Earnings Call Transcript - OFG Q2 2020

Operator, Operator

Good morning. Thank you for joining OFG Bancorp’s Conference Call. My name is Lorry, and I will be your operator today. Our speakers are José Rafael Fernández, President, Chief Executive Officer and Vice Chairman; and Maritza Arizmendi, Executive Vice President and Chief Financial Officer. A presentation accompanies today’s remarks. It can be found on the Investor Relations website on the homepage in the What’s New box or on the Webcast, Presentations & Other Files page. This call may feature certain forward-looking statements about management’s goals, plans and expectations. These statements are subject to risks and uncertainties outlined in the risk factor section of OFG's SEC filings. Actual results may differ materially from those currently anticipated. We disclaim any obligation to update information disclosed in this call as a result of developments that occur afterwards. All lines have been placed on mute to prevent background noise. After the speakers’ remarks, there will be a question-and-answer session. I'd now like to turn the call over to Mr. Fernández.

José Fernández, CEO

Good morning. Thank you for joining us. Please turn to page 3. First, I would like to thank all our team members for their dedication and commitment during these very challenging times. Like other banks, we faced a number of COVID-19 related challenges during the second quarter. But for us, at OFG, the pandemic also followed the earthquakes we experienced in January and occurred while we were in the process of integrating the Scotia Bank acquisition. Certainly no small challenge. But by acting quickly and with foresight, we produced excellent results for our customers, communities, and people, and continue to help them build better financial futures. In March, governments in Puerto Rico and the U.S. Virgin Islands shut down businesses and personal activities. Restrictions were eased in late May, but recent spikes in new cases have forced Puerto Rico to reduce some of the flexibility. The Federal Reserve Bank cut rates to 150 basis points in March following the 75 basis points reduction in the second half of 2019. Our commitment and preparation enable us to successfully manage these challenges. Easy, fast, done, as we say at OFG. All our branches operated safely throughout the quarter, enhanced by our technology platform. Our full-service ATMs and ITMs, mobile app, and online built-in tools facilitated routine transactions in a contactless manner. Online and mobile appointment scheduling helped make COVID-safe customer meetings possible at branches. We deployed a 100% digital client-friendly application and funds disbursement process for PPP loans. About half of our team members are still working remotely. We also implemented extensive new safety protocols for our customers and people on-site. And we continue to offer new benefits for our people such as free COVID on-site testing and daily online health check-ins, as well as incentives. The results speak for themselves. We provided high levels of customer safety and knowledge throughout all channels. Loan production in the second quarter totaled more than $500 million. Customer deposits increased by $760 million. Our online loan deferral tool and call centers processed relief for more than 44,000 retail customers. We reduced higher-cost wholesale funding, maintained a strong level of net interest margin, and continued to build liquidity and capital. We secured $100,000 in federal home loan bank of New York grants to support local, non-profit, and small businesses in Puerto Rico and the U.S. Virgin Islands. Please turn to Page 4. We have continued to see strong technology utilization trends among both our retail and business customers since the beginning of the year, and in particular since March. Online bill pay enrollment was up by 12% as of March and 24% as of June. Mobile banking users jumped 17% by the end of the second quarter from the beginning of the first. The number of remote deposit capture users is up 68% from the end of March. In another area of success for us, during the second quarter, we scheduled more than 18,000 COVID-safe appointments with our customers through our online and mobile tool. We are very pleased to see these trends; technology is a core part of our overall corporate strategy. We continue to look into new ways and innovative methods to use it to help our customers. Turn to Page 5. Looking at our SBA PPP program, we continue to exceed our market share in Puerto Rico. We generated a total of $286 million in new loans. This enabled us to help more than 4,000 small businesses save more than 50,000 jobs. It also enabled us to attract new accounts in this strategically important customer base. We were able to distribute these funds electronically within five days of application approval. This is a great example of our ability to act quickly in response to changing conditions to the benefit of both existing and new customers and the communities we serve. Let's talk about our results on Page 6. We reported EPS of $0.39 and $0.37 on a non-GAAP basis. Total core revenues were $128 million, most of which was due to a large increase in interest earning assets, chiefly loans and cash. This was partially offset by a declining yield due