M&A Announcement

Jun 27, 2019

Good morning. Thank you for joining OFG Bancorp's Conference Call. My name is Laurie, and I will be your conference operator for today. Our speakers are Jose Rafael Fernandez, 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 and 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 3. Last night, we announced that we entered into an agreement with Scotiabank to acquire their Puerto Rico operations for $550,000,000 and their U. S. Virgin Islands Banking operations for a $10,000,000 deposit premium. This marks our 3rd major acquisition in the last 9 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 and we anticipate closing before year end. Altogether, we are acquiring about $4,000,000,000 in assets, including $2,600,000,000 in gross loans, mostly quality residential mortgages and $3,200,000,000 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 and it is also 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 4. 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 2nd largest bank in Puerto Rico in terms of core deposits, branches, mortgage servicing and 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 500,000 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 and we will be the 3rd 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 and 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 returns and shareholder value. We also anticipate selling about $1,000,000,000 in acquired securities to reduce higher cost borrowings and broker CDs. To reiterate, I consider that the key value from this transaction are the $3,200,000,000 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 Q1 of 2019. Direct Puerto Rico government exposure is down to just $27,000,000 In addition, we anticipate a credit mark of 5% of acquired loans net of existing charges and purchase accounting discounts. Please turn to Slide 5. This transaction is conservatively priced at 1.15x tangible book value and less than 10x 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 3 years. Projected annual cost saves are currently anticipated at approximately 25 percent 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 levels. 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 6. 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 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 see from as you can see from the summary income statement, Scotiabank Puerto Rico generated $217,000,000 in adjusted net revenues last year with a net interest margin of 4.12 percent, and the bank produced $38,000,000 in adjusted net income with a return on average assets of about 1%. Please turn to Slide 7 for a picture of the improved competitive position we'll have in Puerto Rico. We will be the 2nd largest bank on the island, retail network and more importantly by deposit market share. We'll also be number 2 with a mortgage servicing book that will increase fivefold to more than $5,000,000,000 Please turn to Slide 8. I'm also very excited for this expansion of our market footprint beyond Puerto Rico. Here's a look at Scotiabank's USBI operations. Scotiabank is number 3 in market share. It has 2 branches, 1 in St. Thomas, 1 in St. Croix. In total, there are 60 employees and 15 ATMs. The branches have $260,000,000 in loans, dollars 456,000,000 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 9. We anticipate the pro form a bank to have $9,400,000,000 in total assets, including a loan portfolio of $7,200,000,000 Our loan mix will be 1 third in each of our major categories. We will also have $8,100,000,000 in customer deposits. And 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 balance sheet, as I mentioned earlier, of $9,400,000,000 This includes $7,200,000,000 in well diversified loan mix and $1,500,000,000 in securities. On the other side of the balance sheet, we'll have $7,900,000,000 of mostly low cost core deposits with a loan to deposit ratio of 91%. We will also have only $200,000,000 in borrowings and $1,000,000,000 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 2 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. And 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 USVI operations given our success track record acquiring locally and multinationally owned bank operations in the past. Again, I thank you for listening. Operator, please open the call for Q and A. Thank you. 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. So it's 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 CECL is 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? So from a CECL perspective, Brett, you can imagine, this is something that it's very much in our mind, but it's not necessarily to be implemented immediately. So it's a general implementation. So we're working with the process internally as we have communicated in the past. So now when we look at this transaction, we've modeled a seasonal effect on the capital. And I think when you look to accretion, we are really looking more seasonal 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, but 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. But bear in mind, we certainly have CECL clearly on our minds and have a path and a plan not only for ORTHI standalone, but also the expected closing of the transaction at the end of the year and the pro form a 2 banks together. Right. This is Ganesh here. I just wanted to add also comment that as you know, the principal decline PCI or PCD, it is the estimation of the lifetime losses. And therefore, we acquire what we acquire, the majority of loans, we believe it will be handled through the PCD mechanics as we adopt the CECL. And therefore, there will not be an income statement impact, and it's a fair validation 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 be 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 form a margin? And then just where you think we end up on a margin basis? And 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. So we 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. So 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. But bear in mind, we 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, to continue on that, on Page 10 of the presentation, we are presenting the transaction assumptions and 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. So we thought we would preference this for to help you to kind of see how we are modeling these things. So on the right hand side of that page, the net interest income we are providing at that, it will be falling anywhere between $150,000,000 to $160,000,000 over there. And then you can go down the list, free income of $50,000,000 to $55,000,000 expenses, dollars 150,000,000 