Earnings Call Transcript - OFG Q3 2023

Operator, Operator

Good morning. Thank you for joining OFG Bancorp's Conference Call. My name is James, and I will be your operator today. Our speakers are Jose Rafael Fernandez, Chief Executive Officer and Vice Chair of the Board of Directors, and Maritza Arizmendi, Chief Financial Officer. A presentation accompanies today's remarks and is available on the OFG website under the Third Quarter 2023 section. This call may include forward-looking statements regarding management's goals, plans, and expectations, which are subject to risks and uncertainties outlined in the Risk Factors section of OFG's SEC filings. Actual results may differ significantly from those anticipated. We do not have an obligation to update information disclosed in this call based on future developments. I will now turn the call over to Mr. Fernandez.

Jose Rafael Fernandez, CEO

Good morning, and thank you for joining us. We are very pleased to report our third quarter results. All our businesses performed well, and we continue to generate steady year-over-year revenue and earnings growth. Highlights include increased loan balances, stable core deposits with low cumulative beta, increased operating leverage and strong credit and performance metrics. Our digital-first strategy continues to attract customers and speed the transition of routine transactions from in-branch to digital platforms. This makes it easier for customers to do their banking and for us to increase efficiency and engage in more business development activities. In Puerto Rico, consumer liquidity is sound and the economy is doing well. As always, thanks to our team for helping our customers and the communities we serve achieve their financial goals. Please turn to Page 3 for a summary of our third quarter results. First, looking at the income statement. Earnings per share diluted was $0.95, an increase of 9% year-over-year. Total core revenues were $172.2 million, up 10% compared to last year. Net interest margin was 5.8%, provision was $16.4 million and noninterest expenses were $90.2 million. Pre-provision net revenues totaled $82.3 million, up 18% year-over-year. Now turning to the balance sheet. Total assets increased to $10.3 billion from last quarter. Based on our growth and outlook for next year, we will remain above $10 billion. Customer deposits were stable at approximately $8.5 billion. Loans held for investment totaled $7.3 billion, up 2% from the second quarter. New loan production was approximately $563 million, in line with the last 5 quarters. Investments increased to $2.1 billion and cash declined to $533 million. Moving to capital. The CET1 ratio was 14.03%, level with the second quarter. We bought back about 74,000 OFG shares in the third quarter. Please turn to Page 4 for an update on our digital-first strategy. Looking at data year-to-date September compared to the same period a year ago, 87% of all routine retail customer transactions and 92% of all retail deposit transactions are now being made through digital and self-service channels. This has been driven by 11% growth in digital enrollment, 14% growth in digital loan payments, 5% growth in kiosk usage and the success of our recently deployed Oriental Servicing portal. The portal is a cornerstone of our self-service strategy. Customers can manage all loan and deposit accounts in one place. The portal now enables digital account opening for checking, savings and CDs, applying for and accessing loans, managing automatic loan payments, and downloading a wide variety of bank letters and tax documents that customers in Puerto Rico frequently request in our branches or by phone. New features to the portal will continue to be added on a regular basis. All this continues to validate our strategy and investments in technology. As I have mentioned before, they help us provide more value-added service, increase our efficiency and assign more staff for new business development activities. Having said that, branches continue to be an important component of our island-wide sales and service network. During the third quarter, we opened a new branch in Dorado, an area with good commercial and retail opportunities. As you probably already know, Dorado is a growing high net-worth suburb of San Juan that has attracted many new residents from the Mainland. We already have a 9% market share there, and we think we can grow further. These developments, both digital and physical, continue to better position us to serve our customers and communities and grow our businesses. Now here is Maritza to go over the financials in more detail.

