Earnings Call Transcript - OFG Q3 2020

Operator, Operator

Good morning. Thank you for joining OFG Bancorp’s Conference Call. My name is Maria, and I will be your operator today. Our speakers are, Jose Rafael Fernandez, President, Chief Executive Officer and Vice Chairman; and Maritza Arizmendi, Executive Vice President and Chief Financial Officer. A presentation accompanying today’s remarks can be found on our redesigned Investor Relations website on the homepage and 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 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 would now like to turn the call over to Mr. Fernandez.

Jose Fernandez, President & CEO

Good morning to all, and thank you for joining us. Before I begin, I want to thank all our team members for their dedication and commitment during these very challenging times. They’ve done an excellent job, and our results show it. I'd like to start off on the big picture. Once we got past January, the economy and OFG performed well. Overall, we started to see the benefits of the Scotiabank acquisition. Then the COVID-19 pandemic hit, and by mid-March, the Puerto Rico governor had shut down the island. These tough measures, however, enabled Puerto Rico to begin to relax restrictions on economic activity by the end of the second quarter and beginning of the third, with a noticeable rebound in the economy. At the same time, we began to see an increased flow of federal funds for stimulus related to Hurricane Maria, the earthquakes, and the COVID-19 pandemic. In addition to the benefits provided by the bank loan deferrals, all this added to the third quarter's economic rebound and resulted in increased liquidity on the part of businesses and consumers. Altogether, the impact has been much more beneficial on a relative basis than what has happened on the mainland. As it relates to the local banking industry, consolidation, the natural rebounding economic activity, and the growing amount of stimulus, combined with the Federal Reserve Bank's significant rate cuts in March, created a number of banking crosscurrents in the third quarter. By acting with agility and speed, OFG has been able to take advantage of them to the benefit of our customers, communities, and people. The increasing liquidity resulted in continued growth in deposits and cash. This negated virtually all our net interest margin dilution compared to the second quarter. It also encouraged consumers and business customers to step up their loan repayments. Taking advantage of the situation, we continue to expand our customer base and digital migration. There was a large increase in new auto sales, which we translated into a noticeable increase in our own auto loan generation. Mortgage production quadrupled, fee income grew across the board, and deferrals dropped to 2% of loans from 30% in the second quarter. Our commitment and preparation enable us to manage these changes effectively. Branches continue to operate safely, enhanced by our technology. Full service, ATMs and ITMs, our mobile app, and online bill-paying tools continue to facilitate routine transactions in a contactless manner. Online and mobile appointment scheduling continue to make COVID-safe customer meetings possible at branches. In addition, the Scotiabank integration continues on track, and we're starting to see improved operating leverage. In the end, we generated strong momentum in our core businesses as we continue to help our customers, communities, and people build better and stronger financial futures for themselves. Let's turn to Page 4. We have continued to see strong digital migration trends among both our retail and business customers. More customers are becoming online and mobile users, but they are also using an increasing number of digital features. Here are some new highlights comparing September to January of this year. P2P volume is up 40%. Digital money transfers have increased 55%. Online loan payments are up 87%. Retail and commercial photo deposits have doubled. And we scheduled more than 34,000 COVID-safe appointments with customers through our online mobile platform, almost all of them in the second and third quarters. Clearly, customers are using these features to avoid contact during COVID, but as they experience the ease and convenience of banking like this, they have embraced it. More and more customers in Puerto Rico are asking themselves, why would you drive to the branch to deposit a check when you can take a photograph? Why would you even write a paycheck these days? These are positive trends that have accelerated due to the pandemic, and play nicely into our retail banking strategy. We continue to look for new and innovative ways to help our customers interact with us in an agile and easy way. Earlier this week, we became the first financial institution in Puerto Rico and the U.S. Virgin Islands to launch a digital portal to make it fast and easy for our commercial clients to apply for PPP loan forgiveness. Let's start on Page 5 to talk about our financial results. Earnings increased significantly. We reported earnings per share of $0.50, a 28% increase from the second quarter and more than four times the year-ago quarter. The effective tax rate was 19%, compared to 25% in the second quarter. Total core revenues were $127 million, excluding one-time interest recoveries from acquired Scotiabank loans. Net interest income of $99 million was level with the second quarter, while fee income rose 19% to $27 million. Net interest margin was 4.3%. When excluding interest recoveries in both quarters, the net interest margin was 4.28% versus 4.5% in the second quarter. Virtually all the difference was attributable to the increase in cash balances. Non-interest expenses of $83 million fell more than $2 million compared to the second quarter, and that number includes merger and COVID-related costs. Excluding those in both periods, the efficiency ratio improved by 369 basis points compared to the second quarter, as increased operating leverage from the Scotiabank acquisition began to kick in. Customers’ deposits grew by more than $212 million