Should you buy a stock solely based on the reason that it is cheap? I hope your answer is No to this one as a stock usually becomes cheap for a good reason and though there are opportunities where you can separate wheat from the chaff, I think First Bancorp (FBP) does not fall into this category of a compelling opportunity - or at least not yet. Please note that this write up is not intended to be a short idea for FBP but rather should serve as an observation that worst is not over for the bank. First Bancorp referred to as "First bank" or "the bank" in this article is the second largest regional bank in Puerto Rico. Its stock is trading around $4.80 as of this writing. Now it might make you to nauseate to read this but the bank had traded above $200 around April 2007 timeframe. Just because something is cheap, does not mean that it is necessarily a good investment and we are going to discuss the merits of this argument as it relates to First bank.
The bank's primary lending area is Puerto Rico (85%) but the bank also lends in some areas of the US, principally in the state of Florida (about 9%). As of September 30, 2013, the bank had $326.7 million outstanding in credit facilities granted to the Puerto Rico government, its municipalities and public corporations, compared to $158.4 million as of December 31, 2012. Moody's Investors Service downgraded Puerto Rico's general obligation debt rating to junk status on Feb. 07, 2014, days after S&P made the same move on the island commonwealth's debt. This is definitely not good news for the government as its debt costs would escalate only exacerbating the problem of general economic recovery. However the Puerto Rico officials struck a defiant tone after Moody's downgrade saying that they strongly disagreed with the rating agency. Investors should take some comfort in the fact that PR's (Puerto Rico) bonds have changed little since S&P and Moody's downgrades. Some funds that are mandated to hold investment grade bonds would of course be forced to sell out of PR's bonds adding some downward price pressure.
Combine all above with a barrage of bad loans the bank has on its books (about $1B in non-performing loans as of this writing) and you have a recipe for disaster. The bank has about $900 million dollars' worth of Repurchase agreements (also called Repos) with the following banks: Citi group, JP Morgan, Morgan Stanley and Credit Suisse First Boston. Though Repos are not bad in themselves, an important thing to note is that all of these agreements are callable at the option of these counterparties. What this means is that if all counterparties panic at the same time and ask for their money back, the bank might find itself in a precarious position. In such a scenario, the bank might have to sell these at a great loss.
In all fairness, let's look at some positives that the bank reported in its 2013 highlights.
- NPA (non-performing assets) down $513M (though $1B are still lurking in the background)
- Fiscal 2013 loss of "only $164.5 million" (Is path to riches losing less money?)
- Core deposits increased by $248 million, up 4% (Good thing)
- Reduced reliance on brokered CDs by $233 million (i.e. from approx. $3.4B to $3.1B; so how long would it take to get rid of the remaining $3.1B)
- New loan originations up $600 million from last year (total interest earning assets actually decreased from $12.5B in 2012 to $12.3B in 2013)
I have highlighted all above from Q4, 2013 company presentation (comments are mine in brackets). As you can see above, the bank is touting only few good things without providing the full picture (e.g. saying that they reduced brokered CD reliance by $233, without highlighting that $3.1B of CDs still remain etc). For exactly this reason, I have a problem when analysts tout something taken directly from the company's presentations but not correlating all information with 10Ks, 10Qs etc. That's the place where you are going to find the "skeletons" lurking in the background. I can tell you this much that you can lose your job as an analyst at "Netwall Investments" (our money management firm) for deriving your investment thesis solely from company presentations. The company presentations are essentially marketing material intended to highlight only positives and generally keep quiet about negatives unless it is some kind of a big blow up or something. Yes it's OK to roughly browse through company presentations to get a quick look at what company has to say, but you cannot (should not) reach conclusions based on these presentations alone. That's why legendary investors such as Warren Buffett and Marty Whitman always emphasize in their writings the importance of reading company's annual reports. (Our favorite foot-notes are those with thinnest fonts that almost require a magnifying glass to read)
Now let's keep on going with some other obligations that bank has on its books. The bank has issued debentures totaling about $232 million maturing in 2034 and paying a floating rate of 2.75% over 3-month LIBOR average. As of September 30, 2013, the Corporation has five outstanding series of nonconvertible non-cumulative preferred stock: 7.125% non-cumulative perpetual monthly income preferred stock, Series A; 8.35% non-cumulative perpetual monthly income preferred stock, Series B; 7.40% non-cumulative perpetual monthly income preferred stock, Series C; 7.25% non-cumulative perpetual monthly income preferred stock, Series D; and 7.00% non-cumulative perpetual monthly income preferred stock, Series E. The liquidation value per share is $25. My point to make you aware of this is that the issuance of so much preferred is way too excessive for a relatively small bank like First Bancorp
The following table presents the estimated fair value and carrying value of financial instruments as of September 30, 2013
Most recently the First bank has lost a court battle with Barclay's relating to Lehman Brother's swap agreements dating back to 2007-2008 time-frame. Although First bank is appealing the case but it seems that it is going to lose it causing damage of about $66 million to the shareholder equity. Here is what management has said in the most recent 10Q's.
