Live Oak Bancshares, Inc. (LOB) Q1 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Life Oak Bancshares First Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder this conference call is being recorded. I would now like to introduce your host for today’s conference, Mr. Greg Seward, General Counsel. Sir, you may begin.

Thank you and good morning, everyone. Welcome to Live Oak’s first quarter 2016 earnings conference call. We’re webcasting live over the internet and this call is being recorded. To access the call over the internet and review the presentation materials that we will reference on the call, please visit our Web site at investor.LiveOakBank.com and follow the links from there. Our first quarter earnings release is also available on our Web site. Before we get started I would like to caution you that we may make forward-looking statements during today’s call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings. We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today’s call. Information about any non-GAAP financial measures referenced, including reconciliation of those measures to GAAP measures, can also be found in our SEC filings. I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.

Thanks, Greg. In looking at the first slide of Q1 highlights and thinking about the bullet point Live Oak franchise, I think that we are in the third phase of this business. Phase 1, start up, FDIC de novo bank May of 2008 to May 2015. We affectionately call that the foot-on-the-throat phase, where the FDIC would not allow us to grow this business 25% year-over-year. In the second phase, the fall of 2014, we knew that we were going to raise additional capital and put our foot on the gas. And we did that. We took the company public in July. We started six new verticals between January of 2015 and today, and in the last 24 months we hired 240 folks. Not all of these folks were revenue generating folks. Some, again, we call dead expletive overhead around here, included our new general counsel, our new chief operating officer, the head of Live Oak University, the head of HR, a top-notch recruiter, and a very senior loan officer, excuse me, credit officer. We’re now set, not only for these six new verticals, but more in the future. So we’re already in and say story. We need to absorb these verticals, train these folks as to the Live Oak culture, and wrap those businesses with the operational excellence that they require to achieve the operating leverage that has helped us build this business in our mature verticals. And I am excited that loan origination increased 15% Q1 over Q1 of 2015. We are excited about loan sales increasing 14%. And Brett is going to talk about net interest income and servicing income growing to $13.5 million-ish this year versus $8.5 million last year or about 56%. Our construction portfolio is about $760 million and we have about $57 million at today’s prices of gain-on-sale dollars that will be recorded in the future. Brett is also going to talk about flat non-interest expense quarter over last quarter and the seasonality of our business. And Neil is really excited to talk about the right side of our balance sheet and how we funded ourselves, and building out with his engineers a next-generation, fully-digital small business bank throughout all 50 states. Moving to Slide 2, let’s talk a little bit about the nature of these new verticals, the nature of origination and monetization, really excited about the wine and craft business. It looks like the craft guys are marching their way to something over 20% to 25% market share. That is a 75% construction business for us. The pipeline in self storage is on fire, that’s the good news. And it’s also good news, but a delayed monetization plan. It takes about a year to build a self-storage facility and then we lend those folks working capital for another year or so before we monetize the asset. Breaking the trend, independent insurance agents are full funders. Hotels can be broken down in two ways: new construction and what we call PIP, product improvement plan. The franchisors many times come to the franchisees and say please improve your property, please spend $10,000 per room. Or if there’s an acquisition, they might say the same thing. Renewable energy is 100% construction, shorter term there. Really excited about our Washington DC government contracting business, which is some business acquisition and, for the first time, we are getting into the asset-based lending business. Those loans will remain on our books and be guaranteed by the United States government, 75% for some period of time. So we will balance sheet those items. Moving on to Slide 3, where it says revenue Q1 2016 by vertical. Let me see if I can let you inside the tent on how we think about this. It's hard to say that family entertainment and poultry our mature businesses, but draw line with me, if you will, between the poultry headline on this slide and the wine and craft on this slide, so seven mature verticals, six newbies. The overhead in the seven mature verticals in Q1 was $5.5 million. The overhead in the newbies was $2.2 million. The newbies produced $52 million of the originations in Q1, $232 million to the mature guys. We are maniacal here, as many know, at Live Oak about debt. Maniacal about our pipeline and what is the shape of things to come. Our pipeline today is $983 million, broken down by proposal, underwriting, credit review, acceptance, and closing, those five phases. Of the $983 million, $719 million is in the mature group and $264 million for the new fellows. So if indeed the past is a proxy for the future, in 2015 we did $1.086 billion in originations by the mature group, or 94% of the total. So as you drill down on this a little bit deeper and you say, what is the wish list? The wish list, in our judgment, is to have all of the overhead in the vertical covered by servicing revenue. The aggregate servicing revenue in Q1 was $4.6 million of the $5.5 million in overhead. Gain on sale is a bonus that was $15.5 million. It is virtually impossible to predict and model each vertical year-over-year. Wells Fargo is giving away money to veterinarians and dentists, but our guys, as you can see, are holding their own. I guess before I turn it over to Neil I would just tell you that we are mighty excited about training folks, our new folks, both at the corporate level and at the vertical level. Neil, why don't you talk a little bit about how we fund this place?

