Puerto Rican Deal Provides Rare Chance for a Bank Makeover

Oriental Financial Group (OFG) has made a gutsy move in agreeing to buy the reject of a Spanish bank in Puerto Rico.

The price tag for Banco Bilbao Vizcaya Argentaria's (BBVA) 36-branch operation on the island is $500 million, and Oriental would absorb a major hit to tangible common equity.

Yet the strategic gains are so inviting that they justify the risk, investors and analysts say.

The deal would catapult Oriental from an also-ran to Puerto Rico's No. 3 bank, with nearly $12 billion of assets, and transform its balance sheet.

Oriental would become "a different animal," says Joe Gladue, a senior analyst with B. Riley.

Oriental today relies on the thin spread between wholesale borrowings and government securities to make money. BBVA's Puerto Rican unit, a more traditional loans-and-deposits franchise, likely would fatten Oriental's spreads over time.

That result would forgive the huge amount of capital it would burn upon the deal's scheduled closing at yearend, experts say.

Oriental should "fairly rapidly" be able to earn back the "pretty significant" 24% dilution to tangible equity, Gladue says.

Wall Street seemed to agree with the positive assessments. Oriental's shares rose 5.4% to $11.02 on Thursday, defying a yearlong trend of investor sell-offs of banks that announce equity-diluting deals.

Shares of United Financial Bancorp (UBNK) of West Springfield, Mass., shares fell more than 7% on May 31 when it announced its $91 million agreement for New England Bancshares (NEBS) of Enfield, Conn., a deal expected to lower the buyer's tangible book by 9%.

"It is encouraging to see the initial market reaction" to the Oriental deal, says Frank Cicero, the global head of financial institutions investment banking at Jefferies & Co., which advised Oriental on the deal.

The reception shows that "investors still have a high bar as far as what they expect from bank deals" and that buyers need to show significant financial benefits to justify deals that dilute tangible book, he says.

Though bank merger activity will likely remain slow, Cicero says, "when we do see activity, it is going to be like this: Strong midcap players doing in-market deals that are priced to allow for strong returns."

Oriental — which first began to wean itself off securities and wholesale funds with the 2010 purchase of Eurobank's failed Puerto Rican operations — would add $3.7 billion in loans and $3.3 billion in deposits under the deal announced Thursday.

It would book unusually high dilution in this deal for a couple of reasons.

It would dole out $350 million in cash, which exhausts capital. It also intends to issue at a discount to book as much as $159 million of equity and debt at that converts to equity.

Though issuing stock or stock-like instruments often boosts capital, in this instance the offerings probably would be dilutive because Oriental trades at a lower multiple than it would pay for the target.

Oriental is to pay a price equal to about 103% of the tangible book of BBVA's Puerto Rican unit. Oriental as of Thursday traded at about 73% its March 31 tangible book value per share. It is issuing preferred stock in the private placement that converts at a price equal to 77% its tangible book.

The pricing would be reasonable and the payoff great, Oriental executives said in a conference call Thursday morning.

"We are taking advantage of a once-in-a-lifetime opportunity" at a "very attractive valuation," said Jose Rafael Fernandez, Oriental's president and chief executive. "The end result is a well-capitalized balance sheet with significant scale."

Oriental's higher expected post-merger profits should enable it to pay back within two years the capital lost in the deal and to maintain its dividend, he says.

Oriental's estimated returns on average assets for 2014 would be 1.07%, up from its current forecast of 0.9%, he said.

That forecast reflects what should be a more lucrative mix of assets and liabilities.

Oriental is currently a highly leveraged bank: 60% of its funding comes from wholesale borrowings, and 71% of its assets are government securities, other securities and cash equivalents, according to an investor presentation.

Its post-merger wholesale borrowings would decline to 34% of funds, and securities investments would shrink to 37% of assets.

That reflects a higher ratio of loans and core deposits, as well as a combined $1.8 billion in securities investments Oriental and the BBVA unit intend to liquidate prior to closing.

For BBVA, the deal frees up much needed capital as it seeks to shore up its balance sheet amid deep uncertainty back home.

It marks a retreat from a slow-growth market to its larger, more important franchise in the mainland U.S., the $65 billion-asset BBVA USA Bancshares of Houston, the No. 30 U.S. bank holding company by assets and parent of BBVA Compass of Birmingham.

Spain's economic woes have raised speculation that BBVA would seek to sell all or some of BBVA Compass, but experts say the parent company is reluctant to spin out its main U.S. banking assets for two reasons: It wants to maintain a large, primary source of U.S. funding, and the low prices that large banks have been fetching lately means it might not be able to sell BBVA Compass without booking a loss.

"BBVA's commitment to the U.S. remains unchanged," a company spokeswoman wrote in an email. "In fact, this sale allows it to better focus its efforts in the U.S. on BBVA Compass."

BBVA's Puerto Rican unit makes up less than 1% of its parent company's assets, she wrote, adding that given BBVA's "lack of critical mass" in Puerto Rico, Oriental's offer was "an attractive opportunity."