Description

BPOP trades at 0.8x tangible book and 4.7x normalized earnings power, despite a Tier 1 common ratio of 6.9%, a Tier 1 ratio of 10.2%, and a reserve/loan ratio of 4.9%.  This is despite the fact that the company has already charged off nearly half of its (estimated losses) and, very importantly, remains one of the only viable entities that the FDIC will allow to consolidate other troubled banks in Puerto Rico.  We believe BPOP is cheap, has enough capital to make it through the cycle (and if it doesn't will have the ability to raise capital without meaningful dilution), and embeds a free call option on one or more highly accretive FDIC-assisted transactions during the next 3-6 months which could dramatically improve the company's earnings power.  We believe BPOP offers nearly a 100% return over the next two years, before the benefit of FDIC deals.

BPOP is the largest bank in Puerto Rico with $36b in total assets.  The Company has a Puerto Rican banking operation, a US banking operation (mostly targeting Hispanics) which they are restructuring/de-emphasizing, and a processing (ATM/switching) business.  The core Puerto Rican bank has a commanding presence and market share.  As of q2, in Puerto Rico BPOP has 16b in loans (23% market share) and 18.4b in deposits (37% market share ex brokered deposits).  The Puerto Rican subsidiary has 179 branches in Puerto Rico and 8 in the Virgin Islands.  The processing business, named Evertec, processes over 1.1b annual transactions at 95k+ point of sale locations in PR, US and other LATAM, and did 262m in revenue and a 21% ROE in 2008.

Recent capital actions

BPOP recently completed a large exchange offer which dramatically enhanced its capital ratios.  Specifically the company exchanged common for a variety of DRD preferreds and Trust preferreds at discounts to par, ultimately issuing 357m shares and retiring ~$930m in preferreds/trups.  In addition, the US Treasury exchanged its TARP investment in BPOP of $935m for the same par amount of newly issued TRUP securities which also pay a 5% coupon.  The difference between the carrying value of the TARP investment and the fair value of the TRUPS resulted in a $485 gain to shareholder equity (and to common capital ratios). The net effect of these transactions was a near 3x increase the company's tangible common equity from $760m to $2b and a similar increase in its Tier 1 common ratio from 2.5% to 6.9%.

As a result of these transactions, BPOP went from a capital short death spiral stock to an event long favorite, and has rebounded from a low of $1 to its recent price of $2.53.  Several sells side firms upgraded the stock post capital actions (KBW, Sterne Agee) and I urge you to read their reports for an update/description of the business, etc. 

One particularly interesting aspect of the transaction with the US Treasury was unique. The only other bank I know of which has completed a similar conversion was Citi.  I believe this favorable treatment (government agreeing to convert TARP to TRUP generating a gain) was accorded to BPOP to enhance their strength and resultant ability to save the FDIC from future bank failures in PR by enabling BPOP to roll up other struggling institutions.

Earnings power/valuation

Over that past several quarters, BPOP's pretax pre provision income has averaged around $650m annualized.  PTPP has been pressured by declining NIM due to accelerating NPAs, and competition for deposits by weaker banks.  Managent believes as NPAs revert to more normal levels, deposit competition lessens as weaker banks close, and new loans are originated at wide spreads NIM will revert back to the ~400bps+ level.  Note NIM has appeared to have bottomed in q109 at 306 bps and has rebounded to 330 bps in q309.  Before the real estate boom and resultant loan pricing pressure began the last few years, BPOP's NIM was comfortably over 4% from 1999 through 2004.

On loss content, management believes BPOP will stabilize in a band of 100-125 bps as a % of loans, as the credit cycle normalizes.  I would note that this is above the 100 bps average range from 1999-2002, and above the abnormally low ranges of 60-70bps seen from 2003-2006. 

There are two "below the line" adjustments in my example below for the Treasury TRUP dividend and the accretion of the discount for the TARP to TRUP conversion (which accretes to par over many years).  These will both likely appear on the income statement thru NII.

BPOP's normalized earnings of 55c translates to only a 95bps ROA which is below mid-cycle industry medians. 

Based on these assumptions, BPOP trades at 4.6x "normalized earnings".  The regional bank peer group trades between 6-8x "normalized".  At a sub 5x PE BPOP seems cheap on an absolute basis and relatively cheap versus other regionals.  We believe over the next 2 years as NCO's decline, reserves decline, and NIM expands, BPOP will migrate toward a 10x P/E and a stock price of $5.50 offering > 100% return. 

