W Holdings Company Inc. WHI S
April 08, 2007 - 1:46pm EST by
jujuiris15
2007 2008
Price: 4.49 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 814 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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Description

Description:
 
Over levered Puerto Rican C&I Bank whose stock price has 30% downside to $3.46.
 
WHI is a Puerto Rican regional bank whose focus is on C&I lending and levering its large securities portfolio.  It has a low quality funding source of wholesale brokered deposits on the mainland and the security repo market.  It is currently trading at 1.17x multiple (market cap was $814MM as of 04/05/07) of book value ($697MM at 12/31/06) and has a 12.7x multiple of LTM earnings ($64MM).  Over the next year, I believe this stock will trade down from its current price of $4.94 to $3.46 or 30% downside.
 
Catalyst:
 
1)     Continued credit impairment of portfolio will cause higher provisioning and potential losses.
2)     Commercial loan to IYXI has very high likelihood of being impaired.
3)     Large securities portfolio will continue to pressure NIM or cause losses in the HTM securities portfolio.
4)     Intense competition in Puerto Rico and expensive source of funding will cause continued pressure on an already low net interest margin (NIM).
 
Challenges that Puerto Rican banks are facing:
 
Regional Banks have seen many challenges over the last year to include:
 
·                     An inverted yield curve.
·                     Increasing loan delinquencies.
·                     Competition for cash verses traditional bank accounts.
 
Puerto Rican banks have seen even more difficult headwinds to include (not in order of importance):
 
·                     Extra taxes imposed on the banks in Puerto Rico (4.5% additional).
·                     Worsening economic and fiscal conditions (recession).
·                     2 week government shutdown earlier this year - bloated government employee payroll .
·                     Increasing utility prices (some rates have doubled over the last year).
·                     Puerto Rican's are leaving the island for the mainland.
·                     Major Restatements among 4/7 banks - DRL, RGF, WHI, FBP in the past year.
·                     Current financials for FBP and DRL not filed .
·                     Too many banks on the island serving too few people (competition irrational).
 
 
Furthermore Puerto Rican banks have several characteristics that make the current environment extra challenging to them
 
·                     People with cash in Puerto Rico tend to put their money in tax preferred structures such as preferred stocks instead of bank accounts due to preferential tax treatment.
·                     As a result of this, core deposits are difficult to come by and wholesale brokered deposits are the vehicle of choice for deposit growth.
·                     Many of the banks set up International Banking Entities (IBE's) because interest earned on US Government Securities (mostly UST, Agency Debt, and Agency MBS) are tax exempt.  All the banks used the carry trade while fed fund rates were low to book tax free income.  This worked while the yield curve was steep but now has come back to haunt the PR banks. OFG is the most egregious with about 72% of its balance sheet in securities while WHI has about 50%.
·                     The PR banks used reverse repoes mostly to finance these security purchases.
·                     Many of the residential mortgage loans in PR were non-conforming due to high delinquency rates and low income verification and documentation.  As a result these loans were not traditionally sold on the mainland and only banks on the island bought them.  DRL and RGF were the large originators and FBP and WHI were the most significant buyers.  [With the subprime meltdown, these loans which are between Alt A and Subprime are not going to have a market on the U.S. to see into anymore.  DB had bought some before from FBP when it unwound it's DRL loans]
·                     These loans were booked using Gain on Sales with DRL and RGF manufacturing significant earnings (Molly wrote a nice piece on DRL explaining this)
·                     most of the loans that DRL originated got bought back from FBP and were later sold to Deutsche Bank earlier in 2006.
 
Condensed Balance Sheet and Interest Statement
 
You can see that the balance sheet is pretty simple.   WHI has a very large securities portfolio and a very large loan portfolio.  They fund their assets with reverse repurchase agreements and brokered deposits.  The bank is also very highly levered at 24.6x tangible book value. 
 
