ORIENTAL FINANCIAL GROUP INC OFG
May 10, 2010 - 2:35am EST by
grumpy922
2010 2011
Price: 13.39 EPS $1.80 $2.20
Shares Out. (in M): 46 P/E 7.4x 6.0x
Market Cap (in $M): 620 P/FCF n/a n/a
Net Debt (in $M): 4,000 EBIT 100 130
TEV ($): 652 TEV/EBIT n/a n/a

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Description

I am recommending purchase of Oriental Financial Group (OFG). This bank is:

- the cheapest profitable and liquid bank stock in the United States on both a P/E and P/B basis

- expected to show rapid EPS and BVPS growth in the near term, and is

- overcapitalized even though its balance sheet is largely guaranteed by the US Government.

We are currently in a bit of an information vacuum and change-over in shareholder base which is weighing on the stock and will be resolved in the next month. I expect a 25% return over the next 4-6 weeks and a 50% return by the end of the year.

Background:

OFG is based and operates in Puerto Rico. For the last few years it has avoided making loans in a terrible local economy and its P&L was driven by a balance sheet that was primarily mortgage securities funded by wholesale borrowings. This situation changed in the last few months and a major catalyst occurred on 4/30/10.

The Puerto Rican economy and most of its banks were/are a mess. A grinding recession began on the island back in 2006 and unemployment continues to hover around 16%. There were three major banks operating under Cease & Desist Orders from the regulators due to high levels of non-performing loans (NPLs) that the FDIC was getting ready to seize. (See my write-up on Eurobank/EUBK for more background on this). OFG was the only bank that significantly pulled back from local lending over this period and avoided the problems of its peers. In fact it has been the only independent bank on the island that has remained profitable over the last few years. In any event, late last year OFG began to position itself to win a large FDIC-assisted deal. 1) It cleansed its balance sheet of risky securities in 4Q09, 2) it beefed up its loan workout group even though it had very few NPLs and 3) it raised $100M in new capital to be ready to take on assets from the FDIC.

Over the last few months it has seen its loan book grow as it picked up good clients fleeing the expected demise of three sick banks - WHI, RGFC and EUBK. Then on April 30th, the FDIC seized these three banks and OFG acquired selected assets of EUBK from the government in a sweetheart deal. Concurrently OFG also raised an additional $200M of new equity from investors in capital contingent on the consummation of such an acquisition. The stock ran up nicely on rumor of the deal and in the last week after the news it has traded down almost 25% to $13.39.

Where we are today:

Before we dive into the numbers, let's make sure we can see the forest for the trees - what did the 4/30/10 deal do for OFG:

- increased its loan book by more than 100% with the assets purchased at a significant discount and where the FDIC covers 80% of the losses.

- increased its deposits by 50% and its core deposits by xx%

- eliminated three competitors (out of nine prior) so there are now only six banks with retail franchises on the island likely leading to better margins for the remaining players.

- vaulted the bank from a small niche player to  a significant competitor in terms of branch presence as well as having the safest balance sheet to attract clients.

- funded a significant portion of the balance sheet with a below market rate FDIC promissory note.

Going into the 4/30/10 deal OFG's balance sheet looked like this:

                                    Assets                                                              Liabilities/Equity

Cash                            $0.47B                         Wholesale Borrowings

Securities                                                          (mostly repos)                         $4.0B  

(mostly GSEs)              $4.6B                           Deposits                                   $1.8B

Loans                           $1.1B                           Other Liabilities                        $0.2B

Other Assets                $0.33B                         Equity                                       $0.464M

Total                            $6.5B                           Total                                         $6.5B

                                                                                   

The new balance sheet incorporates the following:

- $200M of newly raised equity (minus Ibanker fees = +/-$188M)

- $1.58B of loans from EUBK at a discount of 13.8% (or $1.36B). These loans came with a loss share agreement where the FDIC suffers 80% of all losses on this book and OFG incurs the remaining 20%

- about $100M of all the bank premises assets of EUBK (OFG gets to take just the ones it wants and gives the rest back to the FDIC)

- $785M of EUBK's FDIC deposits for which it paid a 1.25% premium ($10M)

- A 5 year promissory note owed to the FDIC in excess of $600M to cover the amount of the acquired assets minus acquired deposits ($1.46B-$785M). This note carries an interest rate of 2.5% and can be repaid annually by OFG at its discretion.

