OFG Bancorp (OFG) Q2 2015 Earnings Report, Transcript and Summary

Good morning. My name is Paula and I will be your conference operator today. Thank you for joining us for this Conference Call for OFG Bancorp. Our speakers are Jose Rafael Fernandez, President, Chief Executive Officer and Vice Chairman; and Ganesh Kumar, Executive Vice President and Chief Financial Officer. There is a presentation that accompanies today's remarks. It can be found on the Investor Relations website on the homepage or on the webcast, presentations and other files page. Please note this call may feature certain forward-looking statements about management's goals, plans and expectations, which are subject to various risks and uncertainties outlined in the Risk Factors section of OFG's Securities and Exchange Commission 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 which occur afterwards. All lines have been placed on mute to prevent any 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. José Rafael Fernández: Thank you for joining us this morning. We are changing our format slightly for today's call. I want to address the big picture here in Puerto Rico, as it affects OFG, and then we will open it up for question-and-answers. We have all our user quarterly slides in the appendix of today's presentation, and Ganesh and I will be happy to answer any questions on them. To start, please turn to slide 3; there are three major points that we'd like to communicate today. One, there is a lot more anxiety outside of Puerto Rico than the situation warrants here. Yes, given the liquidity levels, the Puerto Rican Central Government faces a fair probability of shutdown. But there also is a lot more pressure on the government to act with more conviction and with more urgency. We believe such actions should address two aspects. One, commit to execute a credible plan to reduce spending and increase competitiveness; and two, bond holders need to be convinced that Puerto Rico has the will to do so. With this in mind, we urge government officials to recognize the impact the current uncertainty is having on the overall business climate in Puerto Rico. Second, we know our investors want to know the impact of all this to OFG. As a result, in this call, we will present our asset tiers and discuss illustrative credit shock scenarios. And as you will see later, even in our most severe scenario, the bank remains well above regulatory capital requirements and above the market cap range in which we have been trading. Three, we are making progress with PREPA. It is important to note that the PREPA loan syndicate is now engaged in active discussions to arrive at a consensual negotiation to term out our credit facility. This is completely different from the situation last quarter, when PREPA had demonstrated an unwillingness to engage in a constructive dialog. Please turn to slide 4 for a summary of second quarter results. While our core business continued to perform well and capital remained strong, the quarter was affected by a few factors. First, some things that were expected; we had a $4.2 million reduction in tax free interest income from our loans to PREPA and PRASA. PREPA, because we placed the loan on non-accrual status in the first quarter, and PRASA because the remaining $75 million balance was fully paid down on June 1st. The second quarter also marked the end of our commercial loss/share agreement with the FDIC. We have all along aggressively managed the receivable to limit any outside residual exposure. This quarter, we took an additional $10 million to write down remaining item indemnification asset related to the commercial portfolio. We have been averaging about $11 million to $12 million a quarter for commercial loss/share. Starting in the third quarter, this will no longer be necessary. Then, there were a couple of non-recurring items that were not anticipated. As part of our proactive derisking effort, we reduced the OREO balance by $14 million [ph]. This increased our loss on OREO by $4.5 million; and we paid $1.8 million in connection with the restitution program of our broker/dealer subsidiary. Importantly, our core business and credit performed well. Excluding the lack of interest income from PREPA and PRASA, income from originated loans are said to run-off on non-covered acquired loans. Without considering the 2015 provision for PREPA, provisions fell by $2.7 million quarter-over-quarter. This was the result of our conscious effort to optimize credit metrics. We also continue to grow the Oriental franchise. We saw strong generation of quality loans with good pricing discipline, strong free revenue levels and good core expense management. Oriental's retail base and mortgage and consumer loans businesses continue to benefit from our marketing program, which is attracting new customers. For example, we opened approximately 5,700 net new deposit accounts in the second quarter. Demand deposits however fell, as we let go off a high cost $90 million deposit from a government entity. Otherwise, our demand deposit balances would have been up slightly. Credit continued to improve. There were declines not only in the net charge-off, but also total delinquencies and non-performing loans. Looking at capital and book value per common share, this declined to 14.67 and 16.81 respectively from 15.12 and 17.25. Regulatory capital ratios continue to be significantly above requirements for a well capitalized institution, and we repurchased approximately 305,000 common shares in the open market in the second quarter. While we are only a month into the third quarter, we have not noted any significant deterioration in our business trends. Please turn to slide 5; now I'd like to address our Puerto Rico Central Government and public corporation loan exposure in more detail. As of June 30th, it totaled $301 million, down 21% from $380 million at March 31. The largest loan is a contractual obligation with PREPA, a non-taxable $200 million fueled purchase line of credit, part of a syndicated $550 million line acquired as part of our BBVA-Puerto Rico transaction. It is the most senior PREPA debt, and has payment priority over the government's utilities, other credit obligations. Even though we placed this loan on non-accrual in the first quarter of 2015, we continue to receive interest payments. Interest payments during the second quarter dropped down the principal balance to $187.6 million. At the end of June, PREPA, the bank