Good morning everyone. Welcome to the Gator Capital Management Q3 2020 Webinar. And thank you for joining us. Our Q3 2020 Webinar will be presented by Managing Member and Portfolio Manager, Derek Pilecki. The webinar will last approximately 30 minutes, after which we will open the floor for a question and answer session. Do you have any questions, you can submit at any time during this session by clicking the Q&A icon on your screen.
Due to time, time restraints, if your question is not answered, we will follow-up with you individually after the webinar to answer your question. And as always, if you have any questions about Gator Capital Management, please do not hesitate to reach out. For those who read our Q2 letter, you will know that Derek highlighted Puerto Rican banks as part of his research spotlight. Today will Derek will review the general opportunity he sees in Puerto Rican banks and then drill down specifically into First Bank Puerto Rico. And as I mentioned, we will then conclude with a question and answer session.
Very quickly for compliance purposes, the views and opinions in this presentation are solely those of Gator Capital Management. Gator Capital Management has made every attempt to assure that the accuracy and reliability of this information provided, but it cannot be guaranteed. And past performance is not guarantee of future results.
With that being said, I would now like to hand it over to Derek Pilecki, Managing Member and Portfolio Manager of Gator Capital Management.
Thanks Jonathan. I wanted to go over my Puerto Rico bank thesis starting here on page three. I want to first focus on the consolidation within the Puerto Rico banking market. So, we have a couple of market share tables here. The first one on the left is the market share of Puerto Rico. And as of June 2019, you can see that there are six banks with reasonable market share within the Puerto Rico market.
Then two of the large foreign banks, Santander and Scotiabank decided to exit the island and announce sales of their Puerto Rican bank operations, the First Bancorp and the OFG Bancorp. This reduces the number of significant players on the island from six to four. I would argue that Citibank’s presence on the island is more retail focused with a slight focus towards multi-national companies operating on the island. So, that really leaves just the top three banks, Banco Popular, First Bank and OFG as being the only three commercial banks on the island.
So, you can see Puerto Rico’s one of the more highly concentrated markets, banking markets in the country. We also don’t see any De Novo players from the US entering the Puerto Rico market any time soon. With this market share concentration in Puerto Rico, we think there’s a very attractive banking market from the standpoint of equity holders. We, we expect strong margins due to less competition. And we think this, competitive dynamic is similar to what we see in Hawaii, which of course is another island type economy with high margins.
The second dynamic in the Puerto Rico banking market is Banco Popular’s pricing strategy on deposits. Until 2015, the cost of deposits on the island were higher than on the US mainland, mainly because Banco Popular’s deposit rate strategy kept deposit rates high, which caused the other banks on the island to have to pay up for deposits. This kept margins and returns low on the island. As we went through the interest rate cycle of 2015 to 2016 … Banco Popular seemed to change their strategy. And they didn’t raise rates along with set fund rate increases. This moved the pricing of deposits on the island from above peer to below peer and has increased returns of all of the Puerto Rican banks on the island. As long as Banco Popular continues to price deposits less aggressively, we think the banking market in Puerto Rico will have higher returns.
In addition to the attractive banking market on the island, we think the economic conditions on the island could improve. Puerto Rico’s pretty much been in recession since 2006, but there are a few things that make us more bullish on the Puerto Rico economy going forward. First is, they’re having a double shot of stimulus right now. As a US territory, Puerto Rico companies and citizens are eligible from the benefits of the CARES Act. Also, Puerto Rico’s government passed its own stimulus. So, we think of this as a double shot of stimulus on the island.
Then Puerto Rico could potentially benefit from onshoring of pharmaceutical and medical device manufacturing. So, there use to be a tax break called Section 936, which gave corporations a tax benefit if they had manufacturing in a US territory. So, a lot of pharmaceutical firms moved their US manufacturing to Puerto Rico. So, there was about 40 pharmaceutical and medical device manufacturing plants on the island. This tax break was taken away in 1996 with a ten year phase out. So, when it finally phased out in 2006, Puerto Rico’s economy went into recession. And it’s pretty much been in a recession since then.
At the beginning of the pandemic in March, a lot of, of PPE, pharmaceuticals and medical devices were manufactured in China and we were having trouble importing those items from China because the Chinese Government wanted to keep the, the production of those items for their own citizens’ use. So, there’s been a call for the US to onshore some of that manufacturing. And Puerto Rico’s a natural place for that manufacturing to occur.
