OFG: Expecting Stable NIM and Continued Efficiency Drive to Generate EPS Growth

OFG reported 2Q20 net income to common shareholders of $20.2 million, up from the $0.2 million net loss posted in 1Q20.

On a per share basis, 2Q20 results were $0.39 compared to $0.00 in the prior quarter. 2Q20 results included $6.0 million of one-time interest recoveries on acquired Scotiabank loans and a $3.5 million favorable adjustment to the bargain purchase gain recorded on the Scotiabank de Puerto Rico acquisition, partially offset by $3.0 million of merger and integration expenses and $2.0 million of COVID-19 related expenses. Some of the significant irregular, one-time or nonrecurring items that affected 1Q20 results include $0.3 million in merger & restructuring charges, and a $4.7 million gain on investment securities. Collectively, the nonrecurring items boosted 2Q20 earnings by roughly $4.1 million after-tax or $0.08 per share. Similarly, 1Q20 earnings were boosted by approximately $3.8 million after tax or $0.07 per share. Adjusted 2Q20 EPS was $0.31 compared to adjusted 1Q20 EPS of $(0.07) excluding the impact of these items. Adjusted results exceeded our adjusted estimate of $0.24 and the median Street estimate of $0.26. The outperformance compared to our estimate was due to a combination of a lower loan loss provision and lower noninterest expenses. Highlights from the quarter include:

• Net interest income was essentially unchanged compared to 1Q20. However, without the $6.0 million in interest recoveries mentioned above, we would have seen a $6.0 million sequential decline. Average earning assets advanced 3.4% LQ, while the NIM contracted 16 bps to 4.78% from 4.94% in 1Q20. The interest recoveries accounted for 28 bps of NIM in 2Q20, so the “core” NIM was actually down 44 bps linked-quarter. Average loan yields fell 3 bps sequentially, but PCD loan yields jumped 142 bps due to the interest recoveries. Absent the recoveries, PCD loan yields still rose, but by a more modest 21 bps. Meanwhile, average non-PCD loan yields declined by 69 bps sequentially. The mix of assets at period end included a higher portion of cash (15.7% of interest earning assets in 2Q20 versus 11.0% in 1Q20) as a result of an influx of deposits. The average cost of interest bearing liabilities fell 14 bps to 0.97% from 1.11% in 1Q20. The average cost of interest bearing deposits dipped 9 bps sequentially in 2Q20, while the average cost of borrowings rose 11 bps linked-quarter. Fair value premium amortization and core deposit premium amortization contributed an incremental 12 bps to the cost of interest bearing liabilities, similar to the 12 bps impact in the prior quarter.
• Noninterest income of $27.2 million was down $4.3 million or 13.7% from the prior quarter. However, if we strip out the $3.5 million bargain purchase gain recorded on the Scotiabank transaction recorded in 2Q20 (compared to $0.4 million in 1Q20) and the $0.6 million gain on MBS sales compared to $4.7 million in 1Q20), “core” noninterest income fell approximately $3.2 million or 12.3%. The decrease was largely due to the COVID- 19-related shutdowns, which led to decreased economic activity and lower transaction volumes.
• Noninterest expenses declined $1.8 million or 2.1% linked-quarter. Merger & restructuring expenses grew $2.7 million from the prior period. In addition, OFG incurred $2.0 million in COVID-19-related expenses during the quarter. Excluding these items from the prior period, core noninterest expenses fell $6.5 million or 7.5% sequentially. There was a $1.0 million decline in compensation costs, with the remainder spread among other G&A categories. Much of the sequential decline reflected the reduced economic activity, which resulted in lower transaction-related expenses and reduced commission compensation. Management still expects to achieve most of the anticipated savings from the Scotiabank integration in 2021. OFG’s adjusted efficiency ratio was 65.86% in 2Q20 compared to 66.13% in 1Q20.
• OFG recorded a $17.7 million credit loss provision in 2Q20, down $29.4 million or 62.5% compared to the $47.1 million provision in the prior quarter. The decline primarily stems from a $29.1 million reduction in COVID-1-related adjustments, which fell from $34.1 million in 1Q20 to $5.0 million in 2Q20. The allowance for credit losses grew $1.9 million or 0.8% linked-quarter, slipping to 3.35% of loans held for investment from 3.41% at March 31, 2020.
• Despite the downturn in economic activity related to COVID-19, overall, asset quality has still not suffered significantly. Net charge-offs fell to 0.92% of average loans in 2Q20 from 1.44% in 1Q20. NPLs decreased $8.4 million or 8.5% linked-quarter, falling 26 bps to 1.81% of non-acquired loans from 2.07%, while OREO and other repossessed assets also fell, leading to a decline of 9.8% in NPAs. Early stage delinquencies decreased from 3.16% of loans on March 31, 2020 to 2.64% on June 30, 2020.
• OFG recorded a tax expense of $7.2 million in 2Q20, producing an effective tax rate of 25.0%.
• Gross loans held-for-investment climbed $186.4 million or 2.8% sequentially. The increase was once again entirely in the commercial loan segment, which grew $281.2 million or 12.2% linked-quarter thanks to $286.4 million of PPP loan originations. The consumer, auto and consumer segments all saw decreases. Despite the unfavorable economic environment, OFG recorded solid loan production. We just noted the significant PPP loan production, but other internal loan originations in the commercial segment also held up well, climbing 82.1% from the prior quarter. Meanwhile, consumer and auto loan originations fell 63.7% and 56.7% respectively. Originations through the mainland loan participation channel declined 24.2% sequentially to $35.7 million from $47.1 million in 1Q20. Meanwhile, mortgage loan production decreased 31.3% to $21.1 million. Much of the declines in mortgage, auto, and consumer loans was driven by the COVID-19-related shutdowns. As some of the restrictions were lifted late in the quarter, originations of mortgage and auto loans began to rebound. Total originations were $504.4 million, up 79.4% compared to the $280.6 million posted in 1Q20, and up 54.2% from the $326.6 million originated in the same period a year ago.
• Total deposits climbed $722.7 million or 9.2% sequentially, led by a $658.9 million rise in demand deposits. Also contributing was a $149.1 million jump in savings accounts. Partially offsetting these increases was a $48.0 million decline in time deposits and a $37.3 million drop in brokered deposits. As a result, the deposit mix improved noticeably, as brokered and time deposits decreased to 25.7% of total deposits from 29.1% on March 31, 2020. The increase in deposits during the quarter was larger than the $186.4 million rise in gross loans held for investment. As a result, OFG was able to reduce securities sold under repurchase agreements by $50.1 million. However, the rest of the deposit funding largely went into cash, which grew $574.1 million sequentially, creating a drag on the NIM.
• Tangible book value per share rose to $16.01 on June 30, 2020 from $15.60 on March 31, 2020, while the tangible common equity ratio declined 41 bps to 8.39%. OFG’s regulatory capital ratios increased further during the quarter. The leverage ratio climbed to 10.16% from 10.14%, the CET1 ratio increasing to 12.03% from 11.69%, and the Tier 1 ratio advancing to 13.71% from 13.36%. All of the regulatory capital ratios remain well above the minimums needed to be considered “well capitalized” under regulatory guidelines.

