Puerto Rico and a "Popular" Pick for Contrarians

05/28/2019 5:00 am EST

Focus: FINANCIALS

Brett Owens

Chief Investment Strategist, BNK Invest, Inc.

Popular Bank (BPOP) has served Puerto Rico since the territory was under Spanish rule. It dominates the island's banking business. Recently the bank has stood tall amidst a mass exit of financial firms from Puerto Rico, explains Brett Owens, editor Contrarian Outlook.

Banks have been increasingly fleeing the island since the start of the decade. Westernbank, the third-largest bank by deposits at the time, shut its doors in 2010. The Federal Deposit Insurance Company (FDIC) stepped in and brokered a sale of its assets to Popular, the top bank in the territory.

Doral Financial meanwhile ran two of the largest mortgage brokers on the island and launched a full-service bank in 2008. The FDIC shut down the entire company seven years later and brokered the sale of its assets to, you guessed it, Popular.

Meanwhile Puerto Rico has amassed more than $70 billion in public debt. This obligation rivals only California among the fifty states. Puerto Rico's municipal bond markets have fallen into disarray as a result.

Then, when category five Hurricane Maria devastated the island in the fall of 2017, it caused more than $8 billion in damage and left 3.4 million residents without electricity. More than half of the island's bank branches were closed for a period of time and ATM use became a hit/miss proposition.

Wells Fargo took this as its cue to exit stage right. It sold about $2 billion in auto loans to Popular. Foreign banks Scotiabank and Santander continued to roll back their Puerto Rico presence. In 2010 they made up 23% of the island's branches, versus just 16% seven years later.

After the Doral deal in 2015, Popular amassed a dominant 45% market share of Puerto Rico's deposits. Since then, that number has ballooned to a transcendent 58%!

In the aftermath of Maria, Popular turned its startup accelerator into a startup shelter, providing local businesses with free Wi-Fi and desk space. Chief Information and Digital Officer Camille Burckhart explained to American Banker:

"After the hurricane, it became a safe haven. People could actually work from our premises. And they are part of the community."

Popular also launched a feel-good program that let Popular customers assign ATM withdrawals to friends and family who may not have a bank account. (Burckhart told AB that some island residents don't have enough money to justify an account.)

It makes economic sense for Popular, with its 58% market share, to be a caring capitalist. Its business and investors are benefiting from its efforts too. Popular's dividend growth makes its market share gains blush–its payout has doubled in just three years! This dividend moonshot has acted like a "magnet" for its share price, which has likewise climbed 85% during the same time period.

The stock yields more now than it did three years ago thanks to its payout growth. The obvious risk to Popular's takeover spree is the quality of the assets it bought. They've actually been quite good. Income from the banks' quality assets is going to double that dividend again.

The assets Popular has acquired have performed well. Its "problem holdings" have decreased in absolute terms, from $933 million in 2014 to just $712 million in the most recent quarter. As a percentage of total assets, non-performing loans represent just 1.5% of the portfolio today, down from 2.8% five years ago:

Meanwhile the bank continues to stack cash. Five years ago, it held nearly as many loans as deposits (89%). Today, the firm holds $1.50 in deposits for every $1 in loans, good for a 65% loan-to-deposit ratio.

The bank has plenty of money with respect to its liabilities. Its Common Equity Tier 1 (CET1) ratio of 16.4% is a comfortable cushion of core capital with respect to "total risk-weighted assets." (These are the bank's loans assessed independently by the likelihood they'll be paid back.)

Higher is better for CET1 and, to put this in perspective, let's see how Popular compares (quite favorably!) with the largest banks in the US.

Doesn't Popular need this cash cushion in case its island home, well, defaults on all of its debt? Not really. Its direct exposure to municipalities is a modest $455 million while its indirect exposure (anything with a government guarantee) is $365 million. Add these up and they are less than 2% of total assets. Quite manageable.

Popular's loan portfolio pays an excellent 6.8% today (a benefit of banking off the US mainland). The bank's deposit and loan growth drop to the bottom line, boosting earnings about 19% more per share year-over-year.

The dividend represents a modest 15% of profits today, less than half the percentage paid out by most of its US counterparts. The bank could double its dividend tomorrow and have plenty of capital, but it's doing something even better: Accelerating its share repurchase program.

In the first quarter the company bought back $250 million worth of its own stock, paying less than seven-times free cash flow (FCF) for shares (cheap!). Recent efforts have reduced "float" by 6.8% and, while the stock stays inexpensive, the repurchase party should continue.

Remember, each share that is retired is one less dividend IOU. Buybacks will add fuel to Popular's already torrid dividend growth.

Another measure of "cheap" for a bank is its book value. Since assets must be marked to market they represent the amount of money the firm should fetch in a liquidation event. Popular is trading exactly at book as I write.

This means we can buy Popular for the value of its assets and get its booming banking business for nothing. This is as close to a free lunch as we'll ever see from Wall Street. Let's grab our shares today, before they double in price from here. Action to Take: Buy Popular up to $65.00.

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