Earnings Call Transcript - OFG Q1 2023

Operator, Operator

Please standby. Your program is about to begin. Good morning. Thank you for joining OFG Bancorp’s Conference Call. My name is Melinda. I will be your operator today. Our speakers are José Rafael Fernández, Chief Executive Officer and Vice Chair of the Board of Directors; and Maritza Arizmendi, Chief Financial Officer. A presentation accompanies today’s remarks. It can be found on our Investor Relations website on the home page in the What’s New box or on the Quarterly Results 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 Factors 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. Instructions will be given at that time. I would now like to turn the call over to Mr. Fernández.

José Rafael Fernández, CEO

Good morning and thank you for joining us. We are pleased to report our first quarter 2023 results. All our businesses performed well and contributed to another strong quarterly performance by OFG. The quarter’s results also reflect the strength of our franchise, supported by high levels of liquidity and capital. This places OFG in a strong position in today’s banking environment. Now let’s turn to page three of our conference call presentation. Core revenues, net interest margin, credit quality, operating leverage and customer acquisition trends all remain at high levels or improved compared to the fourth quarter. Deposit balances were stable with only a 10% cumulative beta. We continue to execute our digital-first strategy, placing more banking kiosks and interactive teller machines in the field. Client digital adoption increased 10% year-over-year. Our key performance metrics also continued at strong levels. Businesses and consumers are in good financial shape in Puerto Rico and the economy continues to do well. We look forward to ongoing progress in 2023. Thanks to our teams for their excellent execution, commitment and drive, helping customers and the communities we serve achieve their financial goals. Looking at the income statement. Earnings per share diluted was $0.96, up 26% year-over-year. Core revenues totaled $164 million, up 21%. Net interest margin was 5.89%, up 142 basis points. Provision was $9.4 million, non-interest expenses were $90.2 million and pre-provision net revenues totaled $74.6 million, up 34%. When we look at our balance sheet, customer deposits were $8.6 billion, up slightly compared to the fourth quarter. Loans held for investment totaled $6.9 billion, also up slightly over the fourth quarter. New loan production remained strong at $561 million. Investments totaled $1.9 billion, down slightly from the fourth quarter due to the maturities of treasuries and the normal paydown of mortgage-backed securities. Cash was $847 million, almost $300 million higher than the fourth quarter. We continue to build capital. The CET1 ratio was 14.07%, compared to 13.64% in the fourth quarter. All in all, excellent quarter, very strong performance. Now here is Maritza to go over the financials in more detail.

