Good morning. Thank you for joining OFG Bancorp's conference call. My name is Lori, and I'll be your conference operator for today. Our speakers are José Rafael Fernández, President, Chief Executive Officer, and Vice Chairman, and Ganesh Kumar, Senior Executive Vice President and Chief Operating Officer. A presentation accompanies today's remarks. It can be found on the investor relations website on the homepage in the What's New box, or on the Webcasts, Presentations, & Other Files page. This call may feature certain forward-looking statements about management's goals, plans, and expectations. These statements are subject to risks and uncertainties outlined in the Risk Factors section of OFG's SEC 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 that occur afterwards. All lines have been placed on mute to prevent 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. Mr. Fernandez, you may begin, sir.
Good morning, and thank you for joining us. Please turn to slide three. Last night, we announced that we entered into an agreement with Scotiabank to acquire their Puerto Rico operations for $550 million and their U.S. Virgin Islands banking operations for a $10 million deposit premium. This marks our third major acquisition in the last nine years, a period of significant growth for OFG. It's an all-cash deal where we are effectively deploying our excess capital. The acquisition is subject to customary regulatory requirements. We anticipate closing before year-end. All together, we're acquiring about $4 billion in assets, including $2.6 billion in gross loans, mostly quality residential mortgages, $3.2 billion in core low-cost retail deposits, along with good fee revenue sources. We've always said that if we do an in-market acquisition, it would have to be financially compelling.
This one is. It also has good strategic benefits. Based on track record of past successful integrations, we are confident we'll be able to realize the value of this acquisition for Oriental and OFG. Please turn to slide four. Strategically, this acquisition strengthens our businesses with enhanced scale. In addition, we're very much looking forward to adding Scotiabank's talented teams in Puerto Rico and the U.S. Virgin Islands. This deal also further establishes Oriental's overall position as the premier retail bank in Puerto Rico. All of this puts us in a position to continue our strategy of differentiation, growth, and strong financial performance. Oriental will be the second-largest bank in Puerto Rico in terms of core deposits, branches, mortgage servicing, in terms of ATM network. It will provide us with an expanded customer base and complementary products and services.
Once combined, we'll have close to half a million clients that will provide us critical mass to create a more meaningful non-interest income profit center. The addition of Scotiabank's insurance business will double ours. We will be the third-largest bank in the U.S. Virgin Islands. Financially, we anticipate the deal to be 40% accretive to next year's earnings, resulting in robust capital generation. Therefore significantly increasing our return on average tangible common equity going forward. All in all, this transaction also provides us with an ideal opportunity to deploy our excess capital to increase return and shareholder value. We also anticipate selling about $1 billion in acquired securities to reduce higher-cost borrowings and broker CDs. To reiterate, I consider that the key value from this transaction are the $3.2 billion in low-cost core deposits. This gives us enormous flexibility to pursue additional loan growth as the opportunities arise.
Importantly, Scotiabank in recent years has substantially improved its credit quality in both Puerto Rico and the U.S. Virgin Islands. Total Non-Performing Assets declined 62% from 2016 to the first quarter of 2019. Direct Puerto Rico government exposure is down to just $27 million. In addition, we anticipate a credit mark of 5% of acquired loans, net of existing charges and purchase accounting discounts. Please turn to slide five. This transaction is conservatively priced at 1.15 times tangible book value and less than 10 times 2020 earnings, including cost saves. Both metrics compare extremely well to U.S. transaction multiples. We anticipate 15% tangible book value dilution on closing. With the 40% accretion, we will have an earn back of less than three years. Projected annual cost saves are currently anticipated at approximately 25% of Scotiabank's non-interest expenses. Approximately 75% of the savings are expected to be realized in 2020.
These are anticipated to result from more efficient back office operations along with vendor consolidation. Just like Oriental, Scotiabank has undergone a period of rationalizing its branch network. Our goal here is to retain and grow the franchise value while enhancing the customer experience level. Usually, in this combination, cost savings synergies typically mean network consolidation. In this case, we will not be focused on that. We'll be looking for efficiencies elsewhere. The end result is a very well-capitalized balance sheet. At closing, we're looking at Tier 1 leverage ratio of about 9.5%, a CET1 ratio of 11.5%, and a total risk-based ratio of 14.5%. Please turn to slide six. Let me provide a little background on Scotiabank's Puerto Rico operation. Scotia has a storied presence on the island and in the Caribbean region in general. The business in Puerto Rico is more than 100 years old.
