The Banks of the Caribbean

We mainlanders may tend to overlook our island territory in the Caribbean when it comes to investing. Yet according to the latest FDIC figures, Puerto Rico's total bank deposits nearly equal that of the entire state of South Carolina -- while growing nearly twice as fast since the year 2000. Among only a handful of banks, W Holding (NYSE:WHI), the holding company for Westernbank, and First Bancorp (NYSE:FBP) have emerged as market leaders, along with well-established market leader (and Motley Fool Income Investor recommendation) Banco Popular (NASDAQ:BPOP). While any of these three banks may make for good investments, I believe W Holding is not only the best-managed company among its peers, but also sells at the greatest discount.

Daring to be different
Westernbank has worked hard to differentiate itself from its competitors. Bank branches remain open until 7 p.m. -- breaking that unwritten industry rule that the doors must close by 5 o'clock -- and keep convenient hours on weekends. Westernbank is now rolling out a redesigned model bank branch that throws out the teller window in favor of kiosks that enable friendlier interaction between bank associates and customers. Sales associates use wireless keypads and notebooks to conduct transactions, which often take place at the bank's own coffee cash bar -- a creative touch for creating an inviting atmosphere.

OK, so that all sounds good when you're reading about it in the annual report. But if President and CEO Frank C. Stipes' enthusiasm about Westernbank's excellent customer service is more than just salesman fluff, we should look for numbers attesting that Westernbank is indeed growing and attracting accounts from competitors.

Growing market share
Below I have summarized deposit market share data for Puerto Rico's three largest banks (by total domestic deposits) for the island territory as a whole and for the markets of San Juan and Mayaguez, where Westernbank is headquartered.

Puerto Rico % Deposit Market Share

San Juan Metro Area % Deposit Market Share

Mayaguez Metro Area % Deposit Market Share

Westernbank is exhibiting pronounced yet steady and manageable growth across the island and in two vital markets. Meanwhile, market leader Banco Popular has slipped across the board in comparison with its smaller competitors. (Banco Popular's market capitalization is almost $7 billion, while Westernbank's and First Bancorp's are around $2 billion.) The most notable change is in Mayaguez, where Banco Popular has fallen to second place behind Westernbank. While this neither spells doom for Banco Popular nor means that Westernbank will continue on its current path, the trends indicate that Westernbank is a notable competitor.

Shunned by the Street
While both Westernbank and the Puerto Rican banking market have been growing at a healthy pace, this has been a rough year for Puerto Rico-based banks on Wall Street. From January through May, the three aforementioned banks steadily declined, posting an average 36% loss. Doral Financial's (NYSE:DRL) aggressive accounting practices have obviously created some fear, considering that the stock prices of all Puerto Rican banks have slid in conjunction with Doral's collapse. In addition, there have been reports that Puerto Rico might increase taxes on financial institutions. If this happens, perhaps investors will see a slight impact on margins, but the best-managed banks should be able to continue in the pattern of their past success.

Meanwhile, Westernbank has posted yet another quarter of excellent growth, increasing earnings per share by 20% in the first quarter of 2005 while continuing to show strong performance numbers. Is it fair for the Street to bash the stocks of Doral's competitors simply by association?

A look at valuations and management ratios
While posting steady growth numbers, Westernbank has a valuation that appears cheap. Both First Bancorp and Westernbank's PEG ratio valuations have been hit by the 40%-plus declines that their stocks have suffered this year.

The efficiency ratio tells us how a bank's operating costs (excluding interest expenses) compare with its income. Since a lower ratio indicates lower expenses compared with income, a lower ratio is better. Investors should look for banks sporting efficiency ratios less than 60%; Westernbank's ratio of 29.8% tells us that it is keeping a tight rein on expenses.

Non-current loans are those that are at least 90 days overdue and not accruing interest. Of course, these percentages should be kept as low as possible. Westernbank is maintaining excellent loan quality while growing its loan portfolio at the same time.

