Live Oak Bancshares, Inc. (LOB) Q2 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to Live Oak Bancshares Second Quarter 2016 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions following at that time. [Operator Instructions] And as a reminder, this conference is being recorded. Now, I will turn the conference over to your host, Greg Seward, General Counsel of Live Oak Bancshares. Please begin.

Thank you and good morning everyone. Welcome to Live Oak’s second quarter 2016 earnings conference call. We are 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 website at investor.liveoakbank.com and follow the links from there. Our second quarter earnings release is also available on our website. 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. As you have seen from our press release Q2 can be best described as being very deceiving given various special charges related to moving our franchise forward that I will go over shortly. Our reported bottom-line totally masks strong organic growth as evidenced by record origination levels and strong year-over-year growth in key metrics. Interestingly, today is the one-year anniversary of the date we announced the closing of our IPO. Fundamentally we are pleased to announce Live Oak Bank 2.0. We are growing up and morphing from an SBA gain on sale-centric bank with a fair amount of revenue volatility to a nationwide small business bank that provides unique digital products and services to the nation’s 28 million small businesses that creates 66% of the new jobs in this country and we will be growing into a bank with a stronger base of recurring revenue. You have seen that we reported net income of $123,000 and zero EPS. Several unusual events occurred in Q2 that need clarification. Number one, we have decided to retain all unguaranteed loans that we generate. Please recall that in order to remain compliant with the FDIC de novo rules from 2008 to 2015 we were restricted to 25% annual asset growth. To do this we sold unguaranteed paper at par to various banks and credit unions without any additional servicing revenue. This is no longer necessary. Therefore, we have moved about $300 million in loans from held for sale, HFS, to held for investment, HFI and now get to enjoy the incremental net interest revenue on these loans. This move of these performing loans necessitated a one-time loan-loss provision of $4 million, or $0.07 a share. Total non-performing assets of $2.6 million or just 19 basis points of total assets. Number two, as disclosed on March 21 we issued RSUs with performance conditions and RSUs with performance and market price conditions to certain individuals. Accounting rules require that we begin to recognize the cost of these grants which resulted in a $2.2 million or $0.04 per share reduction to earnings in Q2. We will complete a large portion of this non-cash charge totaling $6.7 million or approximately $0.11 per share over the next two quarters. Prior to this event, our non-cash stock-based compensation expense was an inconsequential $700,000 per quarter. Because of our unique position and unique skill set in the financial services industry, there is a real demand for Live Oak’s talent which we must be attentive to in order to avoid disruption to our growth plan. As such, we will continue to issue RSUs to ensure we have the right people not only to operate the business but to take Live Oak back beyond 2.0 to capitalize on our significant competitive advantages. We must attract and retain talent as we build a next-generation, fully digital, nationwide branchless small business bank. To do otherwise would be exceedingly shortsighted. Number three, as many of you know, our chicken vertical has experienced great success since its inception two and half years ago. Although $38 million of these loans were contractually sold at the end of June we were unable to settle until July. The result was $3.5 million in pre-tax dollars or an estimated $0.06 per share that will be reflected in Q3 results. You can adjust your models accordingly. Therefore, the combination of a one-time loan-loss provision, stock-based compensation expense that expires this year and loan sale slippage totaled $0.17 per share for Q2. Number four, we have had tremendous success on the deposit gathering side over the past few quarters. With a stronger funding model in place we can now confidently proceed with additional moves to more profitably deploy some of the capital we raised a little over a year ago. Thus we are announcing today that we will be opportunistic in retaining guaranteed loans that we generate. From time to time, secondary market pricing is such that we think it is better to hold than to sell where we expect net interest revenue over the longer term to exceed sale related revenues. Brett will be walking you through the profit dynamics on this. We estimate that this may be as much as 25% of production. Again, less dependency on gain on sale dollars. We feel that this is a very good use of the capital we raised. As promised, we have looked at a number of eclectic specialty finance companies. We are rapidly coming to the conclusion that organic growth within our cultural boundaries will serve us better. Now by no means should any of you view these moves as signaling that we are migrating to a more traditional bank model. I can assure you this is the furthest thing from our minds. The significant distinctions we enjoy with mainstream banks are very much in place and thriving. Our nationwide footprint is growing. Our unique digital platform is evolving. Our focus on carefully chosen verticals remains, and we will continue to be unencumbered by costly branch network. Rather these moves are simply about elevating the Live Oak Bank franchise to the next level and putting our ample capital to optimal use. Our talented people are poised to move Live Oak Bank into the next era of financial services. With that, I would like to turn it over to Brett for a financial overview of the second quarter.

