OFG Bancorp (OFG) 2010 Q2 法說會逐字稿

Good morning. My name is Brandi, and I will be your conference operator today. Thank you for joining us for this conference call for Oriental Financial Group. Our participants today are Jose R. Fernandez, President, Chief Executive Officer and Vice Chairman; Julio R. Micheo, Senior Executive Vice President, Chief Investment Officer and Treasurer; and Norberto Gonzalez, Executive Vice President and Chief Financial Officer. 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 Oriental'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. During the question-and-answer session, we ask questioners to not use cell phones or BlackBerries, as they might cause loud static on the line. I would now like to turn the call over to Mr. Fernandez. Please go ahead, sir.

Thank you. Thank you for calling in this morning. I will review the highlights for the quarter and the performance for the Eurobank acquisition and our strategic focus. I will turn to Norberto to review second-quarter financial results, and then Julio will join us for the question and answers.

We have a presentation that accompanies our remarks today. It can be found on the Oriental Financial Group investor relations site on the page titled webcasts, presentations and other files. We will be discussing more numbers than usual on today's call, since it was a transformative quarter resulting from the Eurobank transaction.

Turning to our second-quarter highlights, it certainly has been a very eventful quarter. In April we raised $189 million in net new capital through a mandatorily convert convertible preferred Series C in anticipation of our winning an FDIC-assisted bid. The preferred was converted into 13.3 million common shares following a special shareholders meeting on June 30. This capital raise followed a $95 million net equity raise in the first quarter.

On April 30, our bid for selected Eurobank assets, liabilities and operations was successful. We acquired assets with a fair value of approximately $1.5 billion. These include $840 million in loans and FDIC loss indemnification assets of $518 million and $100 million in cash. We also assumed $730 million in deposits.

Since April 30 we have been busy with acquisition-related matters resulting in filing on July 16 the required 8-K disclosing the fair value of assets acquired and liabilities assumed, as well as integrating and streamlining the acquired Eurobank operations. As noted on our news release, the acquisition is proceeding well on all three levels -- financially, operationally and strategically. It is fitting as expected into our plans of generating more return on income from loans and from our fee-based businesses and our early view that with Eurobank we can build the value of Oriental banking and wealth management franchise. This is beginning to happen now.

From a Eurobank acquisition perspective, from a financial point of view, the acquisition has been accretive to net interest income and is expected to continue to generate non-interest revenues at the rate of approximately $6 million a year. The transaction has significantly increased our assets and deposits, making Oriental the fourth-largest bank in Puerto Rico. We do not expect to incur significant losses on the loans we acquired. Their fair values already reflect a 45% estimate of expected credit losses.

Our operating results will only be adversely affected by losses to the extent that they exceed the expected losses, if indeed they do. As previously detailed, 80% of our losses on covered assets will be reimbursed by the FDIC.

The transaction also increased our regulatory capital, and from an operational point of view, this transaction we acquired 22 branches, a leasing business, an expanded insurance business, a trust business that adds to our retirement plan business and a good commercial loan business that targets professionals and small to medium-sized businesses. This fits very well with Oriental or are complementary to what we already do. Our integration team, led by Ganesh Kumar, our Chief Operating Officer, is working diligently to achieve all our established goals.

From a strategic point of view the transaction has significantly expanded our customer relationships. We have nearly tripled our number of credit relationships, increased by about 12% our deposit clientele and expanded by 20% the base of customers who have both a credit and a deposit relationship. We have also been pursuing new business opportunities created by many disenfranchised commercial clients who previously did business with larger institutions. Our commercial and retail bankers are going after these clients full speed.

To better take advantage of this opportunity, on Monday we announced that Jose Ramon Gonzalez has joined Oriental as Senior Executive Vice President, Banking and Corporate Development. Jose has assumed responsibilities for all areas of Oriental's growing commercial banking business, including commercial products and services acquired in the FDIC-assisted Eurobank acquisition and will be instrumental in implementing plans to expand our commercial market share.