Altogether, the Puerto Rico and USVI operations have 19 branches, 210 ATMs, about 200,000 customers, and about 1,000 employees, which will help deepen our bench in many areas, from client-facing to back-office operations. Despite differences in our history, Scotia is similar to Oriental in terms of its emphasis on adding value to its customers, differentiating itself in terms of superior service, and valuing its cherished employees while delivering strong financial performance. Scotiabank also provides its retail and commercial customers similar set of products and services as we do. As you can see from the summary income statement, Scotiabank Puerto Rico generated $217 million in adjusted net revenues last year with a net interest margin of 4.12%. The bank produced $38 million in adjusted net income with a return on average assets of about 1%.
Please turn to slide seven for a picture of the improved competitive position we'll have in Puerto Rico. We will be the second-largest bank on the island measured by our retail network and more importantly, by deposit market share. We'll also be number two with a mortgage servicing book that will increase fivefold to more than $5 billion. Please turn to slide eight. I'm also very excited for this expansion of our market footprint beyond Puerto Rico. Here's a look at Scotiabank's U.S.V.I. operations. Scotiabank is number three market share. It has two branches, one in St. Thomas, one in St. Croix. In total, there are 60 employees and 15 ATMs. The branches have $260 million in loans, $466 million in deposits. As a result, the loan-to-deposit ratio is 57%, and the cost of deposit is low at 30 basis points, providing additional good funding opportunity for Oriental.
Please turn to slide nine. We anticipate the pro forma bank to have $9.4 billion in total assets, including a loan portfolio of $7.2 billion. Our loan mix will be one-third in each of our major categories. We will also have $8.1 billion in customer deposits. As I mentioned earlier, a key driver of this transaction is the well-diversified, low-cost core deposit portfolio. Although the portfolio mix does not change much, we will have significantly less reliance on wholesale funding on our balance sheet. Slide 10 compiles all key assumptions to the acquisition and our plan. Most major ones I've already discussed. The projected results of the deal can be seen on slide 11. OFG will have a balance sheet, as I mentioned earlier, of $9.4 billion. This includes $7.2 billion in well-diversified loan mix and $1.5 billion in securities.
On the other side of the balance sheet, we'll have $10.9 billion of mostly low-cost core deposits with a loan-to-deposit ratio of 91%. We will also have only $200 million in borrowings and $1 billion of equity. To conclude, we'll have a well-capitalized bank with a very strong balance sheet. Please turn to slide 12. In closing, I'd like to summarize the key highlights of the acquisition. It combines two excellent banks to create a strongly capitalized market-leading institution focused on the needs of consumers and businesses in Puerto Rico and the U.S. Virgin Islands. It's an opportunity to leverage a strong core deposit base as funding for loan growth. It's also an efficient way to use our excess capital to increase franchise value and financial performance. It is expected to be highly accretive to earnings per share with robust capital generation and significantly expanded return on equity.
Finally, it is conservatively priced with model returns that exceed internal hurdles. We are really excited about how this transaction will add value to shareholders and clients, and how it will expand our team and growth path in Puerto Rico. We are confident in our ability to integrate both the Puerto Rico and U.S.V.I. operations given our success track record acquiring locally and multi-nationally owned bank operations in the past. Again, I thank you for listening. Operator, please open the call for Q&A.
Thank you. At this time, I would like to inform everyone, if you would like to ask a question, please press star then the number one on your telephone keypad. Again, that is star one to ask a question. Our first question comes from the line of Brett Rabatin of Piper Jaffray.
Hey, guys. Good morning.
Good morning, Brett.
Congratulations on the deal. I know you've been working pretty hard on this. I'm sure it feels good to get this announced.
Thank you, Brett. The hard work starts now.