Maritza Arizmendi, CFO

Thank you, José. Please turn to page four to review our financial highlights. Let me start with total core revenues. Net interest income of $136 million held steady compared to the fourth quarter. This primarily reflected the full effect offset of the fourth quarter 2022 increase of 50 basis points, but only a partial effect of the 50 basis point increase in the first quarter of 2023. Also, higher yields on higher average balances of loans, in particular, auto, commercial and consumer. And we did have two fewer days during the quarter compared to the fourth quarter, which reduced net interest income by $2.2 million. Banking and wealth management revenues were $29 million, compared to $33 million in the fourth quarter. This primarily reflected reductions of $2 million in mortgage service valuation, $1 million in wealth management revenues from the annual recognition of insurance fees in the December quarter and $0.5 million from the sale of the retirement plan administration business that we announced at the end of last year. Looking at the efficiency ratio. It was 54.87% in the first quarter. That’s a minor change from the first quarter and significantly better compared to a year ago. This reflected our increased positive operating leverage in line with trends we have seen over the last year. Non-interest expenses totaled $90 million, compared to $92 million in the fourth quarter. That primarily reflected lower general and administrative costs. In part, that was due to $0.5 million of lower costs as a result of the sale of our pension administration business. Non-interest expenses should continue to average about $90 million to $92 million per quarter in 2023. Our efficiency ratio target should also continue in the mid-50% range. Looking at our performance metrics, return on average assets was 1.87% and return on average tangible common equity was 19.13%. Looking at tangible book value per share, that was $20.57. That’s an increase of about $1 compared to the fourth quarter. This reflected increased retained earnings and lower other comprehensive loss. Please turn to page five to review our operational highlights. Looking at average loan balances, they increased $96 million from the fourth quarter. End-of-period loans increased to $6.85 billion. That is a 1.1% annualized increase from the previous quarter and a 4.7% increase year-over-year. Sequential growth reflected increased balances of auto and consumer loans. This was partially offset by paydowns of residential mortgages and commercial lines of credit. Looking at loan yield, it was 7.58%. That’s a 26-basis-point increase from the fourth quarter. That’s due to Fed rate increases combined with a higher proportion of auto, consumer and commercial loans versus residential mortgages. Looking at new loan origination, this reflected continued high levels of auto lending and increased commercial lending in the U.S. Puerto Rico commercial lending was lower compared to the fourth quarter. However, our commercial pipeline remains strong. Looking at core deposits. Compared to the fourth quarter, average balances decreased, but end-of-period deposits increased. Over the course of the quarter, we saw a shift from demand deposits to savings accounts, time deposits and to a lesser degree to our wealth management business. During the quarter, government deposits went down from $295.4 million to $231.4 million. We also saw a marginal decline in retail deposits of 0.3% and a noticeable increase in commercial deposits of 2.3%. Looking at core deposits, that was 53 basis points, an increase of 14 basis points from the quarter ago. So far, our cumulative deposit beta has been about 10%. We expect cumulative deposit beta of about 25%, well below expected last level through this cycle. Borrowings increased as that reflected a $200 million two-year advance from the Federal Home Loan Bank. Looking at net interest margin, that was 5.89%, an increase of 20 basis points from last quarter and 142 basis points year-over-year. Our NIM outlook generally remains the same. Our tax rate for the first quarter was 29%. For the year, we are anticipating an effective tax rate of 32%. Please turn to page six to review our credit quality and capital strength. Looking at net charge-offs, they totaled $10 million, compared to $11 million in the fourth quarter. That reflected a significant reduction in auto loan net charge-offs. In addition, the delinquency and non-performing loans rate fell across the board. Looking at provision for credit losses, that totaled $9.4 million, reflecting $6.2 million due to increased loan volume, $2.1 million from a commercial loan held for sale and a $1.1 million increase adjustment due to increase in recessionary risk in the United States. Looking at non-performing loans, that total NPL rate was 1.32%. That was down 29 basis points from the fourth quarter and 34 basis points from a year ago. Overall, credit improved noticeably from the fourth quarter. Looking at some of our other capital metrics, total stockholders’ equity was $1.1 billion. That’s up $47 million from the fourth quarter and TCE ratio increased to 9.85%. Now here is José.

José Rafael Fernández, CEO

Thank you, Maritza. Please turn to page eight for the outlook. The Puerto Rico economy continues to show strength on the part of both businesses and consumers. Business activity is robust and building momentum as reconstruction projects continue to roll out. This is helping to create a more resilient infrastructure, but we must continue to keep a watchful eye on interest rate changes, inflation and a probable mainland recession. Within this environment, our deposits overall have remained stable with retail customer flows moving to higher yielding products like CDs and to our wealth management business. High levels of liquidity put us in a strong position in the current banking environment, and this enables us to continue to focus on our plans by adding value to our customers and building stronger relationships, investing in people, technology and infrastructure to provide easy, fast, around-the-clock self-service digital solutions for clients and growing market share in our main businesses. I want to thank again all our dedicated team members for their commitment to the customers and the communities we serve. With this, we end our formal presentation. Operator, please open the call for questions.

Operator, Operator

Thank you. And we go to our first question from Timur Braziler with Wells Fargo. Please go ahead.

Timur Braziler, Analyst

Hi. Good morning.

José Rafael Fernández, CEO

Good morning.

Timur Braziler, Analyst

Maybe starting just on a bigger picture question. So can you take us back to the week of March 13th when things were kind of falling apart on the mainland? What was the feeling on the island, what was the level of conversations you were having with your own deposit base, and ultimately, what was the dynamic that was taking place in Puerto Rico?