Thanks, Chip. Good morning, everyone. We are sharing with you this morning a presentation. I would like to let you know the presentation mostly presents background information and we will be covering just a few of the slides. For those of you who have had a chance to view our earnings release you undoubtedly noticed our GAAP reported net income of $123,000 and the resulting earnings per share. Chip communicated much of the background for these reported earnings. I would like to take a few minutes to discuss the drivers of these results and for the first time since our IPO discuss the non-GAAP net income for the quarter. I will also elaborate on the positive earnings aspects of the balance sheet initiatives that Chip spoke about. As we have often indicated in the past one of our planned uses of the capital raise as part of the IPO was to hold a larger volume of loans on book as held for investment. We believe there is tremendous value in our loan portfolio to be recognized by retaining unguaranteed loans versus selling at par with no retained servicing fee. There is virtually no benefit to unguaranteed loan sales at this phase in the company’s growth. Additionally, our unguaranteed portfolio has proven to be comprised of high-quality, low credit risk small business loans with attractive spreads. For these reasons we adopted a new practice in the second quarter whereby we will not seek to sell unguaranteed portions of our loans. There may be future periods where we look to mitigate industry concentration or sell loans to meet a short-term liquidity need but for now we are comfortable with our owned book exposures and our liquidity resources. We believe strongly in the long-term value of the risk-adjusted returns on this portfolio. As a result, we reclassified just over $300 million of unguaranteed loans from held for sale to held for investment in the second quarter. This reclassification resulted in an additional $4 million of provision expense or $0.07 per share as we needed to provide for them in our loan-loss reserve. While this is a large expense to incur in any one quarter it is our strong belief that holding these loans and retaining the related net interest income will provide a much greater long-term positive impact to the bottom line. We were able to commence this change in our loan sales strategy due to the significant strides we have made in our funding model resulting in ample liquidity for such an initiative as we discussed in detail during Q1’s earnings call coupled with the capital surplus we have had since our IPO. Similarly, beginning this quarter, Q3, we are planning to reduce the volume of guaranteed loans we sell in the secondary market. While not a hard and fast percentage, our plan is to hold approximately 25% of the guaranteed volume that is available for sale. This is possible by our strong capital position and its success in our funding model. First and foremost, this decision is driven by the long-term value we can now realize on the guaranteed portion of our loans as shown in the accompanying presentation. As you will see on slide eight of the presentation, although the gain on sale revenue is immediate the premium paid often does not capture the full value inherent in the loan. This slide represents a typical quarterly adjusting loan with our assumed seven-year life. Over the long-term we will record more revenue by holding onto a larger guaranteed volume as held for sale while reducing earnings volatility which is important to us and many of our shareholders. This volatility was on full display in Q2 as roughly $38 million of guaranteed loans that were contractually sold did not settle by June 30 and as a result did not contribute to Q2’s earnings. Had these loan sales settled in Q2 they would have contributed over $2 million of after-tax earnings or about $0.06 per share. Additionally, this decision will slow the growth of our servicing asset whose related to quarterly revaluation is also a source of earnings volatility. As you can see Live Oak is very focused on creating sustainable long-term value. We believe the decisions we made in Q2 along with Q3’s decision to hold more of our guaranteed production will result in greater revenue, continued growth opportunities and less volatile earnings over time. Thirdly, we believe Live Oak is poised to deliver exceptional value over the long term and a key to that delivery is retaining our top talent, as Chip described. As a nationwide small business focused alternative to bank and non-bank lenders there is a strong demand for the skill sets we possess. As shown on our March 31 Form 10-Q RSUs were awarded to retain key personnel. The Q2 impact of these awards totaled $2.2 million or $0.04 per share. As detailed in our 10-Q filed in May there will be additional expenses related to this award, the majority of which will occur in the third and fourth quarters of 2016. Turning back to Q2 results, you should have seen non-GAAP net income and EPS in our earnings release of $3.9 million and $0.11 per share. These values incorporate the adjustments for the incremental provision expense related to the transfer of unguaranteed loans from held for sale to held for investment and the stock-based compensation expense related to those specific equity awards. Of course, we have not included the $0.06 per share associated with the timing of guaranteed loan settlements that carried over to Q3. For those of you updating your models consider these earnings as part of your revisions to the loan sale output in Q3. Looking more specifically at Q2’s performance with a few highlights shown on slide 9 we experienced a record-setting loan origination quarter at $357 million. This brings the total originations for the first half of 2016 to just over $640 million, a 22% growth over the first half of 2015. And as Chip indicated we expect to be at or above the upper end of our targeted range of originations for 2016. As shown on slide four, our new verticals started after January 1, 2015 contributed roughly $22 million of origination in the first half of 2015. In the first half of 2016, these same verticals contributed approximately $140 million of our originations, showing the growth of scalability of our new verticals. Total loans on book increased by 72% from $594 million in Q2 2015 to just over $1 billion. The held for sale category of loans declined $27 million from Q2 2015 as a result of the previously mentioned reclassification of unguaranteed loans. Loan levels also rose by 20% compared to the first-quarter balance. Of the $1 billion in loans approximately $660 million represents the unguaranteed portion of SBA loans and conventional loans, roughly a 70% increase over the second quarter of 2015. The weighted average interest rate on these unguaranteed loan portions was 5.6% as of the end of the quarter. Net interest income rose to $9.9 million, attributable to the growth in the loan portfolio and partially offset by a 26 basis point decline in net interest margin compared to Q1 2016. The margin decline is the result of our efforts to secure funding and maintain proper levels of liquidity considering our loan growth and plans for loan sales. Our recent success in raising funds affords us an opportunity to capture the long-term value of our loan originations. We settled $136 million guaranteed loan sales in the secondary market in Q2 flat with one year ago and a $20 million decline from Q1 of this year. The corresponding net gain on sales in the second quarter was $14.6 million or approximately $107,000 of revenue for each $1 million of loans sold versus $15.7 million a year ago at $115,000 per $1 million sold. As discussed earlier, roughly $38 million of sold loans did not settle by June 30 and are not reflected in Q2 sold volume or gain on sale revenue. The revenue associated with these loans which settled this month totaled $3.5 million. The note amount of our guaranteed loans held for sale, the majority of which are multi-advance loans that can only be sold when fully funded and excluding the previously mentioned $38 million increased to approximately $600 million from $430 million a year ago, a 39% increase. This increase in the note amount reflects the increase in our construction lending activities resulting in the growth of unrecognized revenue in our model which would exceed $60 million under the sale and service model, again excluding the influence of loans that were sold but did not settle in Q2. Loan originations have remained approximately 60% construction loans and we expect the backlog of construction loans to fully fund over the next 18 months. Overall, the secondary market remains strong on a historical basis. Pricing has remained fairly steady for the bulk of loans we sell. Low interest rates have kept prepayments low which increases returns for investors who pay a premium in the secondary market. However, we have seen some softening in investor demand for our five-year adjustable loans which negatively impacts the premiums received. Five-year adjustable loans cannot be pulled which limits who is willing to buy them. 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 $5.1 million for the second quarter compared to $53.9 million for the second quarter of 2015, a 31% increase. This servicing revenue arose from a weighted average servicing fee of 1.06% on $1.97 billion guaranteed outstanding in the secondary market. The servicing asset value at quarter end was $48.5 million after a revaluation adjustment of $1.6 million for the quarter compared to a negligible adjustment in the first quarter. The credit quality picture was exceptional in the second quarter. At quarter end the unguaranteed exposure of nonperforming loans and foreclosed assets was $2.6 million compared to $2.9 million at March 31, 2016. As a percent of total assets, nonperforming loans and foreclosures were 19 basis points, the lowest percentage over the past five quarters. Both the dollar volume of nonperforming loans and foreclosed assets showed improvement from the prior quarter. Further illustrating our credit quality improvements, we experienced net recoveries of $240,000 in the second quarter and have net recoveries year-to-date. As previously mentioned, the reclassification of unguaranteed loans from held for sale to held for investment resulted in a slightly more than $4 million increase to the reserve for loan losses. This increase was partially offset by improving credit quality. Also during the second quarter we enhanced the methodology for estimating our allowance for loan losses. This enhancement primarily included refinements to the measurement of qualitative factors. The result was a net provision expense of $3.5 million in the second quarter. Noninterest expense totaled $25.1 million in the second quarter. While this is a significant increase both year over year and quarter over quarter, the RSU awards contributed $2.2 million to the total for the second quarter. Adjusting for this expense, noninterest expense grew from $21.7 million in the first quarter to $22.9 million in the second quarter. Irrespective of the expenses associated with equity compensation to be incurred in the third and fourth quarters, we do expect to see some additional growth in noninterest expense as we have decided to bring portions of the legal process associated with our loan closings in-house and plan to staff for that improvement to the services we provide for our customer base. As you know, we only provide guidance on annual origination levels but, we’ll expand that this quarter to a few other key metrics to help you with your models in light of the strategic initiatives we’ve implemented. With a robust loan origination engine in operation we are excited to inform you that we expect our total loan originations in 2016 will be about $1.5 billion up from our original estimate of $1.35 billion to $1.4 billion. Our capital position is solid. This combined with our liquidity position and alternative funding sources gives us great flexibility in how we fund our existing businesses and consider strategic opportunities. With the growing strength of our balance sheet our move to begin holding portions of our guaranteed production has been made possible. While holding some loans on balance sheet we estimate $620 million to $640 million of guaranteed loans will be sold in the secondary market for the full-year 2016 and a total loan portfolio on balance sheet of $1.35 billion to $1.45 billion at year-end. With that said I will turn it over to Neil to elaborate upon some of our other opportunities.

