OFG: Strong Loan Originations, Closing of Major Acquisition Suggest Good 2020; Raising EPS Estimates, Maintaining Target Price; Reiterating Outperform Rating.

        OFG Bancorp (OFG – NYSE – Closing Price: $19.92)

                       Rating: Outperform / Buy Price: $24.00  / Target Price: $27.00

Overview: OFG reported a 4Q19 net loss to common shareholders of $(2.3) million, down 139.5% compared to the $7.4 million net income posted in 3Q19. On a per share basis, 4Q19 results were $(0.04) compared to $0.11 in the prior quarter. There were some substantial one-time or nonrecurring items that affected 4Q19 results, primarily $21.5 million in merger & restructuring charges and incremental provisions of $6.6 million related to NPLs the company decided to sell in the preceding quarter. Similar one-time or nonrecurring charges in the prior quarter included the sale of $121 million of NPLs, the sale of $322 million of MBS, merger expenses, and several one-time credits. Collectively, the nonrecurring items reduced earnings 4Q19 earnings by approximately $17.6 million (after-tax) or $0.34 per share. In the prior quarter, these charges had a $19.1 million or $0.37 per share (after-tax) impact. Adjusted 4Q19 EPS was thus $0.30 per share compared to adjusted 3Q19 EPS of $0.48 excluding the impact of these items. Adjusted 4Q19 results exceeded our $0.21 estimate but fell $0.04 short of the $0.34 median Street estimate. Driving the better-than-expected adjusted results versus our estimate was a negative effective tax rate for the quarter reflecting the loss in the period and bringing the full year effective tax rate to 28.5%.

· Net interest income slipped $1.5 million or 1.9% compared to 3Q19. Average earning assets declined 1.8% LQ, while the NIM held firm at 5.35%. Average loan yields climbed 1 bps sequentially, though a 16 bps drop in average securities yields drove a 5 bps decline in average asset yields. The mix of assets was tilted toward lower yielding cash and securities as part of the preparation for the acquisition of the Puerto Rico and USVI operations of Scotiabank. The average cost of interest bearing liabilities fell 7 bps to 1.07% from 1.14% in 3Q19. The average cost of interest bearing deposits dipped 5 bps sequentially in 4Q19, and the average cost of borrowings rose 8 bps linked-quarter, but borrowings declined as a percentage of interest bearing liabilities from 8.2% in 3Q19 to 7.6% in 4Q19.

· Noninterest income of $19.7 million was down $2.5 million or 11.1% from the prior quarter. However, if we strip out the $0.3 million bargain purchase gain recorded on the Scotiabank transaction recorded in 4Q19 and the $3.5 million gain on MBS sales in 3Q19, “core” noninterest income rose $0.7 million or 3.8%. This increase was largely due to a $0.2 million rise in mortgage banking revenues and a $0.5 million advance in financial services revenues.

· Noninterest expenses advanced $27.6 million or 54.5% linked-quarter. The previously mentioned $21.5 million of merger & restructuring expenses accounted for $19.9 million of the incremental expenses. In addition, 4Q19 expenses included a $2.8 million contingent legal reserve and $1.5 million in incremental health insurance and technology development expenses. The prior quarter also included several nonrecurring items, including $1.6 million in merger expenses, offset by a $1.5 million FDIC insurance credit and a $1.0 million credit from the Puerto Rico Treasury Department (Hacienda) for employee retention following Hurricane Maria. Excluding these items, noninterest expenses rose just $0.8 million or 1.6% compared to 3Q19. As a result, OFG’s adjusted efficiency ratio for the full year 2019 was 53.31%. For 4Q19, the efficiency ratio was 79.63% as a result of the merger and other nonrecurring charges, as compared to 51.11% in 3Q19.

· OFG recorded a $23.1 million loan loss provision in 4Q19, down $20.7 million or 47.3% compared to the $43.8 million provision in the prior quarter. We had projected an $11.7 million provision. There were several contributors to the change in the provision. The biggest was the sale in 3Q19 of non-performing commercial and mortgage loans, resulting in a $6.6 million increment to the provision in 4Q19 following a $39.0 million increment to the provision in the prior quarter. The 4Q19 provision also included $3.6 million for the balance of a commercial loan on a property destroyed in a fire.

· Management updated the guidance on the impact of adopting the CECL accounting standard in 1Q20. Management expects the allowance for the originated loan book to increase 25%-30%, with the impact phased into capital over the 2020-2022 time frame. Management estimates the non-PCD acquired Scotiabank portfolio will have a $16 million to $22 million allowance.