syndicate and bondholders agreed to extend the forbearance agreement on to September 15th, after PREPA stepped forward with a payment proposal. You might recall that earlier this month, the U.S. Courts of Appeal for [indiscernible] upheld the creditors position, that the local bankruptcy loan was unconstitutional. As a result of PREPA finally moving on to a proposal, there was no need for additional provision. The latest forbearance requires an agreement to be in place by September 1st. We are hopeful, these will be accomplished and that the results will be satisfactory to all. We had a $100 million loan to PRASA, the water authority. $25 million was paid off in the first quarter and $75 million balance was repaid on June 1st. The Puerto Rico State Insurance Fund has a $78 million loan with us. It is collateralized 130% by a portfolio of eight plus or better rated securities, pledged and held in an account at JP Morgan Chase in New York. This agency is not part of the government's plan to negotiate bond terms, and the loan is well secured. We have a $25 million loan in a long term credit facility to the Puerto Rico Housing Finance Authority. It is repaid from inactive and unclaimed customer deposits from local financial institutions. We started disclosing our exposure to the Puerto Rico Central Government and Public Corporation in the third quarter of 2013. At that time, our exposure was $772 million. Today, that exposure has been reduced to $322 million. This represents close to a 60% reduction. But if you remember, our total Puerto Rico Government Exposure was $1.1 billion when we acquired BBVA Puerto Rico operations in December of 2012. From that date, we have reduced 70% of the exposure without incurring a loss other than the $24 million provision for PREPA. Please turn to slide 6; it is important to view our $240 million in loans to five Puerto Rico municipalities as separate from that of credit related to the Puerto Rico Central Government and its public corporations. These loans do not share the same credit characteristics. These municipalities are autonomous from the Central Government and its agencies, which have a higher debt load and have grabbed headlines with the Governor's recent statements. A common misconception over here, is that this portfolio consists of muni bonds. On the contrary, these are individual loans, underwritten under our own credit policy, and are not traded as municipal paper in the market. The credit was extended to the top five municipalities in Puerto Rico in terms of population and property values. They are also the most important centers of economic activity, and have the highest potential to generate property tax revenue among the municipalities in Puerto Rico. These loans are not only collateralized and guaranteed by a first lien on property taxes or a special additional tax, called CAI in Spanish, but also secured by monies set aside in a special escrow account, which is outside the reach of the reach of the municipality and the central government. The weighted average aggregate debt service coverage ratio is around 2.3 times. Our shock scenarios, assuming drops in property tax revenues indicate north of a 100% coverage, ensuring loan repayments. Therefore, we believe any loss assumptions attributed to this by outside parties, are not justified. Please turn to slide 7; now, let's turn to the result of our own internal exercise on credit shock scenarios. First, I asked you to keep in mind that we still have one-third of our loan portfolio under purchase accounting, which has built-in loss assumptions from those loans. Second, we took a conservative approach in modeling. Losses shown here are what we expect over two years, in addition to past charges, allowances and also trade assumptions already included in non-attributable discount for the SOP book. The moderate scenario includes full impact on consumer portfolio or the government shutdown, sales increases, sales tax increases, etcetera. And the acute scenario further stresses our government loan exposures. Third, we assume an immediate one time impact of projected losses, with no consideration of future earnings, and we assume a static balance sheet. Let me summarize the scenarios; in the moderate case, we lose 4.3% or $194 million pre-tax; and in the acute case, we lose 6.05% or $284 million pre-tax. Please turn to slide 8; here you can see the impact of the acute scenario on capital levels. OFG capital levels in this scenario will continue to be above the regulatory requirements for a well capitalized institution. Our current price to tangible book value is above 65%. This implies a discount at levels close to or below our acute scenario, with no consideration to future earnings, franchise value or credit risk levels of the remaining balance sheet. Please turn to slide 9 for our current outlook. To sum up, we are doing well on aspects we can control; loan generation, fee revenue, credit and expenses. We are originating consumer loans at record levels with good credit quality and at higher interest rates. We don't have any major commercial credit problems, and non-performers are chiefly under purchase accounting or PREPA. We have a healthy amount of liquidity. We have excess capital, and we are proactively tackling the issues as they emerge, like we have always done. We cannot control what the Puerto Rico central government will do in their negotiations with their bondholders. So our strategy is to approach the next few quarters cautiously, continuing to seek opportunities to further derisk the balance sheet, and as an example, reevaluating alternatives to dispose covered non-performing commercial loans. We recently reached an agreement with the FDIC, providing for up to $20 million in coverage under our Eurobank loss/share agreement for losses incurred in the sale in bulk of covered non-performing commercial loans. And of course, we will continue to closely monitor our PREPA exposure as well. Beyond these two items, as you saw in the previous slide, our credit remains relatively strong, with good capital level and on balance sheet makeup, we are well positioned to navigate the challenging economic environment we face. However, given the deteriorated economic conditions and the uncertainty in the market, we are revising down slightly our long term performance targets, as seen on slide 12 in the presentation/ With this, we end our formal presentation. Operator, let's open up the call for questions.