Sure. Thanks, Chip, and good morning. Just a quick update on deposits had a great Q1, in Q1 we launched a very successful deposits campaign, opening up 2,706 new accounts, yielding close to $200 million in new core deposits. As a reminder, these are one and two-year CD accounts opened up completely online, as a result, the cost of our funds remained 1% or close to 1% across the portfolio. In terms of more strategic sticky low-rate cost of funds, our business checking project, internally codenamed Acorn, is on track for the June pilot and general availability at the beginning of the year. This next slide is for those that like a little bit more of a graphical view and it really speaks to the evolution of the platform. Many of you know the story, building a new bank platform on top of the force.com. We talked about what we call e-lending, a complete online, from click to close, of processing of credit. We launched that, as you recall, in August of last year. Again this new deposit strategy, the Acorn project, the business checking project, is on track for pilot in June. The interesting thing that we see, however, as we build out this platform is the ability to layer on top of that an elegant API infrastructure that will allow us not only to go direct to our current customers, such as the dentists, the pharmacists, the veterinarians, but also look for other partners that wants to own the eyeballs of the customer, and we call those the white-label channels and offer effectively API banking through this platform, more to come on that later. But again a very successful deposits quarter in Q1, Brett, over to you.

Thanks, Neil. Good morning, everyone. We have often communicated that given the revenue patterns in our business model, we consider annual comparisons more relevant than quarterly ones when assessing our growth. So that will be the primary point of comparison for key measures, particularly for the income statement. This is especially relevant to the first quarter of any given year where we typically see seasonality in our general business activities. And on that basis, we had a very strong Q1 with our strongest ever first quarter performance as it relates to both loan origination and core revenue drivers. As historical trends demonstrate, business volumes tend to ramp up later in the year following Q1. Looking more closely at loan originations of $285 million for Q1 which as Chip said, are up 15% from a year ago, veterinary, healthcare, and family entertainment stood out as legacy verticals that showed marked growth over Q1 2015. New verticals that were not around a year ago, wine and craft beverage, self-storage, hotels, and insurance agents, contributed approximately $50 million of originations this quarter. Growth in the legacy verticals of healthcare and family entertainment, as well as the newcomers, wine and craft beverage, self-storage, and hotels, were biased toward construction. As such, the percentage of our originations in Q1 that were fully funded at closing was approximately 40%. This will obviously vary from quarter to quarter, but we feel comfortable that the percentage of our originations that fully fund at closing will remain around 40% for the year. Total loans on book increased by 62% from $525 million in Q1 2015 to roughly $850 million with about two-thirds of the portfolio in the held-for-sale category, low levels also rose by 12% compared to the fourth quarter balance. Of the $850 million in loans, $580 million represents the unguaranteed portion of SBA loans and conventional loans, a 71% increase over the first quarter one year ago. The growth in loans, combined with a 55 basis point improvement in net interest margin, drove a 72% increase in net interest income to $8.7 million versus Q1 2015. We did, however, see a modest decline in the margin from 3.66% in Q4 2015 to 3.52% in Q1, primarily as the result of a very successful deposit campaign in the first quarter. As Neil covered, we opportunistically raised funds in anticipation of strong expected loan growth and we're excited about the success of that effort. This ability to attract relatively lower cost deposit funding is a competitive advantage versus non-bank lenders in our space. We sold 156 million guaranteed loans in the secondary market in Q1, up 14% from the first quarter a year ago. The corresponding net gain on sales was $16.4 million versus $15.5 million a year ago. The note amount of our guaranteed loans held for sale, the vast majority of which are multi-advanced loans that can only be sold when fully funded, increased to $542 million from $369 million a year ago, a 47% increase. This increase in the note amount reflects the increase in our construction lending activity, resulting in the growth of unrecognized revenue in our models, which totals approximately $50 million under the sale and service model. We expect the backlog of construction loans to fully fund over the next 18 months. The average net gain on sale in the first quarter was just under $106,000 per million sold. This is below the first half of 2015, when it exceeded $110,000 per million sold. However, in line with our previous comments of a gradually strengthening secondary market after the sharp decline at the end of the third quarter 2015, the net gain on sale was significantly higher than the $95,000 per $1 million of the fourth-quarter 2015. Overall, the secondary market remains strong. After seeing the drop in pricing in December, pricing recovered through mid-March and has remained steady. The continued stability in interest rates has kept prepayments slow, helping the secondary markets. I will remind you that the mix of loans sold in any given quarter will have an effect on our reported net gain on sale revenue, regardless of the overall market characteristics. The servicing revenue from our sold loan portfolio increased to $4.8 million for the first quarter compared to $3.6 million for the first quarter of 2015, a 33% increase. This servicing revenue rose from a weighted average servicing fee of 1.06% on $1.9 billion guaranteed outstanding in the secondary market. The servicing asset value at quarter end was $47.4 million, an increase from the fourth quarter of 2015, due to a higher servicing portfolio and market conditions more favorable than year-end 2015. The credit quality picture remained in good shape in the first quarter. At quarter end the unguaranteed exposure of nonperforming loans and foreclosed assets was $2.9 million compared to $2.4 million at December 31, 2015, and roughly the same dollar amount as the first quarter of 2015. As a percent of total assets, non-performing loans and foreclosures were unchanged from the fourth quarter 2015 at 23 basis points. Net loan charge-offs were 30 basis points of average loans held for investment annualized in the first quarter of 2016, also unchanged from the prior quarter. The provision expense was $1.4 million in the first quarter, consistent with the growth of our held for investment loan portfolio. Non-interest expense has risen since Q1 2015, consistent with our strong growth path, building out the Live Oak franchise, increasing roughly $7 million, or 48% to $21.7 million. This reflects a significant expansion in staffing and facilities, doubling the number of loan-originating business units, and undertaking several technology-driven growth initiatives. We invested heavily in new initiatives in 2015, especially new verticals, which we expect to contribute meaningful revenue to the business in future quarters. As these development efforts progress, we expect the pace of expense growth to moderate. In fact, noninterest expense in the first quarter was actually below fourth quarter levels. Our capital position remains in great shape with many key ratios still in the high teens to 20%. We have ample liquidity, given the deposit inflows, which provides flexibility in how we fund our existing businesses and consider strategic opportunities. So all-in-all we’re off to a great start in 2016 and are confident as ever in the Live Oak franchise. At this time, we would like to thank everyone that has joined the call today and we would like to answer any questions you may have.