Moving to page four, we think Puerto Rico’s handled the virus relatively well. If we ranked all the states and territories, Puerto Rico would rank 44th of the 54 states and territories as far as coronavirus cases per capita. Although, we’d note in recent weeks, they’ve had, they have seen an increase in, in virus spread. Puerto Rico benefited early on in the pandemic from a, a strict curfew where citizens couldn’t be on the streets passed 7:00 PM. As this curfew was lifted, we’ve seen the virus start to spread, but it’s still at a manageable level.
Another aspect of the Puerto Rico bank stories, we know that the Puerto Rico banks are, familiar with how the economy operates after shutdowns. They’ve had a couple shutdowns in the last five years, one mainly, most notably because of Hurricane Maria where the economy lost power and the utility wasn’t able to get power to a large majority of the island for several weeks. And then they recently had an earthquake. So, I think the, their response to the pandemic will, will follow along the, the lines from these natural disasters and they’ll be able to navigate these fine.
The last two points of the, the general Puerto Rico bank thesis is, we think regional banks in general are cheap. They’ve lagged the broader market. They’re still down 30% for the year. And we think as people get comfortable, that the credit losses in the banking systems aren’t, uh, going to pose an existential threat that regional banks will increase in value. And Puerto Rico banks will increase along with US banks.
And then, uh, if we look at Puerto Rico banks relative to the US banks, they’re very cheap. Whereas the US banks trade at 1.1 times tangible book, the Puerto Rico banks trade at about 60% of tangible book. And we think with the ongoing margin dynamics in the, in the Puerto Rico market, they shouldn’t trade at such a steep discount to the US banks. So, that wraps our, our, our thesis, general thesis of Puerto Rico.
Derek, thank you, Derek. That was, uh, that was fantastic. Um, if you could, uh, would love to, to get your thoughts on what, you know, you think are the biggest risks to, uh, Puerto Rican banks.
Yeah. I think, I, I’d say the two biggest risks for the Puerto Rico banks is, uh, or what we worry about is the economy, because the … We, we’re really, we don’t need the economy to be booming in Puerto Rico. We just need it to, to bounce along and, um, not shrink drastically. And so, one … you know, if a, a real weak economy could potentially impose higher credit losses in the banks. And we think that would be, would be difficult.
We think that between the stimulus and the potential onshoring, we think that there could be some net employment growth on the island. And I think that would be fine for the Puerto Rico banks. The other risk that we worry about that we can’t really predict is if there’s a change in the, the posit pricing dynamic like we saw from 2010 to 2014 where Popular just priced deposits at a irrationally high level.
And we do-, we don’t have any evidence to suggest that we would go back to that type of market, especially with the consolidation. But it’s just something we think about. We can’t explain why they priced where, where they did it during those years, but if they went back to that strategy, it wouldn’t be good for, for the Puerto Rican banks.
That’s great. Thank you. And could you, um, you know, drill down into a, into an example for us?
Yeah, sure. So, I, I’m going to highlight First Bancorp Puerto Rico. It’s the number two player on the island. So, you … we own all three. We own Banco Popular, OFG and, and First Bancorp. But First Bancorp has, uh, a couple dynamics that it, I think will make it particularly attractive. First is, the, they’re making a very financially compelling acquisition of Santander’s operations. So, prior to, um, prior to this acquisition, First Bancorp was the number two player on the island and Santander was number three. So, their acquisition of Santander consolidates the number two and three market players.
The deal is 35% accretive to earnings per share for First Bancorp. So, they’re, they’re paying a little above book value. And they’re paying in cash for, for the acquisition. So, it’s very creative, especially when you consider the cost savings that they’re getting it, get from the overlap. Um, you know, First Bancorp had been running with excess capital for a number of years in anticipation of this acquisition. So, we think it’s an excellent use of their capital. First Bancorp’s earnings per share estimates for 2021 are higher than their, what they earned in 2019, which is unusual for regional banks.
Our next point on First Bancorp is, we think the valuation is extremely low. The stock trades are five and half times next year’s earnings and only about .95 times tangible book. Twice in a, the past 10 years, First Bancorp’s traded up to 1.2 times tangible, once in June ’13 and again in March ’19. We expect First Bancorp to trade up to 1.2 times again. And we don’t think 1.2. is necessarily feeling on its valuation because of the potential improvement of profitability of banks in Puerto Rico due to the consolidation. We think that the combination of the acquisition and the low valuation makes First Bancorp particularly compelling.
