OFG reported 3Q20 net income to common shareholders of $25.8 million, up from the $20.2 million posted in 2Q20.

On a per share basis, 3Q20 results were $0.50 compared to $0.39 in the prior quarter. 3Q20 results included $0.5 million of one-time interest recoveries on acquired Scotiabank loans and an additional $3.5 million favorable adjustment to the bargain purchase gain recorded on the Scotiabank de Puerto Rico acquisition, partially offset by $2.7 million of merger and integration expenses and $2.1 million of COVID-19 related expenses. 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. Collectively, the nonrecurring items boosted 3Q20 earnings by roughly $0.8 million after-tax or $0.02 per share. Similarly, 2Q20 earnings were boosted by approximately $4.1 million after tax or $0.08 per share. Adjusted 3Q20 EPS was $0.48 compared to adjusted 2Q20 EPS of $0.31 excluding the impact of these items. Adjusted results fell $0.06 short of our adjusted estimate of $0.54 but well above the median Street estimate of $0.38. The shortfall compared to our estimate was primarily due to greater NIM compression than we anticipated, largely because we had assumed some accelerated fee accretion from PPP loan forgiveness during the quarter.

Highlights from the quarter include:

  • Net interest income declined $5.5 million or 5.3% compared to 2Q20. However, without the previously mentioned $5.5 million sequential decline in interest recoveries from $6.0 million in 2Q20 to just $0.5 million in 3Q20, net interest income would have been essentially flat. Average earning assets advanced 4.2% LQ, while the NIM contracted 48 bps to 4.30% from 4.78% in 2Q20. The interest recoveries accounted for just 2 bps of the NIM in 3Q20 compared to 28 bps of NIM in 2Q20, so the “core” NIM was actually down 22 bps linked-quarter. Average loan yields fell 40 bps sequentially, while PCD loan yields slumped 94 bps due to the decline in interest recoveries. Absent the recoveries, PCD loan yields rose 9 bps. Meanwhile, average non-PCD loan yields declined by 16 bps sequentially. The problem of excess liquidity continued in 3Q20, as cash constituted 20.9% of average interest earning assets in 3Q20 versus 15.7% in 2Q20. The average cost of interest bearing liabilities fell 10 bps to 0.97% from 1.07% in 2Q20. The average cost of interest bearing deposits dipped 8 bps sequentially in 3Q20, while the average cost of borrowings was unchanged linked-quarter.
  • Noninterest income of $31.3 million was up $4.2 million or 15.4% from the prior quarter. This includes a $3.5 million bargain purchase gain recorded on the Scotiabank transaction. However, this was unchanged from a similar amount posted in 2Q20. The increase was largely due to increased economic activity, which drove a $2.6 million or 19.2% sequential rise in banking services revenues. Increased mortgage loan production and the resulting sales of this production generated a $0.8 million or 27.5% advance in mortgage banking revenues, while financial services revenues jumped $0.9 million or 14.2%.
  • Noninterest expenses declined $2.0 million or 2.4% linked-quarter. Merger & restructuring expenses fell $0.3 million from the prior period. In addition, OFG incurred $2.1 million in COVID-19-related expenses during the quarter, up a modest $0.1 million from the prior quarter. Excluding these items from both periods, core noninterest expenses fell $1.8 million or 2.2% sequentially. There was a $2.6 million decline in compensation costs and a $1.2 million drop in OREO expenses, offset partially by a $1.9 million rise in “other” noninterest expenses due largely to increased banking activity. The sequential decline in core noninterest expenses occurred despite the rebound in economic activity that drove rising loan originations and noninterest income. Management still expects to achieve most of the anticipated savings from the Scotiabank integration in 2021. OFG’s adjusted efficiency ratio was 62.17% in 3Q20 compared to 65.86% in 2Q20.
  • OFG recorded a $13.7 million credit loss provision in 3Q20, down $4.0 million or 22.8% compared to the $17.7 million provision in the prior quarter. The decline primarily stems from a $4.2 million reduction in COVID-19-related adjustments, which fell from $5.0 million in 2Q20 to $0.8 million in 3Q20. The allowance for credit losses grew $3.1 million or 1.3% linked-quarter, rising to 3.48% of loans held for investment from 3.35% at June 30, 2020.
  • Lower economic activity related to COVID-19 has still not shown up noticeably in asset quality figures, even as loan deferral periods have largely ended. Net charge-offs fell to 0.62% of average loans in 3Q20 from 0.92% in 2Q20. Non-PCD NPLs increased $23.1 million or 25.6% linked-quarter, rising 52 bps to 2.33% of non-acquired loans from 1.81% at June 30, 2020. Meanwhile, PCD NPLs dipped $1.8 million or 2.2% sequentially and OREO and other repossessed assets fell $3.4 million or 13.8%, leading to a 9.3% advance in NPAs and an increase in NPAs/Assets to 2.17% from 2.00% at the prior quarter-end. Early stage delinquencies decreased from 2.64% of loans on June 30, 2020 to 2.50% on September 30, 2020.
  • OFG recorded a tax expense of $6.3 million in 3Q20, producing an effective tax rate of 18.7%. Management expects the effective tax rate in 2021 and 2022 to be in the 30%-32% range.
  • Gross loans held-for-investment declined $192.2 million or 2.8% sequentially. The decrease was once again primarily in the commercial loan segment, which fell $155,7 million or 6.0% linked-quarter, while residential mortgage loans decreased $63.4 million or 2.6% and consumer loans shrank $24.8 million or 5.4%. The driver of these declines was payoffs and paydowns, as low economic activity, low interest rates, and cash from government relief programs all contributed to payoff activity. Still, OFG recorded very strong loan production in 3Q20. The best performing segment was residential mortgages, which saw originations jump 294.4% linked-quarter t0 $93.7 million. This is greater than originations for all of 2019, which totaled $92.8 million. Not far behind was the auto segment, which generated growth of 229.0% in loan originations to $155.9 million. Also contributing to the strong production were consumer loan originations, which grew 65.4%, while originations through the mainland loan participation channel advanced 154.5% sequentially to $90.9 million from $35.7 million in 2Q20. Meanwhile, commercial loan production decreased 15.3% to $83.5 million and PPP loan originations dropped 96.4% to $10.3 million. Low interest rates, pent-up demand, and easing of some of the COVID-19-related restrictions all helped fuel the increase in loan originations. Total originations were $457.8 million, down 9.5% compared to the $506.0 million posted in 2Q20, but up 57.1% from the $291.4 million originated in the same period a year ago. If we exclude PPP loans, originations grew 103.7% sequentially from 2Q20 to 3Q20.
  • Total deposits climbed $90.5 million or 1.1% sequentially, led by a $312.6 million rise in demand deposits. Also contributing. Partially offsetting these increases was a $58.3 million drop in savings accounts, a $41.7 million decline in time deposits and a $122.1 million decrease in brokered deposits. As a result, the deposit mix improved noticeably, as brokered and time deposits decreased to 23.5% of total deposits from 25.7% on June 30, 2020. The increase in deposits during the quarter, occurring while gross loans held for investment decreased $192.2 million led to another increase in on-balance sheet liquidity. This additional deposit funding went into cash, which grew $383.0 million sequentially, creating a further drag on the NIM.
  • Tangible book value per share rose to $16.51 on September 30, 2020 from $16.01 on June 30, 2020, while the tangible common equity ratio advanced 19 bps to 8.58%. Most of OFG’s regulatory capital ratios increased further during the quarter. The leverage ratio dipped to 10.00% from 10.16%, but the CET1 ratio increased to 12.55% from 12.03%, and the Tier 1 ratio advanced to 14.25% from 13.71%. All of the regulatory capital ratios remain well above the minimums needed to be considered “well capitalized” under regulatory guidelines.