to $160,000,000 cost savings according to the assumptions we presented in the model and then the tax rate that we expect marginal tax rate for that those back income. So 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. So Ganesh, when I look at the guidance on NII and 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 form a cost of funds and their I would agree with you, Brett, primarily because today their NII, they carry a whole lot of cash and for less securities, right? So if you really eliminate the cash because we are using the cash, let's say, just from a financing the deal and eliminating the securities from their side as well. So the resulting book is the loan book, which would definitely have a higher NIM to begin with or a yield to begin with. And see, that's the major factor over here. Of course, there are other moving parts of how we go forward and enroll their mortgages into where we did for redeploy and all the kind of things had in place. But there is an immediate pickup after the close, primarily because of what I told you. And 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. So when the excess deposits are coming in at 62 basis points and then we are rolling off the borrowing, naturally the NIM improved. So what we assume is it will be range bound closer to our range what we have at this point. Okay. I'll step back in the queue and congrats on the deal. Thanks. Thank you, Brett. Your next question comes from the line of Alex Twerdahl of Sandler O'Neill. Hey, good morning, guys. Good morning, Alex. So 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? Yes. We're again, I 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 disruptive. And we feel that with higher scale, as we have it now with 50 we'll have it then with 56 branches, I think that gives us great leverage and momentum for us to grow. So 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 8 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 the opportunity to fill in some of the geographical gap that we may have so far. So net net, there might be some relocations, but we're not the strategy going forward is not to cut down the network side and derive savings out of that. And on the big picture perspective, we're going to focus on growing. So again, having 500,000 customers, having the network, the retail network that we have, we believe that we have a great the balance sheet even further with the resulting effect on the balance sheet even further with the resulting effect on income. Okay. So then transitioning to the growth question at $9,400,000,000 $9,500,000,000 you're kind of right underneath that $10,000,000,000 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 $10,000,000,000 and whether or not that's something that we should expect to see in the next 2 to 3 years? We are already crossing at closing if but for the securities deleverage, we will be over. And we are trying to sort of do the same because we want to optimize capital efficiency, CPA numbers and all those kind of things. And I think we are prepared organization wise to cross that, right? So now we need to ask, we put the both organizations in, we can factor in other things like certain impact and all those kind of things. And I think we just want a little bit more time after the acquisition to get into all of those things. And we don't we are not trying to interrupt. We are not avoiding $10,000,000,000 Yes. And also, this transaction adds a talented team of bankers from Scotia that will deepen our bench precisely for our passing and surpassing the $10,000,000,000 mark, which will require a deeper bench for us to manage all these functions. So again, we looked at this transaction, Alex, and 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 move to move beyond the $10,000,000,000 as we as Ganesh just mentioned. Okay. What would be the direct impact Durbin on the combined operation if you were to cross $10,000,000,000 tomorrow? In terms of dollars? Yes. We have to model that and that we have preliminary numbers and we have to model that and that's one of the reasons why we chose to remain under $10,000,000,000 Okay. And then just final question for me. When I run the transaction through the St. Louis Fed HHI indicator, it looks like is a little bit of branch overlap down in Ponce. Is that something that we should expect there to be some will there have to be any divestitures in terms of overlap from either a depository standpoint or from concentrations on assets? So you're correct in terms of what you're referring to. But in terms of the HHI, at this point, we don't think we need to do that, but we need to go through the process, regulatory process. And as I mentioned in my prepared remarks, this is an announcement that we'll now we will engage in not only preparing ourselves for the integration, but 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. But 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 across at least as of December data and March data, we've been continuously watching it. It's $38,000,000 over the limit in the matter of like $8,300,000,000 in deposits. And as you know, it's a moving number. From here to closing, it might probably might flow away. Okay. And certainly, regardless of the HHI, it certainly would still be the number 2 bank in that region, and the larger bank will have almost double our market share in that market. We are not the 1st bank to cross the enterprise and make sense. Exactly. Okay, great. Thanks for taking my questions. Yes. Thank you, Alex. Your next question comes from the line of Joe Gladue of Alden Securities. Good morning and congratulations. Good morning, Joe. Thank you. I know you've talked about you'd like to focus more on growing this franchise and consolidation. But I'd just like to Scotia has not been particularly aggressive in this market and they I guess their balance sheet has been shrinking a bit lately. Do you anticipate any issues with sort of restarting the growth mindset at the in Scotia? 