· Following significant sales of NPLs in the previous quarters, overall, asset quality was fairly stable in 4Q19. Net charge-offs fell back to 1.45% of average loans in 4Q19 from 3.57% in 3Q19. NPLs increased $4.8 million or 6.4% linked-quarter, rising 7 bps to 2.07% of non-acquired loans. Total delinquencies decreased from 5.39% at September 30, 2019 to 5.31% at December 31, 2019. The total delinquency rate remains well below its pre-hurricane level (6.31% at June 30, 2017).

· OFG recorded a negative tax expense of $(1.9) million in 4Q19, reflecting the loss for the quarter and bringing the full year effective tax rate to 28.5%. Management expects the effective tax rate for 2020 to be roughly 32%-33%.

· Gross loans held-for-investment jumped $2.2 billion or 49.3% sequentially, largely as a result of the completion of the acquisition of Scotiabank’s PR and USVI operations on December 31, 2019. The bulk of the increase was in the residential mortgage segment, which jumped $1.4 billion, but the commercial, auto and consumer segments also saw big increases. Somewhat obscured by the scale of the acquisition-driven growth was loan production. Loan originations were up significantly in the commercial segment, rising 230.0% from the prior quarter. This was more than enough to offset modest declines in originations in the consumer and auto segments. Originations through the mainland loan participation channel edged up to $12.5 million from $12.2 million in 3Q19. This segment is very lumpy and depends on what loans are available to OFG. Total originations were $404.9 million, up 38.9% compared to the $291.4 million posted in 3Q19, and up 25.4% from the $323.0 million originated in the same period a year ago.

· Total deposits also increased significantly as a result of the Scotiabank PR & USVI transaction. Total deposits climbed $2.8 billion or 57.8% sequentially, led by a $1.35 billion spike in demand deposits. Also contributing were advances of $906 million in time deposits and $608 million in savings deposits. Partially offsetting these increases was a $45 million decline in brokered deposits. As a result, the deposit mix improved noticeably, as brokered deposits decreased to 3.2% of total deposits from 5.9% at September 30, 2019. Meanwhile, average noninterest bearing checking accounts rose 1.5% to $1.11 billion, representing 23.0% of average deposits, up from 22.2% three months prior. The increase in deposits during the quarter was larger than the $2.2 billion rise in gross loans held for investment.

· Tangible book value per share fell to $15.97 at December 31, 2019 from $17.11 at September 30, 2019, while the tangible common equity ratio declined 510 bps to 8.97%. OFG’s regulatory capital ratios were reduced considerably by the Scotiabank PR & USVI transaction, 2019, with the leverage ratio sliding to 13.99% from 15.41%, the CET1 ratio decreasing to 10.78% from 17.98%, and the Tier 1 ratio falling to 12.50% from 20.43%. Despite the declines, all of the regulatory capital ratios remain well above the minimums needed to be considered “well capitalized” under regulatory guidelines.

Earnings Estimates: OFG reported a very good quarter, with significant loan growth a stable NIM, low core operating expense growth and stable asset quality. All of this occurred while the company was completing the acquisition of Scotiabank’s Puerto Rico and US Virgin Islands operations. Not only does this transaction boost OFG’s balance sheet substantially while expanding its reach into the USVI, it also utilizes OFG excess capital, bringing the bank’s capital ratios more in line with industry peers and making the company more efficient.

OFG generated better-than-expected loan originations in 4Q19 and management indicates the current loan pipeline remains strong. The Scotiabank transaction increases OFG’s scale, creating new opportunities for larger loans. We are still expecting mid-single digit loan growth over the next few years. The acquisition also brings a significant source of core deposits to fund the loan growth with lower cost deposits, helping support the NIM. The new low-cost core funding, coupled with the removal of the excess liquidity OFG had built up on the balance sheet in order to fund the acquisition should offset much of the NIM pressure from the decline in interest rates in recent months. For 2020, we expect the NIM to remain within +/- 5 bps of the 5.35% posted in 4Q19.

After adjusting our model for the above items, we are raising our 2020 EPS estimate from $1.79 to $2.14 (From $2.12 to $2.26 excluding merger & integration expenses). We are also raising our 2021 EPS estimate from $2.35 to $2.62.

Valuation:

Peer banks on the mainland are trading at a median tangible book value multiple of 169.8% and a median price-to-trailing twelve month EPS multiple of 13.4x. OFG is now trading at just 126.3% of TBV and, as a result of the loss posted in 4Q19, 21.7x TTM EPS. Our $27.00 price target translates to a 12.0x P/E multiple applied to our $2.26 EPS estimate for the next four quarters (1Q20-4Q20 – excluding merger & integration charges). This multiple is down from the prior 13.0x multiple we had been using, reflecting a discount relative to peers for the bank’s concentration in Puerto Rico.

Our target suggests a potential gain of 35.5% from the current price. If we include the stock’s 1.41% dividend yield, it leads to a potential total return of 31.0%. Consequently, we are reiterating our Outperform rating on OFG stock.