Popular Inc. (BPOP) is currently under-earning, has little credit risk, and trades at 0.4x tangible book value and 3x normalized EPS. At a reasonable multiple of 1.0x pro-forma tangible book, equivalent to 9-10x 2013E EPS of $0.40 which will become increasingly visible over the next year, the stock will be up nearly 300%.

BPOP is the parent holding company for Banco Popular Puerto Rico (BPPR) and Banco Popular North America (BPNA) and has a total of $33B of earning assets and a $1.2B market cap. BPPR is the largest bank in Puerto Rico with approximately 45% market share which translates into $19.2B of loans on the island, with nearly 25% of these loans guaranteed by the federal government because they were acquired in an FDIC-assisted transaction in April of last year when BPPR acquired the assets of Western Bank. BPNA is a small regional bank with operations primarily in NY, CA, and FL and. BPNA has approximately $6B of loans, primarily commercial & industrial, and $1.2B of tangible equity.

There are two hidden assets on the balance sheet. The first is a 49% interest in Evertech, a transaction processing subsidiary in which private equity firm Apollo Management purchased a 51% stake in 2010. Based on Apollo’s strategy of continuing to build Evertech as the leading processing company in the Carribean and Latin America, with an eventual exit to a strategic buyer or the public market, we believe this could translate into another $0.20-0.30/share. The second hidden asset is a $1.3B deferred tax asset that is completely reserved against, representing nearly $1/share. Management believes they will be able to reclaim this at some point, likely through an acquisition.

POSITIVES

Net Interest Margin (NIM) Stability. Concerns over “low rates for longer” and their impact on regional bank NIMs have many investors concerned about shrinking revenue at other regional banks. Yet BPOP has fairly high deposit rates due to the legacy of the historically competitive deposit market in Puerto Rico, which has changed substantially due to a more consolidated market today. Nearly 50% of BPOP’s $22B in deposits are priced at 1.8%, down from 2.2% last year, versus mainland deposit costs at significantly below 1.0%. As BPOP re-prices its higher cost deposits as they roll off, and leverages its dominant market share on the island to get more pricing power, the Company will continue to see NIM expansion.

Earnings Tailwind. In Q2 BPOP increased the value of the accretable yield in its covered loan pool by nearly $0.5B, which creates a near-term earnings headwind as the Company has to amortize its FDIC-loss sharing asset as a result of the unusual accounting for FDIC-covered loans. However, the FDIC asset has an approximate 1.5-year life, while the covered loans have a 7-year life. As a result, BPOP negatively amortizes the FDIC asset over 2 years while the earnings benefit is drawn out over 7 years. As this amortization rolls off over time and the accretable yield continues, BPOP’s NIM will benefit from a tailwind.

High Credit Quality. BPOP had 8.4% of its loan book classified as non-performing loans at the end of Q3. However, nearly 40% of those non-performing loans are Puerto Rican residential mortgage loans which have historically had much lower loss rates (typically less than 100bps) than residential mortgages in other regions. There are a variety of reasons for this, but the main one is that 70% or more of non-performing residential mortgage loans in Puerto Rico cure as a result of the lack of a rental market on the island and the somewhat common practice of delaying a mortgage payment temporarily to fund other purchases. Excluding these low-loss residential mortgages, the Company’s NPL ratio is a more reasonable 5.5%, with a 60% coverage for its allowance.

Strong Capitalization. BPOP has 11.6% Tier 1 Common Equity and 8.4% Tangible Common Equity. This capitalization makes it one of the better capitalized regional banks and the second best capitalized bank of those that have exited TARP (#1 is KeyCorp).

Disproportional Benefit from Housing Stimulus. Although Puerto Rico is in its fifth year of recession, the island’s economy is substantially better off than it was one year ago and continues to improve. As noticed by the WSJ this past August, “home sales are sizzling…in Puerto Rico.” This performance is the direct result of housing stimulus which is expected to be ongoing and the disproportional impact it is having on a relatively small, closed island economy. One of the incentive program's popular provisions offers qualified buyers down-payment assistance for homes purchased with a mortgage, as well as a second mortgage of as much as $25,000 that can be used to make down payments and pay closing costs. Buyers of new homes also pay no transfer taxes when a property changes hands, escape paying property taxes as well as future capital-gains for five years, and pay no taxes on rental income for 10 years. Sellers do not have to pay capital-gains taxes on profits. 2011 new and existing home sales on the island are up massively over 2010, with a total increase over the last twelve months of 38% in units and 31% in dollars.

Puerto Rico has Effective and Rational Government. The governor of Puerto Rico over the past two years, Luis Fortuno, has made tremendous strides in fixing the island’s bloated government by radically reducing its fiscal deficit, which in turn, resulted in S&P’s recently upgrading the sovereign’s credit rating to BBB, stable. As part of his continued economic plan, there are several privatization efforts underway on the island, with numerous buyers bidding on the airport and toll roads. These privatizations should fill the island’s coffers and create new jobs. Furthermore, the governor recently reduced the corporate tax rate to 30% from 41% and lowered personal income tax rates by 25% with more cuts coming over the next five years. The most recent economic statistics show unemployment has flattened, although a still relatively high 15%. Cement sales, typically a leading economic indicator, were up 18% sequentially in October. Finally, hotel registrations are at all-time highs.

“The transformation of Puerto Rico’s dysfunctional economy has begun to attract attention. Retailers such as Nordstrom, PetSmart, Saks Fifth Avenue and Victoria’s Secret have announced store openings in San Juan in 2012. Honeywell International and Merck & Co. have announced expansion of their manufacturing operations on the island.” –“How Puerto Rico Stepped Back From An Economic Abyss”;  The Globe and Mail 12/13/11

Insider Buying. The CEO purchased $500k of stock in October and other senior managers of the company (including the CFO) purchased a total of $250k of stock over the last few months.

RISKS

Share Dilution. BPOP still has $1.0B of TARP funds, so some investors may be concerned about potential dilution. However, we do not believe the Company would issue stock at the current price, the bank has plenty of liquidity, and BPOP would have more capital after paying back TARP than many other banks who have already repaid.

Management Communication. Management communication at the bank has been criticized by investors. However, they have made continual improvements with the Company’s first investor held at the beginning of December. Despite the economic turmoil, they chose this event to state their belief that normalized EPS is $0.36, which we believe is conservative.

Economic Downturn. There is always a risk that the Puerto Rican economy goes into a decline. Although the island is improving off of its lows and given all the recent trends, this seems remote.