Description

Long: Banco Popular (BPOP). 100%+ Upside.  If This Wasn’t Puerto Rico, Would These #’s Be Compelling?  

Thesis: I love this investment because it seems like a complicated mess, but it’s actually very simple – it’s cheap because no one wants to touch Puerto Rican exposed stocks.  But, BPOP is a bank that has ~45% market share, limited exposure to Puerto Rican gov’t bonds, and a significant amount of excess capital.  Plus, the stock (along with MBI, AGO, and others) faces technical pressure as it is used as a hedge for funds holding Puerto Rican gov’t debt.  BPOP is experienced managing a profitable bank in a poor PR economic environment – the island has struggled for nearly 10 years. Over the next few years, I expect to benefit from both a return on capital and return of capital, as they are able to deploy pent-up equity.  The process has begun as BPOP initiated a dividend in 3Q15 (2% yield).  And, in 4Q15, the North American sub sent $200m of capital to the holdco – a signal of future buybacks.    

This stock has been written up in the past on VIC, but I think it’s another good opportunity to buy.  You should consider reading the prior write-ups as well. 

BPOP trades at 0.60x tangible BV.  You might suggest that’s reasonable for a company that has earned a 7-8% ROE.  But, one of the reasons that ROE is depressed is because they are holding excess capital.  That’s prudent as the country works through its fiscal issues, but ultimately that capital should get returned to shareholders.  Let’s go through some quick math.  First, I’ll take GAAP equity and boil down to economic capital (what’s necessary to run the current business), then I’ll build back up to shareholder capital (what the company is worth to me):

• BPOP has $5b of common equity and $4b of Tier 1 Common (deferred tax assets and intangibles don’t count for regulatory capital).  Compared to BPOP’s risk-weighted-assets, the bank has a 16.2% common equity ratio.  Of the 50 largest banks, they rank #3.  A more reasonable equity ratio is ~12.5% (the top 50 average 11.5%).  That’s ~$1b of excess capital. 
• They also have a $545m DTA (they reversed a valuation allowance in 2Q15).  Let’s exclude that from economic capital too (since they can’t lend against a DTA). 
  • So, they need ~$3.5b of capital ($5b GAAP less $1b excess less $500m DTA) to operate.  Earnings the last two years have been ~$350m, so BPOP is actually earning a decent 10% return on its economic capital.  I’d say the operating business is worth 1 – 1.2x BV or $35 - $42.     
• I excluded the DTA, but it is worth something.  BPOP has ~$4b of NOL’s that were generated from sub-prime loans written in their US business. The US business currently earns ~$100m and these NOL’s expire over 18 years.  Using an 8% discount rate, these NOL’s are probably worth ~$3 per share. 
• BPOP also owns shares in Evertec (payment processing business) that is on its books for ~$1.50 per share less than its market value (including a charge for capital gains tax).  It also owns 15% of a Dominican Republic Bank (BHD Leon) – maybe worth another $1.  Now, I’m at $40 - $47. 
• Last, the $1b of excess capital.  That’s $10 per share if it were paid as a pure dividend (though it could get used to grow the business). The real kicker would be if they start to buy back shares at a low price. With a $1b buyback at $25, BPOP could reduce the share count by 39m shares and increase the fair value to $62-$74 per share. 

Other Considerations: 

• In BPOP’s DFAST June ‘15 stress test disclosure, it estimated that it would lose ~3% of capital in the adverse scenario provided by the Fed (house prices -10%, Unemployment 19% in PR, recession).  That’s slightly less than the excess capital I estimate they have (and they have ~$300m in excess reserves). 
• BPOP’s exposure to PR gov’t debt is minimal – nothing with central gov’t and only $60m with utilities.
• BPOP has a high non-performing asset ratio, but also has one of the highest reserve-to-loan ratios among the large banks.  Over the past three years, BPOP has provisioned 100m in excess of its charge-offs.  

Puerto Rico Economy

The general macro trends have been poor for the past 10 years, but the data has stabilized recently.  The population has declined from 3.72m people in 2010 (as of July 1) to 3.47m people as of 2015.  But, the labor force declined by just 67,000 people over the same time period.  And, over the past 15 months has increased by 32,000 people.  This has brought the unemployment rate down to 12.2% from 15-16% a few years ago. 

Home prices are down 17% from 2008, but were up 0.5% y/y in 3Q15.  And, the economic activity index has stabilized over the past 6 months after being down for most of the past few years. 

Plus, lower oil prices are a benefit to the economy because a majority of their electricity is generated from petroleum inputs.  As of October 2015, electricity prices were down 30% y/y. 

The bottom line is that although the economy isn’t strong, it isn’t completely faltering either and BPOP is capable of managing their business in this type of environment as they have never had an unprofitable year in Puerto Rico despite the poor economy.  

Catalyst

Buybacks below tangible book value.