Wanted to, I guess just start with thinking about the acquired loan book, the mortgages, and the implications. I know this is a tough question, but the CECL's coming up and wanted just to get your thoughts on how you were planning to address CECL next year with this acquisition, PCI versus PCD, and kind of how we should be thinking about discount accretion relative to the 40% accretion guidance.
From a CECL perspective, Brett, as you can imagine, this is something that it's very much in our mind, but it's not necessarily to be implemented immediately. It's a January implementation. We're working with the process internally as we have communicated in the past. Now when we look at this transaction, we've modeled a CECL effect on the capital. I think when you look out to accretion, we are really looking more CECL into the impact on capital. Now, how are we going to go about it in terms of PCD, PCI, and all the accounting derivatives of CECL? We can go into an accounting call here, we can take that offline and really emphasize here the great enhancing of the franchise that this provides to us and how financially accretive this is.
Bear in mind, we certainly have CECL clearly on our minds and have a path and a plan not only for key stand alone, but also the expected closing of the transaction at the end of the year and the pro forma two banks together.
Okay.
Brett, this is Ganesh here. Just wanted to add also comment that as you know, the principle behind PCI or PCD, it is the estimation of the lifetime losses. Therefore, what we acquire, the majority of the loans, we believe it will be handled through the PCD mechanics as we adopt the CECL. Therefore, there will not be an income statement impact, and it's a fair valuation methodology, base methodology, and it is a capital impact.
Okay. That helps and also kind of aids my next question as well. The 40% accretion, which is obviously a huge number, but what you get the net of when you do a cash deal for a reasonable price and have a ton of excess capital, still seems to me like it could be a little conservative depending on a few items. Wanted to make sure I'm thinking about, could you just walk me through the mechanics for the pro forma margin and then where you think we end up on a margin basis? Then I assume the idea will be to run off all of the CDs that you can, given what you're doing with the balance sheet over the next few quarters as well.
As you can imagine, we have a model, and we have several variables to that model, which we've shared with you some of those, including selling some of the investment portfolio and utilizing the core deposits that are coming in as a way to get rid of higher cost deposits from institutional deposits. Those are taken into the model. I'll let Ganesh go into a little bit more detail in terms of the other variables that are affecting the accretion. Bear in mind, and you know us for a while now, we don't tend to be aggressive in our modeling. We try to do things conservative.
Brett, just continue on that. On page 10 of the presentation, we are presenting the transaction assumptions as well as some sort of range guidance because the income of the target has been a little bit choppy over the couple of years. We thought we would present this to help you to kind of see how we are modeling these things. See on the right-hand side of that page, the net interest income we are providing a guidance, it will be falling anywhere between $150 million-$160 million over there. Then you can go down the list, pre-income of $50 million-$55 million expenses, $150 million-$160 million cost savings according to the assumptions we presented in the model, then the tax rate that we expect, marginal tax rate for that income.
Basically, I think that's what I would ask you to kind of take a look at it for you to get to the accretion number on what we are presenting.
Okay. Maybe I didn't ask the question very well. Ganesh Kumar, when I look at the guidance on NII, I think about what they've currently been doing. It would seem, when I look at your balance sheet, I look at their balance sheet, I look at what you're giving for NII guidance going forward, it would seem like you would have the opportunity to improve that relative to your pro forma cost of funds and their. I would agree with you, Brett Rabatin, primarily because today their NII, they carry a whole lot of cash and a lot of securities, right?
If you really eliminate the cash because we are using the cash, let's say just from a question of financing the deal and eliminating the securities from their side as well. The resulting book is the loan book, which would definitely have a higher NIM to begin with or a yield to begin with. Correct. See, that's the major factor over here. Of course, there are other moving parts of how we go forward and roll their mortgages into where we redeploy and all those kind of things that add into play. There is an immediate pickup after the close primarily because of what I told you. Yep. Also what you don't see is we are also getting from the acquisition, we are getting excess deposits, and we are able to eliminate some of the borrowing from our side as well.
When the excess deposits are coming in at 62 basis points, then we are rolling off the borrowing, naturally the NIM improves. What we assume is it'll be range-bound closer to our range what we have at this point.
