Oriental Financial Group: Banking on Recovery

Sep.18.07 | About: OFG Bancorp (OFG)

If you have run a value-oriented stock screen lately, chances are the output was populated with bank stocks. Many issues are trading near 52-week (if not multi-year) lows and sporting enticing dividend yields in the 4% to 6% range. The question—always pertinent—is which issues are genuine value plays and which are bait for the dreaded value trap?

More are probably of the former than of the latter. The “great mortgage meltdown of 2007” has painted banks—particularly those that have ever originated, serviced or bought a mortgage—with the same broad black strokes of the American Home Mortgages (OTCPK:AHMIQ) and New Century Financials (NEWCQ.PK) of the world. (Note: A five-letter stock symbol ending in “Q” is never a good thing.)

But old-school banks, those that take deposits and make loans, are a different breed. Sure, many have mortgage-loan businesses, but they tend to be conservatively funded, relying more on passbook savings, CDs and checking accounts and less on volatile commercial paper, broker deposits and subordinated debt.

That’s not to say that the economic paradigm of borrowing at a short-term rate and lending at a longer-term rate isn’t without challenges; it is. Over the past two years, the yield curve has been flat or inverted, making it difficult to profitably borrow short and lend long.

Small banks have been hit particularly hard by the yield curve inversion, for the simple reason of their revenue stream and geography being generally less diversified than their money center brethren. Investors could reasonably play the eventual recovery with behemoths like Citigroup (NYSE: C), Wells Fargo & Company (NYSE: WFC) and Bank of America Corp. (NYSE: BAC), but the more remunerative opportunities reside with the small-fry. Why? Free markets are, to a large extent, self-correcting—the more spurned an industry or company, the higher the probability for future returns. Bad news depresses stock prices and lower prices set the potential for strong future returns.

Investors seeking a small-bank stock with a beaten-down stock price and potential for strong future returns need look no further than Puerto Rico’s Oriental (Eastern in Spanish) Financial Group Inc. (NYSE: OFG), which specializes in retail and small business banking services through its network of 25 branches.

And, boy, has Oriental been beaten down. Over the past two years, its market value has been sliced by 67% to today’s $245 million. Like most small banks, Oriental has been squeezed by rising short-term rates and mortgage-market turmoil. A stagnating economy hasn’t helped, either. Puerto Rico's gross domestic product is forecasted to grow 1.4% this year, with the rate dropping to 0.8% in 2008.

Guilt by association has only exacerbated matters. A close competitor, Doral Financial (NYSE: DRL), had its stock decimated last year in the wake of a multiyear restatement that sliced $694.4 million off retained earnings. (Doral recently had to implement a 1-for-20 reverse stock split to circumvent de-listing.)

Fortunately, Oriental is no Doral. The former is very well capitalized, at least according to the Federal Deposit Insurance Corp. [FDIC], which defines well capitalized as a total risk-based capital ratio of at least 10% and a tier 1 risk-based capital ratio of at least 6%. Oriental’s ratios are 19.8% and 19.3%, respectively.

Resting on solid capital structure and waiting for a macroeconomic turnaround would be the laziest of strategies, but Oriental’s management is anything but lazy. Over the past nine months, Oriental has sold $865 million of lower-yielding securities and purchased $1.76 billion of higher-yielding securities, restructured $1.9 billion of short-term borrowing and retired $36 million of high-cost subordinated notes.

The result to date: significantly improved interest income and net earnings. Indeed, net interest income jumped 65.2% to $17.7 million in the second quarter of 2007 compared to the same 2006 quarter, while net income soared nearly 400% to $5.25 million, from $1.32 million.

The improvement is barely reflected in Oriental’s stock price, which suffers from the same pathogen afflicting many small-cap stocks: lack of visibility. Whereas Citigroup’s coverage could be compared to Britney Spears (25 analysts parse and vet Citigroup’s financials), Oriental’s coverage could be compared to William Hung. Only two analysts follow Oriental. Both are from off-Wall Street boutique firms and neither is exactly beating Oriental’s drums. Keefe Bruyette & Woods analyst Bain Slack offered the most contemporary opinion in May, reiterating his "market perform” opinion, with a price target of $12 based on EPS estimates of $0.70 for 2007 and $0.80 for 2008. Soleil Securities Group analyst Anthony Polini initiated coverage 10 months ago with a “hold” and a 2007 EPS target of $0.12. (Unless the wheels fall off in Q3 and Q4, he is going to look silly: Oriental has already earned $0.25 through June.) Polini hasn’t said much since.

At a current price of around $10.00, Oriental’s stock appears to have sufficient price support. The $0.56 annual dividend translates into a 5.6% yield. The price is further buttressed by management’s recent decision to spend another $15 million on stock repurchases, doubling the current buyback program.

Of course, no investment is without risk and risk at Oriental is unmitigated nonperforming-loan growth. On that front, the trend has been discouraging. Through June 2007, non-performing loans were $50.1 million (3.9% of total loans), compared with $43.9 million (3.5%) on March 31, 2007, and $29.4 million (2.5%) on June 30, 2006. The difference is essentially all composed of non-performing residential mortgage loans.

Management says that the increase is unlikely to translate into significantly higher losses “as these loans are generally well collateralized with adequate loan-to-value ratios.” Maybe, but discretion, being the better part of valor, says to keep a sharp eye on the trend anyway.