from June 30, to $8.5 billion, due to the increased deposits as well as the repayment of loans and securities. Cash increased by $383 million to $2.3 billion. As a result, total assets grew by $84 million to $10 billion. We do not anticipate exceeding this total asset level from December 31, 2020. Loan production was strong, totaling $458 million. Excluding Paycheck Protection Program loans in the second and third quarters, production increased by $228 million. The allowance coverage increased to 3.64%, excluding PPP loans. Capital continued to build, and shareholders’ equity increased to $1.06 billion. All regulatory capital ratios remain significantly above the requirements for a well-capitalized institution. The CET1 ratio was 12.55% on September 30, 2020. Please turn to Page 6. The effects of all this are that our tangible book value per share increased by $0.50 in the third quarter to $16.51. In addition, all three of the key performance ratios we track improved sequentially. The efficiency ratio improved to 65.69% on a reported basis. On an adjusted basis, it was 62.17%. Return on average assets was 1.11%, and return on average tangible common stockholder equity was 12.23%, and 12.10% on an adjusted basis. Return on average tangible common equity now exceeds our performance as compared to the year-ago second quarter before all the transactions related to the Scotiabank acquisition and increased provisioning affected the business. Please turn to Page 7 for our operational highlights. Average loan balances declined by $54 million from the second quarter, reflecting net loan repayment in mortgage, commercial, and consumer, overall increased. Average core deposits excluding brokered grew by $524 million from the second quarter. End of period core deposits are now up by more than $1 billion from the end of last year. That is on top of the $2.8 billion that came with the Scotiabank acquisition. Loan generation excluding PPP loans, by order of magnitude was driven by $174 million in commercial lending, $156 million in auto, $94 million in residential mortgage, and $24 million in consumer. Loan yield at 6.57%, declined by 40 basis points from the second quarter. This was mainly driven by PCD loans due to lower interest recoveries. Non-PCD loan yield declined by only 16 basis points. The cost of core deposits declined by 5 basis points to 56 basis points. Please turn to Page 8 to review credit quality. Credit quality continued to be under control, with the net charge-off rate declining by 30 basis points from the second quarter, mainly due to declines in auto. Provision declined by $4 million, largely due to the declining COVID-related provisioning; otherwise, provision was approximately level. The non-performing loan rate increased by 52 basis points quarter-over-quarter, mainly in mortgage and auto. We believe this is more about getting customers back in the payment cycle now that most deferrals are over, but we are keeping a close watch on it. As for our customer relief program, if you recall, as of June 30, we processed relief for more than 44,000 retail customers for $1.4 billion, or 32% of our retail loans. For our commercial customers, we processed relief on $685 million in loans, or about 27% of our commercial portfolio. As I mentioned earlier, our deferrals are now down to 2% of total loans, most of that relates to about $112 million of commercial loans, mostly longstanding, solid customer relationships in the hospitality industry. Please turn to Page 9. The allowance for loan and lease losses increased by $2.6 million from the second quarter and is now equal to 3.48% of total loans. Excluding SBA guaranteed PPP loans, the allowance was 16 basis points higher than in the second quarter. Please turn to Page 10. We're in a very strong capital position. Our CET1 capital ratio is now up 164 basis points this last year after the Scotiabank acquisition. Please turn to Page 11. To conclude, we believe our history, culture, team, and approach to business, as well as our most recent results demonstrate our ability to quickly respond and adapt to changing economic environments. During the second and third quarters, we have built momentum in our core businesses and developed a strong pipeline of new loans. Looking at our liquidity, capital, and balance sheet, we are well-positioned financially and strategically. We have $8.5 billion of sticky core deposits with an excess of more than $1 billion, giving us a significant amount of dry powder. Our agenda remains the same: Finish integrating the former Scotiabank operations by year-end, achieve the full benefits of the acquisition by the end of next year, continue to invest for the future to further simplify operations and enhance our ability to serve customers, and continue to play a significant role in the economic rebound of Puerto Rico and the U.S. Virgin Islands. From a macro perspective, the increased liquidity from ongoing stimulus should continue to benefit the economy. This favorable environment should be further enhanced by the fiscal board finally working towards a resolution with Puerto Rico creditors and by pharmaceutical companies as they onshore more production back to Puerto Rico. We are now incrementally more confident that the economy will improve further. Let's be clear, we still face tremendous challenges from COVID-19, the elections in Puerto Rico and the U.S.A., and completing our Scotiabank conversion and integration. But we believe the economy is starting to move in the right direction, and the future is beginning to look brighter. By staying close to our customers and communities, we should be able to continue to deepen our relationships and grow the financial services we provide to them as we enter what appears to be a nascent and potentially expanding recovery. Again, I want to thank all our team members for our excellent results and for their dedication and commitment this year. Crises bring out the best in people to help others. Our team demonstrates that every single day. With this, we end our formal presentation. Thank you all for listening. Operator, let's start the Q&A.