to significantly lower rates on cash and lower yields on variable rate commercial loans. In addition, we had lower investment security balances. As a result, we generated net interest income of $105 million with a net interest margin of 4.78%. Banking and wealth management revenues totaled $23 million. Noninterest expenses were $86 million, primarily due to the addition of the Scotia Bank acquisition. Second quarter results included several items: $9.5 million in revenues from Scotia Bank interest recoveries and bargain purchase gain. We added $5 million in provision for the pandemic, and within noninterest expenses, we had $5 million in emergent and restructuring charges and COVID-related operating costs. Please turn to Page 7. The effects of these results are that we're building tangible value and our return on asset and return on equity continue to improve sequentially from the fourth quarter. Please turn to Page 8 for operational highlights. Average loan balances increased by 52% year-over-year and 2% quarter-over-quarter. Average core deposits, excluding brokered deposits, increased by 76% year-over-year and 5% quarter-over-quarter. Loan generation was strong; increased production from PPP and other commercial loans was partially offset by reduced production in our retail category, primarily due to the economic shutdown. We ended the quarter with good momentum and good pipelines in the mortgages and auto businesses. Loan yield at 6.97% continued to hold up well despite the recent Federal Reserve cuts. The cost of core deposits declined by four basis points year-over-year. Net interest margin declined to 4.78%. Please turn to Page 9 to review credit quality. The net charge-off and non-performing loan rates declined year-over-year and quarter-over-quarter reflecting loan paydowns and the effects of deferrals. Provision for credit losses of $18 million was level with last year. I'd like to note the year-ago provision included an extra $9 million related to loans transferred to help for sale. Please turn to Page 10 to review our loan deferrals. After disruptions in economic conditions caused by COVID-19, we offered several loan payment deferral programs ranging from one to four months. We enhanced this effort by quickly developing unique and first-to-market digital tools to help consumers apply for forbearance on an individual basis. Our online loan deferral tool and call centers processed relief for more than 44,000 retail customers. In total, we have about $1.4 billion or 32% of our retail loans on deferral. The pace of retail requests is significantly slowing. In addition, we have about $685 million or 26% of our commercial loans on deferral. Please turn to Page 11. The allowance for loan and lease losses of $233 million increased by $70 million year-over-year, and we have almost doubled the level of reserves from December 31, 2019. Compared to March 31, 2020, the allowance increased by $2 million. Excluding SBA guaranteed PPP loans, the second quarter 2020 allowance was 3.49% of loans, eight basis points higher than the first quarter. Please turn to Page 12. We are in a strong capital position. Our CET1 capital ratio, as you see on that slide, at 12.03% is up 112 basis points since last year. Please turn to Page 13. While we still face much uncertainty regarding COVID and the economy, we are in a strong financial position, ready to help our customers during these trying times. Once we get through this, Puerto Rico stands to benefit significantly from COVID stimulus and still unspent, undistributed María and earthquake-related stimulus programs. At OFG, we believe our results and our history demonstrate our ability to quickly respond and adapt to changing economic environments. During the second quarter, we continued to build momentum in our core businesses and develop a good pipeline of new loans. From a liquidity, capital, and balance sheet point of view, we are well positioned both financially and strategically. Our agenda going forward is clear. We plan to continue integrating the former Scotia Bank operations and finish by the end of this year. At the same time, we must achieve the full benefits of the acquisition by the end of 2021. We also plan to continue to invest in the future to further simplify our operations and enhance our ability to serve customers. Ultimately, we intend to continue to play a significant role in the recovery of Puerto Rico and the U.S. Virgin Islands. Again, I want to thank all our team members for our excellent results and for their dedication and commitment throughout these trying months. Crisis brings out the best in people to help others. Our people demonstrate that with purpose every single day. With this, we end our formal presentation. Thank you for listening. Operator, please open the call for the Q&A session.

Operator, Operator

Your first question comes from Alex Twerdahl of Piper Sandler.

Alex Twerdahl, Analyst

Hey. Good morning. I'm well. Thanks. Just to start off on the reserve and the provision. Maybe you could help us kind of just break down the provision for this quarter and the $5 million that you put aside for COVID. Was that related mostly to a change in the Moody's S3 scenario or was it related to internal downgrades of credits related to COVID or how should we be thinking about that?