Thanks, Brett. We continue to forge ahead in making Live Oak a truly digital small business bank both in loans and deposits. As you recall, we launched our e-lending initiative less than a year ago and it continues to hit the mark. To date we’ve executed hundreds of loans from click to close completely online. These are SBA 7a loans with an average loan size of a little over $200,000. While still early asset quality is pristine, demonstrating our use of both technology and traditional credit discipline. The product teams have been busy adding additional online loan products to the mix. The next few slated for release this quarter are SBA Express and Fast Fund Conventional. These products will allow us to compete head-to-head with the alternative lenders both in turn time and yield. On the customer acquisition front we are finding our vertical go-to-market strategy scales down to smaller loans, allowing us to take advantage of an already existing market footprint. On the deposits front we have had great success in the first half of the year, raising $310 million in funding completely online. Our Acorn initiative is on track and we are rolling out the first Phase 2 production on August 5. This will extend our online lending platform to include deposits functionality such as new account opening, transaction summary detail, account aggregation and categorization. We will continue to iterate this year and as previously committed launch the full suite in January 2017. It is important to note that this will include API banking functionality, allowing us to capture deposits through channels as well as direct. We’re excited about the progress we’ve made in the first half of the year and look forward to continuing the momentum in the second half. At this time we’d like to thank everyone that has dialed in for the call today. And we’d like to answer any questions that you may have.