[Operator Instructions]. Your first question comes from the line of Brian Klock of Keefe, Bruyette & Woods.

Good morning gentlemen. José Rafael Fernández: Hi Brian. Good morning.

So I guess -- and maybe, I can walk through some of the numbers with Ganesh first, its just -- I know there is a lot of noise in the quarter with some of the actions you took to sort of clean up the loss share and get those things behind you. So I think there is a lot of things this quarter that we would not expect to recur. So I think, if you move towards the loss/share drag and to what normally going forward would be what -- maybe normally about a $3 million drag versus a $23 million hit in the first quarter? Is that the way to think about the first part of that normalization, if you will, Ganesh?

It should be plus or minus $2 million per quarter, Brian. Remaining is the $24 million indemnification asset.

Got it. Then I guess I was normalizing at first, kind of coming up to a $0.20 positive operating recurring number going forward, but just suggesting for that move in the loss/share to a more normal going forward end, to get the OREO loss, to see if that wouldn't be something that would recur? But there is [ph] also the restitution charge and branch closing costs we wouldn't expect to recur, and not even the impact of the preferred and the share count, because it was anti-dilutive with the loss. So is it right to think that maybe we should think about a normal recurring quarter, like a third quarter EPS number that's closer to $0.26 to $0.27, does that sound in the ballpark?

Sure. If you pare back the earnings -- drop in earnings from PREPA and PRASA and then add back all those non-recurring items that you saw in the FDIC amortization and the non-interest expenses, that should give you the recurring run-rate that you can come to.