For those of you new to Jose, he most recently served as a member of the Board of Directors of Santander. From 2002 to 2008 he was vice chairman of the board, president and CEO of Santander in Puerto Rico. During his tenure as CEO, Jose expanded Santander's footprint in the island by building its commercial business and by acquiring assets and businesses of other banks. He is also continuing as a member of the Board of Directors of the Federal Home Loan Bank of New York.

Meanwhile, our cost reduction program involving Eurobank corporations and branches is running ahead of schedule. Because some areas are clearly redundant, there will be some branch closings and personnel reduction in certain departments. Our current plans call for retaining approximately 50% of the former 420 Eurobank staff and nine to 12 of Eurobank 22 former branches.

The integration itself is going well. Former Eurobank branches are referring business to Oriental operations. Commercial and residential mortgage lending and trust and insurance are blended well with Oriental's existing operations. The former Eurobank leasing operation is being rationalized, and the Eurobank branches and operations that will be retained are scheduled to transfer to Oriental's third-party technology platform in the fourth quarter. All of this is just starting to be reflected in our second-quarter results.

Now, to review income and balance sheet for the quarter, I would like to turn the call to our CFO, Norberto Gonzalez.

Thank you, Jose. We reported income available to common shareholders of $12.5 million, or $0.38 per diluted share on a higher share count due to the third-quarter equity raise. For purposes of this discussion, I will be comparing results on a sequential quarter basis, unless otherwise indicated.

Net interest income was up 31% to nearly $39 million. Interest income of $81.5 million increased almost 16% sequentially, resulting in a yield of 4.84% for the second quarter of 2010 compared to 4.50% in the preceding quarter. Interest income from loans expanded 76.5% sequentially, this mainly as a result of the addition of the former Eurobank loans. As a share of total interest income, income from loans represented 38% versus 25% in the previous quarter.

Interest expense of $42.9 million reflects a reduction in cost of deposits from 2.71% to 2.18% and also in the cost of borrowings from 2.95% to 2.78%, reflecting the higher yield on loans and the reduction in the average cost of deposits and borrowings. Net interest margin increased to 2.29% from 1.88% in the first quarter.

In the third quarter of 2010, the cost of funds is also expected to benefit from not renewing a $100 million 4.39% repo which expires on August 16, 2010, and also on continued reduction in the retail cost of funds.

Looking now at banking and wealth management revenues, that was up 32% to almost $10 million. Banking service revenues increased 70%, reflecting fees from Oriental and the former Eurobank's commercial and retail deposit accounts as well as commercial point of sale on cash management services. Wealth management revenues are up 16%. That's primarily due to continued growth of Oriental's business and the addition of approximately $140 million in trust assets from the former Eurobank operations. As a result, trust assets managed and broker dealer assets gathered, most of which generate recurrent income, increased 7% to $3.2 billion.

Revenues from mortgage banking activities rebounded 30% from the first quarter of 2010. We sell most of our conforming mortgages, which represent approximately 90% of our production, into the secondary market. Thus, the quarter's results reflect higher production, better pricing of products sold into the secondary market and also increased origination and servicing fees.

Turning to other gains and losses, that totaled a net gain of $2.5 million. In the second quarter there were $26.6 million in losses on derivative activities. This reflects the steep drop in long-term interest rates we saw during the quarter. There also was a [one-point-million] (sic -- see press release -- $1.8 million) other-than-temporary impairment charge on the BALTA private label CMO. We terminated our former forward sales swaps with a notional value of $900 million and replaced them with another [contracts]. This resulted in realized losses of $24.7 million.

However, this enabled us to enter into new forward settled swap contracts for the same notional amount on maturity but effectively reducing the interest cost of the basic sites from an average cost of 3.53% to an average cost of 2.45%. There also was a valuation loss of approximately $1.5 million on the new forward sales swaps.

These losses were more than offset by several items -- a $16.5 million FDIC bargain purchase gain, $1.4 million accretion on the FDIC loss share in the mitigation assets related to the former Eurobank loan portfolio and a favorable $909,000 in the estimated fair value of an equity appreciation instrument issued to but not exercised by the FDIC in connection with the Eurobank acquisition.