Thanks, Neil. Before we go to Q&A I just wanted to direct your attention to slide six and a comment or two on operating leverage. At the top of the slide it says year-to-date 2016 revenue mature versus new verticals. Yes, we are extremely excited about the 29% increase in originations quarter over quarter 2016 to 2015 and yes, we are excited about the 22% increase in originations year-to-date 2016 versus 2015. But here’s what I want to point out, and we are not a traditional bank, notwithstanding some of the comments that you just heard. If you look at the left side of that slide, our more mature verticals, veterinarian, healthcare, pharmacy, death care, investment advisors, family entertainment centers and chickens did about $0.5 billion worth of originations. Our overhead to operate those businesses with a little under $12 million and those folks generated a little over $60 million in revenues. As excited as we are about the right side of that slide, our newer verticals, wine and craft beverage, self-storage, hotels, insurance agencies, government contracting and renewable energy, those folks did $140 million in originations compared with $20 million last year but generated only $4 million in revenues. So is the past a proxy for the future? We think so. Now do I think that the guys on the right are going to do $0.5 billion every six months? No. But at maturity is see the operating leverage of the business and as you compare that to a normal and customary traditional bank, let’s say at a 60% loan to deposit ratio, their only operating leverages maybe go to 80% and maintain enough liquidity to operate their business. So with that one point, we will certainly open it up to questions.

