A simple earnings model for FBP

FBP management will put out a presentation before they embark on their roadshow to raise capital. In those presentations, it is common to present an earnings forecast for a few years forward. In this post, I am going to attempt to present an estimate of what that earnings forecast will look like. This is not a bottom-up earnings forecast based on fundamentals. Rather it is based on what management has said directly or alluded to in regulatory filings. I am trying to guess what they are going to say not defend that as being likely. In fact, I think most would say that this is very optimistic. It probably is and maybe their forecast will be less rosy. But the take-way will be that even if it is much less rosy, they should be able to attract capital at a pretty good price and there should be considerable upside for the stock.

So what is the evidence of what management expects for earnings?

One main piece of evidence is a press release on April, 26 2010 where they say the following:

Mr. Alemán concluded, “The Corporation continues to reduce its credit exposure through disposition of assets and different loss mitigation initiatives as we approach the end of this difficult credit cycle in the Florida region. In Puerto Rico, our main market, there are initial signs of stabilization in the local economy. During the first quarter of 2010 we have experienced an improvement in the absorption rates of our residential construction projects, as well as an increase in auto sales financings and stable residential mortgage originations. Being far enough through the credit cycle, we expect a decrease in the demand for additional loan loss provisioning during the upcoming quarters.”

and

The Corporation and its advisors have been meeting with a number of prospective investors. The Corporation has provided those investors with internal projections that suggest that, by 2014, First BanCorp could have $290 million in pre-tax earnings. This projection assumes, among other things, that the Corporation will have no significant loan portfolio write-downs after 2011. That will require a strengthening of the Puerto Rico economy and a number of other improvements in the Corporation’s operating environment, which may or may not take place. In addition, it will require that FirstBank’s competitive position not be weakened by the expected consolidation of the Puerto Rico banking industry. Finally, this projection does not reflect the benefit from any additional capital, which is expected to improve the Corporation’s financial prospects. As with any forward looking information, there is a substantial possibility that the projected level of earnings will not be achieved.

So we have our first data point. With the usual caveats of (it depends on the economy etc..), they are expecting 2014 Pre-tax earnings of $290MM. We should also note that this press release was in April. They probably made that forecast to investors in March, seven months ago. That was before the economy in Puerto Rico showed many signs of stabilization. It has now been relatively stable (though not yet growing) for 9 months according to Government Development Bank Data. That was also well before the Puerto Rico Housing Stimulus was launched and before the Fortuno administration announced their dramatic tax cuts. If anything, their long term forecast should have improved since then.

We will make the assumption that after 2014, earnings grow by 4% per year which is typical of banks in normal times. Will the period after 2014 be abnormal? Who knows. But we are just trying to come up with a simple reasonable model based on what management has said.

We have another data-point based on some more subtle technical points made in their most recent 10-Q on page 80. This has to do with the amount of their Deferred Tax Asset (DTA) that is allowed to be included in Tier 1 capital. As it turns out, this depends on their expectations for earnings over the next 12 months.

Approximately $64 million of the Corporation’s deferred tax assets at September 30, 2010 December 31, 2009 — $102 million) were included without limitation in regulatory capital pursuant to the risk-based capital guidelines, while approximately $44 million of such assets at September 30, 2010 (December 31, 2009 — $12 million) exceeded the limitation imposed by these guidelines and, as “disallowed deferred tax assets,” were deducted in arriving at Tier 1 capital. According to regulatory capital guidelines, the deferred tax assets that are dependent upon future taxable income are limited for inclusion in Tier 1 capital to the lesser of: (i) the amount of such deferred tax asset that the entity expects to realize within one year of the calendar quarter end-date, based on its projected future taxable income for that year, or (ii) 10% of the amount of the entity’s Tier 1 capital. Approximately $7 million of the Corporation’s other net deferred tax liability at September 30, 2010 (December 31, 2009 — $5 million) represented primarily the deferred tax effects of unrealized gains and losses on available-for-sale debt securities, which are permitted to be excluded prior to deriving the amount of net deferred tax assets subject to limitation under the guidelines.

This allows us to estimate what they think pre-tax earnings will be over the next 12-months. That depends on the tax rate. That is currently 39% but will be lowered to 30% by (I think) April. Let's split the difference and call it 35%. They say they expect to realize $64MM in taxes over the next 12-months. The expected pre-tax earnings is therefore the realized tax divided by the tax rate which is $64MM/0.35 or $183MM.

So, our second data-point is that they expect to realize $183MM in pre-tax earnings over the next 12 months. Lets call that 2011 earnings even though it technically runs over the 4 quarters from Q4 2010 to Q3 2011. They expect pre-tax earnings of $290MM by 2014 so lets use that for 2014. So we just need earnings the two years in between. We will just linearly interpolate for lack of any other info. That gives $218MM in 2012 and $254MM in 2013. Finally, we can write down a table of our expectation for management's expected earnings.

I have also assumed that as they make taxable income, they reverse their DTA valuation allowance of $290MM. So they pay no taxes the first 4 years until it is used up. Alternatively, they could reverse it all sooner but the effect on final tangible common equity is the same. This allows us to calculate net income and tangible common equity in each year. I have further assumed a $500MM capital raise at $0.50 and calculated final TBV. I then valued the stock price at some multiple of TBV. I have assumed 70% the first year and rising to 120% by 2014 and thereafter. So finally, this gives you a stock price target and also the appreciation factor for new investment. For example, in this model, they invest at $0.50 and have more than quadrupled their investment by 2015.



I will end with the disclaimer that no one knows the future; not even management. This isn't even management's prediction. Rather it is my estimate of what it will look like based on what they have already said. When they issue their presentation in a few weeks, we will get more concrete information (hopefully!). For the actual results, we will have to wait for the future to arrive. Good luck!