"Because of the Bankruptcy Court's May 10, 2013 decision, the Corporation has determined that it is probable that the asset has been impaired and recognized in the second quarter of 2013 a non-cash charge of $66.6 million associated with the write-off of the carrying value of the pledged securities and related accrued interest. The Corporation does not anticipate that this impairment charge will result in future cash expenditures by the Corporation other than additional costs relating to the appeal of the Bankruptcy Court's decision."
This also causes me to question management's judgment as to why they are prolonging the case (and hence incurring additional legal expenses) if they are reasonably sure that they are going to lose the case anyway. Is ego overruling sanity?
The bank still has a quite high exposure to commercial and consumer loans and earns majority of its interest income from these types of loans. We don't know how disciplined lending standards have become for First bank post financial crisis but with general economy in turmoil, investors should look out for future surprises. When the bank says that NPA (non-performing assets) are down $513 million, it fails to mention that it still has $1B to go. How long would it take to wind that down, perhaps a couple of more years if the bank keeps current pace - only if there is no more bad news in regards to the loans that are current. This is another risk factor a prudent investor to look out for when investing in FBP.
If you compare the bank to its peers on the island, it does not appear to be the cheapest. For example (see table below), the bank is not a great bargain based on either P/E or P/B as compared to two other relevant banks. This is not to mention that there are many much bigger banks doing business in Puerto Rico such as Banco Santander Puerto Rico, Citibank National Association, Scotiabank de Puerto Rico, which would present additional competition and headwinds for these regional banks.
So what model should you use to arrive at the fair value? Dividends are neither paid from our bank nor from the peers so dividend discount model is irrelevant. The bank does not look cheap using any metric that could be utilized to value a bank. Both Banco Popular (BPOP) and Doral Bank (DRL) are cheaper on P/B basis alone. There have been few recent articles on SA that tout how cheap the bank is with a buy recommendation at current levels. So what should you do? Just rely on management's best judgment to make things right in the future or wait for the things to get better in Puerto Rico's economy? The truth of the matter is that the facts still remain murky and thus investing in FBP a tricky decision. If you invest in FBP today, it would be more of a leap of faith than an informed decision, in my opinion.
Although First bank has made some good moves towards improving its financial affairs, it remains a far off from becoming a well-run and profit generating institution. In all fairness, management can be credited for making improvements but there are still many unknowns both at micro and macro levels since not only the bank is mired into problems of its own but in addition must deal with problems of Puerto Rico where bulk of its business is based in. In my opinion, the dust has not settled yet in order to make informed decision regarding this investment. True there are some well-known investors (including Howard Marks of Oaktree Capital, who I personally respect and admire) has bought large stakes in this bank but it might be too early to jump into the bandwagon.
So what should investors do? I would wait on the sidelines but keep an eye on how the bank performs in 2014 and also see if the bank truly is headed in the right direction while management maintains its discipline in cleaning up toxic assets and improving its capital structure. In parallel, I would watch Puerto Rico's economy and would look out for some real signs of economic recovery. True that stock might have had a slight run-up before you make your buying decision, but at least you would be making a more informed decision than shooting in the dark and not relying on luck alone to bail you out.
Notes & Disclosures:
This is not an investment advice. Please perform your own due diligence before making an investment.
This article was written by "Syed Saqib," a portfolio manager at Netwall Investments LLC. I don't intend to portray that Netwall Investments LLC is either invested in above securities or going to invest in the future. Investing or not investing in any security is solely upon our discretion and it can change without notice. Furthermore, we can get out of a position at any time as we deem fit. This is our foremost fiduciary duty to our clients who have invested their capital with us.