- As the loans, deposits and FDIC note were acquired at less than their actuarial fair value, the bank and its auditors will calculate a bargain purchase discount (BPO) which needs to be added to OFGs equity balance and will result in an increase in book value. We don't know the exact amount of the BPO yet but we can make some assumptions as to its size.

That brings the new balance sheet to something approximating:

                                    Assets                                                              Liabilities/Equity

Cash                            $0.57B                         Wholesale Borrowings

Securities                                                          (mostly repos)                          $4.0B  

(mostly GSEs)              $4.6B                           Deposits                                   $2.6B

Loans (legacy)              $1.1B                           Other Liabilities                        $0.2B

Loans (covered)           $1.6B                           FDIC note                                $0.6B

Other Assets                $0.43B                         Equity                                       $0.46B

 

Total                            $8.3B                           Total                                        $7.9B

 

(* note Assets does not equal Liabilities + Equity right now as we have yet to calculate the BPO

OFG had 33.1M shares outstanding before the contingent capital raise. That raise was $200M at a price of $15.02 = an additional 13.3M shares for a new total of 46.4M shares.

Equity calculation is as follows:

$464M equity 3/31/10

$188M equity raise 4/10

Total = $652M

$652/46.4M shares = $14.05 BVPS.

So before the BPO, OFG  has a P/BV of less than 1X. And the company was expected to add another $1 of BVPS from earnings the rest of 2010 before factoring in the accretive EUBK deal. So OFG should have a BVPS greater than $15 by the end of the year. This valuation stands in contrast to:

- more than 1/2  of its assets are securities which are +95% GSEs, USTs, or GNMAs which now have a significant embedded capital gain with the recent rally in Treasury rates.

-more than 2/3 of its loans are covered by an 80% FDIC loss share,

- it has a high percentage of core deposits

- a chunk of its funding base is covered by the FDIC promissory note that is less than market rate

- it is overcapitalized.

Now almost every losing-money regional bank across the US is currently trading at above 1X P/B. Even Synovus (SNV), which is expected to lose money this year and in 2011 is trading at above 1X expected 12/31/10 P/B. In contrast, OFG currently trades on a large discount to 1X P/B

BPO Calculation

I calculate that the acquired EUBK loans will suffer a cumulative loss rate of 25-30%. This may sound high, but I want to be conservative and we also know the acquired EUBK loan book was close to 15% NPLs and the Puerto Rican economy is still in a deep Recession. We can also back into the expected FDIC loss rate on the loan book and the FDIC did a significant amount of due diligence on EUBK before they seized it.

The FDIC reported on their website that they expect to lose $744M on the closure of Eurobank. We know the approximate balance sheet on Eurobank before it was seized:

                                    Assets                                                              Liabilities/Equity

Cash                            $0.1B                           Wholesale Borrowings

Securities                      $0.7B                           (mostly repos)                          $0.47B

                                                                        Deposits                                   $1.9B

Loans                           $1.6B                           Other Liabilities                        $0.1B              

Other Assets                $0.2B                           Equity                                       $0.1B

Total                            $2.6B                           Total                                        $2.6B

And after the selected assets went to OFG, the seized Eurobank's balance sheet that the government needs to run down looks something like this:

 

                                    Assets                                                              Liabilities/Equity

Cash                            $0.1B                           Wholesale Borrowings

Securities                      $.07B                           (mostly repos)                          $0.47B

Due from OFG                $0.6B                           Deposits                                   $1.1B

Loans                           $0                                Other Liabilities                        $0.1B              

Other Assets                $0B                              Equity                                       $0B

Total                            $1.3B                           Total                                        $1.67B

Now the FDIC wipes out the equity but it does have to pay off the repos and the FDIC-insured deposits and some of the other liabilities. Then there is accrued interest on the deposits and there will likely be some costs of running down the securities book and remaining employees have to be paid out. So let's assume the FDIC loses about $375M closing down this balance sheet ($1.3B-$1.67B)

That leaves the FDIC telling us it expects to lose about (744-375) $370M on the 80% loss share on the $1.6B of loans it sold to EUBK. $370/$1.6 = 23% Grossing up this number for OFG's 20% loss share gets us to about 28%. Now this number is high and could come in a lot lower but the FDIC would prefer to err on the side of saying it is going to lose a larger number than a smaller one as shareholders of a seized bank can attempt to sue (never worked so far) and the government would rather say things were so bad the bank had to be closed.