José Rafael Fernández, CEO

Thank you for your question, Timur. I appreciate the chance to discuss the current banking environment in the United States and its implications for Puerto Rico. The present situation in the U.S. banking sector highlights the positive differences within the Puerto Rico banking market compared to peers on the mainland. In Puerto Rico, we are witnessing an economy that is gaining momentum alongside a robust banking industry that supports the island's economic development. This is evidenced by higher capital levels, increased liquidity, stable deposit trends with lower betas, and no signs of credit deterioration or concentration, all of which are favorable compared to our stateside counterparts. Regarding the events in mid-March in California and New York, while there was awareness of those developments in Puerto Rico, there is a strong perception that our banking sector is solid, rational, and efficient. The current situation in the mainland provides a positive focus on the Puerto Rico banking market. Our market is quite competitive, yet very different from what investors have known over the past few decades. We have excess deposits, a lack of irrational market players, and an economy that is growing and undergoing reconstruction. Reflecting on my nearly 20 years as CEO of OFG, I have seen building momentum in recent years. Today, I observe the island being rebuilt, which is extremely encouraging as it allows us to connect more closely with our customers and contribute to the island's economic development. That's how I perceive the current state of affairs.

Timur Braziler, Analyst

Great. Thank you. That’s great color. And then maybe just taking that and expanding on that just a little bit. So as you are looking at the deposit base for the remainder of the year, have the activities on the mainland kind of stemmed the outflows that we have seen in the back end of 2022, where you might have some migration within DDA to higher costing or higher yielding products from a depositor basis, but not as much leaving the institution or is there still an element of deposits that are at risk for either going to a larger institution, heading into treasuries or otherwise leaving the banking system?

José Rafael Fernández, CEO

So the trends are the trends, right? And remember that in the fourth quarter of 2022, as well as in the fourth quarter of 2021, we were managing below the $10 billion mark. So that is really what kind of drove, particularly in 2021, but also in 2022, to some degree. So what has happened in the first quarter is that you are seeing that kind of stabilizing, and to some degree, we have higher deposit balances. Certainly, the remix is taking place and that is the normal thing to happen and we are seeing some savings deposits moving towards a one-year, two-year CD. We are also seeing, as I said in my remarks and I think Maritza mentioned it too, we are also seeing wealth management benefiting from some of the flows going to our business in wealth management. But our expectation throughout the year is, as Maritza pointed out, 25% beta cumulative. That’s how we are modeling the year and the reason for that is we are seeing the remix playing out. And again, based on what I just said earlier, our expectation is for deposits to remain stable and it’s just going to depend on how we do business development, but I really don’t see the same dynamics that are occurring in the U.S. banking market.

Timur Braziler, Analyst

Okay. Great. And then just last for me, looking within your commercial buckets, can you fill us in on kind of broader commercial real estate exposure? What you have in terms of if any commercial real estate office exposure on the mainland and then more broadly how you are thinking about commercial real estate in Puerto Rico versus commercial real estate on the mainland?

José Rafael Fernández, CEO

We don’t have much exposure to commercial real estate on the mainland. Here in Puerto Rico, we do have an office building that makes up approximately 8% of our commercial portfolio. Puerto Rico is an island, so office buildings are mostly concentrated in the metropolitan area. We are experiencing similar global trends with hybrid work, but we are not facing the severe challenges that the office market in major U.S. cities is currently dealing with. Despite the shift towards hybrid work and post-pandemic changes, we are seeing high levels of office occupancy without any significant decline.

Timur Braziler, Analyst

Got it. Thank you for the color. Much appreciate it.

José Rafael Fernández, CEO

Yeah. You are welcome.

Brett Rabatin, Analyst

Hey. Good morning, everyone. Appreciate the questions.

José Rafael Fernández, CEO

Good morning.

Brett Rabatin, Analyst

I wanted to first start, José, with auto, and on the mainland, you have seen things like Capital One pull back from their floor plan lending platform, but in Puerto Rico, it’s obviously a different environment. There’s not a great public transportation system and so people need their cars, but I was a little bit surprised to see the improvement linked-quarter in credit across the board in auto specifically. And I get, you talked earlier about the economy, I get that the EAI index is up a little bit in March to 126 and I think March sales of auto were 10,700 for the island. But I was just hoping to maybe get some color around credit improvement in auto specifically, if you would ascribe that to anything in particular?