 
Balance Sheet
2003
2004
2005
2006
 
06Q1
06Q2
06Q3
06Q4
 
 
 
 
 
 
 
 
 
 
Total Cash
         780
      1,145
         901
      1,077
 
         928
      1,089
         949
      1,077
Investment securities HTM
      5,724
      6,921
      7,074
      7,008
 
      7,401
      6,980
      7,012
      7,008
Loans net of allowances for loan losses
      4,683
      5,941
      7,816
      8,641
 
      8,023
      8,180
      8,455
      8,641
AFS Secs, FBLB Stk, Trd Secs
           95
           60
           48
           59
 
           48
           68
           64
           59
Foreclosed real estate held for sale
             4
             4
             4
             6
 
             4
           -  
             5
             6
Premises & equipments
         103
         110
         118
         125
 
         119
         121
         122
         125
Other assets, Accd Int Rcv, Dfd Taxes
         130
         156
         191
         240
 
         191
         218
         224
         240
Total assets
    11,519
    14,337
    16,152
    17,155
 
    16,714
    16,655
    16,832
    17,155
Non interest-bearing deposits
         193
         249
         277
         374
 
         289
         306
         315
         374
Interest bearing deposits
      5,193
      5,982
      8,099
      8,963
 
      8,639
      8,515
      8,698
      8,963
Total Deposits
      5,385
      6,231
      8,376
      9,337
 
      8,928
      8,821
      9,013
      9,337
Federal funds purchased and repoes
      5,046
      6,684
      6,260
      6,320
 
      6,246
      6,314
      6,316
      6,320
Advances from Federal Home Loan Bank
         146
         211
         172
         127
 
         162
         157
         137
         127
Mortgage note payable
           37
           37
           36
           36
 
           36
           36
           36
           36
Accrued expenses & other liabilities
           76
           92
         114
         106
 
         130
         109
         103
         106
Total liabilities
    10,691
    13,255
    14,958
    15,927
 
    15,502
    15,437
    15,605
    15,927
 
Stockholders' Equity
 
 
 
 
 
 
 
 
 
Preferred stock
         385
         512
         531
         531
 
         531
         531
         531
         531
Equity
         444
         570
         663
         697
 
         682
         687
         696
         697
Total stockholders' equity
         829
      1,082
      1,193
      1,228
 
      1,212
      1,218
      1,227
      1,228
Total liabilities and stockholders' equity
    11,519
    14,337
    16,152
    17,155
 
    16,714
    16,655
    16,832
    17,155

You can see the trend.  WHI peaked in earnings in 2004.  Once the fed started cutting rates, their earnings power started decreasing.  Also, their provision for loan losses as a percentage of Net Interest income is increasing substantially
 
 
 
 
 
 
 
 
 
 
Income Statement
2003
2004
2005
2006
 
06Q1
06Q2
06Q3
06Q4
Interest Income
 
 
 
 
 
 
 
 
 
Loans, including loan fees
276
322
479
         672
 
150
160
175
         186
Securities
         174
         250
         280
         290
 
           72
           73
           73
           73
Money market instruments
12
20
36
           38
 
9
10
10
             9
Total interest income
462
591
795
      1,000
 
231
243
258
         268
Interest Expense
0
0
0
           -  
 
0
0
0
           -  
Deposits
115
144
241
         366
 
79
89
97
         101
Fed funds purchased and repoes
102
141
235
         307
 
71
76
80
           80
Advances from FHLB
6
7
8
             8
 
2
2
2
             2
Total interest expense
223
292
484
         681
 
152
167
179
         183
Net interest income
239
300
312
         319
 
79
76
79
           85
Provision for loan losses
27
37
31
           65
 
7
18
11
           28
Net interest income after provision for loan losses
212
263
281
         254
 
72
58
68
           57
Total non-interest income
7
31
36
           37
 
9
8
10
           10
Total Net Int Income and Non Int Income
219
294
316
         291
 
81
65
78
           67
Total non-interest expenses
85
100
108
         125
 
29
31
30
           34
Income before income taxes
134
194
208
         167
 
51
35
47
           33
Total Provision for Income taxes
21
22
41
           66
 
16
13
22
           16
Net income
113
172
167
         101
 
35
22
26
           18
  Less Pfd Stock Dividends
0
27
37
           37
 
9
9
9
             9
Net income available to  stockholders
113
145
130
           64
 
26
13
16
             9
 
Provision for loan loss / NII
11%
12%
10%
20%
 
9%
24%
14%
33%
 
Catalyst Details:
 
Continued credit impairment of portfolio will cause higher provisioning and potential losses.
 