Yep. Okay. I'll step back in the queue and congrats on the deal. Thanks. Thank you, Brett Rabatin.
Your next question comes from the line of Alex Twerdahl of Sandler O'Neill.
Hey, good morning, guys.
Good morning, Alex.
First off, I just want to be clear. I think in your prepared remarks, you said that the 25% cost saves does not contemplate any branch closures. Is that correct?
Yeah. What we're focusing on here is on the customers and trying to make sure that the customer experience and the customer behaviors are not disrupted. We feel that with higher scale as we have it now, we'll have it then with 56 branches. I think that gives us great leverage and momentum for us to grow. When we're looking at cost saves, we're not assuming an immediate consolidation of branches or immediate reduction of branches. We're actually, even though there's a little bit of an overlap here in some eight to 10 branches, we feel that we need to maximize and optimize our branch network from a customer side versus an efficiency side. With the expansion of the customer base, this also gives us a opportunity to fill in some of the geographical gaps that we may have so far.
Net-net, there might be some relocations, but the strategy going forward is not to cut down the network size and derive savings out of that. On the big picture perspective, we're going to focus on growing. Again, having 500,000 customers, having the retail network that we have, we believe that we have a great opportunity to actually deploy the deposits that we're acquiring into loans and grow the balance sheet even further with the resulting effect on income.
Okay. Transitioning to the growth question at $9.4 billion, $9.5 billion, you're kind of right underneath that $10 billion threshold, which I still think is something that needs to be considered. Can you just talk a little bit about where you are sort of in the process of preparing to cross $10 billion and whether or not that's something that we should expect to see in the next two to three years?
Sure. We are already crossing at closing. For the securities de-leverage, we'll be over. We are trying to sort of do the thing because we want to optimize the capital efficiency, CA numbers, and all those kind of things. I think we are prepared organization-wide to cross that, right? Now we need to as we put both organizations in, we can factor in other things like Durbin impact and all those kind of things. I think we just want a little bit more time after the acquisition to get into all of those things. We are not shying crossing. We're not avoiding $10 billion. No.
Also, this transaction adds a talented team of bankers from Scotia that will deepen our bench precisely for our passing and surpassing the $10 billion mark, which will require a deeper bench for us to manage all the functions. Again, we looked at this transaction, Alex, from the financial side, from the strategic side, and even from the talent perspective, we're really excited about it and think that it will allow us and to move beyond the $10 billion as Ganesh just mentioned.
Okay. What would be the direct impact from Durbin on the combined operation if you were to cross $10 billion tomorrow?
In terms of dollars?
Yes.
We have to model that. We have preliminary numbers, and we have to model that, and that's one of the reasons why we chose to remain under $10 billion.
Okay. Just final question from me. When I run the transaction through the St. Louis Fed HHI indicator, it looks like there is a little bit of branch overlap down in Ponce. Is that something that we should expect there to be any divestitures in terms of overlap from either a depository standpoint or from concentrations on assets?
You're correct in terms of what you're referring to. In terms of the HHI, at this point, we don't think we need to do that. We need to go through the process, a regulatory process, and as I mentioned in my prepared remarks, this is an announcement that now we will engage in not only preparing ourselves for the integration, but at shorter term, we will be working with the commissioner's office, the FDIC, and the Fed New York, and those issues will be addressed at that point in time. It's a little premature for us to reach conclusions in that sense.
Moreover, Alex, I think you might have seen that the Ponce market that you indicated crossed at least as of December data and March data. We've been continuously watching it. It's $38 million over the limit in the matter of like $8.3 billion in deposits. As you know, it's a moving number. From here to closing, it might drop or might go away.
Yeah.
Okay.
Certainly, regardless of the HHI, it certainly would still be the number 2 bank in that region. The larger bank will have almost double our market share in that market.
We are not the first bank to cross the asset size in this market.
Exactly.
Okay. Great. Thanks for taking my questions.
Yeah. Thank you, Alex.
Once again, if you'd like to ask a question, please press star one. Your next question comes from the line of Joe Gladue of Alden Securities.