José Rafael Fernández, CEO

I appreciate your insights. What we're observing in the management of our auto business is that we have high FICO scores. We're adjusting interest rates accordingly and currently originating loans at around a 9% rate with an average FICO score of approximately 720. The trends in credit and delinquency rates in the auto sector further confirm that our consumers have ample liquidity, which they are using to purchase vehicles and renovate their homes. There's a sense of optimism in the market. This situation is influenced by several factors. We've consistently maintained a conservative approach to underwriting in the auto sector, but we also acknowledge that the current economic environment is quite favorable.

Brett Rabatin, Analyst

Okay. I wanted to ask about PREPA, which I see as a key factor in moving things in the right direction, especially with the ongoing discussions regarding the debt. From your perspective, do you have any updates on PREPA and whether the cost of electricity could be resolved in the near term, or do you believe it will take longer to address?

José Rafael Fernández, CEO

PREPA is a long-term issue. The current actions, such as the privatization of distribution, transmission, and now generation, are complicated but necessary to get things moving. It will require time. Meanwhile, there is significant momentum in the private sector for solar panels, which is also being supported by the federal government. We should remember that Puerto Rico benefits from the attention Washington is giving us economically, which is another reason for our current position. While PREPA will take longer to address, I believe there will be both private and public efforts involved. The U.S. Secretary of Energy has already visited multiple times, indicating that addressing electricity issues in Puerto Rico is a priority for the federal executive branch. Together with the local government and private sector, we, as banks, are also supporting the financing of solar panels for businesses and residences. This will help expedite the transition towards a more diversified and resilient electricity production system in Puerto Rico. So, in terms of electricity and PREPA specifically, please remain optimistic despite the surrounding noise. The foundation is already being laid to reduce costs and improve service quality and resilience.

Brett Rabatin, Analyst

Okay. Appreciate that. And then maybe just lastly, I wanted to make sure I understood you are still talking about guidance of a mid-50s efficiency ratio. And so if I am just thinking about the implications of that, it would seem like your margin maybe has peaked out here. But in terms of the net operating income, it would seem like your expenses would maybe climb $0.5 million to $1 million quarterly from here and fee income doesn’t change too much. Is that a fair way to think about the implicit guidance from the mid-50s efficiency ratio?

José Rafael Fernández, CEO

I think you are looking at it the right way. Remember, we have some variability throughout quarter-over-quarter in terms of the non-interest expenses just simply, because we are deploying technology and as the deployment comes out we need to capitalize those investments. But you are looking at the right way, Brett. I don’t know, Maritza wants to add anything?

Maritza Arizmendi, CFO

That’s correct. That’s why we are providing a guidance of $90 million to $92 million quarterly expense range.

José Rafael Fernández, CEO

And Maritza, do you want to add anything… on the margin on the income...

Maritza Arizmendi, CFO

Well, yeah. In intra-region, as I mentioned in my prepared remarks, we continue to have the same expectation for the full year that we will be in the same level as the last quarter. That was around 5.69%, so we will be between that range through for the full year and that’s our expectation.

José Rafael Fernández, CEO

Part of it has to do with our, I think, you guys are pointing it out in your write-offs are higher yielding assets and that’s kind of what’s driving it and it helps us mitigate some of the shifting on the deposit side that I mentioned earlier.

Brett Rabatin, Analyst

Okay. Great. Thanks for the color.

José Rafael Fernández, CEO

Yeah. Thank you for your questions. Have a good day.

Operator, Operator

Next we go to the line of Alex Twerdahl with Piper Sandler. Please go ahead. Your line is open.

Alex Twerdahl, Analyst

Hey. Good morning.

José Rafael Fernández, CEO

Good morning, Alex.

Alex Twerdahl, Analyst

I wanted to revisit the discussion on the 25% through-the-cycle deposit beta and ask if you could clarify whether this figure refers to total deposits or only interest-bearing deposits. Additionally, how do you see potential rate cuts later this year impacting the beta? It seems to me, based on my calls this morning to various Puerto Rican banks, that it’s challenging to align with that 25% beta given the current market conditions.

Maritza Arizmendi, CFO

Sure. Alex, we have shared our observations for this quarter regarding the transition from DDA and savings accounts to high-yielding time deposits. We anticipate this trend will continue for the rest of the year. Currently, the cumulative beta stands at 10%. Customers are actively seeking higher yields, which will contribute to the growth of our time deposit portfolio. Therefore, in our base case scenario, we are projecting a beta of 25% by the end of the year.