Maritza Arizmendi, CFO

Thank you, Jose. Please turn to Page 5 to review our financial highlights. Let me start with total core revenues. Net interest income totaled $142 million, an increase of 1.5% from the second quarter. This increase reflected the full impact of the Federal Reserve's 25 basis point hike in the second quarter and the partial effect of another 25 basis point rise in the third quarter. We saw higher yields from increased loan balances, particularly in variable rates and new loans, as well as higher yields on investment securities, along with an extra day that contributed about $1 million. Banking and wealth management revenues were $30.4 million, approximately the same as in the previous quarter and the same quarter last year. Other noninterest income was about $300,000, compared to a loss of about $800,000 in the second quarter due to early sales of our $200 million treasury loans. The efficiency ratio was 52.36%, reflecting ongoing growth and strong operating leverage. Noninterest expenses totaled $90 million, which was $1 million higher than in the second quarter. This increase was due to lower gains on the sale of closed real estate, partially offset by reduced general and administrative expenses. We expect noninterest expenses to average about $90 million to $92 million in the next quarter and next year. The efficiency ratio will remain in the low to mid-50% range. Other performance metrics were strong. Return on average assets was 1.76%, return on average tangible common equity was 17.59%, and tangible book value per share was $21.01. Please turn to Page 5 to review our operational highlights. Average loan balances increased by $188 million from the second quarter, with the end-of-period balance rising by $144 million. This growth was driven by increases in Puerto Rico and U.S. commercial loans as well as retail auto and consumer loans. This was somewhat offset by regular paydowns on residential mortgages. Loan yield was 7.84%, an increase of 8 basis points from the second quarter, reflecting higher yields from variable rate commercial loans and new auto, consumer, and commercial loans. Average core deposits grew by $90 million in the second quarter, while the end-of-period balance remained roughly the same as on June 30. Retail deposits fell by $102 million, while commercial deposits rose by $73 million and government deposits increased by $30 million. We continue to observe a shift toward time deposits and wealth management. The cost of core deposits was 90 basis points, up from 69 in the second quarter. This increase of 21 basis points was mainly due to 6 basis points from higher rates on government deposits, 6 basis points on time deposits, 4 basis points on commercial accounts and savings, and another 4 basis points on retail accounts and savings. As of the third quarter, our cumulative deposit beta stood at 19%. Excluding government deposits, it was 14%. We expect a cumulative deposit beta of about 25% by the end of this year. Average borrowings were $264 million, with the end-of-period balance at $452 million, reflecting our asset-liability management strategies during the quarter. Net interest margin was 5.80%, down from 5.90 in the second quarter. Our effective tax rate was 32%, which we expect will remain steady for the rest of the year. Please turn to Page 7 for an update on our credit quality and capital strength. Net charge-offs totaled $18.8 million, compared to $6.6 million in the second quarter. The third quarter included about $7 million for two U.S. loans that had previously been substantially reserved, whereas the second quarter included a $4 million recovery from the sale of older fully charged-off auto and consumer loans. The provision for credit losses amounted to $16.4 million, comprising over $11 million due to increased loan volume, $4 million in quantitative adjustments mainly related to the auto loan portfolio, and $700,000 for a specific sale of a small portfolio of nonperforming Puerto Rico small business commercial loans. Overall, our credit performance remains robust. Early and total delinquency rates were 2.75% and 30.78%, respectively. The nonperforming loan rate of 1.33% remained in the lower range observed over the last five quarters. Regarding our capital metrics, total stockholders' equity stood at $1.1 billion, with a tangible common equity ratio of 9.4%. In summary, during the third quarter, we experienced steady revenue growth fueled by higher yields on increased loan and security balances, along with strong originations driven by auto, commercial, and consumer lending. Although deposit costs rose due to higher average balances and interest rates, our betas remained significantly below peers. End-of-year balances were roughly the same as in the second quarter, credit conditions continued to be favorable, and higher net charge-offs were primarily due to U.S. commercial loans, while expenses fell within our anticipated range. Now I will hand it over to Jose.