Thank you, ladies and gentlemen -- go ahead.

Sorry, Tyrone. I made a mistake. I would like for Steve Smits, our Chief Credit Officer, to comment on the very last slide.

Thank you, Chip. I’m very pleased with credit quality. The portfolio is on solid ground. First, our small business borrowers, they are doing very well. We collect quarterly financials from our small business borrowers. We analyze them on a quarterly basis and we update how they are doing. Our portfolio continues to see debt service coverage of over two times. So that’s really good thing. They are also paying their bills. I will make a comment that delinquency for us historically has been very low. It’s trending in the right direction and we actually ended the quarter with delinquencies, total delinquencies of one-half of 1%. So we’re pretty pleased with that, as well, so that’s evidence that our small businesses are also doing incredibly well. You can also see from this slide charge-offs. You can see the trends. We actually had a net recovery this quarter in charge-offs. But I will also add that since inception, we’ve only charged off 55 basis points, so we’re also very pleased with that from a portfolio perspective, as well. And then non-performing loans, you can also see from that chart how we’ve looked over the last year. And in terms of our non-performing loans and foreclosures it’s 19 basis points of total assets. That’s about 33 basis points when you look at the net portfolio as far as non-accruals, so again that’s also very favorable. Also I will add that the health of this portfolio really illustrates our discipline in the front side and how we underwrite our credits at the very beginning. But it also illustrates our continued commitment and diligence towards a very proactive servicing approach. So we can’t be lost in the importance of very proactive servicing that helps with the health of our borrowers and translates into a very healthy portfolio. So overall a really stellar portfolio, very pleased with the quality, Chip.

Okay. Tyrone, sorry. We’re ready for Q&A now.

[Operator Instructions] Our first question is from Aaron Deer of Sandler O’Neill. Your line is open.

Good morning, everyone. I’d like to start with a question on the decision to retain versus sell loans. Brett, you had mentioned that the premiums on five-year adjustable are down some. We didn’t see that necessarily evident in the loan sales that you made this quarter. But I’m curious to know how much of your decision to retain more loans stems from what you’re seeing in the secondary market and anticipated premiums versus just a decision to deploy more of your capital and grow your net interest income at a faster pace?