So my numbers are rough, but they seem to be in the right ballpark of a 25-30% loss rate on the EUBK loans that OFG acquired.

So now we can do a bit of assumption work on the BPO

- 20% loss share of a 30% loss rate on $1.6B in loans (.2*.3*$1.6B) = $96M of losses for OFG.

- Recall that OFG got the total $1.7B in assets for a 13.9% discount ($1.7B*.139) = $236M discount

- $236M-$96M means that OFG has a minimum BPO in this scenario of $140M.

- But there has to be some additional fair market value to the 70% of the EUBK loans that will not fail and continue to pay interest well above the rate OFG has to pay on the FDIC note and the acquirer EUBK deposits. Let's assume $1B of good loans at a 300bp spread over OFG's new cost of funds for 2 years for the average life of these good loans = ($1B*.03)=$30M per year or $60M

- So I get a BPO of around $60M + $140M = $200M.

- And that just about matches the difference between Assets - (Liabilities + Equity) on the new OFG balance that we calculated earlier.

- The point here is that the BPO (or sometimes called negative goodwill) will increase the equity of OFG by around this $200M number.

- Sometime within the next several weeks (I have been told sometime in June) the company will hold a conference call and give us some sort of range of the Fair Value of what they got vs. what they paid.

Putting the math together - new Book Value for OFG

So if we go back to our BVPS calculations and now add in a $200M BPO:

Equity calculation is as follows:

$464M equity 3/31/10

$188M equity raise 4/10

$200M BPO

Total = $852M

$852/46.4M shares = $18.36 BVPS.

With the stock closing on Friday at $13.39, OFG is on a post BPO P/B ratio in the range of 73%. Add in a buck of BVPS from earnings the rest of the year and you get to a year end P/B in the 65% range.

With most loss-making regional banks in the US currently trading at above 1X P/B I expect that OFG will be trading somewhere similar to this range by the end of the year which gets the stock to almost $20 for six month return of (20-13.39) of 50%.

On a P/E basis the stock is absurdly cheap as well. KBW recently published a note moving their expected numbers for 2011 up to $2.28 which is in line with what management told me was reasonable in the event that they won the EUBK bidding at the sort of price they planned to bid This puts the stock ($13.39/$2.28) on less than 6X 2011. This seems very low for a bank where the balance sheet is significantly guaranteed by the US Government, the economy is unlikely to get much worse (and has been showing some signs of stabilization) and the bank is likely to be able to grow its loan book over time due to its capital strength and better competitive positioning.

Shareholder turnover

Almost half the outstanding shares were purchased in the last four weeks. Lots of hedge funds got involved simply to play the deal. The deal occurred, the market is down due to European contagion fears, etc., and over the last week the stock has sold off hard (almost 25%). We are seeing the short-term investors get out of their positions and longer-term investors are likely to take their place.

Information flow

For better or worse, the company has been radio silent except for an 8-K that describes the EUBK transaction without telling us about accretion, cost savings, BPO, etc.  Also for better or worse, EUBK relies on an external IR agency that can answer very few questions at this time. I have been told that the house broker (KBW) analyst is heading down to PR to meet with the company this week, and that OFG plans a conference call in the next few weeks to bring investors up to date on the deal as the dust settles.

I own this stock and believe that it represents a great value opportunity with hard catalysts and significant margin for error.

