Earnings Call Transcript - FBP Q2 2020

Operator, Operator

Good morning and welcome to the First BanCorp Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the conference over to John Pelling, Investor Relations and Capital Planning Officer. Please go ahead.

John Pelling, Investor Relations and Capital Planning Officer

Thank you, Andrew. Good morning everyone and thank you for joining First Bancorp's conference call and webcast to discuss the company's financial results for the second quarter of 2020. Joining you today from First Bancorp are Aurelio Alemán, President and Chief Executive Officer; and Orlando Berges, Executive Vice President and Chief Financial Officer. Before we begin today's call, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings and capital structure as well as statements on the plans and objectives of the company's business. The company's actual results could differ materially from the forward-looking statements made due to important factors described in the company's latest SEC filings. The company assumes no obligation to update any forward-looking statements made during the call. If anyone does not already have a copy of the webcast presentation of press release, you can access them at our website, 1FirstBank.com. At this time, I'd like to turn the call over to our CEO, Aurelio Alemán. Aurelio?

Aurelio Alemán, CEO

Thank you, John, and good morning everyone. This time, before going into the details of the quarter, I would like to discuss what we consider a more pressing matter at hand. Earlier this morning, in our separate press release, we disclosed an exciting piece of news. Yesterday, we received regulatory approval to move ahead with our strategic transaction with Santander. We're very pleased to have achieved this step. We do expect to meet our closing conditions and close the deal by September 1. As we shared before, this is a transformational transaction for our company. And while there have been many moving parts since October, we actually expect that the resulting deal metrics, meaning TBV dilution EPS acquisition and earn-back, will be in line with those that we reported in October as compared to our standalone projections. Please keep in mind that the deal excludes just to remember some of the metrics that we shared at that point in time; it excludes NPAs. The premium is calculated based on the size of the balance sheet at closing. In addition to what we disclosed in the agreement in October, we expect that Santander would deliver to us an additional $28 million in loan loss reserve to account for loans that are subject to COVID-related moratoriums. We also have to consider that over the past few quarters we have incurred expenses associated with the transaction of about $50 million already. This has impacted our bottom line and tangible book value already. Also, obviously that will reduce the remaining quarter going forward. And I think it's important to note here that, given the timing, most of the savings of the transaction and the synergies will occur in 2021. We do expect to complete the full integration by the end of the second quarter of 2021. I think it's important to mention that when we disclosed our transaction in October, we did not mention the DTA but this transaction should have a potential benefit to our DTA; we can expand on that later in the Q&A. And I just want to comment, obviously, we've been operating under this new private environment and we have learned a great deal from an operational standpoint as we move through the pandemic and now as a larger institution with greater scale, we will definitely look forward to identify larger synergies and additional opportunities for growth in this consolidation. We are greatly appreciative and welcome both the employees and the expanded client base, and we will work hard to continue enhancing our products, services, and channels to meet or exceed our expectations. So we're very pleased to have achieved this step. Please, let's now move to Slide 5 of the presentation, so we can cover the highlights of the quarter. Definitely the landscape has changed, I would call the operating landscape of the industry, and from the operational standpoint, I must say that we are extremely proud of our team and the dedicated frontline employees and also to our customers for their ability to adapt in this challenging operating landscape. Priority number one has been the safety of our employees and customers while we provide the services. As of today still more than 80% of the support staff