WHI Loan’s portfolio is broken up as follows:
 
 
1)     Residential Mortgages                           12.3%
2)     Construction loans                                7.7%
3)     Commercial real estate loans                 56.4%
4)     Commercial and Industrial Loans            14.1%
5)     Consumer Loans                                   9.5%
 
·                     Of the residential mortgage loans - 10.7% of the 12.3% is from Doral Financial and is classified as a  commercial loan secured by residential mortgages.  This loans was originally booked as a sale but later came back on DRL  balance sheet .  (more below)
·                     Of the consumer loans, 1.6% / 7.7% is in the Expresso Division.  This division makes small loans of $1,000 - $15,000 and charges really high rates - 23% or so
·                     Of the commercial loans, most are from the WesternBank Business Credit Division – which prides itself on being an asset based lender.  I mention the 3 above groups of loans because this is where WHI has already gotten itself into trouble.  While I suspect general conditions in Puerto Rico are going to eventually cause problems for their very large Commercial Real Estate Portfolio, we have not seen it yet.
 
 
 1) WHI had extended DRL a secured commercial loan of $913MM backed by mortgages on non-conforming loans.  This loan was originally treated as a purchase of loans form Doral but later was reclassified in the ensuing restatements on the island.  WHI had a specific allowance of $2.7MM for these loans on 2006Q1. They do not break it out for Q4 but their total allowance for Residential (including these secured commercial loans) and construction was $2.89MM as of 2006Q3 or 17bps.  They do not show what the delinquency rate for these loans are as it is just categorized as one big commercial loan.  However, these underlying mortgages are similar to the $1.4B of mortgage loans on DRL's parent company balance sheet.  The delinquency rate at DRL’s holding company is over 10%.  Should DRL ever produce the proper loan sale documentation and they come back on WHI's balance sheet, the delinquency rate could be very high.  Many analysts would argue that the actual default rate tends to be very low and the recovery very high but this argument ignores the 50% refinancings that occurred in PR and the US for that matter over the past few years.  Many of these loans may no longer have much equity left.  If you view these loans very skeptically, you could say that WHI has kept them classified as a commercial loan secured by mortgages so that it would not have  to show the underlying delinquency rates.  DRL has booked these very same loans as loans that have been sold to WHI hence no longer on DRL's balance sheet.  In any case, I think 17bps is not reasonable as a loan loss allowance for construction and residential mortgage loans
 
 2) WHI has been cutting back on making loans out of their Expresso division due to the high recent loan default and charge offs.  Their current portfolio is about $$129MM. They have a $7.8MM loan loss reserve.  Last quarter had $2.5MM in charge offs and a $1.9MM provision.  Their provision is 5.8% of the portfolio and the average yield last quarter on these loans was 22.5%.  Charge offs for the last 4 quarters were 9.3MM.  I can't break out the provisions but they have been running at less than the chargeoffs.  While WHI states they are shrinking this business, their provision levels are less than what they were one year ago on a portfolio of similar size.  Given what is happening in Puerto Rico with the economy, I would expect to see increasing charge offs necessitating the need for higher provisioning.  It is reasonable to assume that people would rather make their car or house payments before paying off an unsecured loan should they get into trouble.

 3) The Westernbank Business Credit Division is where the big bombs lie.  See the table below:
 
 
Total Loan Portfolio
2003
2004
2005
2006
 
06Q1
06Q2
06Q3
06Q4
Expresso Division
     156
     144
     135
     129
 
     134
     135
     133
     129
C&I Loans (majority of Westbank Credit Div)
     525
     769
   1,001
   1,274
 
   1,138
   1,106
   1,212
   1,274
Other Loans (mostly real estate)
   4,158
   5,172
   6,815
   7,367
 
   6,885
   7,074
   7,243
   7,367
Loan Receivable
   4,683
   5,941
   7,816
   8,641
 
