Puerto Rico Banks

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July 27, 2020

We purchased shares in three publicly-traded Puerto Rico Banks, OFG Bancorp (“OFG”), Popular “BPOP”), and First Bancorp Puerto Rico (“FBP”), during Q2.  We believe they represent extraordinarily good values in the current market.  We previously owned OFG from 2016 to 2019, so we’ve been familiar with these banks for awhile. The total position size of the three Puerto Rican banks in the Fund is about 15%.

1. Banking consolidation within Puerto Rico – Puerto Rico is on its way to 3 banks down from 5 two years ago and 9 banks fifteen years ago. This presents an oligopoly banking market that we think will persist for a long time.  We do not believe any mainland U.S. banks will look to expand into Puerto Rico.  We would point to Hawaii as an example of a closed island banking market with oliogopoly characteristics.  In Hawaii, the main banks have wider margins and higher returns than the median bank in the U.S.  We believe the Puerto Rican banks may follow a similar path.
2. Deposit market became less competitive on island – Even before the 2019 bank consolidation in Puerto Rico, the deposit gathering environment had become less competitive. In the years after the Great Financial Crisis (“GFC”), Popular kept deposit rates high even though the bank had a 55% market share.  Since Popular had such a large market share, the other banks had to follow the leader.  During the period from 2015 to 2018 when the Federal Reserve raised interest rates, Popular changed their deposit pricing strategy and starting keeping their deposit rates significantly below the Federal Funds rate.  The other banks followed and banking profitability increased across the island.
3. Experienced with an economic shutdown due to Hurricane Maria – The Puerto Rico banks are experienced with an economic shutdown after Hurricane Maria in 2017. The banks made it through the post-hurricane period with minimal loan losses. We believe the current pandemic will produce similar results to a natural disaster.
4. Double-shot of stimulus funds – The Puerto Rico economy will receive a double shot of stimulus funds in response to the COVID-19 pandemic. As a U.S. territory with U.S. citizens, Puerto Rican residents are eligible for the benefits of The CARES Act such as $1,200 stimulus checks, expanded unemployment benefits, and the PPP loan program for small businesses.  The Puerto Rico government has also created its own stimulus program to boost its economy.  The island was already a beneficiary of aid from the U.S. government for Hurricane Maria, so there will be plenty of liquidity on the island, which should boost the economy.
5. Puerto Rico has handled the virus relatively well – If we included Puerto Rico in a ranking of U.S. states in per capita COVID-19 cases, only six states have fewer cases. We attribute this to Puerto Rico having a strict curfew until late-June.  We believe this will allow Puerto Rico’s economy to recover sooner than most states and territories.  In recent weeks, Puerto Rico case count has climbed, but it still remains well below the national average on a per capita basis.
6. Puerto Rico restructuring debt – Puerto Rico has made some progress in restructuring its debt. Although the PR banks have not had direct exposure to the PR government for many years, the debt restructuring has been an overhang on the PR bank stocks. We think the PR debt restructuring is becoming less of an issue as it gets resolved.
7. Pharmaceutical and medical device manufacturing revival – Puerto Rico may benefit from a new trend of onshoring pharmaceutical and medical device manufacturing. During the early stages of the pandemic, the U.S. had difficulty with its health care supply chain because so much of it had been outsourced to China.  Between travel restrictions, slower fulfillment due to shelter-in-place orders, and China taking first priority on fulfillment, there has been a building consensus that the U.S. needs to have more health care related manuafacturing onshore.  Puerto Rico is a natural place for this manufacturing to take place.  Prior to 2006, PR had a tax break that attracted health care companies to build manufacturing plants on the island.  The tax break expired in 2006 and the PR economy has been in a near constant state of recession since then.
8. PR banks trade at cheap valuations – BPOP and FBP trade at about 60% of tangible book value. OFG trades at about 80% of tangible book value.  Each of these banks trade between 6x and 7x 2021 earnings per share (“EPS”).  The median bank with a market cap between $500 million and $5 billion trades at 110% of tangible book and 10.7x 2021 EPS.  The median small cap bank trades at 110% of P/TBV. We believe the PR banks will close this discount.
9. Regional banks are cheap in general – Regional bank stocks have had an awful 2020. The companies have had stiff headwinds of zero percent interest rates and the prospect of higher credit losses due to the pandemic. Through June 30^th, the S&P Select Regional Bank index was down 33%. We understand that the regional banks are one of the few ways that macro players can “short Main Street”. However, regional banks are reporting profits while adding to the allowance for loan losses.  As the stock market investor get comfortable that the provision for loan losses has peaked for the regional banks, the valuations of regional banks will increase. We see the Puerto Rico banks as cheap relative the regional banks, and we see regional banks as cheap relative to the market.

Risks

1. Normal banking risks – The PR banks have the typical risks of commercial banks. They are exposed to credit and interest rate risk. During this time, banks have additional credit risk due to the pandemic.
2. Acquisitions unlikely – We believe it is unlikely that any of the three PR banks will get acquired by a mainland bank from the U.S. Thus, the prospect of a buyout premium is low.
3. Deposit competition – Popular holds a 55% market share. In the past, Popular priced deposits on the island at irrationality high rates which kept profitability low for all the PR banks. We don’t expect a recurrence of this scenario, but we have to acknowledge that it happened in the recent past.
4. Managing credit risk on the U.S. mainland – Each of the PR banks have loan operations on the U.S. mainland. These operations make sense because the Puerto Rico banking market is not large enough for them to invest all of their capital. However, we acknowledge that managing their credit risk on the U.S. mainland adds a degree of difficulty.

Popular, First Bancorp, and OFG Holdings are attractive banks to own because they are inexpensive absolutely and relative to their U.S. peers. We believe each of these banks will manage through the pandemic economy well. We expect each of these banks to benefit from the recent consolidation within the Puerto Rico banking market.

Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.