Investment Thesis                                                                                                                                                                        

I propose a long position in the common stock of Popular, Inc. (BPOP, "Popular" or the "Company") as recent transactions have obscured underlying fundamentals, negative sentiment toward its core market is over-hyped, sell-side coverage is sparse and consequently presents an opportunity to invest in a sound banking franchise at a substantial discount to intrinsic value. In addition, BPOP is a well-capitalized bank with dominant market share, preferred relationships with regulators, an underappreciated subsidiary and strong earnings power potential yet currently trades at 80% of pro forma TBV and 4.6x normalized earnings. Those that can look beyond the obscurity of these current transactions are presented with a risk-reward profile that is asymmetrically skewed to the upside.

Catalysts

Nearer term catalysts to value realization include: 1) the illumination of transaction terms and accounting marks that will provide clarity and generate investor interest (Oriental hosted an investor call on 5/21 discussing its FDIC acquisition of Eurobank, Popular will likely follow); 2) a gain on tangible book from the Westernbank acquisition due to negative goodwill from assets purchases below fair value; 3) increased bank size will attract additional sell-side coverage - PR banks are somewhat neglected, most analysts that cover the space only initiated in the last two months; and 4) demonstrated rationalization of the PR banking market.

Situation Background    

Puerto Rico entered the recession earlier and experienced a more pronounced downturn than the US as a whole. This has led to a perception that it will be permanently plagued structurally and that sound banking cannot successfully take place in the region. One only need look at the successful banking franchises in the poorer areas of the mainland US to disprove this negative position. Further the assertion that fraud is more commonplace in PR banking is also overstated. There clearly were instances of inappropriate lending activity at R&G, but the overall severity and prevalence of these practices was no different than that of the US market as a whole.   

A weak PR economy, credit deterioration, low capital levels and need to raise capital were a drag on stock price through 2009. Since then the Company has successfully raised capital twice (most recently in April) and in a vote of confidence from the FDIC was selected to acquire Westernbank. This deal was one of the most telegraphed FDIC deals in a long time and consequently attracted lots of interest from event driven hedge funds. The deal was announced, the stock ran up and many seemed to have since gotten out. Technical selling pressure and a lack of clarity on fundamentals has kept the stock price depressed.                                                                            

Investment Merits

• Favorable Westernbank Acquisition: Popular's FDIC-assisted acquisition of Westernbank is a high ROIC, low risk transaction. There are a number of favorable qualities to the deal: 1) the FDIC will cover 80% of loan losses on the $8.5B portfolio it acquired resulting in 27% coverage on BPOP's pro forma loan book; 2) it is in-market and will likely result in >40% cost savings driving earnings, more rapidly back to normalized levels; 3) there is a high likelihood that the deal will create negative goodwill, providing a boost to TBV; and 4) it provides Popular with a dominant deposit market share of ~47% in PR. Overall Popular has emerged as a the clear winner in the ongoing rationalization of the PR market. Despite these factors the stock has sold off and the short ratio has escalated higher as limited disclosure has led to a confusion of uncertainty with risk.
• Strong Core Earnings Power & Market Position: Historically Popular has generated pre-tax, pre-provision returns on assets of ~2% and in the last quarter (1Q'10) recorded $146M in PTPP earnings equating to an annualized ROA of 1.7%. This demonstrates the core earnings strength of the business despite the challenging operating environment. Once credit costs reverse and the Company can release reserves, it will benefit substantially. The acquisition of Westernbank enhances Popular's earnings and return potential significantly. The $2.5B in deposits assumed (none brokered) and $8.5B in loans will increase its deposit and loan share to close to 50% and 40%, respectively. The combined market share of the two institutions will exceed 50% in CRE (56.0%), small C&I loans (49.1%), and medium C&I loans (57.7%). These levels of concentration and anti-trust leniency would be unattainable in any other market environment.
• BPOP is not only the largest bank, but one of the largest and most significant companies across all industries in Puerto Rico. The Company will employee over 10k people once the Westernbank acquisition is complete, making it one of the biggest employers on the island. Given these factors it is likely that the Company will be treated advantageously by regulators/ politicians. So far FDIC intervention in PR has been coordinated and supportive toward BPOP. The FDIC has been aggressively making public service announcement about deposit insurance and have uniformly stepped up to support struggling institutions. The downturn itself increased the onus for bank consolidation and overhaul. Though painful in the short-term this has driven undisciplined lenders and those offering high yield deposits out of the market and will place survivors like Popular in a position of strength once the dust settles.
• EVERTEC Hidden Asset: The IT processing subsidiary, EVERTEC, generated $257M in revenue on an earnings margin of 20% in 2009. With a three-year CAGR in earnings of 25% this unit could be valued at $750M-1B if sold versus $246M as it is currently reported on the balance sheet. Peers include HPY, GPN and CATM. This is somewhat of a free option that could provide a significant source of liquidity. The Company has indicated it is in the process of selling this business.
• Sound Capital Position: BPOP is well capitalized on the basis of the three primary measures and has a cushion large enough to meet regulatory tests even at the proposed higher levels through the credit cycle without the need to raise additional capital. With a loan/ deposit ratio of 91%, BPOP has solid deposit coverage and is toward the lower end of leverage levels relative to its local peers. 
  