José Rafael Fernández, CEO

I think, Alex, when we analyze the beta and differentiate it between retail and commercial, we notice that the beta for commercial is higher. As a result, we will observe some commercial clients requesting higher rates, which also contributes to our base case scenario of a 25% beta. Therefore, our expectation is that the beta for retail will be significantly lower than 25%. However, we anticipate the commercial beta will trend higher for the remainder of the year, particularly as clients, as Maritza mentioned, become more efficient in managing their cash.

Alex Twerdahl, Analyst

As we look ahead for the remainder of the year, do you anticipate that the increases will follow a consistent pattern, or have you observed a stronger push to raise deposit rates in the first quarter? Do you expect this pressure to decrease? How do you see these deposit cost pressures evolving in the coming quarters?

José Rafael Fernández, CEO

I don’t believe we are in a pressured environment. It’s important to consider how we can continue to build and maintain profitable customer relationships on the commercial side. We recognize that the market is competitive, though not irrational. It's difficult to predict when or how interest rates will change and how our customers will respond. Overall, we see a gradual shift throughout the year, which I wouldn't classify as pressure, but rather as a normal trend of rational clients managing their cash effectively.

Maritza Arizmendi, CFO

But mostly in this type of cycle…

José Rafael Fernández, CEO

Correct.

Maritza Arizmendi, CFO

We still have maturities on time deposits that had lower rates, and as those mature throughout the year, we will replace them with higher rates.

José Rafael Fernández, CEO

You also mentioned lower interest rates. If the Fed decides to lower interest rates, that’s not the scenario we are basing our model on. We anticipate that the Fed will lower rates next year, not this year. Currently, we expect the Fed to raise rates slightly from these levels and then maintain that stance until early 2024. However, I don’t have a crystal ball, and we are just making projections.

Maritza Arizmendi, CFO

And just to add, so far, the beta on the asset side has been much higher than on the deposit side, and we still have room for the year to continue having that type of dynamics through the beta on the asset side versus the beta on the deposit side.

Alex Twerdahl, Analyst

Okay. Yeah. I mean, that was the next question I had is just in terms of, one, loan yields, if there’s anything in there that’s, quote-unquote, non-core that’s pushed that higher in the first quarter that we should be aware of. And then, secondly, sort of how much more lift there could be, assuming rates basically stay here, maybe we get one more hike in the next couple of months and then…

Maritza Arizmendi, CFO

So…

Alex Twerdahl, Analyst

Yeah. You start with that.

Maritza Arizmendi, CFO

In this quarter, we experienced a 19 basis point net interest margin increase, with approximately 7 basis points attributed to cash and investments and the remaining 24 basis points from loans. There is nothing unusual about this. We will continue to benefit in the upcoming quarter from the complete impact of the 50 basis points increase by the Fed during the first quarter. Additionally, we have some upcoming maturities within the treasury group, including a $40 million maturity in May and $200 million in August. We plan to reinvest in high-yielding assets. While we have the flexibility to invest as we choose, we anticipate that cash will yield more than the current carrying yield of those assets. Thus, we have the opportunity to maintain a strong positive beta on the asset side.

Alex Twerdahl, Analyst

Great. And then, so I guess, as you boil that down, I mean, is the NIM, I think, one of the earlier questions alluded to the NIM potentially peaking in the first quarter. I am just curious how you are seeing the trajectory of the NIM over the next couple of quarters?

José Rafael Fernández, CEO

So as Maritza mentioned, we are seeing it equal to what we saw in the fourth quarter. The NIM should end for the year around the 5.65%, 5.67%, 5.68%. So that’s kind of how we are modeling the NIM for the full year. So definitely, there is a little bit of a trending down throughout the year as we kind of talked about last on the fourth quarter call and we are repeating it here, Alex, so it hasn’t changed.

Alex Twerdahl, Analyst

I find that helpful. I also wanted to ask about buybacks. You've effectively managed the balance sheet, maintaining high levels of liquidity and what I would consider excess capital. Given the decline in share prices like other banks, how are you approaching buyback activity or potential buybacks in the coming quarters?