is working remotely; in the facilities we continue to execute strict safety protocols including contact tracing and preventative testing of COVID. Since the beginning of the pandemic, we have been committed to maximizing the benefit of the CARES Act to support our customers. This includes referrals and programs such as PPP. And we've also been involved in some other programs such as the FHLB of New York grants and the USDA to support rural communities. We understand that, obviously, those are key benefits to mitigate the challenging times that our customers are all experiencing. The trends that we continue to see in the interchannels continue to enhance the customer experience as mobile and online technology tools have definitely facilitated customer interaction remotely. As you can see on the right side of this slide, transactions have shifted from branches to our alternative data channels, and we're very pleased to see those trends finally taking place in our market. Please let's move now to Slide 6 to discuss the quarter a bit more. Before that, actually reopening trends are important when we talk about the quarter; the drivers are what's happening after the closure and the reopening. Early indicators actually look good, but we continue to track these metrics within our customer base across different industries. The information included here pertains to our customer base, and we are tracking it only on a weekly basis on how the different sectors are moving. Obviously, we are also conscious of the potential impact of additional tightening towards the reopening efforts due to the spikes in cases recently. We have to say that the hospitality sector, including hotels and restaurants, is definitely the most impacted so far, and recovery will depend on the reopening speed. As an example, we're looking into the activity of merchants and point of sale. We experienced a significant increase during the last week of June compared to the last week of March. So obviously, retail being open to the public has seen spending significantly increase. The second-quarter results for us were hampered by the lockdown; remember that in Puerto Rico, we were not able to originate long-term mortgages up until May, and basically half of the quarter showed limited origination activity on the consumer side. We saw a PBT pickup in June. It is worth mentioning that Florida did remain open, and we continued originating normal levels of mortgages, actually better than normal. However, quarterly originations in consumer drawn, auto, and the residential portfolio, as you can see in the graph, showed the positive impact of June. The moratoriums, on the other hand, have materially increased customer liquidity. When we look at growth, we experienced an outstanding $1.2 billion increase in core deposits, 30.5%, and this excludes government deposits. I think it's important to keep in mind that the estimated stimulus for the Puerto Rico market is about $14 billion so far, and this is very material as a percent of the GDP; it has created significant liquidity in the market. This should definitely help offset some of the risks that we face over the next couple of quarters. We compare this to the liquidity that we experienced during the last hurricanes, driven by the support and stimulus provided then. Please move to Slide 7 for a moment; Orlando will expand on this detail, but we ended the quarter with $21 million in net income, or $0.09 per share. As expected, we experienced some deterioration in the economic forecast that required an additional reserve build. This quarter was $29 million, which impacted our bottom line. Pre-tax, pre-provision revenue continues strong at $67 million considering the rate environment and the impact on NIM. I definitely have to say we do have a fortress balance sheet, extremely well capitalized, with a total risk-based capital ratio of over 25%, and now the reserve to loans is at 3.55%, which both of these are among the highest in the sector. APAs continue to move down now below 2.2% of assets. Again, we remain committed to servicing our clients on the new operational challenges of COVID. We're committed to the safety of our employees and customers as a priority, and obviously, while we still face uncertainty regarding the future part of the economy, our fortress balance sheet and battle-tested management team will allow us to navigate this pandemic through the end. So, with that, I'm going to leave you with Orlando to cover the details of the quarter; I'll be available for the Q&A.

