OFG - OFG Bancorp: Downgrading To Hold After Price Rally Expecting Earnings To Be Stable

2023-12-28 13:58:15 ET

Summary

• The margin will likely dip due to a surge in the borrowings’ balance as well as upcoming interest rate cuts.
• Loan growth will likely continue to remain strong because of Puerto Rico’s strong economy.
• The December 2024 target price suggests a small downside from the current market price. Further, OFG is offering a low dividend yield.

Earnings of OFG Bancorp ( OFG ) will likely remain unchanged in upcoming quarters from the first nine months of this year. While loan growth will lift earnings, margin compression will restrict the bottom-line's growth. Overall, I'm expecting OFG Bancorp to report earnings of $3.80 per share for 2023 and $3.87 per share for 2024. Compared to my last report on the company, I've raised my earnings estimate for 2023 because the loan growth so far this year has beaten my expectations. Since the issuance of my last report, wherein I adopted a Buy rating, the company's stock price has rallied. As the current market price is now slightly above next-year's target price, I'm downgrading OFG Bancorp to a Hold rating.

Margin Outlook has Turned Slightly Negative

The net interest margin has increased by around 11 basis points in the first nine months of the year, which is somewhat in line with my previous expectations given in my last report on the company. The margin could face some pressure in the last quarter of 2023 because borrowings surged in the third quarter. The balance of borrowings rose to $451 million by the end of September 2023 from $227 million at the end of June 2023 and $27 million at the end of December 2022. Full-quarter impact of the almost doubling of borrowings during the third quarter of the year will be felt in the fourth quarter.

Moreover, I'm expecting Fed funds rate cuts next year, which will put slight downward pressure on the margin. According to the results of management's rate-sensitivity analysis given in the 10-Q Filing , a gradual 100-basis-points rate cut could reduce the net interest income by 1.69% over twelve months.

Considering these factors, I'm expecting the margin to dip by 15 basis points in the last quarter of 2023, and by another 15 basis points in 2024.

Economic Factors Likely to Keep Loan Growth Strong

Loan growth exceeded my expectations in the second and third quarters of this year. The loan portfolio has grown by 6.1% over the first nine months of the year, which is very impressive given OFG's history. The company's loan book size has declined in five out of the last eight years. Moreover, the company has already achieved the same level of growth in the first nine months of this year as it was able to achieve in full-year 2022.

I largely attribute this growth to a conducive operating environment, as Puerto Rico's economy has gone from strength to strength in recent quarters. Peer banks in the area have seen similar success. Popular, Inc.'s ( BPOP ) loan portfolio has grown by 6.3%, while First Bancorp.'s ( FBP ) loan portfolio has grown by 3.5% over the first nine months of this year.

Strong loan growth is likely to continue through the end of 2024 because of a good outlook for the region. Puerto Rico's unemployment rate is expected to rise only slightly next year, and even then it is likely to remain near record lows.

As a result, I'm expecting the loan portfolio to grow by 1.0% in the last quarter of 2023 and then by 6.1% in 2024. Further, I'm expecting deposits to grow somewhat in line with loans. The following table shows my balance sheet estimates.

In my last report on the company, I projected earnings of $3.60 per share for 2023. I've increased my earnings estimate for this year because the loan growth has beaten my expectations in the first nine months of the year. Moreover, OFG has shown more operating expense discipline than I anticipated.

Risks Are Manageable for Now

Due to the following two factors, I think OFG Bancorp's risk level is currently manageable.

1. We still have half a year till the next hurricane season, so the risk from natural disasters is low for now.
2. Unrealized losses on the Available-for-Sale securities portfolio amounted to $150.9 million at the end of September, which is just 14% of the equity book value.

However, the quality of the deposit book is somewhat worrisome. Uninsured deposits amounted to $3.747 billion at the end of September 2023, which is a massive 44% of the total deposit book.

Downgrading to a Hold Rating

OFG Bancorp is offering a dividend yield of 2.3% at the current quarterly dividend rate of $0.22 per share. The earnings and dividend estimates suggest a payout ratio of 22.8% for 2024, which is in line with the five-year average of 22.0%. Therefore, I'm not expecting any change in the dividend level.

I'm using the historical price-to-tangible book ("P/TB") and price-to-earnings ("P/E") multiples to value OFG Bancorp. The stock has traded at an average P/TB ratio of 1.22x in the past, as shown below.

The stock has traded at an average P/E ratio of around 8.8x in the past, excluding the anomaly in 2019, as shown below.

Equally weighting the target prices from the two valuation methods gives a combined target price of $33.30 , which implies a 12.2% downside from the current market price. Adding the forward dividend yield gives a total expected return of negative 9.9%.

In my last report on OFG Bancorp, which was released on March 22, 2023, I adopted a buy rating. Since then, the stock price has surged by a hefty 42.7%. As the market price is now higher than the target price, I'm downgrading OFG Bancorp to a hold rating.

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