Our third point, we’d point that the credit qualities much improved at First Bancorp, that the bank’s currently running a very high level loan loss reserves, about three and a half percent, even though charge-offs in Q2 were only about 43 basis points. Loan deferrals have come way down. Uh, they were cut in half during the first three weeks of July. We believe that many people took loan deferrals as just an an option. And during the cycle, you know, usually loan deferrals are the fourth or fifth risk management tool banks use. But in this cycle, loan deferrals were given out to anybody who used it.
And with the uncertainty of the pandemic, a lot of people and companies took the loan deferrals just to manage cash flow, not because they necessarily needed it. So, we’re seeing as loan deferral periods are ending that, uh, companies and people are resuming their loan payments. We think credit qualities, um, is going to turn out to be a surprisingly good at, at First Bank along with a lot of other regional banks.
Then we would also note that, you know, during the financial crisis, First Bancorp ran with about 10% non-performing loans. And now, right now, it’s down to about two percent. We think it’s a huge difference between the way First Bancorp operated going into the financial crisis compared to the way they operate now. The recession in Puerto Rico was just starting as The Great Financial Crisis hit. Also, uh, we think the regulators have been all over the Puerto Rico banks for the past 12 years. And so, the amount of bad loans still within the banks is, is very low.
Moving on to loan portfolio. It will, I think the, the loan portfolio at First Bancorp looks very similar to US peers. It’s a mix of CNI, commercial real estate and residential lending. Um, we think the, the Santander loan portfolio they’re acquiring actually is slightly lower risk than First Bancorp’s existing portfolios. So, I don’t think the acquisition of those is undue risk.
Flipping to the … page, page six, um, with the expense base. You know, uh, First Bancorp’s been managing expenses for aggressively for a number of years. And then they’re going to cut out about 35% of Santander’s expense base in this acquisition. So, we think, you know, they’ll be operating efficiently. And that’s a, that’s an opportunity. The deposit franchise is, at First Bancorp has improved. The much larger mix of non-interest bearing deposits. And then it’s going to improve even more with the Santander acquisition. Loan to deposit ratio will decline to 85%. And we think this high level of liquidity will give the bank a lot of flexibility going forward. And they’ll continue to raise deposits to fund loan growth going forward.
On the bottom left part of the slide, I just want to point out the branch map, what it looks like. So, this is the island of Puerto Rico, of course. And the green dots are First Bancorp’s branches. The gray darts are Santander’s branches. And so, there are, is a lot of overlap, especially around San Juan, which is a box, on the right-hand side. We think that this is where most of the expense savings are going to come from branch consolidation. And they’ll have a nice coverage of the whole island after this acquisition.
And then the final point on capital, First Bancorp’s been running a very conservative capital. They pay capital, Common Equity Tier One capital of above 20%. As of June 30th, the acquisition’s going to close here in the third quarter. So, they’re going to use a lot of that excess capital to pay cash for Santander. But even after the acquisition, they’re still going to have at least 10%, CET1 ratio. So, we expect them to generate capital post acquisition and use that capital to, to start buying back shares late in 2021 or early 2022.
Perfect. Thank you, Derek.
You, you can see here
Um … Go on. Sorry.
Oh, you, uh, I was just going to wrap up. And you can see with the chief valuation and the and the low acq-, the low valuation and the, the compelling acquisition. And we think First Bank’s one of our favorite names here.
Thank you, Derek. I do want to remind our listeners, that if you have a specific question, you can submit it in the Q&A co-, Q&A icon at the bottom of your screen. You can do that at any time during this, uh, during this webinar.
While you’re doing that, I do have a couple of questions for you, Derek, that have, uh, have been submitted already. The first one, “As a US-based investor, how do you get comfort with the regulation of Puerto Rican banks?”
Yeah. I, so, we … The, the Puerto Rico banks as a US territory, they’re regulated by the, the US bank regulators. So, the FDIC regulates all three banks. They conduct the, the bank examinations. I, I actually believe it’s the, they’re regulated out of the FDI-, their examiners come out of the New York office of the FDIC. So, um, the same examiners who cover the New York Metro banks also do the exams in Puerto Rico. So, that, that gives us most of the comfort, um, that we’re under the same … they’re operating under the same rules of the US banks.
Perfect. Thank you. Um, the next question is on, uh, First Bancorp Puerto Rico specifically. Uh, “I understand that First Bank Puerto Rico had some trouble during The Great Financial Crisis. How do you get comfort that they are better prepared?”
