OFG Bancorp (OFG)

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August 23, 2017

We’ve owned shares of OFG Bancorp for a little over a year and have added to our position recently. OFG is the third largest of the publicly-traded banks in Puerto Rico (PR). We added to the position because we believe the bank has improved operations, but the market is distracted by the restructuring of the Puerto Rican government’s (“PR Govt”) debt. Below is a summary of our thesis:

1. US regulated bank – Since Puerto Rico (PR) is a territory of the United States, US banking regulators regulate PR-based banks. We believe the compliance and controls at OFG are like US-based peers. OFG’s depositors are covered by FDIC insurance.
2. Solid Profitability – OFG has shown solid profitability despite almost zero economic growth in Puerto Rico over the last 12 years. OFG has posted return on assets (ROA) of about 0.9% over the last five quarters. This level of profitability is close to the median of OFG’s small bank peers.
3. Limited Exposure to PR Gov’t Debt – OFG does not own any of the PR Govt publicly traded bonds. The only credit risk OFG has to PR Govt debt are loans to a few of the larger local governments, and these loans are not subject to the current PR Govt debt restructuring. They are also backed by property taxes.
4. Extreme Discounted Valuation – OFG trades at 60% price-to-tangible book value. Of the 230 small cap banks with market capitalizations between $100 million and $1 billion, the median P/TBV is 160% or 2.6x OFG’s level. OFG has the lowest P/TBV of this same group. As you can see in the chart below, only one other bank has a P/TBV below 1.0x despite at least a quarter of the banks earning lower returns than OFG.
5. PR Banking is consolidated – The banking industry in Puerto Rico is concentrated among a few banks. There are only six banks operating on the island, which is down from at least 11 prior to 2008. We see the benefit of this consolidation in the wide net interest margins (NIMs) the PR banks (4.15%) have compared to the industry average (3.10%). OFG Bancorp is the third-largest bank headquartered in Puerto Rico.
6. High Capital Levels – OFG Bancorp currently has high capital levels. The tangible capital equity ratio is 11.09% compared to a more normal level of 9%. The bank’s management is planning to hold high levels of capital until they have more clarity about how the PR economy will respond to the PR Govt debt restructuring. We agree with this conservative strategy.
7. Potential for Improvement in Puerto Rico economy – Investor sentiment on PR is very low. We think any hint of good news will send PR-based banks higher. Examples of good news may be either a successful restructuring of PR Govt debt or a small package of relief from the U.S. Congress.
8. Long-shot M&A Target – We believe acquisition of OFG is unlikely. But, with US mainland M&A activity and bank valuations increasing, we could see one of the more acquisitive US banks buy OFG. The deal would be massively accretive for the acquirer. For example, if a generic bank with the following characteristics: $2 billion market cap 1.5x P/TBV , 14x 2018 estimated earnings per share, purchased OFG for a 30% premium to the current price with 20% cost savings in a stock swap, the acquirer’s tangible book value would increase by 18% and earnings per share would increase by 22%.

Risks

1. PR banking market has limited growth opportunities – With the economic malaise in PR and the consolidated banking industry, OFG has limited growth potential.
2. Potential downside to PR economy in response to PR Govt Debt Restructuring – The Puerto Rican government is in bankruptcy. It appears that the government’s debt will be restructured as part of the process. The PR government may also have to reduce spending, which could lower economic growth. OFG is holding excess capital to protect against dramatically slowing economic growth.
3. No US banking operations – OFG Bancorp is at a slight disadvantage compared to its PR bank peers because the bank does not have any operations on the U.S. mainland. If it had U.S. banking operations, OFG would have better growth opportunities.
4. Brokered Deposits – OFG does fund a portion of its balance sheet with brokered deposits. We know that brokered deposits are a volatile funding source. Management also recognizes this risk and has started to reduce the amount of brokered deposits and would prefer to further reduce this source of funding.

Disclaimer: The discussion of any security is meant solely as an illustration of our investment and thought process and should NOT be considered as a recommendation or suggestion to buy or sell any securities. Before you make any investment, do your own research and talk to your own financial adviser. Information in this report is received from external sources. Therefore, we can make no guarantee as to the completeness or accuracy of the information provided.