   8,023
   8,180
   8,455
   8,641
 
 
 
 
 
 
 
 
 
 
Loan Loss Allowance
 
 
 
 
 
 
 
 
 
Expresso LLA
10
13.8
8.4
7.8
 
8.3
8.5
7.8
7.8
Westerbank Credit Division LLA
6.6
12.9
30
74.3
 
31.2
57.9
62
74.3
Other LLA
45
53.4
54
44.7
 
56.7
42.1
45.2
44.7
Loan Loss Allowance
61.6
80.1
92.4
126.8
 
96.2
108.5
115
126.8
 
 
 
 
 
 
 
 
 
 
Net Charge Offs
 
 
 
 
 
 
 
 
 
Expresso LLA
7.9
12.4
9.8
8.9
 
1.7
2.2
2.5
2.5
Westerbank Credit Division LLA
0
0
5.3
15.8
 
2.3
2
0.94
10.5
Other LLA
4.6
5.8
3.5
5.4
 
1.4
2.5
2.36
4.3
Total Charge Offs
12.5
18.2
18.6
30.1
 
5.4
6.7
5.8
17.3
 
 
 
 
 
 
 
 
 
 
Non Performing Loans
 
 
 
 
 
 
 
 
 
Commercial RE and Westernbank
24.1
25.4
55.6
154.9
 
60.2
79.1
117
154.8
Residential RE
2.3
1.7
2.1
1.6
 
2.0
2.0
1.8
1.6
Consumer Loans
4.8
7.1
6.3
9.3
 
7.7
9.1
10.8
9.3
Total Non Peforming Loans
31.2
34.2
64.0
165.8
 
69.9
90.1
129.3
165.8
OREO
2.5
3.8
4.1
5.9
 
4.0
4.7
5.4
5.9
NPL+OREO
33.7
38.
68.1
171.7
 
73.9
94.8
134.7
171.7
 
 
 
 
 
 
 
 
 
 
Reserve Impaired Loans
         5
         8
       14
       34
 
       13
       37
       42
       34
 
 
 
 
 
 
 
 
 
 
Non Performing Loans / Total Loans
 
 
 
 
 
 
 
 
 
Consumer Loans
3.1%
4.9%
4.7%
7.2%
 
5.7%
6.7%
8.1%
7.2%
Commercial RE & C&I
4.6%
3.3%
5.6%
12.2%
 
5.3%
7.2%
9.7%
12.2%
 
            It is rather difficult to truly pull the picture out of WHI’s filings.  Just this year, they started making specific mentions of certain impaired loans in the Westernbank’s Credit Division which is mostly asset based lending.  This is where the IYXI loan sits.  What is interesting is that they make an allowance for certain loans that they mention while others they just say are impaired but make no allowance.  The 10-Q filings are not consistent so I’m not going to go into too much detail on making the numbers match because they don’t.
 
            In their 2006 Annual, they mention 4 specific loans totaling $106.9MM which a specific reserve of $33.8MM.  From my understanding, this does not include the IYXI loans which would add another $130MM.  Management states “These loans are current and have not missed their payment schedules but have shortfalls in the collaterals and in the financial conditions of the borrowers.”  I suspect WHI keeps changing the covenants as well as payment dates to make these loans work for the borrowers but it is a troubling sign.  Another observation is that they are lowering their reserves on their real estate portfolio while raising it on the consumer and C&I side.  I suspect this is to keep their reserve allowance ratio palatable to investors or at least optically.
 
            I suspect what is happening is that they are in big trouble with their asset based lending division.  Their Expresso division continues to cost them money hence WHI shrinking the portfolio.  They just aren’t going to impair their real estate portfolio because they believe that even if they have to foreclose, they won’t be impaired.  Please note the speed at which this portfolio is deteriorating.
 
 
 
 
Commercial loan to IYXI has very high likelihood of being impaired.
 