Orlando Berges, CFO

Good morning, everyone. I want to start by noting that we reported a net income of $21.3 million for the quarter, which translates to $0.09 per share. This is a significant increase compared to $2.3 million or $0.01 per share in the first quarter of 2020. During this quarter, we encountered several special items in both income and expenses related to the pandemic and the Santander transaction. Additionally, an insurance recovery in the quarter contributed to our income, and I will provide further details about these on the following slides. If we adjust our balance sheet for these items on a non-GAAP basis, our net income for the quarter would be $22 million or $0.10 per share, compared to a net loss of $5.9 million, which also adjusted to $5.9 million in the first quarter, equating to $0.03 per share. As we anticipated, our net interest income decreased in the second quarter to $135 million, down by $3.4 million from the previous quarter. This decline was primarily due to the significant drop in interest rates and the reduced volume of loan originations stemming from the pandemic and lockdown, during which we did not originate loans for half of the quarter. We also saw a substantial increase in deposits, leading to higher cash levels in money markets, which currently yield significantly less in this interest rate environment. Specifically, interest income dropped by $3.3 million from cash and investment securities and an additional $3.3 million from loans. Despite an increase in average balances related to PPP loans, these are lower-yielding. On the contrary, while the average balances of interest-bearing deposits increased by nearly $400 million for the quarter, interest expenses fell by $3.2 million, reflecting a 22 basis points reduction in the average cost of interest-bearing liabilities. The current cost of deposits is approximately 61 basis points, down from about 77 basis points in the first quarter. For the quarter, the margin was 422 basis points, compared to 463 basis points last quarter. Analyzing the components, the impact includes a 4 basis points decrease related to PPP loans, a 7 basis points decrease from the repricing of cash balances, and an 11 basis points decline due to a higher ratio of cash balances to interest-earning assets, which alters the mix of earning assets. The downward repricing of commercial loans and credit cards contributed around 9 basis points, while accelerated premium amortizations from investment securities prepayments impacted us by about 4 basis points. We also experienced a 4 basis points decrease due to late fees, resulting from a higher proportion of the portfolio being on payment deferral programs. Our non-interest income for the quarter was $20.9 million compared to $30 million, but both quarters included special items. In the first quarter, we had an $8.2 million gain from the sale of around $275 million of available-for-sale securities. In this quarter, we benefited by $5 million from the final settlement of business interruption insurance claims related to hurricanes Irma and Maria in 2017. Excluding these items, non-interest income still dropped by about $6 million, with $3 million of this decline resulting from the seasonal contingent insurance commission, which occurs every first quarter. Additionally, we noticed decreases in service charges on deposits and transactional fee income, largely due to lower transaction volumes caused by reduced business activity because of the COVID-related impacts. On the expense front, we reduced expenses by $2.4 million for the quarter, from $92.2 million to $89.8 million. These expenses also incorporate some of the aforementioned special items, including $2.9 million in merger-related expenses tied to legal and integration efforts associated with the Santander transaction, with about $800,000 recorded last quarter. We incurred around $3 million in COVID-related expenses this quarter, which include cleaning costs, employee testing, protective materials provided to employees in branches, and additional security measures for traffic control. We also allocated about $1.7 million for special compensation to our customer-facing and support employees who have been present throughout this process. In the first quarter, we registered a $1.5 million insurance recovery against expenses. When excluding these items, expenses fell by $8.2 million, primarily due to decreased business volumes. For expense control measures, we have ceased hiring for vacant positions, adjusted business promotion strategies, eliminated travel, and reassessed project plans, leading to these reductions, which are detailed in our press release. There is a significant portion tied to volume-related expenses, and as volumes return to normal, those expenses may increase. Estimating forward, without considering COVID-related and Santander expenses, we anticipate expenses will fall within the $88 to $90 million range over the coming quarters, excluding transaction and integration costs. Regarding reserves, the provision for the quarter was $39 million, contributing to a $29 million increase in the allowance for credit losses, now totaling $337 million as of June 30, including $319 million related to loans. Since adopting CECL, the allowance for credit losses on loans has increased by about $164 million, growing from $155 million in December to $319 million currently. This allowance reflects 3.55% of loans, excluding PPP loans, which is significantly higher than the 1.72% percentage we recorded in December. We believe this provides substantial coverage against potential losses and positions us well for anticipated economic conditions. Furthermore, in addition to the $319 million allowance on loans, we have an extra $7 million allowance related to unfunded commitments on some lending facilities. Moving on, moratoriums have been a key aspect of our strategy. As discussed in the first quarter, we implemented payment moratorium programs to help customers during the pandemic's initial stages. By the end of June, 36% of our portfolio was under moratoriums, many of which were for a three-month duration. However, by July 24, this percentage had decreased to about 18%, reflecting borrowers starting to resume scheduled payments. It’s important to highlight that legislation in Puerto Rico requires banks to extend moratoriums for qualified residential mortgage borrowers through the end of August. We continue to engage with borrowers and have conducted thorough reviews of commercial borrowers across different sectors. Although the hospitality industry is still facing significant challenges, other sectors are showing signs of normalization. Charge-off levels for the quarter decreased, reflecting lower inflows to non-performing status, registering $10 million this quarter, which is $20 million less than last quarter, largely due to the effects of the deferral programs, as many customers continued making their payments. Overall, non-performing loans dropped by $14 million to $303 million as of June 30, compared to $317 million as of March 31. We remain vigilant in monitoring our portfolios and understanding customer behaviors. As mentioned, several customers have already opened non-operating accounts, indicating we are on the right track to continue executing our strategy. With that, I would like to open the floor for questions.