José Fernández, CEO

Yes. I'll provide a brief overview and then Maritza will explain in more detail. We are continuing to use the S3 Moody's scenario as a basis for our provisioning. Given the global uncertainty caused by COVID-19, we believe this also applies to Puerto Rico. Therefore, we have decided to maintain the S3 Moody's scenario for our provisioning strategy. Now, I’ll let Maritza share more specifics.

Maritza Arizmendi, CFO

Hi, Alex. Regarding the additional $5 million, as Jose mentioned, we keep the Moody's S3 scenario, and we also evaluate the qualitative adjustments that we did during the last quarter. We updated them, and as a result of that, we added $5 million in the retail portfolio, mostly based on the most recent information, and that's the $5 million adjustment for the COVID-related provision.

Alex Twerdahl, Analyst

Okay. So is retail-oriented mostly, but I'm just kind of curious if there was a specific factor in retail that you're looking at, just kind of thinking about the amount of stimulus money that's flowing down to the island and seeing the deposits really balloon at you and some of your peers. It seems like the retail might be in better shape today than they normally would without that stimulus. So kind of how should we think about how you're expecting the retail portfolios to perform?

José Fernández, CEO

Yes. I think the assumptions that you pose are correct. There's certainly stimulus flowing down from COVID and still from the hurricane Maria and the earthquakes and that's going to play out. I think there's a portion of it that will play out in the short term, and we would like to see the deferral program ended on June 30th and see how the retail portfolios behave forward to feel more comfortable on the scenarios. But I agree with you longer term; we just think that the economy, it's hard for us to pinpoint how the economy is going to be doing in the next six months. But we do agree that the economy with the stimulus and all the items that you mentioned should have a good momentum in a longer-term scenario. So we will update as we see and feel more comfortable with the data on the credit side.

Alex Twerdahl, Analyst

Right, and you guys have done the full reviews at this point on all your commercial customers and gone through and of course if there's something that you saw you would have added to the reserve this quarter.

José Fernández, CEO

We are closely monitoring various industries, especially hospitality, as it remains our primary focus regarding the impact of the COVID-19 pandemic. Recently, all deferrals on our large and middle market commercial portfolios ended on June 30th, with only 12 loans in hospitality requesting an additional three months. This gives us a positive outlook on our middle and large commercial sectors. We are also optimistic about our small business initiatives and how we are tracking those. Overall, we are satisfied with the recovery of our commercial clients. However, when it comes to provisioning, we recognize that the implications of the pandemic on the retail sector are still quite uncertain, and we are unsure how the government will respond to the recent spikes.

Alex Twerdahl, Analyst

Understood, and then just to switch gears a little bit and looking at expenses. If you kind of back out the COVID adjustment as well as some merger expense, you get to kind of like an $80.5 million run rate for expenses. Is that the right run rate to use going into the third quarter or I guess where's the starting point and then kind of as you near the end of the integration of Scotia where do you expect expenses to kind of end the year and start 2021?

José Fernández, CEO

So on the expense side; remember the second quarter has lower activity. So we showed lower costs based on the lower transactional activity that we're seeing from the customers. So as the economy picks up, we expect those expenses to come back up. But on the other hand, we started the efforts on extracting the savings from the Scotia acquisition in this third quarter, and we're very, very cautious simply because of the environment in terms of the COVID, but we are going to see some benefits from those efforts, and we feel more comfortable giving you a comfort on us extracting the 25% cost savings from the acquisition by the end of 2021, because again, we're operating in a different environment than normal. So that's kind of the best I can give you, Alex, on the expenses. I really think that we are in good shape there as we are executing on our efficiencies, albeit at a slower pace than we anticipated given COVID-19.

Operator, Operator

Your next question comes from the line of Glen Manna of KBW.

Glen Manna, Analyst

Hi. Good morning. I just wanted to discuss the NIM for a minute, maybe we could talk about what portion of the quarter-over-quarter decline came from excess liquidity? And what portion came from rates and PPP? And if you could discuss it in the context of excluding the interest rate recovery, that would be helpful.