Earnings Estimates:

We were impressed by OFG’s 3Q20 results. Though loan balances declined due to high payoff activity, the company generated much higher loan production than we anticipated. We believe that this is partly due to federal disaster relief finally making its way to the island, along with some loosening of COVID-19 restrictions that together helped boost economic activity. However, part of the loan origination growth likely also stems from the larger platform created by the Scotia transaction and good execution. We believe these factors should carry forward into future quarters. Likewise, better-than-expected noninterest revenues were probably helped by the same set of circumstances. The bank continues to reduce operating expenses and we expect continued efficiency improvements as the systems conversion from the Scotia transaction takes place in 4Q20. Our prior forecast anticipated that the PPP loan forgiveness would begin in 3Q20 and that the bank would start to see some accelerated fees included in net interest income during the quarter. Our faith in the government was misplaced. In the absence of these fees in 3Q20, the NIM contracted sharply due in some measure to the significant excess liquidity on the balance sheet. We still expect to see some of the accelerated fee income from PPP loan forgiveness in 4Q20, leading to roughly 8 bps of NIM expansion, though the core NIM is likely to suffer at least a few basis points of compression as overall interest rates remain low and cash balances remain high. We still expect that asset quality will start to show the impact of the COVID-19 lockdowns and reduced economic activity in 4Q20, leading to growth in net charge-offs, but we have reduced our provision projection modestly to reflect the significant build-up of the allowance for credit losses over the last three quarters.

After adjusting our model for the above items, we are raising our 2020 EPS estimate from $1.27 to $1.30 ($1.35 excluding merger & integration expenses). We are reducing our 2021 EPS estimate from $1.62 to $1.39, and our 2022 estimate from $1.86 to $1.50.

Outlook:

OFG’s 3Q20 results were encouraging. We have noted the strong loan originations reported for the quarter, but we should also comment on Management’s outlook. We found the overall tone of management’s comments on the conference call to be more optimistic than usual. That being said, we still expect an extended period of low interest rates, combined with the fallout from many months of economic shutdowns to create significant headwinds for banks. OFG has the opportunity to gain efficiencies from the integration of the Scotia transaction over the next few quarters, while reducing some of the NIM impact of extra liquidity, but the overall economic environment will still be difficult. Though we are reducing our forward EPS estimates, we still think OFG is in a good position, and that Federal disaster relief will soften the economic impact of some of the issues we’ve just noted.

While we have enjoyed covering OFG for close to twenty years, shifting corporate responsibilities do not allow us time to provide the same level of diligence to our equity research as we would like. Consequently, we are discontinuing coverage of OFG Bancorp.

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