Earnings Estimates:

There is greater than usual uncertainty right now due to the COVID-19 pandemic situation. The unknown path of the pandemic makes it difficult to gage the state of the economy over the next three to six months. This makes forecasting loan and deposit levels, as well as the NIM problematic. One thing that seems certain is that we will see credit quality deteriorate as payment moratoriums end. That being the case, we’ll start with credit costs. OFG has solid reserve coverage relative to average loans. While we believe net charge-offs will increase noticeably in coming quarters, a significant portion of the charge-offs should reflect loans already reserved for. We are projecting a credit loss provision in the $16 million to $17 million range over the next three quarters. This is similar to the 2Q20 level, though 2Q20 included a $5.0 million COVID-19-related adjustment. This results in total provisioning of $98 million in 2020 and $73 million in 2021, down from our prior projections of $120 million and $98 million.

We are assuming minor balance sheet shrinkage over the next few quarters as PPP loans get repaid or forgiven and deposits stemming from government stimulus programs get drawn down. The reduction in deposits will allow OFG to reduce low-yielding cash and investments at the same time as low yielding PPP loans are paying off should help keep the NIM fairly stable despite the low interest rate environment. We expect noninterest income to rebound modestly as the economy gradually reopens, while noninterest expenses should remain contained due to efficiency efforts and gradual integration of the Scotiabank operations. We still anticipate most of the cost savings from the Scotiabank acquisition in 2021.

After adjusting our model for the above items, we are raising our 2020 EPS estimate from $0.54 to $1.27 (from $0.63 to $1.35 excluding merger & integration expenses). We are also raising our 2021 EPS estimate from $0.90 to $1.62 while initiating a 2022 estimate of $1.86.

Outlook:

Puerto Rico has seen many catastrophes in recent years, from the government debt crisis and Hurricane Maria in 2017 to the earthquakes of early 2020, and now the pandemic. Thought there are still many challenges to overcome from these events, there is also a considerable backlog of disaster relief still due that could help the island respond to the COVID-19 downturn.

We believe that OFG is well positioned to improve profitability as the economy rebounds. With the stock still trading below tangible book value, we believe that OFG remains an attractive investment.

Due to changes in our coprorate structure and a desire to avoid conflicts of interest, we are discontinuing the practice of providing target prices and stock ratings in our reports. However, we still believe we have insights to offer and value to add for the small number of securities that we continue to provide research coverage for.

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