Jose Rafael Fernandez, CEO

Thank you, Maritza. Please turn to Page 8. Our outlook has not changed from the second quarter call. The economy continues to do well, supported by the flow of federal funds to rebuild the island infrastructure as well as additional federal funding from the inflation reduction on the CHIPS Act. With this as a backdrop, consumers continue to deploy their liquidity, and U.S. private capital and local businesses are investing to acquire, expand and grow their operations on the island. Having said that, we continue to keep our eye on the potential impact of interest rate changes, inflation and a possible mainland recession. Also, and while it's unlikely to affect Puerto Rico directly, the recent incursions in Israel and the mounting events in the Middle East region leave us with a heavy heart, and our wishes for an early end to the fighting and for peace. We cannot help but be concerned about the possible global economic ramifications as well. All in all, we remain optimistic about Puerto Rico’s strength and its continued resiliency from mainland economic uncertainties. Now turning to OFG and to sum up on my end, we had another excellent quarter confirming our operational and financial strategies. Results benefited first and foremost, from our efforts over the years to grow our commercial and consumer business capabilities, which are helping us gain market share and increase capital; second, from our stable, low-cost core deposit base; and third, from our new Oriental Servicing portal and other technology investments, which have increased the use of customer self-service channels, allowing our teams to spend more time on new business development activities. Externally, we benefited from the positive and more resilient economic environment in Puerto Rico. All this translates into a strong commercial lending pipeline for us into the fourth quarter and into 2024, and our ability to continue to deploy innovations to better service the banking and financial needs of our customers. Against a higher base, this should result in continued growth across most of our businesses next year. In closing, I want to reemphasize that our performance could not have been possible without the hard work and purposeful commitment of all our team members. We are thankful to them for executing our corporate vision. This ends our formal presentation. Operator, let's start the Q&A.

Operator, Operator

Our first question today will come from Timur Braziler with Wells Fargo Securities.

Timur Braziler, Analyst

Could you provide us with your expectations regarding deposit beta? You’ve mentioned a 25% beta by year-end, which seems quite conservative. Looking at the longer term, given the low starting point and a higher for longer environment, do you anticipate that deposit betas and costs will remain elevated, or do you expect some relief as we move past the final rate hike?

Jose Rafael Fernandez, CEO

Thank you for your question, Timur. We assess this in terms of deposit costs and relevant data. Firstly, our market is quite different from the U.S. market, which provides a favorable environment for us. Secondly, we consider our business strategy and customer relationships. We want to maintain flexibility to attract new customers and strengthen our relationships with existing commercial clients. Therefore, we are maintaining a 25% beta for the end of the year. At that time, we will evaluate the situation as interest rates are likely to stay elevated for an extended period and consider the impact on our market. Currently, with a cumulative beta of 19%, including government deposits, we believe that keeping a 25% beta for the end of the year is a prudent decision.

Timur Braziler, Analyst

Okay. What is the balance of government deposits at quarter end?

Jose Rafael Fernandez, CEO

The balance of government deposit is in the $350 million range.

Timur Braziler, Analyst

Okay. So I guess as we're thinking about next quarter, next year, if deposit betas do lag, if they do go up to that 25%, maybe it's not in 4Q, maybe it's 1Q or 2Q next year, the growth profile still seems pretty strong. Is the expectation that you're able to offset this NIM compression with growth and NII continues to go higher? Or is that going to be more challenging in the current environment?

Jose Rafael Fernandez, CEO

Yes. So as you saw this quarter and you've seen so far this year, we have pretty good loan growth and we expect that to continue to build throughout the next year. So our way of looking at this is if the scenario plays out next year, where we need to think about higher cost of deposits, we'll mitigate that with our loan growth from a net interest income perspective. So yes, we might have, right now, a lower trending NIM, but that does not necessarily mean it will be a lower trending net interest income because we expect loan growth to compensate for that.

Timur Braziler, Analyst

Okay. Great. And then just lastly from me. On the credit front, we saw a bump-up in net charge-offs, and Maritza explained that and kind of the corresponding decline and allowance ratio. I know it's a hard question to really get a good answer for. But as you think about this normalizing credit environment, how should we be thinking about net charge-offs? And then would the allowance ratio still well over 2% of loans, is that pretty flat and kind of goes hand-in-hand with charge-offs? Or is there maybe an ability to reach some of those reserves as the broader Puerto Rico story continues to improve?