Losses/Capital

The following is an estimated breakdown of BPOP's loan book at the beginning of the cycle (q108).  As you can see construction has been a sore spot due to extremely high severities.  I estimate BPOP will incur close to 1,200 bps of loss on their book as they migrate through the cycle between now and the next two years.  This will translate into cumulative losses of approximately $3.2b.  Note my assumptions are ahead of management's own forecasts and more stressful than the government's SCAP test.  While this is a staggering amount of loss, BPOP over the last seven quarters has already charged off 480bps or 42% of estimated losses.  In addition they have grown reserves to nearly 500bps of loans which I believe can migrate to a more normal 300bps as the credit cycle matures/reverses.

Through a combination of existing capital, PTPP generation, reserve bleeds less remaining losses, it seems unlikely to me that BPOP will need to raise incremental capital.  If we stress their remainder loss and assume it happens over the next year (unlikely given construction has already been mostly charged off and CRE is later cycle), BPOP's Tier 1 common ratio should hover ~ 450 bps in a worse case, and they may have to raise an insignificant amount of common.  Again this assumes remaining losses happen all over the course of the next year (unlikely), PTPP doesn't expand but only stays at recent run-rate, and that they require a 4.75% tier 1 common minimum.  In the more likely scenario that losses occur over the next two years, BPOP should be fine on capital with a Tier 1 common ratio of 6.60%.   

In addition, before resorting to trying to raise capital at distressed levels BPOP has a few other options.  The company still has close to $500m in TRUPS (ex govt) which it could tender for at a discount to par using stock.  More likely, BPOP can monetize its Evertec processing business which generates $40m of net income annually and at a modest 12x P/E could generate $300m of after tax gain (assuming tax basis of 0) to further bolster capital if need be.

One note on BPOP's deferred tax asset.  The company has fully reserved for its US DTA, and its Puerto Rican operations have made money through the cycle so BPOP will not need to write this down.

FDIC deals

BPOP is in a relatively good position to acquire other banks in FDIC assisted transactions.  BPOP already has a large market share in Puerto Rico, has strong capital ratios, and given the weak Puerto Rican economy (recession for several years, 16% unemployment) new entrants do not want to build a presence on the island. 

To see the power of FDIC assisted deals, look at the stock charts of EWBC and FFBC.  These were both up >50% immediately post deals.  The FDIC's motivation for assisted transactions is to prevent depositor loss and forced selling of assets by placing a bank with another well capitalized competitor.  This way the acquirer can work off the assets in an orderly fashion.  There are several accretive aspects to these transactions.  For one, the FDIC grants loss sharing agreement on acquired assets which cover substantially all losses.  Second, the risk weighting on the acquired assets is generally < 20%.  Third, there is often a gain at close which enhances the acquirers tangible book value due to the creation of negative goodwill (purchase of assets below fair value).

There are several troubled Puerto Rican assets BPOP could potentially acquire.  These include FBP, DRL, RGFC, and WHI.  If their respective stock charts don't tell their distressed story, RGFC as an example has negative TCE as of q2 and a 15% NPA/loan ratio.

The hypothetical example below illustrates what an FDIC assisted deal could look like for BPOP.  This assumes BPOP can earn a similar PTPP ROA%  to its current run rate on the acquired assets, the acquired assets have no losses due to the purchase accounting mark and loss share, and there is no gain generated on close.  As you can see, on a conservative assumption of only $5b of acquired assets, with or without maintaining similar capital levels the deal should be highly accretive. 

Risks

As I mentioned, the Puerto Rican economy has been in recession for several years and struggles with 16% unemployment.  First lien Mortgage NPAs are above 10% but loss content is < 100 bps.  There was no housing bubble in Puerto Rico, i.e. HPA was not significant.  Mortgage NPAs have traditionally  been elevated in PR but the lack of home equity products in PR and an undeveloped rental market will continue to keep losses relatively lower than NPAs would suggest.  In addition, I believe with a > $3b cumulative loss assumption I am adequately accounting for the loan book risk.  I think BPOP has enough capital to make it through.  Should normalized eps take longer to achieve, buying in at < 5x P/E still provides adequate upside if the $5.50 target takes longer to realize.

Catalyst

FDIC deal(s), credit improvement