Puerto Rico's banking market grew 10% annually during the five years ended June 30, 2004, defined by total deposits held on the island. That's not bad ... good enough, in fact, to edge out California's 9.4% deposit growth over the same period. Plus, Westernbank is claiming a larger piece of the pie for itself every year -- usually at Banco Popular's expense. While it might be a bit too greedy to project that Westernbank's recent 30% growth rate in sales and earnings will continue for another five years, 15%-17% growth seems entirely within reason.

Assigning Westernbank a P/E ratio of 15 for the purpose of estimating a fair value results in a current value of $13.35 per share, based on the trailing four quarters' earnings of $0.89. Westernbank just released earnings on July 20 showing earnings growth of 11.6% for the quarter and 15.8% for the first half of the fiscal year. A reasonable 13% growth rate for the whole year would deliver EPS of $1.01, pegging Westernbank's fair value in the neighborhood of $15 per share.

Let's quickly look at another valuation metric to see how it compares: Westernbank's 1.45 price/book value ratio compares favorably with those of Banco Popular and First Bancorp, which are valued at nearly 2.5 times their book values. If Westernbank traded at a similar valuation, it would be worth $17 per share.

Past performance, future opportunities, and business risks
Of course, no stock is without its risks. Obviously, Westernbank's fortunes are closely tied to Puerto Rico's economy. Most banks have their operations spread across a greater geographic region, so be aware that while Puerto Rico is booming now, recessions hit every economy sooner or later. In this respect, Banco Popular is a little more diversified, because it has operations on the mainland. (You might notice its ads at baseball games in New York and Miami.)

As is the case with every lender, the prospect of higher interest rates and a flattening yield curve will require adjustments to loan and deposit portfolios. In the quarterly report issued Tuesday, Westernbank executives detail their plans to adapt. The 10-Q reveals that Westernbank's interest rate spread has shrunk from 2.31% to 2% from the same quarter last year. However, it seems that the bank is adjusting well, considering that the estimated impact of a 200-basis-point increase in rates was estimated to cause a 15% decline in net interest income at the close of 2004. As of June 30, that estimated negative impact has dropped to just less than 7%.

Ultimately, one of the best gauges of quality management is the proof that that management has been successful in the past. Sure, past performance does not guarantee future results, but it's not a bad barometer, either. Management depends on skill -- not luck -- so companies that have succeeded in the past, barring massive management shake-ups, are likely to continue growing. According to a Wall Street Journal study cited in Westernbank's 2003 letter to shareholders, Westernbank was one of the top five performers among publicly traded stocks over the preceding 10 years, returning 50% annually.

Still, Westernbank has plenty of room to grow in Puerto Rico. Banco Popular has been growing in New York City, the source of a third of its total deposits, while Westernbank has only begun to establish a presence in San Juan and eastern Puerto Rico and has yet to step foot in the States. I was a bit concerned that CEO Stipes' 2003 letter to shareholders mostly boasted about the stock's decade of market-trouncing returns, but 2004's letter was quite admirable: 10 pages about W Holding's business and the Puerto Rican economic and political situation -- and not one boastful word about the stock's 27.9% increase during the year.

Considering its unbroken history of positive earnings, its consistent growth in both new and established markets, and its creative approach to banking, there are plenty of reasons to believe Westernbank is one of the best-managed banks in Puerto Rico and the United States. Investors seeking to profit from Puerto Rico's growing economy have a unique opportunity to pick up shares of this excellent bank holding company at a discount to intrinsic value.

In Motley Fool Income Investor , Mathew Emmert has selected several banks, in addition to Banco Popular, which are paying big dividends. Take a free, no-obligation trial today to see which ones have made the cut.

Doral Financial is a Motley Fool Inside Value recommendation.

Fool contributor Jason Ramage looks forward to hearing your feedback. He owns shares of W Holding, but none of the other companies mentioned. The Fool has a disclosure policy.