In addition, we had an $11.8 million gain on the sale of securities as we took advantage of the falling interest rate environment to lock in profits on selected securities.

Moving now to non-interest expenses, this increased $7.5 million, of which approximately 4.4 -- $5.4 million was due to the addition of the former Eurobank operations. Of that, about $1 million involves one-time acquisition-related costs for lawyers, auditors, investment bankers, consultants and the like. Including third parties, such as an outside commercial and construction loan servicer we employed, we estimate that the run rate for former Eurobank operations is about $3.5 million a month. This represents a savings of approximately 25% from acquisition date, which puts us slightly ahead of where we thought we would be at this point.

Our target going into next year is about a 35% savings. That will include the aforementioned reductions in the Eurobank-related personnel, branch and other operational costs.

Dividends on the preferred stock increased to $1.7 million from $1.2 million. This increase reflects the dividend we paid on the preferred stock series C at the same rate as if they had already been converted to 13.3 million common shares. In addition, income available for common shareholders for the quarter was reduced by $3.1 million, representing the allocation of net income that corresponds to the series C preferred shares. This did not affect total stockholders equity or book value per common share, but it did reduce income per common share for the quarter and for the six-month period ended June 30, 2010.

Turning to the June 30 balance sheet, total loans net of $1.9 billion was up 72%. Non-covered gross loans, primarily the Oriental existing loan portfolio, increased approximately $8.2 million, while covered loans, which are the FDIC-assisted Eurobank loan portfolio, added $810 million in fair value adjusted balances.

Total loan production and purchases of $89 million increased 14%. More than half of that growth came from Oriental's existing residential mortgage loan production, and about 15% from the former Eurobank leasing operation. The balance came from Oriental's existing commercial and consumer loan production.

With regard to the credit quality of non-covered loans, we might be starting to see some stabilization, although we would require at least two more quarters of favorable results to confirm this trend. Our own portfolio continues to perform well. Provision for loan and lease losses is up only $86,000. Net credit losses increased $765,000 sequentially, but year-to-date are actually down almost 24% from the year-ago period.

As a result, the allowance for loan and lease losses now represents 2.40% of loans versus 2.25% in the first quarter. The non-performing loans increased just $738,000 from March 31, 2010. We do not expect our non-performing loans to result in significantly higher losses, as most are well collateralized with adequate loan-to-value ratios.

We are particularly pleased with our deposit performance during this quarter. Deposits of $2.5 billion increased nearly 40% from March 31, 2010. There was a $360 million sequential increase in retail deposits. That consisted of approximately $100 million from Oriental operations and $260 million from the former Eurobank operations.

With regard to borrowings, the sequential increase primarily reflects our note payable to the FDIC in connection with the Eurobank acquisition.

Looking at our capital position, total stockholders equity was $746 million, up 61% or $282 million from March 31, 2010. The sequential increase primarily reflects the following -- the preferred stock series C capital raised in April, a $78 million improvement in accumulated other comprehensive income due to the favorable environment for fixed income securities during the quarter and increased retained earnings.

We continued to maintain regulatory capital ratios well above the requirements for a well-capitalized institution. The leveraged capital ratio was 9.37%. Tier 1 risk-based capital ratio was 24.17%, and total risk-based capital ratio was 25.09%. In addition, tangible common equity to total assets was 5.88%, and total equity to risk-weighted assets, which takes into consideration that approximately 96% of our securities portfolio is backed by US government-sponsored entities or the full faith and credit of the US government, was 24.55%.

Now I would like to turn the call back to Jose.

Thank you, Norberto. The bottom line -- we're pleased to report that Oriental is benefiting from what we regard as a once-in-a-lifetime opportunity. After many years, we are transforming Oriental into a top customer-oriented banking and wealth management services company serving Puerto Rico. Again, our goal is not to be the biggest on the island, but to continue to be the best and most profitable. We have our work cut out for us, but the results are highly encouraging and our strategy going after the Eurobank acquisition is being borne out financially, strategically and operationally.