Regards, Grumpy

 

Catalyst

- Stock has sold off post a very accretive acquisition due to:
    - short-term investors getting out
    - a vacuum of information regarding the quality of the deal
 
- Company will announce the size of its new book value and expected accretion to earnings from deal cost savings, fair value adjustments, etc. in the next few weeks
 
- Sell side will likely start to put out estimates of the new book value and higher EPS expectations
 
- Stock will rise to trade in line with less profitable peer US regional banks
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    Description

    I am recommending purchase of Oriental Financial Group (OFG). This bank is:

    - the cheapest profitable and liquid bank stock in the United States on both a P/E and P/B basis

    - expected to show rapid EPS and BVPS growth in the near term, and is

    - overcapitalized even though its balance sheet is largely guaranteed by the US Government.

    We are currently in a bit of an information vacuum and change-over in shareholder base which is weighing on the stock and will be resolved in the next month. I expect a 25% return over the next 4-6 weeks and a 50% return by the end of the year.

    Background:

    OFG is based and operates in Puerto Rico. For the last few years it has avoided making loans in a terrible local economy and its P&L was driven by a balance sheet that was primarily mortgage securities funded by wholesale borrowings. This situation changed in the last few months and a major catalyst occurred on 4/30/10.

    The Puerto Rican economy and most of its banks were/are a mess. A grinding recession began on the island back in 2006 and unemployment continues to hover around 16%. There were three major banks operating under Cease & Desist Orders from the regulators due to high levels of non-performing loans (NPLs) that the FDIC was getting ready to seize. (See my write-up on Eurobank/EUBK for more background on this). OFG was the only bank that significantly pulled back from local lending over this period and avoided the problems of its peers. In fact it has been the only independent bank on the island that has remained profitable over the last few years. In any event, late last year OFG began to position itself to win a large FDIC-assisted deal. 1) It cleansed its balance sheet of risky securities in 4Q09, 2) it beefed up its loan workout group even though it had very few NPLs and 3) it raised $100M in new capital to be ready to take on assets from the FDIC.

    Over the last few months it has seen its loan book grow as it picked up good clients fleeing the expected demise of three sick banks - WHI, RGFC and EUBK. Then on April 30th, the FDIC seized these three banks and OFG acquired selected assets of EUBK from the government in a sweetheart deal. Concurrently OFG also raised an additional $200M of new equity from investors in capital contingent on the consummation of such an acquisition. The stock ran up nicely on rumor of the deal and in the last week after the news it has traded down almost 25% to $13.39.

    Where we are today:

    Before we dive into the numbers, let's make sure we can see the forest for the trees - what did the 4/30/10 deal do for OFG:

    - increased its loan book by more than 100% with the assets purchased at a significant discount and where the FDIC covers 80% of the losses.

    - increased its deposits by 50% and its core deposits by xx%

    - eliminated three competitors (out of nine prior) so there are now only six banks with retail franchises on the island likely leading to better margins for the remaining players.

    - vaulted the bank from a small niche player to  a significant competitor in terms of branch presence as well as having the safest balance sheet to attract clients.

    - funded a significant portion of the balance sheet with a below market rate FDIC promissory note.

    Going into the 4/30/10 deal OFG's balance sheet looked like this:

                                        Assets                                                              Liabilities/Equity

    Cash                            $0.47B                         Wholesale Borrowings

    Securities                                                          (mostly repos)                         $4.0B  

    (mostly GSEs)              $4.6B                           Deposits                                   $1.8B

    Loans                           $1.1B                           Other Liabilities                        $0.2B

    Other Assets                $0.33B                         Equity                                       $0.464M

    Total                            $6.5B                           Total                                         $6.5B

                                                                                       

    The new balance sheet incorporates the following:

    - $200M of newly raised equity (minus Ibanker fees = +/-$188M)

    - $1.58B of loans from EUBK at a discount of 13.8% (or $1.36B). These loans came with a loss share agreement where the FDIC suffers 80% of all losses on this book and OFG incurs the remaining 20%

    - about $100M of all the bank premises assets of EUBK (OFG gets to take just the ones it wants and gives the rest back to the FDIC)

    - $785M of EUBK's FDIC deposits for which it paid a 1.25% premium ($10M)

    - A 5 year promissory note owed to the FDIC in excess of $600M to cover the amount of the acquired assets minus acquired deposits ($1.46B-$785M). This note carries an interest rate of 2.5% and can be repaid annually by OFG at its discretion.