Operator, Operator

First question comes from Ebrahim Poonawala of Bank of America. Please go ahead.

Chris Nardone, Analyst

This is Chris Nardone for Ebrahim. Congrats on getting the regulatory approval. Just want to know, are there any performing loans that you are planning to acquire initially but are no longer acquiring given the COVID stress?

Orlando Berges, CFO

The agreement regarding the Santander transaction calls for acquiring all loans that are performing at closing. If there are any non-performing loans that meet all the financial criteria for non-performing, they have to be classified as such and Santander will keep those. So, if any loan has been affected to reach that point to be considered non-performing, it has to be classified as such and will not be part of the transaction. If it's just related to some payment deferrals that have been given in the market under normal terms, then not necessarily; it's a function of the payment capacity of the customer.

Aurelio Alemán, CEO

But the answer is anything that migrated to non-performing since October to closing is not part of the transaction.

Chris Nardone, Analyst

And just a quick follow-up. Appreciate your prepared remarks, but if you could just give us an update on the pro forma capital outlook, just in terms of the tangible book value dilution that you expect and where you expect the TCE ratio to end, that would be great. Thanks guys.

Orlando Berges, CFO

Yes, the ratios. As you know, we had anticipated the Tier 1 ratios to be above 15% on the transaction and those numbers still hold. If you look at the balance sheet, we are a bit larger mostly because of the large increase in deposits, and it's all cash - a lot of cash and investment securities. The risk weighting of that is zero or 20%, depending on the component. The Santander balance sheet has remained fairly consistent with what we had before. I anticipate a slightly lower leverage, only because of the higher average balances that we have on that cash, but other than that, still all the ratios are well capitalized. The leverage ratios were anticipated around 11% originally, maybe slightly lower, but still above 10% at closing. So, it's fairly consistent with what we had disclosed before, including tangible book value dilution similar to what we had disclosed before. We haven't seen any changes, obviously all based on our standalone; there have been some reviews of our standalone estimates, but the transaction will continue to add as we expected.

Operator, Operator

Next question comes from Alex Twerdahl of Piper Sandler. Please go ahead.

Alex Twerdahl, Analyst

So, I just wanted to elaborate or I guess dig in a little bit more to that last comment about the tangible book value dilution being consistent with the announcement. So, I think if I recall, that the announcement is at 7% tangible book value dilution from the transaction and then another - somewhere between 1.5% and 2% dilution from the CECL impact of the acquired loans. Would it be fair and then you also kind of alluded to DTA and kind of I think you'll expand a little bit more upon that - upon me asking. But as we kind of put all that together and then look at tangible book value at 6/30 of $9.83; is the right way to think about pro forma tangible book value just kind of knock in somewhere between 8.5% and 9% off of that, the way we would have upon the announcement, or is there something else we should be factoring in as well?

Orlando Berges, CFO

We believe it's going to be more in the 7% to 7.5% combined with CECL, based on some of the changes in the balance sheet and some of the other components that we have seen, but it's just a bit lower considering CECL, but not too different, and similar earn back to what we had before. The DTA component that you made reference to, we did not include that in any of the analysis and it's something that clearly Santander adds to our borderline some revenue streams that would allow us to utilize DTAs; we'll work exactly on the exact amount. We haven't finished the full analysis of the amount, but clearly, it's going to add some to the bottom line. I don't think it's going to realize the whole DTA evaluation allowance that we have, but it would allow us to realize part of it, and that's going to help also in compensating for any dilution.

Alex Twerdahl, Analyst

And can you remind us what the - what that valuation allowance was at the end of 6/30, the total one?

Orlando Berges, CFO

The evaluation allowance on the bank is about $40 million. From the top of my head, I think it's $47 million; just on the bank remember that their evaluation - it's a valuation allowance on the holding company that it's a bit different because of the individual legal entity taxing component of Puerto Rico plus $50 million was the evaluation allowance on the bank as of June 30.

