BPOP - Challenging And Volatile Near-Term Trends At Popular But Valuation Isn't Bad

Summary

• Popular's fourth quarter results varied away from the typical bank earnings report, and not in a good way, with pressures on spread income, fee income, and pre-provision profits.
• 2023 is looking like a more challenging year, as the bank isn't seeing loans reprice as quickly as deposits and operating leverage options seem limited.
• Popular is a huge presence in the Puerto Rican banking sector and economy, making it harder for the bank to sustainably and significantly outperform the underlying economy.
• Popular shares do look undervalued and I think management is good, but I'm not as confident in a sustained turnaround for the Puerto Rican economy at this point.

While there’s plenty of uncertainty and volatility among mainland banks, the more volatile nature of the Puerto Rican economy adds another twist to the investment analysis process for Popular ( BPOP ). I’m guardedly bullish on the economic outlook for Puerto Rico, but there’s no question that the period from 2005 to 2018 was awful and a bank can only outperform its underlying economy just so much. On top of that Popular has its own quirks that complicate the investment case, including a loan beta that is likely to drive weak pre-provision profits in FY’23 ahead of a stronger result in 2024.

At this point the valuation for Popular looks okay, and I can make a case for a fair value above $80 based upon long-term core earnings growth around 3% to 4%, but I don’t see a compelling enough undervaluation to want to take on the risks that go with a somewhat heterodox operating outlook (relative to similarly-sized mainland banks) and a more challenging local economy.

Limited Growth Drivers Lead To Unimpressive-Looking Fourth Quarter Numbers

With a comparatively low loan beta, rising deposit costs, and not much momentum in the core fee-generating portfolio of businesses, Popular came up short on growth drivers this quarter and the results don’t stack up all that favorably with other similarly-sized banks (even allowing that these trends aren’t exactly new and should be factored into estimates and investor expectations).

Revenue rose 10% year over year, but fell about 3% quarter over quarter on an adjusted FTE basis. Net interest income (on an FTE basis) rose 14% yoy and fell 4% qoq, with net interest margin up 62bp yoy but down 7bp qoq to 3.64%, making Popular one of the relatively rare banks to see net interest margin erosion. Popular also saw weaker earning asset balances, with a 2% sequential decline.

Non-interest income fell 3% yoy and 1% qoq on an adjusted basis, as mortgage banking remains weak and other service charges aren’t growing enough to compensate.

Operating expenses rose 13% yoy and about 3% qoq, driving negative operating leverage for the quarter. Pre-provision profits rose 6% yoy but fell 11% qoq, and with pre-provision profits making up about 1.9% of average earning assets, I can’t say that it’s an especially profitable bank.

Funding Costs Are Okay, But Loan Rate Leverage Has Been A Little Sluggish

Funding costs are probably the number one talking point with bank stocks now, and Popular isn’t doing too bad here. Deposits declined almost 6% qoq, and non-interest-bearing deposits were down more than 9%, but the cumulative beta of about 18% is still lower than average. Total deposit costs rose 73bp yoy and 51bp qoq to 0.89%, with interest-bearing deposits up 100bp you and 70bp qoq to 1.20%. While deposit volatility (usually around public funds) does create some noise, it’s not a new issue for the bank and management has experience working around this.

On the loan side, sequential growth of about 2% wasn’t all that impressive next to mainland banks, but it also wasn’t all that bad. C&I lending grew about 2.5% and leasing was up more than 3%, while mortgage was up about 1% and auto was down less than 1%.

Loan and earning asset yields are more of a concern to me, though. Average loan yields look impressive at 6.70%, but improved just 44bp yoy and 31bp qoq, and the bank’s cumulative loan beta for the cycle is just 15% - hurt by the larger skew to fixed-rate consumer loans on the books.

Credit quality is mixed, but generally positive. I say “mixed” because Popular’s charge-off, non-performing loan, and non-performing asset ratios are all higher than mainland comp averages, but the rate of change has been similar (though charge-offs did accelerate a bit). I think Popular’s reserves are fine at 2.25%, but a sharper economic slowdown in Puerto Rico would likely drive higher credit costs in 2023 and 2024.

The Outlook

Management seems to be taking a realistic view of the situation. They are expecting higher unemployment and a slowdown in the economy in PR, and they’ve switched to more of a capital-preservation stance, announcing a pause in buybacks back with third quarter results. I have no particular concerns with management’s ability to execute, but with 63% share of the island’s deposits, I’m not sure how much they can do to navigate around a more challenging economic backdrop.

I’m expecting long-term core earnings growth of around 3% to 4% from Popular. While that may look low next to the historical 8% tangible book growth rate (ex-AOCI), that growth took place as the company built significantly on its leadership position in the Puerto Rican banking industry. A longer sustained upturn in the Puerto Rican economy would offer some upside to my estimates, but likewise another period of prolonged weakness could make my estimates too ambitious.

Discounting those earnings back, I can support a fair value for Popular shares close to $83, while my near-term P/E-based approach (using a 10.5x multiple on FY’23 EPS) gives me a fair value closer to $77. My ROTCE-based P/TBV methodology is less supportive now, but I expect weaker results in 2023, so that would be why (if I use my numbers a year forward, the ROTCE-based fair value is closer to $80).

The Bottom Line

For me, Popular’s stock is a case of liking the house but having some concerns about the neighborhood. I think management will do a good job, but a lot depends on the health of the Puerto Rican economy (which is beyond their control) and that has been a tough bet to win for much of the past decades. Investors with a more bullish stance on PR should take a closer look, though, as I do think there is undervaluation here and better growth ahead after a challenging 2023 goes into the books.

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