José Fernández, CEO

Including the interest rate recovery, you said, Glen.

Glen Manna, Analyst

Right. The final portion is excluding.

José Fernández, CEO

Okay. Now I understand. All right. I'll let Maritza answer that one.

Maritza Arizmendi, CFO

Hey, Glen. To your question, the 34 basis point reduction, excluding the recovery, is based on several assumptions about how much cash we will maintain moving forward. Overall, we believe that approximately one-third, or about 15 basis points, is related to the cash balances we held during the quarter. The increases from the PPP loan program account for about 15 basis points as well.

Glen Manna, Analyst

So that would be one-third from excess liquidity and two-thirds of the drop was just on rates?

Maritza Arizmendi, CFO

Yes, because cash balances, as you know, were impacted because of the Fed cost rate cuts, and also the depots of the commercial portfolio that is indexed variable rates that we have around 52% of our portfolio of the commercial portfolio is viable, but we are expecting that this quarter already has the full effect of different cuts. So going forward, we are expecting a more stable type of NIM as we will see during the third quarter. The full effect of the PPP loan program in the loan yields, but also we will experience lower cost of borrowing.

Glen Manna, Analyst

Right. I was looking at the repo balances and it looked like on an average basis they were still in there, but on a spot basis you've paid off, you've taken off all the repos?

Maritza Arizmendi, CFO

Yes.

José Fernández, CEO

And, Glen, we still have some maturities coming in the next several quarters and into 2021, but will certainly will use the excess liquidity to cancel them.

Glen Manna, Analyst

Okay, and on the PPP loans, what was the average yield you used in the quarter? And what's your expectation on forgiveness for those loans going forward?

José Fernández, CEO

I'll tell you, I'll talk to you about the expectations and forgiveness, and I'll let Maritza talk about the view. On the forgiveness, we're still expecting the federal government to give more guidelines on the forgiveness, but we feel that there is a large proportion, more than 80% of those loans that will be forgiven. It's hard for us to pinpoint when that will occur, but we are more and more of the opinion that there's going to be a larger percentage of our PPP loans that will be forgiven. And on the rate, I'll let Maritza follow.

Maritza Arizmendi, CFO

Yes. The all-inclusive deal, including the amortization of the fees, we are expecting to be around 2.95% - 3% considering the life of the loans, but also remember that as Jose is mentioning, if they are repaid before maturity, we will be able to recognize the unamortized portion of that fee.

Glen Manna, Analyst

Okay, and you're using the level yield method?

Maritza Arizmendi, CFO

Yes.

Glen Manna, Analyst

Okay, and on the deferrals with some of them beginning to roll off have you got an idea of what redeferral rates are or redeferral request rates?

José Fernández, CEO

It's too early to tell. We're not seeing much activity in the large and middle commercial sectors; so far, our focus has been more on the hospitality industries. On the retail side, it's still early. We've only been in the third quarter for three weeks, so we'll provide an update in the next quarter's call. However, the initial signs are definitely positive. Ultimately, it will depend on how everything unfolds by the end of the third quarter when we can fully assess the impact of the end of the deferrals, including how many may request additional deferral programs or how many return to take action.

Operator, Operator

Your next question comes from the line of Joe Gladue of Alden Securities.

Joe Gladue, Analyst

Good morning. Just one quick question, just wondering if you could give us since the economy started opening up a little bit more lately in the quarter just wondering if you could sort of walk us through some of the trends you're seeing in the different lending markets, mortgage and auto and whatever.

José Fernández, CEO

We are experiencing positive momentum in our mortgage lending business with strong pipelines. The auto lending sector is also showing a good pipeline. Specifically, about 50% of our mortgage business consists of refinancing while the other 50% is for home purchases, which is encouraging. We're noticing an uptick in residential activity, benefiting from the Scotia acquisition, which strengthened our servicing portfolio and residential mortgage operations. We're pleased with the progress and seeing that pipeline develop. On the auto side, higher new car sales are translating into increased volume for us, as seems to be the case for the wider market. However, we haven't seen much movement in consumer lending, particularly in installment loans. On the commercial lending side, we are working on building a pipeline, but it remains below pre-pandemic levels due to continued caution and uncertainty among business leaders that is felt across various industries.