Alex Twerdahl, Analyst

$50 million. So, some portion of the $50 million will likely come back in when the deal closes or I guess subsequent to the deal closing?

Orlando Berges, CFO

Yes.

Alex Twerdahl, Analyst

And then, just last question from me, just as I think about the margin going forward, and if you back out the PPP impact of 4 basis points, the 4 basis points of accelerated prepayments amortization, and then I guess 4 basis points from the lower late fees, is that kind of the right starting point for the margin going into the third quarter? And then, as you kind of look out and the opportunities you have on deposits and the pricing pressures on loans - how should we be thinking about the NIM trajectory over the next couple of quarters?

Orlando Berges, CFO

We expect the PPP to be present for the next few quarters, as we believe many of the loans will remain in place for about six months. Therefore, the impact will still be felt in this quarter and the next. To be honest, I anticipated higher prepayments, which makes it somewhat challenging to estimate on the investment side. Regarding loan repricing, it depends on the curve, which we currently see stabilizing and slightly decreasing, but not significantly. Thus, we don’t expect it to have a considerable impact moving forward. We have noticed growth in deposits, and the reimbursements are based on the same low market conditions. If the market reopens and returns to origination levels, as mentioned by Aurelio, the trends have improved in June and July in certain consumer portfolios. A shift from a 1.5% investment alternative to a 7% or 8% consumer loan can create a significant difference. Assuming normal trends, if deposits remain strong, we might see some changes. While we shouldn't be decreasing, our asset mix could alter that slightly. The late fees are somewhat influenced by moratoriums, and while the impact may not completely disappear, I expect it to decrease. Additionally, I assume that prepayments on investments should be lower, leading to a smaller impact in the upcoming period compared to what we experienced last quarter.

Alex Twerdahl, Analyst

And then just as a follow-up, when you layer on the Santander balance sheet, initially it was supposed to be NIM dilutive, but given what's happened to the NIM already, do you still expect NIM dilution or is it going to be relatively neutral to the margin?

Orlando Berges, CFO

The Santander balance sheet should be a bit NIM dilutive; they still have a significant amount of securities in their portfolio. Even though the transaction is cash-focused, some of it will still affect income as well. So, it should still be a bit dilutive as we had anticipated before, only because of the mix.

Alex Twerdahl, Analyst

Thank you for taking my questions.

Orlando Berges, CFO

Just to clarify, the yields on their loans are very similar to ours, they have more commercial and mortgages; they don't have as much in consumer, as you've probably seen on their balance sheet. So, that by itself is a lower yield; their cost of funds is good, so that helps. But they do have large amounts of cash balances and securities there.

Operator, Operator

The next question comes from Glen Manna of KBW. Please go ahead.

Glen Manna, Analyst

Congratulations on getting the approvals for the deal. I'm sure, given the current environment, that it was no small feat to get it done. But just to dive into the NIM, just a little bit farther on yields on the commercial book, given the Fed move and how fast they moved, could you provide some kind of a percentage that you think commercial loans, the variable portion, are pricing in where current rates are given moves in one month and three-month LIBOR and Prime?

Orlando Berges, CFO

So, we did provide some information on the release. Let me give you the exact numbers so I don't misquote. About 70% of our portfolio - let me get the exact numbers for you. When you have information and you don't find it. Okay, let me - the commercial portfolios are - about two-thirds of the commercial portfolios are either based on Prime or based on LIBOR. Most are on LIBOR; it's about a third on Prime, and the other two-thirds of the portfolio, it's LIBOR-based. We do have floors on many loans, so some of the portfolio won't suffer from future changes on rates because of the floors in place, but there are still some that don't have floors, and if rates were to go down, especially the three-month LIBOR, it would affect a bit. At this point, the expectation is that Prime will be sort of at this level for a little bit of time, and the changes to the three-month LIBOR I'm not expecting to be large. So, I don't expect that to be a significant impact; obviously, if things get worse and we move to the old subject of negative rates, that could have some impact on some of these loans that don't have floors. But again, two-thirds of the portfolio is floating, and it will move with either one of these items.