Now at this time we will be happy to take your questions.

(Operator instructions) Chris Gamaitoni, Compass Point.

Could you tell me how much of the increase in interest income was from accretable yield in the first quarter -- or, in the second quarter?

Well, the accretable yield for the life of the loans is $198 million. We have two months in the quarter, so it's got to be around $13 million, $13.5 million.

And if I look at the duration of the Eurobank portfolio, roughly 44% will mature in one year. So am I wrong in thinking 44% of that accretable yield will come through in the first year?

I think that's too short. I think our expectation is for -- we are going to be working with these clients, and some of them we expect to have a longer duration on their loan relationships. So our analysis is the duration should be around 2.5 to three years, on the average, on the whole portfolio. It depends on the buckets, of course. But in total, on the aggregate we are looking at 2.5 to three years.

All right, thanks. And just on the securities portfolio, can you go over your strategy for reducing that securities portfolio? Are you going to reduce as reasonable line contracts come up, or is there a plan to exit those early, maybe do some termination fees? Can you just go over that strategy for me?

Yes. I would like Julio to address that question, as we have in the past.

Yes, the strategy will be -- I think, when you mentioned the former, which is, as repos -- typically, as repos mature without us having to pay any termination fee, that will be the best opportunity for us to delay them from the investment portfolio side.

Okay, perfect. And what was the maturity of that pay fixed swap you entered?

December 2011.

Yes; the basic swap is 2011, which is tied into $900 million of repos that mature in -- specifically, that date is December 2011. So what that does is that it takes down that cost, which is, I'm going to say, roughly 4.30%. It's going to take it down to 2.45%. So that already will work into the 2012 and forward net interest income. That alone is almost $17 million improvement in net interest income from 2012 for the remaining almost three years from that date on.

And one last thing -- there was a big increase in advertising expense. Was that a one-time rebranding charge to do with Eurobank, or is that something we can expect to move forward?

On the advertising expense, most of it had to do with not necessarily a rebranding but the expense on announcing the transaction and all that goes with it. I would say, however, that going forward, marketing -- we are going to have to have a higher expense on advertising and marketing. I think, in the past, we were a smaller player; now, we have a bigger stake here. So we will be advertising a bit more, and we will be looking at an institutional advertising campaign into the future, into the near future. So yes, you should be seeing a higher marketing expense, most likely at the end of this year and then the next year.

I think that's all my questions, thank you so much.

Avi Barak, Sandler O'Neill.

First question, I was hoping you could give us just some idea of any improvement you're seeing in loan and deposit pricing on the island since the consolidation of the three weaker players.

Frankly, we have not seen any. I think there's still a couple of banks in the island that are trying to unwind their huge dependency on brokered CDs, and they are being very aggressive on trying to attract core deposits. And I am a little disappointed that that has not been -- materialized.

Now that the grace period ends in terms of the acquisitions for clients to change banks without fees, maybe we see some initial rationalization on the deposit side. But I wish I could have better news for you, but I still see a lot of pressure.

From Oriental's point of view, though, we have during the quarter reduced even further, as we have done [also well]. They were actually, almost every quarter, on our core funding since last year. And we continue to grow our deposit base in spite of us reducing our cost of funds. So we are very encouraged with that, as they continue to perceive Oriental as the safety net and a quality added value institution.

Okay, no that's helpful. My second question is, when you look as a whole of all of the assets that came over from Eurobank, including those that are covered, etc., on a percentage basis how much of those assets do you think that Oriental retained as a going concern? You will retain those customers, or 50%, 75%? Just kind of a broad idea?

It's tough to give you a specific number there. When we look at the Eurobank portfolio, the loan portfolio particularly, I think the best part of the portfolio is the commercial and industrial book. The construction and commercial real estate has significant challenges from a credit perspective. So I think our sweet spot is there, in the C&I book. There are some good relationships on the leasing part, too. And we will be providing to everyone on the website a detail of the breakdown of the projected losses of each one of the pockets so you guys have an idea on what our projections for each pocket is going to come out, once we file the 10-Q.