Okay. And just a follow-up, and I will get back in the queue; it sounds like on the PREPA and from the news that we have seen, there has been some positive things that have been put out with some of the different proposals, and even PREPA's response to those bondholder proposals. And it seems like in a lot of those proposals, the bank's syndicate is in a pretty positive position versus where they were and where you guys were last quarter. So could it be conceivable that if things get resolved with the banks not having to take a haircut, you guys could potentially put this PREPA loan back on non-accrual and even reverse the reserve? Is that something we could think about? Maybe let us know what you think about that? José Rafael Fernández: Let me just step back a second -- to the several comments that you mentioned on PREPA. One, certainly we are cautiously optimistic with the recent developments since the last quarter, and that's why we didn't have to take any provision this quarter. Recently, PREPA publicly announced what proposals they offered to everyone, bondholders, mono-lines [ph] and banks, and so its pretty obvious that the proposal that they are making to the banks is something that is moving in the right direction. So that's what I would say. And then lastly on, what -- you mentioned on the scenario, on how it would play, I would say that it is possible and is considerable that at the end of the day, we end up having a new loan with a turnout, at five or six or seven years and start earning principal on interest, and that is a possibility.

And then I guess what, would there be a period of time that that new term loan came in? Would it have to -- I guess, perform for a certain number of quarters, or because it’s a new loan, it would not have to be part of it -- sort of TDR --? José Rafael Fernández: I think we need to cross that bridge when we get there, but its accounting and we need to kind of follow the --

Sure, we have our accounting policies based on -- for exits of TDRs [indiscernible] tax to confirm to that after a certain period of performance, things like that, Brian.

Okay. Fair enough. I mean there is a lot of work to be done, and obviously, but it feels like the things are a lot better with that negotiation process than they were, just three months ago? José Rafael Fernández: Yes. And certainly, we have always recognized that this is a very large exposure for us. Its part of what we acquired from BBVA, and we have proactively dealt with it since day one. And as I said earlier, we are cautiously optimistic.

Okay. Thanks for your time guys. I will get back in the queue.

Your next question comes from the line of Emlen Harmon of Jefferies.

Hey, good morning guys. José Rafael Fernández: Good morning Emlen.

Just a question on slide 12; could you walk us through the left hand side of that chart that kind of walks through your cumulative loss analysis? So just on the purchase portion of the portfolio, just kind of -- can you kind of point out to us, what the loan balances are, kind of what the remaining market is against those, and maybe just kind of walk us through that? That will be helpful. Thanks.

I think you're referring to slide 7, Emlen.

Yeah, 7. Did I say 12?

Yes.

Sorry about that.

So I think the idea of presenting the slide, two aspects. One is, on one side -- the left side, it shows the existing allowances, and what's under purchase accounting. If you recall from our conversations when we acquired BBVA. The initial credit market assumptions where they acquired portions, were roughly around 7.5% to 8% credit marked. The reason why we are showing the non-accretable discount larger than that number is, primarily because non-accretable discount also includes the loss of interest income, because of our loss assumptions in our modeling purposes. So to answer your question its about 7.5% credit marked, that's what's inside the non-accretable discount. Related to the loans and the rates, [indiscernible]. So the right side of the chart is basically what we are layering as not considering the allowances, not considering the credit mark. What additional losses we would incur if the situation led to deteriorate into the couple of scenarios that we talk about over here. So the additional losses are what we are estimating as 4.13% and 6.05% additional, over and above what protection that we have in terms of credit mark, and as well as the allowances in case of non-SOP.

Got it. That's helpful. Thank you.

I think José also mentioned that, these are pre-tax numbers, so that we apply using the effective tax rate of 33%, that's just an assumption primarily because, at that point in time, clearly when it happens, there are other things in the mix like what happens to DTA and all those kinds of things. But just applying the 33% tax rate and if you apply the post tax, and this is how we calculate the ratios that we present. José Rafael Fernández: Capital ratios.

Capital ratios, and as well as the tangible book value.

Got it. Okay, perfect, thank you. And I am going to go to slide 12 now; the margin guide going forward calls for margin around 5%. Just because you are a little lower than that currently, does the 5% margin assume that PREPA returns to accrual status, or are there other effects that you think could potentially get the margin up a little bit?