WHI has a $130MM loan outstanding to Inyx Inc. (ticker IYXI).  This is a company that trades on the OTCBB and has a market cap of $136MM and loans of about $130MM.  Its assets are several contract manufacturing plants serving the specialty pharmaceutical business.  One plant is located in Puerto Rico and the others are in the UK.  These plants were purchased for about $60MM and for some reasons, WHI lent them $130MM.  If you look at IYXI balance sheet, you can see that IYXI booked the value of the plants at $120MM even though they only paid $60MM.  I suspect they then used this appraisal to get much larger than normal loans from WHI.  The CEO of IYXI took his previous company into bankruptcy and started IYXI with assets purchased out of bankruptcy. 
 
The WHI loans were due at 12/31/06 but WHI extended IYXI a month to 01/31/07.  When that deadline passed, WHI extended the deadline to 03/31/07.  That deadline has also passed and IYXI supposedly has an offer from management backed by an investment group to take the company private and pay off the loan.  I have no idea why someone would pay $240MM for $60MM of assets unless the guys at IYXI create tremendous value. Their CEO, Jack Kachkar did not seem to add much value to the last company he was add.  Jack is even involved in bidding for a French soccer team, Olympic Marseilles.  The current own cut off negotiations when Jack did not produce the money. 
 
From my conversations with management at IYXI, an investor group out of the middle east is supplying the money for the soccer team, management buyout and payback of the IYXI loans.  IYXI management told me that they had outgrown WHI and hence found a new investors group to lend them money.  IYIX has an offer on the table for $3.02 to current shareholders for a deal that is supposed to close in a month.  For you risk arb types, that is a 18% gross spread for an annualized return of 216%.  The current stock price of IYXI is $2.56.  I guess that market suspects there is a problem with this deal.  I did not bother to short the stock because there is not sufficient borrow to make it worth while for my fund.
 
       Loans greater than $50MM require board of director approval so the WHI board must have been involved in these loans.  One loan is an asset based loan based on a pct of receivables.  IYXI booked some sales premature and booked the item into receivables and drew down on the WHI loan.  Then they reversed those entries in the next 10-Q but did not return the money to WHI (surprise).  I think a bankruptcy filing is imminent.   Now here is the shocking part, WHI has not reserved a dollar against this loan.  The CEO of IYXI has convinced them that they will be paid off and has even committed to a $10MM personal guarantee.  I think both WHI and IYXI are in denial.  This is just one loan that IYXI has.  You will see below that they have even more loans that are impaired and they seemed to be more worried about than this one.

Large securities portfolio will continue to pressure NIM or cause losses in the HTM securities portfolio.
 
WHI has a massive HTM securities portfolio with a cost basis of $7.01B and a fair value of $6.8B.  It is underwater by $213M (31% of BV).  You can argue the merits that an underwater HTM security portfolio does not matter as it does not affect book value and the bank can always hold it to maturity.  I don't buy this but suffice to say this portfolio is very large and the fair value changes a lot.
 
Negative carry experienced by HTM securities portfolio
 
Securities Portfolio
Avg Size
Interest
Stated Rate
Investment Securities
 6,468,173
    65,794
4.04%
Mortgage Backed Securities
    666,086
     6,994
4.17%
Total
 7,134,259
    72,788
4.08%
 
 
 
 
Funding
 
 
 
Fed Funds Purchased and Repos
 6,320,424
    80,390
5.05%
FHLB Advances
    106,891
     1,516
5.63%
Total
 6,427,315
    81,906
5.10%
 
 
 
 
Percent funded by Repoes and FHLB
 
 
90.1%
NIM on Securities Portfolio
 
 
-1.02%
Carry cost per year on 90% of portfolio
 
 
    (65,323)
 
Losses as a percent of Book Value and the inherent volatility of the portfolio
 
Held to Maturity Portfolio
12/31/03
12/31/04
12/31/05
03/31/06
06/30/06
09/30/06
12/31/06
 
 
 
 
 
 
 
 
 Total Investment Securities Cost
 4,724,378
 6,091,089
  6,372,569
 6,709,072
 6,302,026
 6,347,164
 6,347,187
 Net Losses
     (16,988)
     (24,233)
    (161,882)
   (211,805)
   (243,246)
   (157,163)
   (147,903)
Total Investment Securities Fair Value
 4,707,390
 6,066,856
  6,210,687
 6,497,267
 6,058,780
 6,190,001
 6,199,284
 
