This Bank Should Be More Popular

04/03/2012 9:45 am EST


Peter Staas

Managing Editor, Capitalist Times and Energy & Income Advisor

It's rare times that allow investors to speculate on banking stocks, but these are the times in which we live, and this is a stock for you to consider, writes Peter Staas of Personal Finance.

The beleaguered banking industry enjoyed significant improvements in business conditions in 2011.

With US economic growth picking up, pressure on the collateral and cash flows that secure the four basic loan categories should continue to abate. Home values are stabilizing, and the strengthening economy should lower delinquency rates on consumer, commercial, and industrial loans.

The Federal Deposit Insurance Corp’s (FDIC) most recent Quarterly Banking Profile reflects the industry’s tailwinds. During the final three months of 2011, FDIC-insured commercial banks grew aggregate net income by 23% year over year, to $26.3 billion. A 40.1% drop in loan-loss provisions accounted for much of this recovery.

Nevertheless, the banking industry has struggled to post organic growth, as consumers pare debt burdens and commercial borrowers leave credit lines undrawn. FDIC-insured banks’ full-year net operating revenue in 2011 declined for the first time since 1938, prompting investors to bid up the price of names that have won market share and expanded their loan portfolios.

But share prices of small to midsize banks have surged since the beginning of October 2011, with the Dow Jones KBW Regional Bank Index returning 45%. At these levels, the highest-quality names once again appear overbought.

We’ve previously enjoyed success betting on credit-improvement stories that trade at a substantial discount to tangible book value (TBV) but boast solid franchises and underappreciated upside potential. The universe of investment-worthy bank stocks that trade at less than TBV has shrunk as the stock market rallied into the new year; many of these distressed names deservedly trade at cut-rate valuations.

However, aggressive investors should consider a position in the unloved Popular (BPOP), which currently fetches 70% of its TBV after the stock market’s recent run-up.

Deteriorating credit quality has been the biggest headwind facing Popular. These challenges in its local operations (81% of 2011 revenue) and mainland branches in California, Illinois, Florida, New Jersey and New York (19%) prevented the company from turning an annual profit from 2007 to 2010.

Nevertheless, few doubted that Popular would survive, especially after the bank in 2010 acquired Westernbank Puerto Rico’s $9.5 billion in assets and $2.5 billion in deposits as part of an FDIC-assisted transaction. This deal also included a generous loss-sharing agreement with the regulator.

Management had moved aggressively to address the franchise’s credit issues, even before the FDIC in 2011 issued a memorandum of understanding requiring the firm to improve its underwriting process and credit-risk management procedures.

In 2005 and 2006, Popular ramped up its North American franchise, which focused on the Latino community and specialized in marginal residential mortgages that included high loan-to-value ratios and little documentation. In 2008, management began eliminating higher-risk business lines in the US, and in 2011 sold $396 million of the division’s riskiest nonconventional home loans.

These de-risking efforts paid off: Net charge-offs (NCO) in the US declined by 57% last year, while this segment’s loan-loss provision tumbled by 72%, and the number of nonperforming loans dropped by 42%.

Management has also broadened the company’s customer base in select US markets by changing the franchise’s name to Popular Community Bank from Banco Popular. This rebranding effort will continue in 2012.

Today, Popular’s operations in Puerto Rico represent the biggest stumbling block. The commonwealth has been mired in recession from 2006 to 2010, while housing prices have declined by roughly 25%, with the high end of the market bearing the brunt of the pain.

Management has accelerated efforts to clean up its domestic loan book and tighten lending standards. In December 2010, Popular put on the sales block $603 million in construction and commercial loans, the vast majority of which had stopped accruing. So far, the firm has divested a portfolio of these loans with unpaid principal of about $358 million. The remainder will be sold in 2012.

During the second half of 2011, Popular completed an intensive review of all commercial loans of more than $1 million, an exercise that focused on identifying potential problem loans based on the borrowers’ current cash flows. This process resulted in $197 million worth of new nonperforming loans during the third quarter.

Management also shifted all mortgages insured by the Federal Housing Administration and the Dept. of Veterans Affairs that were past due by 18 months or more into the non-accrual bucket.

With nonperforming loans accounting for almost 8% of Popular’s total book, the company still faces an uphill battle to normalize its credit metrics. But management’s aggressive efforts to address these issues, coupled with the stabilization of Puerto Rico’s economy, enabled the bank to eke out operating earnings of $151 million in 2011.

Popular expects efforts to reduce expenses and improving credit metrics to fuel operating earnings of $180 million to $200 million in 2012, while the bank’s solid franchise and pre-tax and pre-provision earnings suggest that the stock should trade for at least TBV once credit quality normalizes.

The stock has run up considerably in the past month and could be vulnerable to a pullback, especially with earnings expected to be lumpy and the US economy facing election-year uncertainty. Aggressive investors should buy Popular under $2.40 and allocate additional capital in the event of a correction.

Subscribe to Personal Finance here...

Related Reading:

The Most Overbought Dow Stocks

This 800-Pound Gorilla Hauls in the Cash

4 Building Trends with Solid Foundations

  By clicking submit, you agree to our privacy policy & terms of service.

Related Articles on STOCKS