No, we did not assume PREPA returning to the -- this is sort of a scenario where it stays in the non-accrual. If PREPA comes back as, both explained, based on our negotiations, that would be incremental to the margin.

Okay. So the margin guidance around 5%, that kind of like 4.9% that you guys were this quarter would fall into the range you were guiding to?

Exactly.

Okay, perfect. Thank you.

Yep.

[Operator Instructions]. Your next question comes from the line of Taylor Brodarick of Guggenheim Securities.

Great. Thank you. I was just curious if you could add more color about maybe the discussions with the PREPA syndicate and just the fact that another bank sounds like they moved their exposure to held for sale, and sort of how that impacts your thinking? José Rafael Fernández: We view our PREPA exposure based on our own factors, and we are certainly, we have a large participation in that syndicate. So at the end of the day, we look at this on how we maximize return to shareholders. We are not in a for-sale scenario, where we want to just look at any pricing and get out. So at the end of the day, when we look at the PREPA exposure, as I said earlier, its something that we have been very cognizant of since the acquisition of BBVA. We have to deal with it, and we have been proactively dealing with it. And at the end of the day, we will make the decision that is best for shareholders in this case, and other banks can -- they make their own decisions and they have their own reasons for making those decisions.

Great. Thank you for your candor. And then -- so it sounds like on the margin, just one more question on that. The $4.2 million out, so then core NIM is sort of 5.17 or so, is that about right, Ganesh? And is that sort of online with where you were thinking the NIM could move towards, the trajectory it has towards 5%?

Correct. So the 4.9% and then we layered in future loan origination profiles and yield rates and securities income, things like that. And that's what bumps it up to 5%.

Okay, great. Thank you very much. Appreciate it.

Welcome.

[Operator Instructions]. We have a question from the line of Brian Klock of Keefe, Bruyette & Woods.

Hey guys, just wanted to follow-up. And I know you said this, and I just wanted to make sure that, I guess, it was clear. But the credit shock scenario that you gave in 7 and on 8, that tangible book per share number you gave, as the burn down if you will; again, that doesn't include internal capital that's generated, right? So I mean, this would be a significant -- you didn't make any money, which again is, even in the DFAST, that's not an assumption?

Brian, very good point. I think you're doing the job that I should have been doing in the first place to explain this. This is not a stress test, this is a credit shock. One time, very conservative treatment; that's why we put, its an immediate impact of the projected two year cumulative losses one time, with no consideration to future earnings and a static balance sheet. It is not DFAST exactly, it’s a little bit more. So we are -- just to illustrate what impact it would have on our tangible book value at the end of the day, even after considering the acute scenario and give you an idea of what it would be.

Exactly. Okay, great. And I think if I just look at it, pre-tax, pre-provision or your PPNR using DFAST, because probably there was something close to the $25 million, $26 million something like that for the quarter? Does that sound right?

As you know, that we haven't disclosed the DFAST, because we are not required to. But I think if you layer in these provisions and things like that, all I can tell you at this point in time is, by doing that exercise, we are not even planning internally to release the allowances and boost our earnings. So we are in fact increasing the allowances in the context of the economy. So I would ask you to kind of look at it from that perspective, and verify our numbers. But at this point in time, what we are disclosing is, purely an analysis of what the shock results would be. José Rafael Fernández: I also think, Brian, that the analysis reflects also the effect of us having 33% of our portfolio under purchase accounting and the benefit of that. So we are trying to make sure that everybody understands that we have a good excess capital cushion. Given our credit risk profile and given the dynamics here in the Puerto Rican economy.

I think that was nicely done, and I just wanted to make sure people understood that. Maybe it could have been bold on the slide about the future earnings piece. But I mean -- I think that's important what you guys did, and I guess I think what I'd also say is -- the thing about the government exposure, I think what you did on slide 6 was very helpful and informative too about the municipal exposure. I think that's an interesting point to make sure people understand it is a lot different? José Rafael Fernández: And as I mentioned earlier, we feel the municipal exposure, we feel very confident about that exposure. We know the loans and we manage them as we have done in the past. So we just don't feel that that should be coming with the rest of the central government and public corporation exposures. So if you exclude that, really, the Puerto Rico government exposures to OFG is predicated basically on PREPA.