Operator, Operator

Thank you. The floor is now open for questions. Our first question comes from Alex Twerdahl of Piper Sandler.

Alex Twerdahl, Analyst

Hey. Good morning.

Jose Fernandez, President & CEO

Good morning, Alex.

Alex Twerdahl, Analyst

First off, I just want to ask you a couple of questions on the margin. Specifically, you guys are now sitting around $2.3 billion of cash, earning 13 basis points. When I looked at your CD book at almost the same amount, paying 154. It just seems like a tremendous opportunity to really get aggressive on deposit costs over the next couple of quarters. Is that the case? And how quickly could we see the cost of deposits continue to come down, just based on maturities that are coming on? And what new product is coming on the book set?

Jose Fernandez, President & CEO

Thank you for your question, Alex. I think that's a good point. And the way we look at this is, first, we need to make sure we extract the full benefits of the acquisition from Scotiabank. As you know, we've been at it for the whole year so far in terms of the integration and now the conversion coming in later in this quarter. So, we are being very strategic in terms of how we address the cost of funds from our customers, because we want to make sure that we extract also the efficiencies from the operations first. Customers come first for us, and we try to focus first on how do we make our operations more efficient. And certainly, with the acquisition of Scotiabank, we had to delay it, given COVID-19. We're starting to get back on track, and we should see the full effects of the operating efficiencies by the end of next year. But as you know, we keep a close look at the market and how deposits are being priced, and we act accordingly. But it is not our intention to be tactical about this. And we want to not only retain our customers but also expand relationships with our customers. We feel that our retail strategy and our commercial strategy are performing wonderfully given the new normal that we will have to operate in, in the foreseeable future and probably on the longer term. So, looking long-term, we think that we're in very good shape, and we're not in any hurry to play a tactical game here.

Alex Twerdahl, Analyst

Okay, understood. And then just switching over looking at the reserve increase this quarter. It seems like it was mostly driven by the auto portfolio. Can you talk a little bit about what drove a higher reserve level for autos this quarter, specifically, was it sort of collection trends? Or is there something else in some of the macro data that got adjusted? And what drove the increase? And what factors you look forward to eventually drive that to go lower?

Maritza Arizmendi, CFO

Hi, Alex. I want to mention that it's always influenced by volume, and our auto loan portfolio saw a significant increase this quarter due to higher production levels, which contributed to the growth. Additionally, we experienced a temporary rise in non-performing loans, and we adjusted our provisions accordingly. These are the main reasons for the increase this quarter.

Alex Twerdahl, Analyst

Okay. And then just talking a little bit about the NPLs, and you sort of alluded to in your prepared remarks, Jose. But do you attribute the increase in NPLs to just returning on collection efforts that maybe were on hold for a couple of months? And can you just remind us sort of what you saw after Hurricane Maria, with the same sort of thing and how that eventually played out?

Jose Fernandez, President & CEO

I think the script is playing out similar to Maria. What we're seeing is the pickup in the NPLs. We feel it's a little bit of two things. One is that the deferrals were over and people need to get back into the payment cycle. But also the fact that we're in COVID-19 has a different dynamic than Hurricane Maria, and that is going out there and canvassing that requires, particularly on the consumer side, which is harder. So again, we use all methods, and I think COVID-19 threw a curveball at everyone with some of the tools that we utilized to get people into the payment cycle. We are keeping a close eye on it. We'll give you an update in the next quarter's results call. At this point, however, we're not seeing any deteriorating trends or anything that tells us that we're having incremental NPLs.

Alex Twerdahl, Analyst

Great. Thanks for taking my questions.

Jose Fernandez, President & CEO

You're welcome. Thank you for your questions.

Operator, Operator

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

Joe Gladue, Analyst

Good morning.

Jose Fernandez, President & CEO

Good morning, Joe.