• Appealing Deposit Composition & Non-Interest Revenue: Core transaction deposits represent 56.1% of total deposits while brokered time represent only 9% of total (only bank other than Santander and Coop that has >50% of its deposits are core). This mix has improved over the last year and will continue to improve once the Westernbank deposits are assumed (none brokered). The Company also has a $20B mortgage servicing platform and has been consistently growing total non-interest income to ~$900M in 2009. This helps provide a more stable and diversified revenue stream. (See appendix for further detail.)

Valuation

The size, complexity and limited disclosure surrounding the recently announced acquisition of Westernbank have obscured Popular's financials. Lack of detailed fundamental information has created a degree of aversion to the Company. These dynamics present an opportunity to buy a sound franchise at a substantial discount. Further, Popular's dominant market position will enable it to more efficiently gather deposits and underwrite loans. The stock will rise once these elements are more fully appreciated by the market, once the Company provides further disclosure and fundamentals become clearer. The Company is currently trading at 4.6x normalized earnings, 72% of pro forma TBV and 68% of my 2011E TBV. If a mid-cycle EPS multiple of 10x is ascribed the implied price is $5.50 per share and if you assume a higher multiple of 14x then the share price is $7.50. If these share prices are reached by 2012 as investors refocus on earnings rather than TBV, the implied IRR is 50-55%. I believe neither the bonds at par (<8% YTM) nor the TRUPs at 72 (illiquid) are very interesting at current levels.

Popular's strong capital and loss reserve levels, EVERTEC asset and potentially negative goodwill provide downside protection. In the event that credit challenges increase from existing levels and persist there is still an equity cushion. As depicted in the book run-off scenario below, current valuations are still less than 100% of 2011 downside TBV.

Investment Considerations & Risks 

• Loan Portfolio Composition: 64% of BPOP's loans are associated with Puerto Rico with the rest with the mainland. Conventional mortgages and consumer loans account for 40% of its book and commercial RE contributes 34%. While only contributing to 7% of loans, construction has accounted for ~25% of losses. On a pro forma basis 27% of Popular's loans will be guaranteed by the FDIC. A high relative portion of commercial real estate loans is something that would ordinarily enable Popular to command a higher multiple, but is serving as a weight on the stock price in the current market. Once credit costs normalize this perceived burden will dissipate.
• Credit Quality: BPOP's loan book is pretty messy. NPAs have been comparable between the PR and mainland segments at 11%, but charge-offs on the mainland have been noticeably higher at 7% versus 4% for PR. Credit quality has stabilized in the recent quarter with NPLs declining 20bps to 10.6% of loans. Despite this, management has indicated that it believes its loan portfolio will continue to deteriorate with NPAs remaining at the elevated 10-11% level given the weakness in the Puerto Rican market. The Company likely has ample loss coverage with a reserve to NCOs ratio of 5.7x and provisions to NCOs averaging over 120% in the last year.

