Puerto Rico's largest bank, Popular (NASDAQ:BPOP), certainly earned its seat at the table with other seriously distressed banks like Doral (NYSE:DRL), Bank of America (NYSE:BAC), and Synovus (NYSE:SNV). This bank's non-performing loan ratio topped out at over 10% at one point, with bad construction loans making up almost a third of bad loans (despite being less than 10% of the loan book).
Like other distressed banks, Popular took advantage of the government's largesse (including TARP) to get its affairs back in order. Bad credit inflows have improved significantly and the bank continues to sport a relatively high net interest margin and a surprisingly competitive efficiency ratio. That has helped the bank join in with those other distressed peers in a fairly solid recovery trade.
The question is, "now what?" Popular has maintained a significant lead on other Puerto Rican banks like First Bancorp (NYSE:FBP) and Doral, not to mention the PR operations of larger banks like Citi (NYSE:C), Santander (NYSE:SAN), and Scotiabank (NYSE:BNS), and though the company's mainland operations lack scale, the opportunities to grow by targeting the Hispanic community are not trivial. The iffy state of the Puerto Rican economy certainly does not help matters, but it would seem that these shares remain undervalued on the basis of the bank's long-term earnings potential.
Still A Dominant Franchise On Its Home Turf
Throughout this mess, weaker banks like Bank of America, Regions (NYSE:RF), and Zions (NASDAQ:ZION) have found themselves put in the position of unwilling market share "donor", as these businesses had to cut back and retrench at a time when other, stronger, banks could acquire and build in their key markets - as seen, for instance, in the amount of mortgage market share BofA has lost.
That does not appear to have happened with Popular. This bank was the leader in most lines of banking business in PR before the crisis, and they remain so afterward. Popular holds about 40% deposit share in the territory, as well as 40% commercial lending share, 30% mortgage share, and 50% credit card share. The only major area they don't lead is auto loans, where First Bancorp holds about one-quarter of the market and about 1000bp more share than Popular.
Puerto Rico is often an afterthought to many Americans, and although the territory has had very real economic challenges, its GDP still larger than 17 U.S. states with a population that would place it at number 29 (between Oklahoma and Connecticut) if it were a state. I mention this because I have read investors scoff at the idea that being the largest bank in PR is worth something, even though I don't see similar dismissals of the value of BOK Financial's (NASDAQ:BOKF) franchise in Oklahoma or Regions' across the Southeast U.S., even though neither have anything close to Popular's market share.
Is Growth On The Mainland A Priority?
While Popular is a major force in its home market, the bank's influence in other markets is far less significant. The company has almost 100 branches outside of Puerto Rico, but aside from the Virgin Islands (which the company effectively splits with First Bancorp), the bank's deposit share is less than 0.4%.
I would not write off the possibility of bigger and better things down the road. Popular's branches are located in New York, California, Florida, Illinois, and New Jersey, all of which are home to significant Hispanic populations that the bank could target as a source of organic growth. I don't mean to suggest that Popular can only succeed with a segmentation strategy, but it can serve as a gateway or foothold that the company can later use to lever into a bigger market presence.
That said, the U.S. operations need work. Prior to the banking crisis, Popular essentially used its PR deposit base to underwrite loans on the mainland and these loans were not only close to 50% of the loan book, but a disproportionate share of bad loans as well. One of the things Popular needs to do is diversify its business - only about 30% of its mainland loan book is consumer-oriented (mortgages and consumer loans), and while I'm absolutely not anti-C&I/CRE lending, I think a more diverse book would help the bank over the long term.
For the sake of completeness, I would also mention that Popular is the owner of the E-loan financial services company and also still owns 21% of EVERTEC (NYSE:EVTC), a merchant acquiring and transactions processing company.
The Fix Is Almost In
It has taken time, but Popular has fixed a lot of its credit and operational problems. Instead of letting bad loans sit on the books and molder, the bank has conducted multiple bulk NPL sales. It is true that Popular is not getting top dollar for these loans and could likely see better recoveries if they held on, but it speeds the process of cleaning up the credit picture, allowing the bank to pay off its TARP obligations and get back to normal operations and capital allocation (including the resumption of a dividend).
Popular still owes $935 million for TARP funds, but announced with third quarter earnings in late October that it had filed an application to repay those funds. Assuming that plan goes through, Popular will be largely through with its restructuring. Construction loans are now only about 1% of the portfolio and NPAs have fallen below 3% - still not perfect, certainly, but a lot better. Popular's revenue mix is a little light on fees (25%, compared to 12% for First Bancorp and 33% for Doral), but that's not surprising given the amount of commercial lending and the relatively higher reliance on brokered deposits.
There are still at least two outstanding issues for investors to consider. First, the PR Economic Activity Index was down more than 5% in October and the health of the Puerto Rico economy is an important component to Popular's long-term health (you can only do just so well if the place where 75% of your loans are written isn't doing so well). I also think there are issues of corporate governance to consider. Bloomberg ran a story back in 2012 highlighting that board members and relatives had delinquent loans owed to the bank. While this may not have technically broken laws or violated banking regulations, it looks bad and harkens back to other management issues that have seriously harmed other PR banks like Doral.
The Bottom Line
I'm not thrilled with Popular's management for letting the director/family loan issue become a talking point, but it's also true that Popular is the leading lender in PR and more than a few wealthy people found themselves with property loans they couldn't repay (and would it look better if they had borrowed money from other banks?). With that, I'm inclined to let this one go but keep a closer eye on the company's disclosures in future filings.
When it comes to valuation, I don't look for Popular to return to the glory days of high teens ROEs, but an estimate of just 9.5% in 2018 is sufficient to support a $32.50 fair value today even with an elevated discount rate. Likewise, Popular's return on tangible assets and equity (and ROE net of cost of equity) suggests it is undervalued on a multiple of TBV basis - Popular's returns suggest a fair value of $35 to $39.
Compared to other banks that suffered greatly from their lending mistakes, I don't believe Popular has damaged its franchise to the same extent. Consequently, even at current prices it looks as though this may be one of the few meaningful bargains in the banking sector.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.