    - As the loans, deposits and FDIC note were acquired at less than their actuarial fair value, the bank and its auditors will calculate a bargain purchase discount (BPO) which needs to be added to OFGs equity balance and will result in an increase in book value. We don't know the exact amount of the BPO yet but we can make some assumptions as to its size.

    That brings the new balance sheet to something approximating:

                                        Assets                                                              Liabilities/Equity

    Cash                            $0.57B                         Wholesale Borrowings

    Securities                                                          (mostly repos)                          $4.0B  

    (mostly GSEs)              $4.6B                           Deposits                                   $2.6B

    Loans (legacy)              $1.1B                           Other Liabilities                        $0.2B

    Loans (covered)           $1.6B                           FDIC note                                $0.6B

    Other Assets                $0.43B                         Equity                                       $0.46B

     

    Total                            $8.3B                           Total                                        $7.9B

     

    (* note Assets does not equal Liabilities + Equity right now as we have yet to calculate the BPO

    OFG had 33.1M shares outstanding before the contingent capital raise. That raise was $200M at a price of $15.02 = an additional 13.3M shares for a new total of 46.4M shares.

    Equity calculation is as follows:

    $464M equity 3/31/10

    $188M equity raise 4/10

    Total = $652M

    $652/46.4M shares = $14.05 BVPS.

    So before the BPO, OFG  has a P/BV of less than 1X. And the company was expected to add another $1 of BVPS from earnings the rest of 2010 before factoring in the accretive EUBK deal. So OFG should have a BVPS greater than $15 by the end of the year. This valuation stands in contrast to:

    - more than 1/2  of its assets are securities which are +95% GSEs, USTs, or GNMAs which now have a significant embedded capital gain with the recent rally in Treasury rates.

    -more than 2/3 of its loans are covered by an 80% FDIC loss share,

    - it has a high percentage of core deposits

    - a chunk of its funding base is covered by the FDIC promissory note that is less than market rate

    - it is overcapitalized.

    Now almost every losing-money regional bank across the US is currently trading at above 1X P/B. Even Synovus (SNV), which is expected to lose money this year and in 2011 is trading at above 1X expected 12/31/10 P/B. In contrast, OFG currently trades on a large discount to 1X P/B

    BPO Calculation

    I calculate that the acquired EUBK loans will suffer a cumulative loss rate of 25-30%. This may sound high, but I want to be conservative and we also know the acquired EUBK loan book was close to 15% NPLs and the Puerto Rican economy is still in a deep Recession. We can also back into the expected FDIC loss rate on the loan book and the FDIC did a significant amount of due diligence on EUBK before they seized it.

    The FDIC reported on their website that they expect to lose $744M on the closure of Eurobank. We know the approximate balance sheet on Eurobank before it was seized:

                                        Assets                                                              Liabilities/Equity

    Cash                            $0.1B                           Wholesale Borrowings

    Securities                      $0.7B                           (mostly repos)                          $0.47B

                                                                            Deposits                                   $1.9B

    Loans                           $1.6B                           Other Liabilities                        $0.1B              

    Other Assets                $0.2B                           Equity                                       $0.1B

    Total                            $2.6B                           Total                                        $2.6B

    And after the selected assets went to OFG, the seized Eurobank's balance sheet that the government needs to run down looks something like this:

     

                                        Assets                                                              Liabilities/Equity

    Cash                            $0.1B                           Wholesale Borrowings

    Securities                      $.07B                           (mostly repos)                          $0.47B

    Due from OFG                $0.6B                           Deposits                                   $1.1B

    Loans                           $0                                Other Liabilities                        $0.1B              

    Other Assets                $0B                              Equity                                       $0B

    Total                            $1.3B                           Total                                        $1.67B

    Now the FDIC wipes out the equity but it does have to pay off the repos and the FDIC-insured deposits and some of the other liabilities. Then there is accrued interest on the deposits and there will likely be some costs of running down the securities book and remaining employees have to be paid out. So let's assume the FDIC loses about $375M closing down this balance sheet ($1.3B-$1.67B)

    That leaves the FDIC telling us it expects to lose about (744-375) $370M on the 80% loss share on the $1.6B of loans it sold to EUBK. $370/$1.6 = 23% Grossing up this number for OFG's 20% loss share gets us to about 28%. Now this number is high and could come in a lot lower but the FDIC would prefer to err on the side of saying it is going to lose a larger number than a smaller one as shareholders of a seized bank can attempt to sue (never worked so far) and the government would rather say things were so bad the bank had to be closed.