Joe Gladue, Analyst

I guess, first wanted to ask about the loan originations. Very impressed with the growth there. I’m wondering if you could give us a little color on some of the drivers. But particularly with the mortgage portfolio, it looks like production in the third quarter was more than you did in all of 2019. Just wondering if that’s some market share gains or if the market is growing that much. You're the first ones to report here in Puerto Rico, just a little color on the drivers?

Jose Fernandez, President & CEO

Yes. I would say, Joe, on the origination side, mortgage was a great performer this quarter. Before the acquisition of Scotiabank, we were originating $20 million to $30 million, probably closer to like $50 million. This quarter, we almost reached $100 million in mortgage origination. That is part of the benefit that we're getting from the Scotiabank acquisition, where we have a larger platform to originate. Certainly, lower interest rates and refis, and we're seeing also pent-up demand to buy homes and good pricing bids for homes as well. All that has contributed to the increasing originations on the mortgage side. In terms of market share, I suspect we have increased our market share, but we don't have enough data at this point to confirm. However, it seems to me with that origination level in the quarter, it looks like we've gained some market share there. On the auto side, we also saw an increase this quarter, as I mentioned in my initial remarks; the third quarter really benefited from the pent-up demand that was created from the shutdown and the reopening. New auto sales and used car sales also went up, and we have great relationships with the dealers that we serve. We moved quickly and served them as fast and agile as we could to gain that origination level. I think those two are the key contributors to the origination increase. On the commercial side, while we're seeing steady, strong production from the small commercial side of the business, we're also seeing steady and strong production on the larger commercial type of loans, and we're seeing good pipelines on both. I am a bit reluctant to be overly optimistic about Puerto Rico and the world, but I can't deny the facts. We are certainly seeing the benefits of the stimulus, and it's translating into greater opportunities for us to originate loans. We are out there. We got to be out there for our customers and ensure that we serve them and provide them the ability to grow their relationships with us.

Joe Gladue, Analyst

Okay. Just in regards to how that production is affecting the margins, just where are average yields on new production versus the averages for the quarter?

Jose Fernandez, President & CEO

Yes. On the consumer side, I'll give you some color on the auto and consumer. On the mortgage, most of it we originate on sale if it's conforming, and most of it is conforming. On auto and consumer, average yield between the two portfolios is probably close to 9.5% to 10% among both. On the commercial side, with lower interest rates by the Federal Reserve Bank, we're seeing lower use there, but we are also seeing much discipline in providing floors to the variable commercial loans that we’re originating. On the small commercial, it's more fixed and variable, and we're seeing yields around 5.5%, 5.75%, and 6%.

Joe Gladue, Analyst

Alright. Thank you. That’s all I had.

Jose Fernandez, President & CEO

Thank you, Joe. Have a great weekend.

Operator, Operator

Our next question comes from the line of Glen Manna of Keefe, Bruyette & Woods.

Glen Manna, Analyst

Hi, good morning, Jose, good morning, Maritza.

Jose Fernandez, President & CEO

Hi. Glen.

Glen Manna, Analyst

I just wanted to dig into the fee income a little bit on the banking service fees. I think, given the merger happened just before COVID, we probably never got a really good run rate on what that would be on the combined company. But the current quarter is $16.3 million. Does that have any lingering effects of customer activity, or is that kind of the run rate that we would have expected after the merger?

Jose Fernandez, President & CEO

On the fee income, we have several factors there. We have a longstanding legacy financial services business; that business did incrementally better this quarter. We also have a larger mortgage business from servicing and all, and we're starting to see the full benefits of that business as we stabilize and normalize in the COVID environment. On the banking services, what we're seeing is a reflection of the economy and business activities returning, along with personal purchasing activity. So, when you look at the results this quarter, we are probably starting to see the full effects of the acquisition in terms of fee income. We are very much on the lookout. Now that we're going to do the conversion and the systems integration, we'll have better visibility. Remember, we're running two systems right now, making life more complicated than one might imagine on a daily basis, given the two systems plus the COVID-19 pandemic scenario. I can't stop repeating how proud I am of our team. What we have accomplished this year is not normal standard operating conditions while integrating two banks.

Glen Manna, Analyst

Okay. And then to that point, in kind of on the expenses, if you take out the merger charges and COVID expenses in the second quarter and the third quarter, it looks like expenses decreased by $1.8 million. Annualized, that would suggest about 20% of the $35 million in cost savings that you had guided to when you announced the Scotiabank deal. Is that right internally? And are those really cost savings from the deal? And are we at the 20% range?

Jose Fernandez, President & CEO

I'll let Maritza give you the color. But I just want to make sure that everybody understands that we are working hard towards extracting the full benefits of the Scotiabank acquisition, but we are very much being cognizant of the COVID-19 environment we're operating in. So, Maritza, why don't you give Glen some color on that?