But it will be very hard for me, Avi, to give you a specific number. I'm just giving you from what we have seen already on credit quality in each one of the pockets. And certainly, the sweet spot is on the middle market, small business and professionals that Eurobank had. And that's how we are viewing it right now.

Okay, no, that's also helpful. And, then my last question -- and I apologize; that's also -- I know there's a lot of moving parts to it, but could you give us an idea of how sensitive your equity is to changes in rates? So, for example, long rates just go up 100 basis points from where they are now, what would be the total effect in capital? Just because there's obviously a large swing in your OCI every quarter, I'm just trying to get a general idea. If rates go up 100 BPS, does capital go down X-million?

Let me give you a preemption to the question, and then I will pass to Julio. But when you referred that we have fluctuation on our balance sheet in terms of capital, it all has to do with how volatile interest rates have been in the market, in the last several months. So it really has been very volatile. So we have been cognizant of that situation, and that's one of the reasons why we have entered into the $900 million swap. So that's my introduction to the answer. I will pass it to Julio, to get more specific.

In the bigger picture, the $900 million swap, which is important and which is what we call the derivative loss of $26 million, it's really part of an overall risk management strategy which encompasses $3.5 billion of repos. And from a duration perspective, it encompasses $5.2 billion in investment. So it acts both as a duration reducer on the asset as well as a net interest income [equalizer] and [maximizer] in terms of what we already mentioned for 2011.

Now, in terms of the actual dollar value of each basis point, what we have guided in the past is that -- look at [signing] 5.5 as a proxy, 30 years. They were up about 2% in the quarter; from March 30, slightly above 2% from March 31 to June 30. So on a $4 billion portfolio, that's roughly $80 million that you're looking there. So a good proxy continues to be on our almost $4 billion of agency mortgage-backeds and pass-throughs, mostly pass-throughs, continues to be signing 5.5, 30 years. And also, you could average that with signing 5%, 30 years.

(Operator instructions) Brett Scheiner, FBR Capital Markets.

Hey, guys, good quarter. A couple quick questions. First, with pro forma tangible common equity to assets where it will play out here, you're going to have a pretty thick cap stack, and with the results you've had in the relatively benign credit numbers, I'm wondering how you are thinking about buybacks and dividends going forward.

It's something that we, at the board level, discuss. At this time with all that we have a good opportunity organically here and also have -- the dynamics in the market in Puerto Rico, in the banking market, warrant that we be on the lookout for potential opportunities. So I really think that in the next couple of quarters we certainly will be looking at the dividend and evaluating potential decisions in terms of dividend and buyback. But at this time, I think ourselves and the board believe that it's best to keep the capital that we have, even if it looks at excess capital, for potential opportunities in continuing to expand our franchise (multiple speakers) .

One anecdotal question -- did you keep the Euro headquarters location?

No, we did not. We announced to the FDIC that we were not keeping them. We are -- actually, we had a good opportunity to restructure the lease in the present offices that we have and reduce the cost. So that's what we did.

Okay, fantastic, all right, take care, guys.

Amanda Larsen, Raymond James.

Could you give us a better idea of what you see for Jose Ramon Gonzalez and what he will be doing to expand Oriental's position in the commercial market?

Well, as you know and as I mentioned, Jose Ramon comes with many, many years of experience. He's a young man but has many years of experience and -- in banking. So Jose Ramon comes in to help us make sure that we take advantage of this great opportunity that we have in Puerto Rico in commercial banking. He has a wide experience managing and leading Santander in Puerto Rico. They had a $4 billion book of commercial loans in Puerto Rico, and I think his experience and his leadership will be extremely valuable and complementary to what we have here in Oriental.

That said, Jose Ramon also has the potential to expand his role here in Oriental as we continue to grow and become more of a bank and financial wealth management type of company, as we grow organically, and transform ourselves from more of a loan and fee income from an investment type of balance sheet.

So his role is, as we detail in our press release, banking and corporate development. He also has experience in executing some transactions in the island in the past for Banco Santander and other institutions. So he will be helping us at looking at those opportunities also.