Hey, good morning. Congratulations.
Morning, Joe. Thank you.
I know you've talked about you like to focus more on growing this franchise than consolidation. Scotiabank has not been particularly aggressive in this market, and I guess their balance sheet has been shrinking a bit lately. Do you anticipate any issues with sort of restarting the growth mindset in Scotiabank?
On the contrary, Joe. I think the fact that they have been relatively neutral in terms of their appetite here in Puerto Rico for growth or somewhat retrenching. We view this and as we model it, we model it from that scenario, which is a very conservative scenario. As I said earlier, as we join together both institutions with the teams integrating and applying our methodology of integration as we've done in the last couple of acquisitions, we think that we have a strong, robust platform to grow. Again, it's a matter of appetite. I think that will play out in 2020 as we become one.
Okay. I'd just like to get a little bit of color on the loan portfolio, particularly the asset quality. Just wondering, are the NPAs primarily residential mortgages? Also just wondering if you anticipate just continuing to work out what's in the remaining portfolio, or if you think there's a possibility of selling some bulk pools.
I'll keep it big picture. I'll let Ganesh Kumar add some more detail. Basically, we mentioned already that we're going to sell $1 billion in securities. That's one of the things that we will be doing. Again, as part of our plan and the plan that we've been executing for the last 2 or 3 years, if there are opportunities for us to look at some of these residential mortgages that might be non-performing. When we look at the economy in Puerto Rico, which has actually turned with the federal funds coming down, if there's an opportunity for us to have a good valuation on some of those assets, we will certainly take a look at it. It's something that we've been doing all along.
As time has passed after Hurricane Maria, what we're seeing is a little bit better of a bid here in the island for those assets. We'll evaluate it.
Joe, just to add on that. As both Rafael pointed out in his prepared remarks, Scotiabank has done an excellent job in reducing the asset quality issues and improving it. One of the things that you might have noticed is the acquisition with Scotiabank, there was more servicing capability. We would have a servicing capability which is capital at this point in time. Today, we do 50/50. We service 50% of our portfolio, remaining 50% is being serviced outside. I think this is an opportunity for us to exploit that capability that we are acquiring and further work on these NPAs.
All right. Thank you. I think that's all I had.
Your next question comes from the line of Glen Manna of Keefe, Bruyette & Woods.
Hi. Good morning.
Good morning, Glen.
Congratulations.
Thank you.
I wanted to follow up on Joe's question. I think if you look at the loans that Scotia has in Puerto Rico, and you take out $940 million in mortgages that are covered by the FDIC, that gives you like $1.3 billion in loans that are kind of a core book for their customers that becomes your base of growth. Do you have any idea what you expect to grow it at? Can we expect that would grow at your expectations for the core OFG Puerto Rico book?
From our analysis and from our model, we really are not putting any growth. The analysis and the way we looked at this transaction does not have a growth component going forward from that operation.
Again, not that they cannot grow, but we are not modeling. We're being conservative. Yeah.
On the deposit side of this deal, it clearly gives you a little more swagger down on the island and maybe a little more pull. Even if you take out the broker deposits and your cost of interest-bearing deposits, you're still above Scotiabank's. Do you have any plans to migrate your cost of deposit structure, the prices you're paying to the Scotiabank platform? Are there any opportunities there?
We're actually going to look at all those in detail as we continue to plan for our integration and how we're going to do the product integration, et cetera. It's a little bit too early for us to be specific on that question. If you look at the cost of funds, you can't just look at the aggregate cost of funds and compare all the costs as the same thing, right? There will be categories, different categories we will want to pick and choose, and that's where the optimization question comes post-closing. Yeah.
Okay, great. Thanks, and congratulations again.
Thank you, Glen.
Once again, if you'd like to ask a question, please press star, then the number 1 on your telephone keypad. Your next question is a follow-up from Brett Rabatin of Piper Sandler.
Hey, Brett.
Hey.