• Local Market Dynamics: Overcapacity in the PR banking market caused widespread loan mis-pricing and financial trouble across the area. In March three of the top ten banks were under cease and desist orders from the FDIC (Westernbank, R&G and EuroBancshares). Turmoil has been a catalyst for a much needed rationalization of the market. This has played out through FDIC-assisted consolidation with BPOP acquiring Westernbank, Oriental acquiring Eurobank and Scotiabank acquiring R&G. Santander has indicated it will seek to focus its efforts in the Americas on Brazil, likely resulting in its departure from the island (10% deposit share). The bank with the #2 deposit share, First Bancorp, is experiencing severe challenges relating to its loan book in Florida and will also be divesting of branches and selling in the next several months. These factors will improve Puerto Rico's operating environment for BPOP.
• As on the mainland, this time of turmoil has resulted in DoJ leniency on anti-trust - enabling the Company to expand beyond its normally permissible market share concentration. Additionally, in 4Q'09 the Treasury agreed to convert its $935M TARP investment to tier 1 qualifying TRUPs to bolster Popular's capital ratios. This unique support (Citi is the only comparable example I could find) paved the way for the Company's subsequent roll-up. By granting Westernbank to BPOP, the FDIC has indicated it prefers to support the largest players rather than prop-up the weak.
• Puerto Rico Macro Factors: Puerto Rico is a commonwealth of the US with a population of 4M. Puerto Ricans are US citizens and primarily live under US banking laws and regulations. PR has been in a recession since 2006, the catalyst for which was a politically motivated labor shutdown for half a month. The island went into the global recession in a position of weakness and as a result was particularly hard hit (40% of economic activity comes from manufacturing and 70% of those good are exported to the US mainland). Additionally, over the last several years a large amount of manufacturing plants have closed as tax incentives were repealed. The current unemployment rate in PR is 15%, placing it alongside Mississippi as the poorest labor markets in the US. Economic forecasts for 2010 are mixed with a bias toward continued weakness, however, consensus estimates are forecasting a recovery in 2011. This said, PR's Economic Activity Index made its first sequential increase since the onset of the recession in April. Puerto Rico has been designated to receive $6B in federal stimulus funds ($1.8B in 2009, $2.5B in 2010 and the remainder in 2011).
• Government spending reductions and tax revenues make PR a likely candidate to receive an upgrading of its municipal bond status to investment grade. Tourism to the island has historically been relatively modest, accounting for ~10% of GNP. Recent openings of hotels by major operators along with expansion of the San Juan convention center and renewed focus on this segment by the government should benefit local commerce. There are also a number of favorable demographic/ market dynamics in Puerto Rico: 1) it has a more rapid birth and family formation rate, so demand for homes and mortgages should increase faster than other regions; 2) over 80% of Puerto Ricans do not have a mortgage and utilize bank services at rates similar to those of emerging markets, presenting opportunity for increased lending and bank cost savings; 3) higher delinquency rates are offset by lower LTVs, resulting in better cure rates and lower loss severities (subprime lending never came about in PR).
• Management: CEO Richard Carrion has over 25 years of banking experience in the Puerto Rican market. The concessions regulators have made to Popular demonstrate the confidence they have in management. The executive overseeing the mainland efforts was recently terminated. A successor has yet to be announced.
• Debt Maturities: $178M in borrowings is coming due in 3Q'11 and $374M in 2012. Should the Company not be able to refinance, it could raise capital by selling EVERTEC. In 1Q'10 the Company was able to successfully extend the maturities of $100M in term debt out a year showing it has the ability to access credit when necessary. TARP dividends increase from 5% to 9% in 12/13, so BPOP will likely seek to paydown or replace this $935M indenture before that time. In May S&P raised Popular's credit rating to 'B' with 'positive outlook.'
• Regulatory Changes: Potential legislation requiring an 8% Tier 1 common ratio (versus 13.8% today). This would cause many bankers to become 'not well capitalized' thus adding additional stress to the system. Given this I don't think such rules will be instituted until the market improves or if they are enacted banks will have lengthy cure periods.

Company & Situation Overview 

With $43B in pro forma assets, BPOP has been the largest bank in Puerto Rico for over 100 years. The Company operates 187 branches in Puerto Rico, 8 in the Virgin Islands, and in the US mainland: 41 in New York/New Jersey, 24 in California, 20 in Florida and 16 in Chicago. Within its non-Puerto Rico markets, the Company targets area with high concentrations of Puerto Rican decedents (currently 4M in the US). Popular acquired the second largest bank in PR, BanPonce, in 1990 and became the dominant depository institution on the island. Facing fewer growth opportunities in its local market, the Company looked to the mainland US. These subsequent expansion efforts were disastrous resulting in $2.1B in losses from 2007-2009, primarily from sub-prime loans in its E-LOAN segment. BPOP has since divested of much of its mainland operations (assets down 50%, 40 branches closed) and has refocused on its core market. The Company has remained profitable in Puerto Rico throughout the downturn. Losses forced a large common for preferred stock exchange in 3Q'09 that raised its TCE/TA ratio to 5.8% from 2.1%. Though this bolstered its capital ratio, it also resulted in ownership dilution of 56% for common share holders. The Company also raised $1.15B in preferred securities in April to support its roll-up plans.