Popular Inc.: Margin Likely To Drag Earnings
- Earnings are expected to decline this year because net interest margin is quite sensitive to interest rates. The 50bps Fed rate cut will squeeze margins, and hence drag earnings.
- Investments in personnel and technology and business promotion are expected to further pressurize earnings.
- For an investment horizon of nine months or more, BPOP appears attractive due to a double-digit price upside and 4% dividend yield.
- For the next three to four months outlook is less bright due to COVID-19.
Earnings of Popular, Inc. (NASDAQ:BPOP) are expected to take a hit from the Fed funds rate cut earlier this month. BPOP's balance sheet is positioned in a way that makes its net interest margin highly sensitive to interest rate movement. As a result, the recent 50bps rate cut is expected to squeeze margin, and consequently drag earnings this year. Earnings are also expected to be negatively affected by an increase in expenses related to business promotion and investments in people and technology. The December 2020 target price suggests a significant potential for capital appreciation. However, for the near term of three to four months, the outlook is less bright due to the panic related to COVID-19. Consequently, only high-risk tolerant investors with an investment horizon of more than nine months should currently consider investing in BPOP. For the near-term of three to four months, a neutral rating on the stock is appropriate.
Earnings to Suffer from High Sensitivity of Margin to Interest Rates
In the third and fourth quarters of 2019, BPOP's net interest margin, NIM, took a hit from last year's Fed rate cuts which shows the high sensitivity of NIM to interest rates. As the funding and earning asset mixes have not changed much over the past six months, NIM is likely to be as sensitive to rate cuts in the first of 2020 as it was in the second half of 2019. Consequently, I'm expecting BPOP's NIM to get compressed in the first and second quarters of this year. In the second half of the year I'm expecting NIM to stabilize because I'm not expecting any further rate cuts. However, there is a risk that COVID-19 may encourage further Fed rate cuts if the outbreak gets much worse. For now, the World Health Organization has refrained from labeling the COVID-19 outbreak as a pandemic in the latest briefing. In my opinion, the rate cut in March seems sufficient to counter the threat of COVID-19 to the economy; therefore, I have decided to assume stable interest rates for the remainder of the year. The following table presents my estimates for BPOP's yield, cost, and NIM for 2020.
The negative effect of NIM compression on net interest income is expected to be partly offset by loan growth. Puerto Rico's economy appears to be recovering, with the latest report on Economic Activity Index showing continued growth. The index grew by 1% in December 2019 compared to December 2018, the third positive growth after four year-over-year consecutive declines. The plunge in international crude oil price following the fall out between OPEC and allies, also bodes well for loan growth as lower gasoline prices will boost consumers' purchasing power and give them confidence.
However, there are certain headwinds that could constrain loan growth this year. These include COVID-19 and the upcoming presidential elections. In addition, further delay in the release of hurricane relief funds can keep Puerto Rico's economy from growing. As a result of these headwinds, I'm expecting loan growth to be lower this year compared to 2019. As shown in the following table I'm expecting BPOP's net loans to grow by 3% year over year in 2020.
Investments to Further Constrain Earnings
BPOP's employee related expenses are expected to rise this year as the management is planning on investing in training its staff and increasing compensation in the wake of a tight labor market. As mentioned in the fourth quarter conference call, the management is also planning on investing in technology. Furthermore, BPOP intends on spending on business promotion, including rewards programs for clients. I'm expecting all of these plans to increase non-interest expenses by 3.6% year over year in 2020.
While non-operating expenses and NIM are expected to constrain earnings, non-interest income is expected to drive the bottom-line. I'm expecting growth in non-interest income to continue to grow on the back of fee-based income, which in turn is attributable to investments and efforts to expand business. Overall, I'm expecting BPOP's net income to decline by 12.6% this year compared to 2019. On a per share basis, earnings are expected to decline by only 5% due to lower number of shares outstanding. BPOP bought back 7 million shares in January under its share repurchase plan, according to a press release.
COVID-19 and its impact on the economy is the biggest risk to my earnings thesis. I'm not expecting any further monetary easing this year, but if the epidemic worsens beyond my expectation, then the Fed may have to resort to additional rate cuts. BPOP is sensitive to interest rates; hence another rate cut may lead the company's results to miss my estimates.
Adopting Neutral Rating on Short-Term Risks
I'm using the historical price to tangible book multiple, P/TB, to value BPOP. The stock has traded at an average P/TB multiple of 0.86 in the past as shown below.
Multiplying this P/TB ratio with the forecast tangible book value per share of $54.6 gives a target price of $47.2 for December 2020. This target price implies a price downside of 22.4% from BPOP's March 9 closing price. The following table shows sensitivity of the target price to P/TB multiple.
Apart from the 22% price upside, BPOP also offers a dividend yield of 4.1% (assuming quarterly dividends are maintained at $0.40 per share for the remainder of 2020). The dividend yield and price upside combine to give total expected return of 26.6% till the end of December 2020. However, for the near term of around three to four months, the outlook is not bright. Due to the uncertainties related to COVID-19, I believe banking sector equities, including BPOP, will remain depressed. Consequently, I'm adopting a neutral rating on the stock. In my opinion, only high-risk tolerant investors with investment horizons of at least nine months should consider taking a position in BPOP.
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