    So my numbers are rough, but they seem to be in the right ballpark of a 25-30% loss rate on the EUBK loans that OFG acquired.

    So now we can do a bit of assumption work on the BPO

    - 20% loss share of a 30% loss rate on $1.6B in loans (.2*.3*$1.6B) = $96M of losses for OFG.

    - Recall that OFG got the total $1.7B in assets for a 13.9% discount ($1.7B*.139) = $236M discount

    - $236M-$96M means that OFG has a minimum BPO in this scenario of $140M.

    - But there has to be some additional fair market value to the 70% of the EUBK loans that will not fail and continue to pay interest well above the rate OFG has to pay on the FDIC note and the acquirer EUBK deposits. Let's assume $1B of good loans at a 300bp spread over OFG's new cost of funds for 2 years for the average life of these good loans = ($1B*.03)=$30M per year or $60M

    - So I get a BPO of around $60M + $140M = $200M.

    - And that just about matches the difference between Assets - (Liabilities + Equity) on the new OFG balance that we calculated earlier.

    - The point here is that the BPO (or sometimes called negative goodwill) will increase the equity of OFG by around this $200M number.

    - Sometime within the next several weeks (I have been told sometime in June) the company will hold a conference call and give us some sort of range of the Fair Value of what they got vs. what they paid.

    Putting the math together - new Book Value for OFG

    So if we go back to our BVPS calculations and now add in a $200M BPO:

    Equity calculation is as follows:

    $464M equity 3/31/10

    $188M equity raise 4/10

    $200M BPO

    Total = $852M

    $852/46.4M shares = $18.36 BVPS.

    With the stock closing on Friday at $13.39, OFG is on a post BPO P/B ratio in the range of 73%. Add in a buck of BVPS from earnings the rest of the year and you get to a year end P/B in the 65% range.

    With most loss-making regional banks in the US currently trading at above 1X P/B I expect that OFG will be trading somewhere similar to this range by the end of the year which gets the stock to almost $20 for six month return of (20-13.39) of 50%.

    On a P/E basis the stock is absurdly cheap as well. KBW recently published a note moving their expected numbers for 2011 up to $2.28 which is in line with what management told me was reasonable in the event that they won the EUBK bidding at the sort of price they planned to bid This puts the stock ($13.39/$2.28) on less than 6X 2011. This seems very low for a bank where the balance sheet is significantly guaranteed by the US Government, the economy is unlikely to get much worse (and has been showing some signs of stabilization) and the bank is likely to be able to grow its loan book over time due to its capital strength and better competitive positioning.

    Shareholder turnover

    Almost half the outstanding shares were purchased in the last four weeks. Lots of hedge funds got involved simply to play the deal. The deal occurred, the market is down due to European contagion fears, etc., and over the last week the stock has sold off hard (almost 25%). We are seeing the short-term investors get out of their positions and longer-term investors are likely to take their place.

    Information flow

    For better or worse, the company has been radio silent except for an 8-K that describes the EUBK transaction without telling us about accretion, cost savings, BPO, etc.  Also for better or worse, EUBK relies on an external IR agency that can answer very few questions at this time. I have been told that the house broker (KBW) analyst is heading down to PR to meet with the company this week, and that OFG plans a conference call in the next few weeks to bring investors up to date on the deal as the dust settles.

    I own this stock and believe that it represents a great value opportunity with hard catalysts and significant margin for error.

    Regards, Grumpy

     

    Catalyst

    - Stock has sold off post a very accretive acquisition due to:
        - short-term investors getting out
        - a vacuum of information regarding the quality of the deal
     
    - Company will announce the size of its new book value and expected accretion to earnings from deal cost savings, fair value adjustments, etc. in the next few weeks
     
    - Sell side will likely start to put out estimates of the new book value and higher EPS expectations
     
    - Stock will rise to trade in line with less profitable peer US regional banks
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