José Rafael Fernández, CEO

Thank you for your question, Alex. We have been patient with our investment portfolio and capital management. Over the past couple of years, we felt there was no urgency to invest in lower-rate securities, and we felt the same way about capital management. We initiated buybacks but paused last year. Now, however, we see ourselves as patiently opportunistic. There are opportunities in the investment portfolio, which is currently yielding 5 with tax benefits. Regarding capital, we have consistently increased our dividend over the past several years and have remained opportunistic with buybacks, which we will continue to pursue. We still have around $60 million available in the authorization for buybacks.

Alex Twerdahl, Analyst

Thanks for taking my questions.

José Rafael Fernández, CEO

You are welcome, Alex. Have a great day.

Operator, Operator

Next we go to the line of Kelly Motta with KBW. Please go ahead.

Kelly Motta, Analyst

Hi. Good morning. Thanks for the question. Great quarter. I think maybe I will circle back to the funding. Just from a high level perspective, with unique to Puerto Rico, you guys have a lot of relief money still flowing in and that’s accelerated at least in the last, like, year or two. Do you guys have a sense of how much of that incremental relief funding ends up sticking in Puerto Rico and kind of staying in the deposit accounts, whether it be in consumer accounts or business accounts and wondering if that can help stem the outflows that we are seeing on the mainland?

José Rafael Fernández, CEO

It's a challenging question to answer because money is interchangeable. There are U.S. retail businesses operating in Puerto Rico that do their banking outside the island, which represents a significant portion of consumer activity. Overall, we are noticing increased balances among retail individuals and commercial entities, primarily due to the liquidity in the system. While these balances are not at the same level as last year, they are certainly higher than before the influx of stimulus and reconstruction funding began. Unfortunately, I can't provide a specific figure regarding how much of that funding stays in Puerto Rico because I don't have the necessary data.

Kelly Motta, Analyst

Okay. I appreciate entertaining it. I don’t think we have talked much about the $200 million of two-year FHLB funding you guys brought on. Just wondering kind of the thought process behind that, if that was kind of a defensive measure in the midst of mid-March and any kind of color to around what the rate is on that would be helpful for modeling purposes?

José Rafael Fernández, CEO

Thank you for your question about our approach to deposits in mid-March. We are mindful of the current environment and are committed to being cautious. We have sufficient liquidity, including access to the Federal Home Loan Bank and other sources. To be prudent, we decided to secure a two-year advance of $200 million from the Federal Home Loan Bank at roughly 4.50% to 4.55%. This was a defensive measure in case any issues arose in Puerto Rico, but fortunately, they have not. Overall, our balance sheet remains in a strong position, and that’s our perspective on the situation.

Kelly Motta, Analyst

Got it. Maybe last question for me is on credit. Your early-stage and total delinquencies are down, NPAs down as well. As you look ahead, charge-off rates are running a lot lower than they were pre-COVID. Do you have a sense of a cadence of normalization from here on out, do you think where you have been the past couple of quarters is a good estimation near term on a go-forward basis or is there anything you are seeing that may indicate there could be a tick-up in credit losses?

José Rafael Fernández, CEO

We are not seeing any reversal or a continued decline in delinquency rates, which is difficult for us to envision. However, what we observe from the consumer side regarding credit is very encouraging. We've been anticipating a return to pre-pandemic levels for about a year, but that hasn’t happened. It seems there is a paradigm shift occurring, indicating a lower level of delinquency. Similarly, Puerto Rico's economy has experienced this shift in unemployment and business activity, including manufacturing. Therefore, it’s reasonable to expect that credit trends will continue to improve in the foreseeable future.

Kelly Motta, Analyst

Great. I will step back. Thank you so much for the questions.

José Rafael Fernández, CEO

You are welcome. Thank you for your questions too.

Operator, Operator

At this time, there are no further questions. I will now turn the call back over to management for any closing remarks.

José Rafael Fernández, CEO

Thank you, Operator. Thanks again to all our team members and to all our stakeholders who listened in today. Have a wonderful day and enjoy the upcoming weekend.

Operator, Operator

Thank you. This does conclude today’s teleconference. We thank you for your participation. You may disconnect your lines at any time.