José Rafael, I wanted to ask. The narrative before this deal was announced for OFG was the thought that you would become kind of the SMid or the small to mid commercial bank, and that is what you were targeting in Puerto Rico. You have now picked up a sizable consumer operation. Can you just give us an update on how this changes your commercial initiative? Does this mean you will go after larger commercial clients? Does this mean you are going to focus more on growth of the consumer book? Can you just tell us how this kind of updates your overall strategy relative to kind of the previous narrative that you had?
Let me just start by saying that our previous narrative is the present narrative. That means when we look at a transaction like this, we always said that we will deploy capital if it was a significant financially compelling transaction, which we believe this is. That is why we are deploying the capital in this acquisition. Now, our perspective is that the assets that we are acquiring gives us a balance sheet that is well-diversified. We have a good auto portfolio that will be increased by around $200 million from this acquisition. Residential is around 24%-25%. It will grow to 36%-37%. Then commercial becomes another third. In reality, when you look at our asset allocation in terms of assets, in terms of loans, I am sorry, it is well-diversified, and we will be focusing on all three businesses as we allocate capital going forward and profitability.
Again, the key here is on what allows us to be financially flexible and actually strategically also optimal is the customer deposit core base. That is what is really valuable here. We not only grow in scale and reach a 15% or so market share in this market, which is certainly skewed. We are going to be using that core deposit to be able to deploy it in loans. If our ROE gets improved by deploying in consumer, commercial or residential, it is just the way we will allocate the capital going forward. Again, Brett, we believe this is a very good transaction for us from a financial and also strategic and the flexibility it gives us going forward. The proof is in the pudding.
We got to get to December, hopefully by then we will have all the regulatory ships aligned and get an approval to closing and then execution on our integration and business development plan. That is what we have
Done in the past in 2 acquisitions. We plan on repeating it a third time. We're excited about it.
Okay. I appreciate that, caller. What does this mean for OFG Bancorp? Does this change the strategy with that platform in any way?
I think the OFG Bancorp strategy will continue. It's a strategy that I think needs to continue its own path for us to geographically diversify. I think given the scale that this deal gives us and given the leverage that it gives us in this market, I think it's justifiable that we continue our prudent, methodical way of deploying some capital to the U.S. on the loan side. That's how we see it. We haven't changed our approach to that.
Would it be fair to assume that book continues to grow 25, $50 million a quarter based on what they can find that makes sense to put on the books?
Depends on the opportunity.
Yeah, the direction or magnitude doesn't change just because of this.
Yeah, exactly.
Okay.
We'll continue to look at opportunities. We'll continue to compare to returns and, again, as Ganesh says, it doesn't change what we've done in the past.
Okay. All right. I appreciate all the additional color.
Thank you.
Your next question is a follow-up from Joe Gladue of Alden Securities.
I just wanted to clarify a little bit about the timing of the cost saves, with the 75% expected to be realized in 2020. Just wondering, that doesn't mean that there's still a significant amount of restructuring that needs to take place after 2020, does it? It just means that all of those actions you've taken up till then won't be fully reflected in the run rate by the end of the year. Is that accurate?
No. Modeling-wise, we are assuming 75% of the $35 million that we are talking about will be realized by the end of the year. What's remaining is the remaining 25%. That's what's going to take into effect. If you're going to ask me is the whole $35 million will be there right from the day one, no.
No.
We have to start doing the integration from day one, and it's going to step up to it.
Okay. Do you have an estimate of when systems conversion is planned?
Let's take a breather, a moment of breather, and celebrate the deal first, and then we can think about that. To not to be frivolous about it, I think we are, as in prior transactions, we hope to shoot for a 12-month timeframe for transition. That's what we are working on, and we are trying to make this thing as quick as possible, as painless as possible for our customers. We'll think about it.
Okay. Thank you.
Yeah. Welcome, Joe. Thanks for your question.
This is your final opportunity to ask questions. If you would like to ask a question, please press star one. Thank you. I'll now return the call to Mr. Fernandez for any closing comments.
Thank you, Operator, and thank you to all the shareholders who have listened in. We will be announcing our earnings result later in the month of July. We look forward to continuing the dialogue with you and look forward to that call. Have a great time, a great day, and we'll be in touch. Thank you.
Thank you. That does conclude OFG Bancorp's call.