[Operator Instructions] And your first question comes from the line of Aaron Deer with Sandler O'Neill & Partners. Your line is now open.

If we can start, please, with the expectations for origination and sale activity for the year, I think last quarter you gave some guidance on what your expectations were. I was wondering if, given the strength that you seem to be seeing early in the year, if there's any chance for upside to that. And you mentioned the $983 million pipeline. How does that compare to where the pipeline was at year-end?

I forgot to reaffirm on the second slide the $1.350 billion to $1.4 billion, so we're still very comfortable with that. The answer to your second question about the pipeline in the last 90 days, I don't have it in front of me, but it's up. I don't know, Brett, do you remember what it was at the end of Q1?

I can't recall right off hand. I am looking for that right now.

And then as that relates to -- obviously there's the pull-through, you gave some commentary in terms of the backlog of construction loans that will fund and the contribution that that will have to gain on sale. Any sense of -- when you think about the timing of the construction completions, particularly in the summer months when you expect to see more construction getting completed, what the timing of sales might be and the volumes as we go through the year?

On that construction backlog, historically we've communicated 15 to 18 months for that to fund. We are seeing that self-storage, as an example of a particular vertical, will have a much longer funding time than that. So on that backlog, without getting granular into each individual vertical and how it funds, we think overall the average will be about 18 months for what is currently there's rollout and fully fund and be sold.

It's impossible to predict. As Brett said, the self-storage guys are doing a fantastic job, a year to build, a year to lease up, so that's at least two years. In the hotel business you're probably talking, and I'm looking at Steve Smith, our Chief Credit Officer, 2.5 years to get all the -- or more. In renewable energy it will be substantially less, those are under six-month projects. And you add that to the chicken business and to the vet business and to the dental business, I mean it's tough. But I would say it would trend a bit longer, if I had to guess.

Okay. What is that renewables business? Can you talk a little bit more about what that is?

So the United States government in Q4 extended the investment tax credit for REEP. Steve, you might want to want to comment on that.