Right, okay. And I guess, one last question if I can; you didn't repurchase some shares during the quarter. I guess, maybe you can just update us on your thoughts? I know it is a lot of headlines and some things that are going on in the next couple of months. But let us know where you stand with the authorization, and I guess what you thoughts are on the buyback? José Rafael Fernández: You know what, I will say a couple of things, and then I will let Ganesh add. From our perspective, we look at repurchase as part of a capital management strategy. We also recognize things here in Puerto Rico and the market we participate in, things have become a lot more uncertain. So we are cautious at looking at all the repurchase. Certainly, the pricing also is very attractive. We are just, from that perspective, continuing to look at repurchase as part of a capital return to shareholders and capital management, and we'd like to evaluate them as opportunities occur.

All right. Again, thank you for your time.

Your next question comes from the line of Jon McCullough of WHV Investment Management.

Thanks for taking my question. And I just wanted to reiterate thanks for all the extra details in the slides, its very helpful. Just going back to the loans to the municipalities; is there anything that the central government can do that would adversely affect your positioning? Or sort of where you guys sit with these loans? José Rafael Fernández: Not to our knowledge. It’s a complete separate jurisdiction. They are called autonomous. So it is municipal autonomous and they are separate.

Sorry. No go ahead. José Rafael Fernández: The loans that we have, they are secure. They are secure with a lien on property taxes and they are secure with escrow monies that are escrowed out for those loans that are outside of the reach of the central government and the municipalities, both. It is worth their money.

Okay. And then just going back to the buyback, I am just going to ask it in a different way. I know in the past, you guys discussed or have mentioned opportunities in M&A, and then balancing that out with buybacks to capital allocation. Given what the share price has done in the recent months, how does that change in terms of your thinking of M&A versus buybacks? José Rafael Fernández: When the stock is trading so deep below the value, there is really no currency to do anything strategic. So certainly that's not out of the table, but its certainly a move into the more longer term scenario. So that's how we view it.

Okay. And then just going back up to the macro, you mentioned what some politicians have said have caused some uncertainty, more uncertainty in the economy. But I guess given what oil prices have done, have you seen any positive flow-through to just sort of the overall economy of Puerto Rico, because of the lower energy prices? José Rafael Fernández: Yeah, at the beginning, back in 2014 when lower prices came down, it did have an impact and we saw it late in the year, and maybe early part of this year. But remember also that, there have been two gas tax increases in the last 12 months. So some of that reduction in oil prices has been absorbed by increases in the gas tax, to be able to -- government was trying to get a bond issue out, that never occurred. So that's -- I think the reduction in oil prices have taken its toll or taking its effect in the Puerto Rican economy, and I am not sure there is going to be any additional benefit from that.

Okay. I appreciate. Thanks so much. José Rafael Fernández: You're welcome.

[Operator Instructions]. We have a question from the line of Taylor Brodarick of Guggenheim Securities.

Sorry, one more for me. Tax guidance, anything new there that we need to be aware of?

No Taylor. I think we would stick to the 32% with the low side of the range is 29% to 34%.

Okay, great. Thank you very much.

At this time, there are no further questions. I will now turn the call back over to José Rafael Fernández for closing remarks. José Rafael Fernández: Thank you all for being in the call today. We will be in New York next week, on the KBW and Community Conference, and looking forward to continuing the discussions and dialog regarding Oriental's results and our outlook. In Mid-September we are scheduled to be at a Credit Suisse conference, also in New York City. Our preliminary date for reporting third quarter results is Friday, October 23rd. So thank you again and have a great day and a great weekend.

Thank you. This concludes today's conference. We thank you for your participation, and ask that you please disconnect at this time.