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 those from that scenario, which is a very conservative scenario. And 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. And again, it's a matter of appetite. And I think that, that will play out in 2020 as we become 1. Okay. Just like to get a little bit of color on the, I guess, the loan portfolio, particularly the asset quality. Just wondering, are the NPAs primarily residential mortgages and also just wondering if you anticipate just continuing to work out what's in the remaining portfolio or if you think there's possibility of selling some I'll keep it big picture. I'll let Ganesh add some more detail. But basically, we mentioned already that we're going to sell $1,000,000,000 in securities. That's one of the things that we will be doing. But 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 nonperforming and there's when we look at the economy in Puerto Rico, which has actually turned with the federal funds coming down. And 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. But it's something that we've been doing all along. And as time has passed after Hurricane Maria, what we're seeing is a little bit better of a bit here in the island for those assets, and so we'll evaluate it. And Joe, just to add on that, Scotia has done as Rachael pointed out in his prepared remarks, Scotia done an excellent job in reducing the asset quality issues and improving it. But one of the things that you noticed you might have noticed is the acquisition with Scotia that was marketing for servicing capability. So we would have a servicing capability, which is capital at this point in time. Today, we do fifty-fifty. We service our 50 percent of our portfolio, remaining 50% is being serviced outside. And 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 Glenn Manna of Keefe, Bruyette Woods. Hi, good morning. Good morning, Glenn. Congratulations. 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 940,000,000 dollars in mortgages that are covered by the FDIC, that gives you like $1,300,000,000 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 that? 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. So the analysis and the way we looked at this transaction does not have a growth component going forward from that operation. So again not that they cannot grow, but they're not modeling. We're being conservative. 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 brokered deposits in your cost of interest bearing deposits, you're still above Scotiabank. Do you have any plans to migrate your cost of deposit structure, the prices you're paying to the kind of the Scotia platform? Is there are there any opportunities there? We are actually going to look at all those things in detail as we continue 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, etcetera. So it's a little bit too early for us to be specific on that question. Also, if you look at the cost of funds, you can't just look at the average cost of funds and compare all the deposits that's the same thing, right? There will be categories, different categories we might want to we will want to pick and choose and that's where the optimization question comes post closing. Okay, great. Thanks and congratulations again. Thank you, Glenn. Your next question is a follow-up from Brett Rabatin of Piper Jaffray. Hey, I wanted to hey, Jose Rafael. I wanted to ask, so the narrative before this deal was announced for OFG was the thought that you would become kind of this mid or the smalltomid commercial bank and that's what you were targeting in Puerto Rico and you've 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'll go after larger commercial clients? Does this mean you're 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? So let me also 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 our capital if it was significantly a significant financially compelling transaction, which we believe this is. And that's why we're 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 $200,000,000 from this acquisition. Residential is around 24%, 25%. It will grow to 36%, 37%. And then commercial becomes another third. In reality, when you look at our asset allocation in terms of assets in terms of loans, I'm sorry, it's well diversified, and we will be focusing on all three businesses as we allocate capital going forward and profitability. But again, the key here is and what allows us to be financially flexible and actually strategically also optimal is the customer deposit core base. And that is what's really valuable here. We not only grow in scale and reach a 15% or so market share in this market, which is certainly skewed. So we're going to be using that core deposit to be able to deploy it in loans. And if our ROE gets improved by deploying in consumer, commercial or residential, it's just way we will allocate the capital going forward. But 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. And the proof is in the pudding. We got to get to December and hopefully by then we'll have all the regulatory chips aligned and get an approval to closing and then execution on our integration and business development plan. And that's what we've done in the past in 2 acquisitions and we plan on repeating it a third time and we're excited about it. Okay. I appreciate that color. And then, what does this mean for OFG USA? Does this change the strategy with that platform in any way? I think the OFG USA strategy is will continue. It's a strategy that I think needs to continue its own path for us to geographically diversify. And 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 don't we haven't changed our approach to that. So would it be fair to assume that book continues to grow $25,000,000 $50,000,000 a quarter based on what they can find that makes sense to put on the books? It's an opportunity. Yes, the directional magnitude doesn't change just because of this. Yes, exactly. Okay. We'll continue to look at opportunities. We'll continue to compare to returns. And again, as Ganesh said, 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. Yes. I just wanted to clarify a little bit about the timing of the cost saves with the 75% and expect it 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 $35,000,000 that we are talking about will be realized by the end of the year. So what's remaining is the remaining 25%. That's what's going to take into effect. And if you're going to ask me is the whole $35,000,000 will be there for right from the day 1 now, we have to start doing the integration from day 1 and it's going to step up to it. Okay. Do you have an estimate of when systems conversion is planned? It's let's take a breather moment of breather and celebrate the deal first and then we can think about that. But to not to be privileged about it, I think we are as in prior transactions, we hope to we hope to shoot for a 12 month time frame for transition, and 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. So, yes, we think about it. Okay. Thank you. Welcome, Joe. Thanks, Jorg, for your question. 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. And we will be announcing our earnings results 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 and great day, and we'll be in touch. Thank you. Thank you. That does conclude OFG Bancorp.