Yeah. So, I, I mentioned this briefly. I think that the … You know, they had a near death experience in, in the financial crisis where they had to, um, do a, a prefer for common exchange to raise capital. I, I think that their loan portfolio is just a world different than it was going into the financial crisis. I think it’s a, a much more granular portfolio. I think, um, think the … they’ve been managing through the 13 or 14 years of Puerto Rico recession. So, I think they’ve been managing under a, a, you know, a relatively stressful environment for more than a decade now.
And so, I don’t think there’s a lot of fluff in their loan portfolio. And, you know, I, I have comfort that the, um, you know … you know, we meet with Puer-, First Bancorp’s management about once a year. We’ve been meeting with them for about six years. We have comfort how they approach the lending business. And then the, you know, having the regulators in there. I don’t think, um, you know … I think that it’s been a … I think they’re a little harsher on the Puerto Rico banks because of what happened in the financial crisis than they are on US banks.
Great. Thank you. Um, we have some, uh, new question submissions. Uh, “Derek, what do you see, uh, biggest risks with the Santander acquisition?”
Yeah, I think it’s, it’s integration. And it’s going to … you know … As they integrate the Santander, does it, um, cause them to lose focus on taking care of their customers? Or are there good customers in, that Santander had that, um, will be easy to pick off from the other banks? I guess one of the good things about that is, OFG’s going through its own integration with the Scotiabank branches. So, they’re a little … They’re slightly distracted as well. Um, you know, and Banco Popular already has 60% market share. So, you know, it can be, you know, uh, anybody who banks on the island and has already had a look at, uh, what Popular has offered. So, you know, we’re not that concerned about that. But, you know, the, with any acquisition, there’s integration risk. Um-
Perfect. Thank you. Um, another question here. “What are the short term and long term ROA, ROEs of the Puerto Rican banks? What is the long term multiples, and what is your upside, downside?”
Sure. So, you know, it depends on what the ROA is to, with the multiple. Multiples tend to follow what ROA is. So, I think the ROAs of the, the Puerto Rican banks can get above, um, get above one. Can they get to one and a half percent? I think they can. Uh, you know, it hasn’t been proved out yet, because, you know, we haven’t had a long enough time period with, um, you know, less competition on the island.
Uh, you know, I don’t want to … You know, the Hawaii banks trade for a premium because the margins are so wide there. I think, I don’t, I’m not arguing that they will get, the Puerto Rican banks will get to a premium. I think they can trade in line with US banks peers, especially if they prove that margins are wider, um, than US peers, I think trading in line with US peers. Because I think there will be, always be a some persistent discount for being a territory rather than a state. But, um, you know, I think it’s … I don’t think it’s unreasonable for them to trade in line with US peers.
So, can … I think US peers are trading cheap right now, one times book, 1.1 times book. You know, can US peers trade up to 1.7 like they were in 2018? Possibly. Maybe we need higher interest rates to get them that, to that valuation. But, um, I think in line with US peers. And then US peers recovering some is where we can go. So, if the Puerto Rico banks trade at 60% intangible now, can they get to one and a half or 1.7 times? You know, ar-, basically arguing for almost a triple of their, their valuation. I, I don’t think that’s unreasonable under a long enough timeframe.
Okay, perfect. Uh, next question. We have some more submissions here. Um, “On the last webinar, you shared your outlook on Q2. Uh, what were the major contributors to your, uh, performance in Q2?”
Yeah, so in Q2, the, the mortgage names, uh, were helpful. So, PennyMac, uh, we owned both PennyMac companies. And we also owned a mortgage insurer, NMI Holdings, that had had a tough Q1. So, that balanced a little in Q2. And then the, the other area that helped in Q2 was the, the capital markets, firms like Morgan Stanley and Credit Suisse that, that with the, the send back stocking, the, the capital markets, the debt capital markets new issuance and trading buyings were just off the charts.
And so, neither Morgan Stanley nor Credit Suisse had especially … have a big credit risk. So, a lot of their, um, underwriting revenue and trading revenue dropped to the bottom line. Uh, and so those were the, the two areas, mortgagings and capital markets, um, helped in Q2.
Perfect. Thank you. Um, next question. “Do you expect CET1 to be at 10% post acquisition?”
I do. I do. So, I think, um, you know, based on my model, uh, I think it’s going to come in slightly above 10%, um, post acquisition.