Glen Manna, Analyst

And maybe, given the addition of Santander, can you discuss or just remind us of some of the opportunities that you have on the funding side of the balance sheet after the deal closes?

Orlando Berges, CFO

Well, I mean at this point the funding meaning we have changed a lot of funding components. As deposits have grown, we have been able to eliminate a lot of wholesale funding, it's significantly down; broker CDs are significantly down. We tend to use some broker CDs in our Florida market, which has a different funding profile at this point. It has remained an expensive deposit market, so we tend to use Puerto Rico funding or wholesale funding to fund that market. At Santander, we'll just add to that - I believe, at the end it's a function of what makes sense in terms of portfolios and being able to mix correctly; they don't have wholesale funding; it's almost nothing what they had on the balance sheet the last time I looked. And obviously, we want to keep all those deposits. So, it's not going to change. We don't want to take away - their deposits are not expensive deposits; they are normal market deposits. So, we want to keep all those customers, so that's only going to add to that deposit mix that we have to help fund the assets. So, the Santander part is not going to change much what we have been doing so far within our own balance sheet, it's just going to add to that diversity of our customers.

Glen Manna, Analyst

And on the payment deferrals, just kind of a last question, the slide shows a 36% drop from 36% of the portfolio down to 18% here in July, and you had mentioned some of the government mandates with respect to residential mortgages. But still, that shows a pretty big drop in what's on deferral. Could you talk about customer behavior and maybe some of the people that are on deferral that are still paying and how they are responding to it?

Orlando Berges, CFO

Behavior has been really, really good. This decrease I've mentioned has significantly been from customers that have already started payments; their payment patterns in July have been really consistent with that. The overall payment patterns we've been tracking weekly compared to prior to the pandemic implications, and it's been really, really consistent with that. So far, things have been looking good. I think that it's important to keep in mind that deposits in the market have grown significantly; just ourselves, we grew about $1.2 billion in deposits, including government, and that means our liquidity also, so that helps in that component. There are customers that we've had a number of customers that originally we were anticipating that we could need on the commercial side extensions, from the three-month, maybe up to six months, and many of them have come back and said no, we don't need any more extensions. I think, the challenge is going to be with the hospitality industry, and we have to continue to work with those; and some retail could be affected. What happens with the lockdown and whether we have to revert back to some of it could change a bit, but as of now, the trends - the payment trends have been really good during the month of July. So, it makes us comfortable with what's going on with these customers.

Operator, Operator

This concludes our question-and-answer session and the First BanCorp conference call. Thank you for attending today's presentation.

Orlando Berges, CFO

I think we have one more on the line.

Operator, Operator

Okay. So, I'll put in that - a question from Alex Twerdahl of Piper Sandler. Please go ahead.

Alex Twerdahl, Analyst

Sorry. Thanks. I want to sneak one more in here.

Orlando Berges, CFO

Put the buzzer.

Alex Twerdahl, Analyst

With respect to sort of pro forma capital, I don't want to put the sort of the horse too far or that cart too far ahead of the horse here, with the deal not even closed yet. But with the pro forma tangible book value of $9.10-ish that's trading at 65% of tangible book value and 15-ish percent common equity Tier 1, how should we be thinking about the time frame for additional capital return with respect to things like buybacks, once the deal actually is closed?

Aurelio Alemán, CEO

I think Alex, this question had a different answer three months ago, but with the pandemic I think it's not really prudent to - we need to rethink the capital plan; definitely, if things go well and the pandemic gets resolved and the recovery is as expected in the most recent trends, obviously something should happen next year regarding next capital actions. But I think it's going to be driven by how we see the pandemic, and how we see the additional provisions, if any, or not. It's the most prudent thing to do, obviously it is there. Hopefully that will be the next step as the economy continues to improve. That's our main goal to move ahead, complete this one, and then be able to move to our next capital action.

Operator, Operator

And this concludes the question-and-answer session and the First BanCorp conference call. Thank you for attending today's presentation. You may now disconnect.