We're looking at opportunities within the solar industry space and we've found that there's a number of opportunities that are consistent with how we approach lending. Again, I think we're going to see more as the year rolls out, but we think that there's a good opportunity here.

Is this rooftop solar?

There's a number of opportunities that we are looking, both within our existing verticals in the space of renewable energy, as well as specific projects that are strictly, solely solar-driven.

So this would be lending to the folks putting it on -- commercial borrowers putting it on existing roof tops and covering the cost of the installation? Is that...

Yes.

And then, Brett, the servicing asset, was there any sort of valuation mark in the quarter?

Yes, it was -- the mark, it was de minimis, it was $26,000 negative. So, the improving market conditions compensated for the natural amortization in the portfolio.

And our next question comes from the line of Doug Mewhirter with SunTrust. Your line is now open.

This is actually Matya on for Doug. The rate you are getting on guaranteed loan sales improved from the fourth quarter. Are you able to tell us what you are seeing in the market quarter to date? And then also you mentioned that the rate depends on mix. Can you tell us which verticals are performing better than others?

I guess by mix -- I will answer the second part first. By mix, it's less about vertical performance, but more about the terms of the loans that we make. Healthcare, for example, its loan type does a mix of some quarterly adjusting, prime plus 175, prime plus 2, versus an alternative product that is adjustable on a five-year schedule rather than a quarterly schedule. So when we talk about mix of loan types affecting market premiums, that would be one, so not necessarily vertical-specific, but loan characteristics specific based on terms. The other example is our chicken vertical, which I suppose is more vertical-specific. Those loans are typically on annual pay and those loans are not pullable in the secondary market so they tend to get a lower premium. And then probably the final point on mix would be 25 year versus 10 year. Right now our portfolio is roughly 50/50, 50% of what we do is 25 year versus 10 year. 10 year, obviously, gets a lower premium, so in a quarter where a vertical that is more heavy into short-term or the shorter terms, the 10-year loan structure, if they have a knockout quarter and the 25-year loans are less, you will see a lower gain on sale premium. Not as a function of market condition, but just as a function of the fact that you sold more 10-year loans than 25-year loans. On the secondary market question and the overall conditions, we did see premiums continue to rise through the end of February and then they leveled off in March. And they remain at that level point through current date. Back to the prior comments, given the interest rate environment, the fact that through April prepayment speeds have remained relatively low, we feel that this supports continued secondary market activity where it currently is. However, I think we have all seen in the past that it can be a volatile market. It can bounce around overall and then bounce around as a function of the types of loans that we are selling.

And then you increased your allowance a little bit this quarter. Are there any verticals or regions that you are concerned about in particular?

So I can take that. So since inception, we have been on pretty solid ground with our credit quality and I see that continuing. The allowance really has been consistent with the growth of the portfolio so we have stayed pretty much in tune with that. So that is just a reflection of our continued growth. I haven’t seen any systemic changes in any one vertical. I think it’s just tied to growth. I also watch our watchlist and that has also consistently, been consistent with our growth. I haven’t seen any additional increases in the watchlist, which is also tied into the allowance.

Then can you provide a little more detail on loan production within your new verticals like hotels or maybe self-storage or insurance?

We don’t disclose that.

And your next question comes from the line Jefferson Harralson with KBW. Your line is now open.

I want to start out with kind of a booking question. You probably have mentioned this number already, but what’s the backlog of construction loans that are growing that’s to be sold in the future?

The face amount of those construction notes is roughly $540 million.

Guaranteed.

Face amount, the guaranteed portion is $506 million, so that is what will ultimately be sold as they…

Well, that’s up from $500 million last quarter I think?

While he’s looking that up, the answer to Aaron’s question is, in the last 90 days, the pipeline was up slightly over $100 million.

Yes, and that’s up from $498 million. The guaranteed construction backlog is up from $498 million last quarter.

I want to follow up on one of Aaron’s other questions on that servicing income item that went from the mid-$2 millions to the $4 millions. You are saying it wasn’t a mark, but is it an expectation of lower prepays or lower losses or? I guess what made the change quarter to quarter and what should we expect there? Is it just going to be volatile between $2 million and $4 million, or what should we expect there? And what drove this change?

I don't like to get into predicting what the reval is going to be. Really the only predictable part of the reval is what we think the natural amortization of our portfolio will be. So we had a favorable reval, what we consider to be a favorable reval for Q1 in that we didn’t take much of a downward mark on the portfolio. There is, I guess I will go back to my prior comments that the current environment we are in with prepayment flow, that would continue to support some level of robustness in market conditions that would not necessarily result in a markdown of that portfolio. However, those fundamentals can change swiftly and the mark could turn deeper against us as the market conditions change or prepayments pick up.