Maritza Arizmendi, CFO

Well, thank you, Timur, for your question. This quarter included about $7 million in the charge-off of 2 loans that were previously reserved and we discussed during our last call. In the second quarter, we talked about these loans that were ported in all accrual. And we completed the restructuring of one of them during the quarter, and it requires about $4.2 million in charge-offs. The other one was transferred to held for sale at the end of the quarter, and it requires about $2.7 million in charge-offs. That loan was already sold on October 18. So those reserves were already established in prior quarters. So if you exclude those 2 loans, our net charge-off is about 0.62% for the quarter, which compares really well with the prior quarters. And as we look forward, I think we are starting to see a more normalized level of charge-offs compared to 2021 and 2022. But we need to keep monitoring that trend to see what would be the normal trend. We think the credit conditions continue to be benign in Puerto Rico compared to prepandemic levels, and that's how we see it.

Operator, Operator

Our next question will come from Alex Twerdahl with Piper Sandler.

Alex Twerdahl, Analyst

First off, just it sounds to me, José, now like you're fairly committed to being above $10 billion. And I'm just curious how you're thinking about the overall strategy, the overall growth strategy. If that's no longer sort of an upper level on assets, how you think about how the balance sheet might transition over the next couple of quarters as you continue to deploy the excess capital that you have.

Jose Rafael Fernandez, CEO

Yes, our perspective on reaching the $10 billion mark this year is different from the previous two years when we stayed below that threshold. This change is largely influenced by current interest rates and the dynamics of our balance sheet, including loan growth and deposits. We believe it's a good time to surpass this mark and capitalize on opportunities to expand our loan portfolio, especially in Puerto Rico. We're dedicated to this growth, with promising prospects in both commercial and retail sectors. Regarding the management of our balance sheet moving forward, I may need clarification on your question, but I can assure you our balance sheet will exceed $10 billion, largely driven by the loan growth I mentioned earlier. If you have follow-up questions, feel free to ask, as I want to make sure I fully understand your inquiries.

Alex Twerdahl, Analyst

Yes. I mean it looks like sort of just high level on the balance sheet that you guys added some borrowings, added some securities. I don't know if leverage is the right term there or maybe it's just sort of a mismatch in timing. But I guess, as you look to grow loans, how are you thinking about funding it the complexities there?

Jose Rafael Fernandez, CEO

I understand your question, Alex. The way we see it, our expectations for interest rates are that they will stabilize around 5.25 to 5.5 percent, with a decline expected in the second half of 2024. As an asset-sensitive bank, we believe it's wise to invest in certain securities as mortgage-backed securities are yielding above 5.60 percent and shorter durations are around 4.5 to 5 years. Given that interest rates are projected to decrease, we think it’s a prudent strategy to extend our duration to benefit from these higher yields. While this may not be perfect, it certainly helps us prepare for a potential recession and lower interest rates. We're also utilizing short-term federal home advances and repos for financing, and while the current spread isn't large, we anticipate that our borrowing costs will decrease as interest rates drop in the latter half of next year. That's how we're approaching our strategy, and as I mentioned previously, we're focused on maintaining strong banking relationships on the deposit side as well.

Alex Twerdahl, Analyst

Okay. That's good. Just expanding on your comments on loan growth and the strong pipeline into the fourth quarter in 2024. I think some of us have been talking about the Metropistas deal that was announced earlier this week, and you guys are listed as a bank that would be potentially participating in some of the financing. Can you talk a bit about your appetite for something like that and sort of how big of a piece you might be willing to take on?

Jose Rafael Fernandez, CEO

So the way we look at it is we are part of a 3-bank market pretty much. And we are very much part of the community. So we need to be an important participant in those types of privatization. Certainly, it depends on who, how, where and what, right, in terms of the opportunity. But yes, we are a participant. We're not a significant participant by no stretch of imagination, but we are certainly a solid participant for our size and our appetite. We think it's also our way of contributing to the reconstruction and improvement of the infrastructure in Puerto Rico.