Operator, Operator

You now have a follow-up question from Alex Twerdahl of Piper Sandler.

Alex Twerdahl, Analyst

I was looking at slide 5 regarding the PPP and noticed the bullet point about attracting new clients and strategically important small business segments. Could you elaborate on that? It seems significant enough to highlight, so what is the potential opportunity there? How substantial is it?

José Fernández, CEO

Yes. For us that's always been a focus on the small business side. And we've been for the last three or four years incrementally doing more business in that segment. PPP gave us a great opportunity to act quickly to be agile and to deploy our technology and deploy our processes to be there for our customers. We got great reviews from our customers throughout the PPP process and the fast and agile way that we dispersed the funds particularly in the middle of the lockdown that we were operating in, which no other state or any other jurisdiction in the United States had a situation like that. So I have to tell you the results from that program have given us quite good momentum in that segment and excellent credibility by being close to our customers. But also reputationally, we're benefiting from that slowly but surely. It's not going to move the needle from your perspective in terms of the results at the end of the day, but for us, it's important to be close to the communities, and our team on the retail channel put their heart out and they demonstrated what living a life with purpose at Oriental means. And I'm really proud of that, and that's why I wanted to highlight that effort.

Operator, Operator

You have a follow-up from Glen Manna of KBW.

Glen Manna, Analyst

Hi. I just wanted to ask a question on the ACL. I think when we look at your competitors that reported yesterday and you guys we've seen some stability in ACL to loans versus last quarter. So could you talk about what's kind of giving you comfort with that level? And some of the banks on the mainland have talked about whether or not they expect continued reserve building in forward quarters. And maybe if you could just discuss that a little bit too.

José Fernández, CEO

We're approaching this from a long-term perspective, rather than trying to predict what will happen in the next quarter or the next six months, which is quite challenging given the current environment that demands significant adaptation and flexibility. Our operations are prepared to handle these uncertainties and challenges. However, making predictions about the next three months is very tough. Regarding your question on provisioning, we want to be cautious as we assess different scenarios, which is why we feel comfortable maintaining the Moody's S3 rating. The positive aspect is that we have a resilient bank with a strong balance sheet, enabling us to focus on long-term opportunities in a market with limited competition. Our aim is to succeed over the long haul, rather than focusing on short-term forecasts. I apologize for the lengthy response, but I can't provide specific numbers as you requested.

Glen Manna, Analyst

No. I appreciate what you did give. And just I wanted to follow up on Alex's question a little bit. You guys have been considered a challenger bank on the island, high digital. When you look at some of the numbers of your customers that are moving into to using more digital platforms. I mean, it's no secret that Puerto Rico has lagged the mainland in some of the adoption of digital. Is COVID kind of pushing down that wall? There's a feeling that once customers start depositing a check online, they don't go back, and is this really an opportunity for Puerto Rico to push past that kind of resistance that may have been there before?

José Fernández, CEO

You're right on target. We have been focusing on technology for over a decade, and the pandemic is speeding up adoption. This acceleration aligns perfectly with our strategy from the past few years. We're highlighting these charts because the pandemic is indeed boosting adoption in Puerto Rico. While we see great opportunities, we must continue investing in technology and finding faster, more agile, and proactive solutions for our customers. We have strong competitors on the island, and we need to stay on our toes. It's an exciting time for us, and our teams are dedicated to leveraging our strong balance sheet and resilient culture to simplify processes for our customers. Despite the challenges of the current pandemic, I'm motivated by the commitment and hard work of our team, especially seen in the last few months. I'm optimistic about our future, aware of short-term uncertainties, and eager to keep moving forward.

Operator, Operator

There are no further questions. Mr. Fernandez, are there any closing remarks?

José Fernández, CEO

Thank you, operator. Thank you also to all our stakeholders who have listened in. Our concern goes out to those who have suffered from this pandemic. Our hope is that it ends as soon as possible and that everybody stays safe and healthy. Thank you again. And have a nice day and a great weekend.

Operator, Operator

Thank you. That does conclude the OFG Bancorp second quarter 2020 earnings conference call. You may now disconnect your lines. And have a wonderful day.