Derek Hewett, KBW.

This is Bain. I wanted to say, first of all, good quarter and, I guess, follow up on the Jose Ramon questions. Obviously, given his experience in the industry and most recently at Santander, do you think there's any opportunity for some potential lift-outs or bringing over of some banking talent?

You know, anything that I say right now would be complete speculation, but logic says that a person who has been very closely tied to a financial institution of the caliber of Santander will have a good relationship left there that we can look at for increase our talent base here in Oriental. So he comes to us to say that there is a good potential there. And he also has the potential to bring clients, too. So both apply.

And just lastly, following up on somebody's previous question on the pro forma capital ratios, do you have them with regard to TPE, tier 1 common, and then the regulatory?

You mean a pro forma including the preferred converted to common?

Correct.

We don't have them with us right now, but we can provide that to you. That is an issue that has been extensively discussed with our external auditors, and it's something that we've got to provide at a future time. We'll discuss that and give it to you guys. We can even post it on the website, if we want to, if you guys want it.

And then just last question, maybe toward Julio, can you give us any indication with regard to the bond portfolio performance subsequent to the end of the quarter, in other words, for the month of July?

Yes. The month of July continues to -- prices continues to improve from June 30 is what we are seeing. Do you want the specific numbers or does that general comment suffice?

I think there are two points. One is what Julio mentioned, the prices continued to firm up. Certainly, there is the pressure on the reinvestment risk in the reinvestment yield. So there is a quid pro quo there. And that's why us becoming more of a commercial bank and growing that side will help improve that situation.

One thing that you [notice] is that we are running a cash position, paying almost of $600 million. And we took what I guess the market is telling us was a good decision in late May, exactly May 27, that at the high level of rates we deployed about $350 million of that cash and securities which are now, by now, almost 1.5% higher than when we bought them. So that clearly should be accretive to both NIM and to book value on an ongoing basis.

Is there opportunity with some potential gains in the portfolio to take them now, maybe pay down some repos and, now that you have moved forward with hiring some talent like Jose Ramon, get the remix of the balance sheet more bank-like quicker rather than later? And I guess, also within that question, I'm assuming that the $100 million of repo that I think is coming up in the next couple of months --

It's coming up August, August 16, I think.

$100 million August 16, to be precise.

Yes.

Okay.

And the next point will be $900 million, December 11.

Yes.

And I'm assuming those would be, as the organic opportunities are achieved, that those can be paid down. But I'm just wondering, is there an opportunity to maybe to prepay some of that and shrink it a little bit faster and thereby remixing a little bit faster?

Let me say a couple of things there, Bain. One is the cost of unwinding repos at these low levels of interest rates and a 4% cost that those repos are at, it's very expensive. That's the first thing.

Yes, we can take some gains and deploy them potentially into commercial lending -- in commercial loans, but let's remember that we are in an economy that it's starting on a five-year recession. And we -- Jose Ramon is joining us to help us develop the plan and start moving forward in a faster way than we have done in the past, but certainly with a cautious eye regarding the local economy, which begins its fifth year of recession.

So it sounds like it's an easy task, but it's not an easy task here in Puerto Rico, especially when you see the marks on all these failing banks in the island. It takes quite a creative effort to bring in the good customers. We've got to cherry-pick the good customers from those larger banks that are disenfranchising their clients because of their focus on credit quality and integration and solving their own problems, and that's a great opportunity for us. But the speed with which we can execute that situation is not going to be a quarter or six months. It's going to take a year, a year and a half, to start to see those results in a material way.

Okay, great.

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

Thank you, everybody, for listening in today. We look forward to talking to you again when we report the third quarter results. Again, appreciate all your involvement in this call and the questions that you guys asked. Hopefully, we have been able to show to you that Oriental is certainly moving in the right direction in the local environment here in Puerto Rico, and that the acquisition of Eurobank has been clearly an accretive transaction from an operational, strategic and financial point of view.

So, thank you, everyone, and looking forward to the next quarter.

This concludes today's Oriental Financial Group conference call. You may now disconnect.