Okay, perfect. And then, uh, the question following that was, “Remind me of what is the threshold for CET1.”
Yeah, so, uh … Usually you think banks have to, uh … I don’t see banks with CET1s below eight percent. Um, most banks have, regional banks have targets of, you know, anywhere from nine to 10%. Um, I think 10%, uh, is a reasonable target. Maybe it’s, uh, more on the conservative end, but right around 10% is where I would expect First Bancorp to operate.
Okay, perfect. Thank you. Um, I think we have time for a couple more questions. Um, it looks like we’ve got some here. Um, and it looks like we’ve got two here. I think you could, you could possibly, um, sort together. So, first one, “Banks have lagged the border market significantly this year. What scenario do you think banks will outperform moving forward?” And then the next question, which I think relates, “Over the weekend, it was revealed that Warren Buffett sold most of his banking positions. Uh, do you think banks are in a good position going forward?”
Yeah, so the performance of banks has been definitely frustrating this year. So, I mean, I think there’s a couple things going on there. One is, there is, you know … PSTD from The Great Financial Crisis where the banks lost a lot of value and didn’t recover it. It was, um, you know, it was a little asymmetric downside risk in the banks from the credit losses. And so, I think with the economic shutdown, there’s just a normal, um, lookback to what happened in the last cycle.
Um, I think another part of the, the risk here, or the reason why banks have underperformed is that when you look at companies that are doing well during the pandemic or the shutdown, it tends to be more national big firms that have, um, maybe a technology aspect to them and Main Streets, that area of the economy that’s really hurting. But it’s hard to short Main Street through the, the stock market.
And so, I think there’s some, some part of the investment community that looks to banks as a way to short Main Street, because they have, uh, you know, credit risks, the Main Street. And then, you know, the other reason is rates. You know, zero percent interest rates is a headwind for banks. So, you know, they still earn spreads, but it, you know, it’s just, they, they can’t reprice checking accounts below zero yet. Um, and I don’t expect them to.
So, uh, so I think those are the three reasons why banks have, have underperformed. I think where banks are going to outperform, I think there’s going to be two things that are going to happen. I think that as we come out of loan deferrals and payment rates on, on loans or lack of delinquent loans will surprise investors. So, it … I think that a lot of loans are going to come off deferral and start repaying again.
And then I think the, the banks are one of the best, um, best bets for the economy reopening or from, for a vaccine getting introduced. I think, you know, they’ll … they have the most opportunity to snap back from a normalization of the economy. So, you know, to the extent that we get a vaccine introduced that people feel comfortable with, I think the banks are one of the best ways to, to play that.
I think, um, you know, I think the Buffett sales are interesting. You know, I think of those, the, the companies that he sold as pretty inexpensive and well run. So, you know, one thing when I looked at his, when I look at his portfolio, I was always surprised how overweighted he was to banks. So, he didn’t sell all his banks, he, you know, actually added to Bank of America. So, I think, you know, it might just be a, a reconfiguring going to the bank he feels most comfortable with. And it also might be just a realization that he was too overweighted to banks.
So, um, I do think that there’s opportunity in banks, especially since they flagged so much this year without, uh, you know, without this being a capital event. The, uh … You know, I think the, the credit losses that the banks are going to experience are going to … you know, they have hurt earnings this year. It might last a little bit into next year, but we’re not seeing tangible book values go down because of the, the economic shutdown.
So, it’s not, you know, permanent in inf-, impairment of ca-, of value. It’s just, uh, one, uh, one year’s earnings gets wiped away. And ev-, and it’s not even that bad. It’s like 40% of one year’s earnings gets wiped away. So, um, so, I mean, I think there’s … for the, the stocks to be down 40% or 30% because of that, I, I think is, is a, it’s been overdone.
That’s perfect. Thank you, um, Derek. That was, uh, that was great. Well, we’re approaching, uh, the 30 minute mark. So, um, uh, I’m going to, I’m going wrap this up. Um, Derek, thanks for your time. And, uh, you know, thank you everyone for taking the time to join us. We wish you all good health and the best during this time.
Um, there will be a replay of this webinar as well as the, um, the presentation. So, that’ll be accessible in the next couple of days. Um, but as always, if anybody needs any additional information from us, or would like to discu-, discuss specific questions in more detail, um, please do not hesitate to reach out. Thank you again, Derek. And thank you everyone for joining us. Have a good day.
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.