Doral Financial Corporation DRL
March 12, 2005 - 4:50pm EST by
2005 2006
Price: 38.60 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 4,170 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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DRL is the largest mortgage banking company in Puerto Rico and is benefitting from the substantial increases in construction and mortgage activity there over the past several years. In the past couple of years, DRL has dramatically increased its commercial and construction lending businesses to the point where they comprise approximately 1/2 of the company's revenues. The company has also grown its property insurance business as well. DRL has consistently grown at 15-20% per year, has expanded its market share and maintains a very high quality loan portfolio. DRL has 53 branches under 4 separate divisions. It is also a large and fast-growing commercial bank, with 33 branches in Puerto Rico and with branches in New York. DRL’s mortgage business in Puerto Rico is driven by a severe, multi-year shortage of affordable housing that is not dependent on interest rates to spur demand. In addition, DRL has reduced its computed value of its mortgage servicing rights in the past or taken reserves as mortgage prepayments increase. These actions will likely reverse if rates climb, adding to income.

DRL’s net spreads are over 200 basis points and has been able to lock in those spreads for several years. As a Puerto Rican institution, DRL enjoys tax advantaged status which will not change in the forseeable future. The company is averaging $2 billion in mortgage originations per quarter and is also growing rapidly in its other businesses such as its insurance agency operations. DRL is using its extensive network to introduce additional products and services, which are generating high margins and returns on capital. Their revenue pipeline on its core mortgage business (in part due to its substantial participation in a long-term government sponsored middle income housing program) has extraordinary visibility over a period of the next several years. Thus, its earnings stream is highly predictable.

In its recent years, DRL has experienced strength everywhere. Its mortgage originations and sales, construction lending, commercial lending, retail banking and insurance income generating activities are all doing extremely well. New lines of business have been growing at the rate of 50%. Additionally, their efficiency ratio has continually declined as the result of solid expense control and increased operating leverage. Return on assets for the quarter is approaching 4.0% and return on equity exceeds 35%. Currently, DRL has a market capitalization of $4 billion and trades at less than 8.5x forward earnings and a little more than 9.5x trailing earnings. Its earnings are expected to grow in excess of 12-15% next year (although the company has said that the estimates are too low) and at similar levels over the next few years, making this an incredibly cheap stock. Additionally, insiders/management owns approximately 20% of the company and have been buyers of their stock recently and in the past.

There has been a short story which has circulated from time to time regarding servicing rights prepayment assumptions, the level of refinancings that they do, some hedging activity gains, and gain on sale of loans. It should be noted that their servicing rights are valued externally and internally and the company takes the lower of the two numbers. Prepayments in Puerto Rico have traditionally been lower than in the mainland US so the company has been consistent with the past in how they have booked servicing rights. The company is simply not playing accounting games with respect to their servicing rights. Additionally, the level of refinancing activity as a percentage of their income is fairly consistent with their past. The Puerto Rican consumer is very different than that of the US. Refinancings in Puerto Rico are generally done to exchange mortgage debt for consumer/credit card debt—the level of refinancings in Puerto Rico has been very steady over the last 30 years. Further, the company does not utilize hedging to boost returns. While it is true they booked a hedging gain a few quarters ago which did increase their eps by a few pennies, interest rates were especially volatile during that quarter. As the company will tell you, their hedging program worked well for that quarter. In more recent quarters, they have had hedging losses and still beat their expected eps number handily. Lastly, the company originates paper that is particularly interesting to Puerto Rican institutions due to their tax advantaged status. Thus, the company is able to sell their mortgages at very attractive levels and have done so for years.

Recently, a Hibernia research report came out and downgraded the stock based on several factors. The first was that the company would have to take additional IO losses of significant magnitude (an IO writedown last quarter is what has hurt the stock recently. While further impairments (unrealized losses) are possible to a limited extent, new hedges have been put in place to protect the IO against further flattening or Libor rates going up. Previously the company only hedged for parallel shifts in the yield curve. Therefore, in the event of further impairments (unrealized losses), these should be offset by hedges or other gains.

Hibernia’s analyst also stated that the Company’s gain on sale margin is not sustainable. I disagree. The Company has sold forward all of its expected non-conforming production in 2005 and some of 2006. The Company has priced already its non-conforming production to offset increases in Libor. Therefore, future gains on sale should be sustained on new originations. The report also mentions risk of slowdown in production, which is just the opposite of the mortgage pipeline and visibility that the company is been experiencing. The company has said their business is stronger than ever and that it expects originations to continue at the current record pace even under a higher interest rate scenario. Giaven their track record i find it hard to dispute their assertion. The report did not mention that the Company owns over $3 billion of mortgage loans that qualify for delivery for the forward commitments. The Company could always sell some or all of these loans, make a sizeable gain on sale, and re-invest the proceeds in tax-exempt mortgage backed securities in order to preserve its margins.

Inexplicably, the analyst questioned the company’s capitalization. The Company is one of the best capitalized financial institutions with Tier 1 ratio over 20% compared the norm which is between 8-10%. The company has stated that all of its regulators and rating agencies agree that it has significant excess capital. As an aside, the analyst report assumed incorrectly that the IOs require 100% capital. The capital requirement is only 25%.

Lastly, the analyst questioned whether the company will achieve earnings expectations and took down his numbers. The Company has previously said that it expect to meet or exceed consensus earnings estimates and has consistently exceeded estimates in its past. Further, the Company has about $2.5 billion (16% of assets) sitting in cash or money markets awaiting to be redeployed into higher yielding tax exempt securities providing the company with the ability to substantially increase future earnings, well beyond consensus expectations.

The company earned $4.05 per share this year and is expected to earn in excess of $4.50 in 2005 and at least $5.15 for 2006 (the company believes it will exceed both of these numbers handily). At $38.60 per share, there are few stocks that I can think of which the growth prospects and earnings visibility that DRL has that are trading at 8.5x ‘05 numbers and less than 7.5x ‘05 earnings. The company has a unique and powerful franchise and a top tier management team that is driven to excel. Their performance over the last couple of years demonstrates the strength of all of the companies’ businesses – if the stock stays down here we can expect management to continue buying shares. This is a top notch franchise that can be purchased at a significant discount to its intrinsic value.


1--Continued strong operating performance by the company.
2--management share purchases which will continue if the stock remains down here.
3. Next quarter results will show a limited IO write-down (if any) and effective hedging which will offset any earnings impact.
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