 
 
 
 
 
 
 
 Total MBs Cost
    999,332
    830,290
     701,456
    692,280
    677,849
    664,447
    660,392
 Net Losses
     (67,906)
     (60,249)
      (61,054)
     (79,351)
     (92,185)
     (67,223)
     (65,416)
 Total MBs  Fair Value
    931,426
    770,041
     640,402
    612,929
    585,664
    597,224
    594,976
 
 
 
 
 
 
 
 
Total Portfolio Cost
 5,723,710
 6,921,379
  7,074,025
 7,401,352
 6,979,875
 7,011,611
 7,007,579
 Net Losses
     (84,894)
     (84,482)
    (222,936)
   (291,156)
   (335,431)
   (224,386)
   (213,319)
Total Portfolio Fair Value
 5,638,816
 6,836,897
  6,851,089
 7,110,196
 6,644,444
 6,787,225
 6,794,260
 
 
 
 
 
 
 
 
Tangible Book Value
    443,615
    569,935
     662,552
    681,552
    686,719
    695,845
    697,049
 
 
 
 
 
 
 
 
Loss as Percent of Book Value
19%
15%
34%
43%
49%
32%
31%
 
I don’t believe that a bank should be paid to carry a large securities portfolio.  People’s a Bank, a well respected bank in Fairfield County, CT exited this strategy as they stated they add not value.  I believe this is the case for WHI.  It worked nicely when the curve was steep but is now haunting them.  The average life of their HTM portfolio is short at 31 months but they are still looking at booking a loss of $213MM through reduced net income from their loan portfolio.
 
 

Intense competition in Puerto Rico and expensive source of funding will cause continued pressure on an already low net interest margin (NIM).
 
Competition among the Puerto Rican banks is irrational.  Banco Popular is the most conservative bank on the island and every conference call they have, they mention the fact that the competition is not abatting.  This translates into lose loan standards and irrational deposit rates.  WHI’s NIM was1.59% at 2006Q3.  It is  paying 4.33% on its deposits and $7.6B of its $8.9B of deposits are jumbo CD's.  Its core deposit growth (excluding Jumbo CD's) has grown a total of 17% non annualized since the end of 2003.  They have been funding the majority of their growth through brokered CD's.  At 2006Q3, the bank had $6.5B of brokered deposits.
 
You can see that many banks on the island are offering 1 year Jumbo CD’s at rates well in excess of 5.5%.  Most of the banks in Puerto Rico just have no ability to get people to put money in the bank without paying an extremely high interest rate, hence tapping the brokered deposit market in the U.S.
 
           
 
HOW I GET TO A STOCK PRICE OF $3.50
 
 
Year end 2006 book value was $697MM or at 164.8MM share outstanding a value of $4.22.  I’m going to start here because the earnings power of this bank has clearly been deteriorating.  If you take their current loan loss ratio up to the level of their NPL+OREO, you would need to provision another $44.9.  This lops off $0.30 to $3.92.  Assume the IYXI loan is 25% impaired (I am giving Jack the benefit of creating some value here) or another $32.5MM or $0.20 to $3.72.  With $900MM in a commercial loan secured by residential real estate to Doral, I think they will need to reserve 5% of this or another $45MM dropping BV another $0.27 to $3.45.  With all the provisioning and bad loans, I think their earnings will be wiped out so a multiple of earnings does not make sense here.  I can’
Current Value at 1.17X book                                       $4.94
Compression to Book Value        -$0.72                    $4.22
Increased Provisioning                  -$0.30                    $3.92
IYXI Loan Impairment                     -$0.20                    $3.72
Doral Loan Impairment                  $0.27                     $3.45

Catalyst

1) Continued credit impairment of portfolio will cause higher provisioning and potential losses.
2) Commercial loan to IYXI has very high likelihood of being impaired.
3) Large securities portfolio will continue to pressure NIM or cause losses in the HTM securities portfolio.
4) Intense competition in Puerto Rico and expensive source of funding will cause continued pressure on an already low net interest margin (NIM).
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