OFG Bancorp: The Risk Is Worth The Reward

| About: OFG Bancorp (OFG)
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Summary

OFG continues to improve by shedding its troubled assets.

Priced similar to other banks based on earnings, investors stand to gain from the expiration of one very large non-cash charge.

In addition to great fundamentals, management continues to prove it is top class by initiating timely buybacks and growing the dividend.

Compared to its island peers, OFG Bancorp (NYSE:OFG) appears to have a repellent for common Puerto Rican bank diseases like bad loans and nonperforming assets. The bank has now had a little more than a year to integrate its very large asset purchase from Banco Bilbao and the fruits of its labor are starting to ripen.

This has been my favorite holding for some time now but shares have barely budged from my two prior calls. Because of this, it would probably be easier to write an update siding with the market and turning this bank into a money pit destined to fail along with the Puerto Rican government as bonds default and its other major competitors continue to distance themselves from the country by moving stateside BUT, operations continue to improve and I frankly haven't seen a bank with this much potential in a very long time.

Fear

At the start of the year, Paulo Santos wrote an article about the bank titled "Not a Bank In Cyprus But It's Close" that drew a dire picture about the bank based on it's large holdings in Puerto Rican government bonds that looked more than destined to fail at the time. This is a real risk with investing in the bank and there is absolutely zero reason to think lightly about it. I will not even try to predict the country's bond outcome but the bank has been reducing its share of these potentially toxic assets at a very rapid pace.

Puerto Rico Government Related Loans and securities (excluding municipalities)

9/30/13 - $771.8 million

12/31/13 - $631.6 million

3/31/14 - $545.5 million

This is still a sizeable position compared to assets and equity but management's intentions are clear and investors should continue to see the balance fall throughout 2014. Remember though, these assets are 1) still earning money and 2) may never end up producing losses.

Operations

In the first quarter of 2014 the bank reported $20.3 million in income available to common shareholders ($0.42 per share) which was higher than the prior quarter's $17.7 million ($0.37 per share). Annualizing this performance yields just under 9% based on the bank's market cap of $816 million which is somewhat attractive considering it means you can still get shares for less than 10Xs pre-tax earnings BUT, this and every earning number that investor's are being reported include some very large non-cash charges that hide a big chunk of the bank's profitability.

Just this last quarter, for instance, the bank's FDIC indemnification asset was written down (amortized) by $17.2 million dollars. This is a pre-tax number but this is a charge that falls to the bottom line and is almost as large as reported earnings were.

To get a little background on this, when a bank acquires FDIC covered assets, they enter the books at fair value with the amount the of the FDIC's potential loss share also entered into the books as an indemnification asset (receivable). The loss is based on the fair value of the assets but the receivable will never be collected, or owed, unless the assets are sold and the loss is actually realized. Because of this time lag, the assets could potentially rise in value which would require the FDIC asset to be written down. This being the case, the bank has been writing down the indemnification asset at a very rapid pace.

1Q2013 - $283.1 million

2Q2013 - $253.3

3Q2013 - $225.5

4Q2013 - $189.2

1Q2014 - $166.1

This amortization is needed to reflect the receivables' fair value but the charges, which are not real losses, are hitting earnings so hard that the bank appears to be trading in-line with most other banks (based on EPS) who's results are unimpaired by any similar non-cash charges. AND, still at $166.1 million, this 'clouding' looks set to continue for the better part of a year. Once over, however, the bank's true potential will shine through and the share price now will look like even more of a home run. Or, as the football fanatical Puerto Ricans would say, a golazo!

In addition to this development, the bank's nonperforming assets have continued to improve at a very fast pace. Last quarter's figure stood at 3.25% compared to 3.32% in the last quarter of 2013 and significantly down from the 9.31% during the same time last year. Getting through the tough times has lead to a buildup in foreclosed properties that showed a balance of $110 million in the first quarter which is up 16% YOY. This inflow is most likely below fair value and has the potential to be sold for gains but it has also slightly brought up operating expenses. Even so, the bank's efficiency ratio is still most banker's dream at a very low 50.03%. Going forward, dark spots like these could be turned around to increase earnings but investors need to monitor the efforts because a significant downturn could be very costly. Fortunately though, the base the bank is operating from is already very profitable and, unlike a lot of other banks, still in OFG's backyard considering it still has the ability to clean up around the edges to further improve the bottom line.

Shareholders First

This is a very volatile bank holding because of the constant inflows of bad news on both the macro and micro sides. Neighboring banks like Popular (NASDAQ:BPOP) and Doral (NYSE:DRL) continue to show just how hard banking in Puerto Rico can be but OFG's history is more like Hawaii's Territorial Bancorp (NASDAQ:TBNK) in that management does not outstretch its capacity and favors a very large amount of capital. Because of this, and the bank's recent profitability, timely share repurchases have been made and the dividend has increased.

In the first part of 2014, management quickly stepped in and repurchased 707,400 common shares at an average price of just $14.66 per share. This is just above tangible book value (of $14.07 - book value of $16.23) but a very substantial discount from where shares stand right now ($18.13), less than two months later.

In addition to the repurchases, the bank's dividend rate grew 25% to $0.08 in the fourth quarter of 2013 which is well below quarterly earnings even with the amortization discussed above.

Bottom Line

When there is more risk investors should get more reward and OFG Bancorp is priced very attractively because of this. But, unlike other banks that overstep their bounds, OFG's risk is more from outside forces and not so much because of its own fundamentals. This, again, is not to be taken lightly because the government problems are real and OFG could get burned from them. However, the bank is earning a ton of money and the government ties are being brought down at a very quick pace.

All in all, shares look extremely attractive and higher earnings are in-store when the FDIC asset is written down to a point where its amortization has a smaller impact on reported earnings. Up until this point, I believe, shares will continue to be highly volatile, misunderstood and CHEAP.

Other 1st quarter highlights (Please note that these returns are depressed due to the amortization of the FDIC asset)

Tier 1 - 10.79%

Tier 1 Risk-based Capital Ratio - 14.76%

Return on Average Assets - 1.18%

Return on tangible common shareholder's equity - 12.86%

Also, be aware that this is a foreign entity and dividends do include a slightly higher tax rate.

Disclosure: I own both common and Series A Preferred Shares.

Disclosure: I am long OFG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also own shares of OFG's Series A Preferreds.