Alex Twerdahl, Analyst

Okay. And then I guess as we think about the loan mix going into next year, this year and last year's auto has been a very big component of that, do you expect that to continue? Or do you think we'll see a little bit of a mix shift over the next couple of quarters to more commercial?

Jose Rafael Fernandez, CEO

So yes, that's a question you ask me every quarter. Each time, I express my pleasant surprise that auto loan growth continues to hold steady. I believe we're beginning to see it plateau. In the latter part of the third quarter, we noticed a slight slowdown, which I attribute more to competitive forces than anything else. We're keeping an eye on it, and while we probably won't see a significant drop, it is starting to level off at these levels and may gradually decline into 2024. That's how we view the auto lending business at this moment.

Operator, Operator

We'll now hear from Kelly Motta with KBW.

Kelly Motta, Analyst

So I love all the detail on Slide 4. It seems like this digital-first strategy is really nice penetration here. Just wondering, with the success you're having there, is there opportunities to gain greater efficiencies and with potentially reallocating branch personnel? And how you're thinking about that relative to some other investments you may be making?

Jose Rafael Fernandez, CEO

Yes. Thank you, Kelly. We've been going at this for the last 4 or 5 years, right? We've been investing in the technology. We're deploying dollars into adding capabilities towards commercial lending and consumer lending. And certainly, it's starting to pay off. And you're starting to see not only the adoption levels going up and not only the consolidation of the portal as a vehicle to serve our retail customers, we're also providing similar types of innovations on the commercial side and working on them and more to come. So those are the dollars that we're investing. And as you saw today, Maritza mentioned our guidance for expenses next year, we're keeping it at the same level. And this is the beginning. In our minds, it's the beginning of us starting to extract some efficiencies from the investments we've made in technology. Not all of them will trickle down to a reduction in noninterest expenses, because we also want to utilize some of those efficiencies to continue to innovate and continue to bring technology that will help the market that we operate in here, which is significantly different than the way customers behave than in the States. So some of what you're seeing already into 2024 includes some of the efficiencies that we're seeing. And us, the team in general, is working into 2024 to add additional efficiencies. But again, we're very happy and excited about the innovations that we're bringing in and how our customers are adopting them, and we're going to continue to do so, because that's the way we can differentiate from our competitors on the island.

Kelly Motta, Analyst

Thanks for the insights, José. Moving on to capital levels, they remain very strong. We're witnessing significant loan growth, and it seems there was a slight reduction in buybacks this quarter. Can you remind us of your comfort and appetite regarding buybacks at the current stock price, as well as your plans for capital returns in the latter half of this year and beyond?

Jose Rafael Fernandez, CEO

Yes. So Kelly, we will use capital primarily for loan growth and the opportunities that arise, and we plan to deploy that capital accordingly. I mentioned earlier regarding the investment in MBSs as part of our capital management strategy. Additionally, we are very focused on increasing our dividend and our buyback. We will discuss this in the January Board meeting and provide an update. Our expectation is to manage capital as we have in the past; if opportunities arise in the Puerto Rico market, which we are currently observing, we will allocate that capital for loan growth, while also considering dividend increases and buybacks. Our approach to capital management remains unchanged from previous quarters.

Kelly Motta, Analyst

Lastly, on the margin. I appreciate color on the MBS purchases. In terms of loans and loan yields, can you remind us where new loan originations, what rates are coming on at? That would be helpful in terms of how to think of the margin.

Jose Rafael Fernandez, CEO

Yes. In the short term, we might see a slight decrease in net interest margin from current levels. However, this does not necessarily mean a reduction in net interest income, as we anticipate continued loan growth. For now, we are observing a plateau and a slight decline in net interest margin. We will provide an update on our outlook for 2024 during the fourth quarter call, but early indicators suggest that we will be in a strong position regarding net interest margin for 2024.

Operator, Operator

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

Jose Rafael Fernandez, CEO

Thank you, operator. Thanks again to all our team members and to all our stakeholders who have listened in. Looking forward to update you in January. Have a great weekend.

Operator, Operator

This does conclude today's conference call. Thank you for your participation. You may now disconnect.