Maritza Arizmendi, CFO

Yes. As Jose mentioned, the consolidation process started later than we planned. During the third quarter, we started to see the initial steps that we have taken to take full advantage of the consolidation. This simple version is a big deal for us to continue realizing these expected savings. When we complete this process, scheduled to be completed by the end of this year, we will have better visibility on what could be the run rate in the long term. We are looking forward to the operating leverage that the Scotiabank position has, and we expect potential operating leverage. The last quarter will be key for us to have full visibility of the long-term savings, and I would be in a better shape to share with you any long-term run rate.

Jose Fernandez, President & CEO

Having said that, Glen, the trends are positive. We're happy with the lower expense trend. We just want to ensure that we get through the fourth quarter to have a better idea of how fast we can extract the benefits.

Glen Manna, Analyst

Okay. You had touched on it, Jose; the non-acquired book yields were down 16 basis points quarter-over-quarter. They were down 59 basis points the quarter before that. Given where LIBOR is now, how much of that back book repricing would you expect? Or given that LIBOR has flattened out, where are we at with some of that back book repricing?

Jose Fernandez, President & CEO

As we mentioned throughout this call today, the lower rate environment is here to stay for longer. We still have some remnants of lower yields on our loan portfolio. Still, I think we have pretty much all of it already baked in given the lower rate environment we operate in. I expect we'll still see loan yields trending downward for a couple more quarters, but not in a significant way.

Glen Manna, Analyst

Okay. And then just a question on the tax rate. When we go through all of the adjustments to get to an operating number, it looks like the effective tax rate was in the 18%, the operating number probably about 22% versus the 25% where you ran. Where can we expect the tax rate to go in '21, '22 going forward?

Maritza Arizmendi, CFO

That's a good question, Glen; I'm glad you asked. This year, we did have higher proportions of exempt income that I can anticipate won't be repeated during the next two years. We're looking at a range of 30% to 32% as a normalized effective tax rate for the next two years.

Glen Manna, Analyst

Okay. And then just the last question on reserving. You guys, with PPP, ex-PPP, you're in that mid to high 3% range. Could you maybe talk about your economic outlook? If there's no change in the basis of the outlooks that you're using from outside services, are you well reserved here? Do you expect at some point, we could start to see max charge-offs or maybe even a little reserve release?

Jose Fernandez, President & CEO

To answer your first question, are we well reserved? The answer is yes. Regarding the macro, we see the beginnings of an economic rebound, and we are encouraged. We see a brighter future for Puerto Rico. As I said, there are tremendous uncertainties and challenges. There are still several things that need to settle for the Puerto Rico economy to have safe sailing into the future. So, when we look at our credit allowance and how we view credit risk, the macro outlook is improving. Again, we need to deal with the current situation, which still poses certain challenges. We want to ensure that we can navigate these effectively. But again, I feel that this is the beginning of a brighter future for the macro in Puerto Rico over the next several years as we benefit from ongoing stimulus and reconstruction funds that are starting to flow. We have about 30% to 35% of our gross domestic product in medical devices due to more pharmaceutical production in Puerto Rico. We are in a good position; if you add that to the credit performance, you can get the answer.

Glen Manna, Analyst

Okay, thank you. I just want to bring up one point on the taxes, Maritza, thank you for that guidance. I wanted to confirm that if there’s a change in administrations on the mainland here, and we see an increasing corporate tax rate, OFG would be relatively unaffected by an increase in mainland corporate tax rates. Am I correct?

Maritza Arizmendi, CFO

Yes, because at the end, the U.S. income that we have is proportionately lower than anybody; it’s really small. So we won't be significantly impacted.

Jose Fernandez, President & CEO

Most of our business is in Puerto Rico.

Maritza Arizmendi, CFO

Lots of the business is in Puerto Rico.

Glen Manna, Analyst

Thank you for confirming that. And thank you for taking my questions.

Jose Fernandez, President & CEO

You’re welcome. Have a great weekend.

Operator, Operator

I'm showing no further questions at this time. I'd like to turn the floor back over to Mr. Fernandez for any additional or closing remarks.

Jose Fernandez, President & CEO

Thank you, operator, and thank you all to all our stakeholders who are listening. I wish you a great weekend. Our concern goes out to those who have suffered from this pandemic. Our hope is that it ends as soon as possible, and everybody stays safe and healthy. So, thank you and have a great day.

Operator, Operator

Thank you. Ladies and gentlemen, this does conclude today's conference call. You may now disconnect.