sales are at the highest levels in the past decade” and up 39% YOY as of October 2018

• Anecdotally, labor is tight with upward pressure on wages and difficulty finding workers (particularly construction)

Net/net the big stimulus package has now set the stage for a period of greater economic prosperity and growth.  This should translate into improving loan growth, better deposit flows, higher net interest income, lower credit losses, and higher earnings.  Consider the following “blue sky analysis” for FBP loan growth in PR –

These numbers are rough, but the analysis haircuts the total stimulus effectively by nearly half and then haircuts the existing loan penetration by another 33%.  The net of it, could be a few billion of loans to FBP over time, which is a > 30% increase to base case EPS currently. Said another way, it feels like relatively little positive stimulus effects are in EPS numbers (numbers have gone up on reduced credit losses and higher deposits realized so far which have led to higher AEA and NII dollars).  Obviously the higher topline trajectory embedded in these numbers would also be multiple enhancing.

In addition to the positive effects of the stimulus, FBP already has a substantial excess capital position.  See below –

With a starting point of 20%, FBP has as much as 1000% of cushion if it were to reach capital levels of its mainland peers.  At a 12% T1C ratio, FBP has 38% of its market cap in excess capital and nearly 50% of its cap in excess capital if it could reach its mainland peers at 10%.  To give a sense for how grossly overcapitalized FBP is, we can look at the results of the Fed’s own stress test. Using highly drastic assumptions that are worse than the 2008 financial crisis (PR unemployment rate of 18.6%, -10% real GNP growth, -20% home price declines), these are the results -

So as you can see, assuming worse macro variables then experienced in the GFC, FBP’s T1C% bottoms out at 13% and so FBP would still have nearly 2x the capital it would need to be well capitalized and still have 3%+ more capital than peer banks today currently have (10% on average).  In addition, FBP has another 2.3% of capital as a starting point versus when this test was last run. While the release of this capital would take time (via dividends and buybacks), I think it’s more likely FBP is able to release it via accretive M&A (discussed more below).

FBP also has a valuable Florida franchise that seems unaccounted for in the stock price.  Florida accounts for ~20% of FBPs loans and has demonstrated good growth over the past several years, growth which is likely to continue to be strong due to favorable FL demographics (no income tax, baby boomers, etc).   Assuming the capital in the Florida bank at the same 20% of total ratio as loans, and putting a peer mainland 1.75x TBV multiple, it’s likely FL itself is worth ~$3 to FBP. Backing out the excess capital (assuming 12% is needed rather than 20%) and the value of the Florida stake, it implies you are creating FBP’s core PR operations at only .7x TBV or ~ 4x EPS which are truly distressed levels.  See below –

FBP has also been making significant progress in disposal of its NPAs which increases balance sheet quality and reduces provisions (see chart below).  As you can see this past quarter they reduced NPAs Q/Q by around $100m to 4.3% of assets, the lowest level in a decade. They have been aggressively moving NPAs to held for sale to speed up the process.  I believe this is important because the level of NPAs/assets is a key metric regulators will focus on before they will greenlight any strong capital actions. My guess is another $100m reduction or so (~3% NPAs), would be a good level for FBP to be able to utilize its capital.  Fortunately they have been able to dispose of assets near their marks of 50% of UPB as well.

In combination with the increased trajectory of NPA dispositions to a level where capital return is more aggressively allowed, the struggles of the competing banks (losing market share and subscale), FBP’s sizeable capital position, and FBP’s own improved prospects (due to the improving economy), I think it’s more likely than not that FBP could do one or more acquisitions within the next year. This is where things should get exciting, b/c it will enable FBP to utilize its capital accretively but also given 50-70% branch overlap of the two other banks, cost synergies should be sizeable.  There are a lot of unknowns (lot of guesses in here) but I assume Santander is doing a near 1% ROA currently and roughly 50% of the cost base could be taken out in a deal and that FBP pays 1x BV. This would be a rough stab at potential accretion –

As you can see the EPS accretion is huge, moreover FBP could still have a decent excess capital position post deal.  

To summarize the positives:

• The stimulus has created a positive economic backdrop which will lead to better than expected balance sheet growth and EPS.

• BPOP is the price setter in the PR deposit market.  Because of their low loan/deposit ratio (67%), deposit betas will remain low on the island, benefitting FBP’s NIM%.

• The credit book is seasoned after a period of low lending growth.  NPAs are getting sold more rapidly and near current marks.

• FBP has ~40% of its market cap in “cash” or excess capital.

• There is some likelihood FBP can buy one or more competitors accretively.

• Despite all this the stock trades at a 40% discount on a TBV basis at 1x TBV and at 7.8x EPS (adjusted for excess cap) or a 30% discount to group.  Creating core PR ops ex FL and capital at < 5x EPS.

Other notes –

• DTA could come back – FBP has ~ $0.65c/share in net DTA which can be recaptured based on better than expected earnings or a deal.  This would increase TBV by the $0.65c, or an 8% increase.

• Very small direct lending exposure to the PR government – as of 9/30/18 FBP has $221m or < 2% of assets in PR govt related securities and loans.  The vast majority of this is municipal exposure backed by the full tax ability of the municipalities.

Valuation –

Assuming modest EPS upside to 75-80c in 19/20 plus credit for excess cap at a 12% T1C level, at a peer 11x EPS multiple, gets you ~ 35% upside.  At that level FBP would still be trading at only 1.3x TBV or a 25% discount to peers.

In a more aggressive scenario where they could buyback stock and improve ROE and EPS, FBP would do a 13-17% ROE and trade at 1.5-1.8x TBV or 40-70% up -

More likely is that they do a deal which could peg PF EPS near $1.15 which at 11x stock plus smaller excess cap would be $14-$15.

Catalysts –

• Continued deposit/loan growth

• Stimulus proceeds

• Restructuring of govt debt

• Consolidation

Catalyst

·         Continued deposit/loan growth

·         Stimulus proceeds

·         Restructuring of govt debt

·         Consolidation