So I should think of it as maybe $4 million to $5 million a quarter, less whatever the reval is? And that can be as low as zero up to maybe $2 million or something like that? Is that how I think about it?

Yes, $2 million, $2.5 million.

Okay, okay. And this might be a Neil question on the small initiative of e-lending. I guess how can you characterize or what can you talk about what's going on so far? What's the plan to grow this business? What can you tell us so far and what can you tell us about what you plan to do with it?

So let's see, we had, without giving you the numbers, they were small anyway relative to the originations, Jefferson. But we had expected to do effectively 3 times the growth year-over-year. We're not quite on track to do that and what we found is that, because we're doing all of these SBA 7(a) that our click-to-close is around 30 days right now. So we are embarking aggressively on a higher-yielding conventional product that requires less documentation specifically tied to the SBA. We will still do SBA small loans, but opening up e-lending to now compete with the non-bank lenders out there truly click-to-close, click-to-funding in five days or less. All electronic documents signed. And we feel, again, the hassle-free, lower documentation relative to the SBA anyway type experience people will pay up in terms of yield. So that plus there is an SBA Express product that will allow us to charge prime plus 6 versus prime plus 2 3/4. So we're examining both those two products for layering on top of the current product set.

And the five-day click-to-close is a non-SBA loan?

It is. However, the SBA Express, which is tied to a conventional credit policy, we feel we’ll also be able to get close within those timetables. And that, just to give you a refresher course, is a 50% guarantee versus 75% to 85% depending upon the loan size. And just as a point of, in terms of asset quality, we still believe staying in vertical represents a massive amount of opportunity. So relative to the conventional product, we would stay in vertical.

And I will ask one to Chip. Chip, you guys have a lot of excess capital. You have the opportunity to acquire businesses, some of these can really change what Live Oak is. So can you talk about the M&A? What you are looking at and the potential that we might be able to see over the next 12 months as far as how the M&A could change this company?

I think we said, Jefferson, in the 67 roadshow visits that we were going to be incredibly careful in that regard. Having spent a lifetime in the M&A business, culture is everything. I think we said in the last call we are continually looking at eclectic specialty finance companies. We have no interest whatsoever in trying to replicate Bank of America and Wells Fargo lending 4% fixed-rate money to veterinarians for 25 years, but there are a few interesting companies out there that may fit. That said it is not lost on us that we have $80 million or $90 million, whatever it is, in excess capital sitting in a checking account at the holding company. And I think you'll see us, as Neil mentioned, begin to portfolio some conventional loans, again, in vertical where we know and understand those businesses. So I would say that M&A is not really a day-to-day focus here. Again, that said, people in your industry know that we have a currency and know that we have cash and are bringing us opportunities to look at. If I had to guess, one out of 10, one out of 15 maybe, so I don't think I would factor that into any projections at this point.

And do you guys have any portfolio -- have you portfolioed any conventional loans yet?

Yes, the answer is yes. So we look at opportunities within our verticals and that's a combination of existing borrowers that have outgrown the SBA, for which we can provide a solution, as well as various opportunities they don't really fit the SBA box but are a great conventional product. So we have offered extensions of credit on a conventional basis, but mainly to existing adjuncts to the SBA that we have already provided.

I think on that too, Jefferson, we have been spoiled over eight years. Our average exposure per customer is under $300,000. So we have -- what do we have at the bank today, $100 million, $110 million worth of capital? So you have a legal limit of $15 million or $16 million there and an additional $100 million of capital-ish at the holding company. So I think you'll see us step out of that a little bit on AAA credits and not be quite as cautious on trying to keep our exposure level down to under $300,000 for a $1.2 billion bank.

All right, got it. Thanks, guys.

Jefferson, this is Neil. Just real quickly, the theme I think that you are going to see over the next couple quarters is adding new product sets, whether it be a conventional partner buy-in product, an ABL product that was referenced earlier on this call. Leveraging the market footprint that we are ready have and being able to cross-sell new products into it, you will see that team. And you will see a theme of less reliance on the SBA exclusively and breaking out of that to become, both in name of deposits and loans, a little bit more like a normal financial institution.

And I’m showing no further questions at this time. I would now like to turn the call back over to Chip Mahan, CEO, for any closing remarks.

No closing remarks at all. Thanks to everyone for joining the call.

Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude today's' program. You may now disconnect. Everyone, have a great day.