Aaron, this is Chip. Let me just make a comment on that and then turn it over to Brett. So specifically we’ve had great success in the chicken business and did a lot of fixed-rate stuff for five years, thought that if we moved to prime plus 2 over 20 years that that would be well received in the secondary market. It was not. Because those are annual pay we were getting somewhere in the $80,000 per $1 million range as opposed to if that was a vet loan or any of our other verticals at prime plus 2 over 20 years we would receive $120,000 per $1 million. So keep it. It doesn’t make any sense to sell it. And now, Brett, you can answer the question.

Yes, thanks Chip. Hey, Aaron. The first comment I will make is our reported gain per $1 million as you addressed, it doesn’t show there being any depression and gain on sale due to those fixed five-year loans. However, I would like to point out that the $38 million of loans that were sold that did not settle, bulk of those were these annual adjust, these fixed five-year loans. So those, that depressed premium, depressed gain on sale revenue was not reflected in that number, so that’s one reason that might look a little higher than what you would expect based on the comments that we made. Also that $38 million that got hung up across quarter end, four of those loans we’re still waiting to settle as of today. And then on the decision to hold, I would say that that’s not much different than the way we had felt since our inception. In the early days of Live Oak Bank we were actually a par seller of loans and we sold for excess servicing. That in itself was a more profitable business model in our opinion given the expected average life of our loans. However, due to accounting treatments we had to switch over to premium sales. So we’ve always believed in the quality and the tenure of our loans. And now with the capital raise a year ago combined with what we’ve been able to do on the deposit front, we feel like we have both the capital and liquidity flexibility to be able to maximize our earnings potential.

Okay, that’s helpful. Then with retaining more, and it sounds like more is going to be retained of the chicken loans and such, I’m curious to know how much of the HFI book today is construction and how does that impact your high volatility CRE as a percentage of your risk-based capital?

Brett, why don’t you take that, go ahead. Go ahead Brett.

Okay. So on the construction question, currently on book we have about $350 million of on book loan balances. That’s comprised of both SBA and a few handful of conventional loans. So that on book any portion of that that is guaranteed we still have coded as held for sale, so that would be about call it $250 million of that $350 million on book balance. The remainder of that would be unguaranteed and that is currently being coded as HFI. Does that answer the first part of your question?

You were talking there specifically about construction?

Correct.

Yes, then that does.

And then for us what we consider high volatility commercial real estate in that category, it would so sort of that same breakout between guaranteed which is coded HFS and then unguaranteed which is coded HFI now, that guaranteed portion carries a 20% risk weight and that unguaranteed portion carries the 150% risk weight during that construction period when it’s considered HVCRE. However, agricultural loans are excluded from that 150% risk weight calculation, so any portion of that construction portfolio, and as you know chickens or agriculture is a big portion of the construction that we do, those would be just given the 100% risk weight on the unguaranteed piece and then the 20% risk weight on the guaranteed piece.

Okay. And then last question for me, the reserve ratio HFI loans down to 177, if you continue to retain more guaranteed loans, is it reasonable to assume that that’s going to continue to drop further?

Steve, why don’t you take that one?

Yes, so a couple of comments on that. We did make some enhancements to our modeling which we will continue to do as we mature. But yes, we did pick-up on the loans that we did move over to held to investments are performing strong loans. And we really took those loans, dropped them into the model and the result of that as you can see. So I suspect we will continue to see actually that figure being consistent going forward based on what we see our portfolio doing.

Okay, but I guess just in terms of if you’re retaining, if what you’re retaining is more guaranteed I guess it would seem that that could trend lower. I’m trying to parse what you’re saying, when you say consistent going forward you mean consistently trending downward or consistently as in flat?

It would definitely be downward given that because we reserve very little for the guaranteed paper.

Thank you. Your next question is from Jefferson Harralson of KBW. Your line is open.

Thanks, good morning guys. So I just want kind of a concept check. So if we’re going to be originating about $375 million a quarter on the $1.5 billion estimate, just to use a regular number let’s call it $375 million a quarter, we’re going to be selling we think 20% of that $375 million or 20% of the 80% of the $375 million? And I guess I’ll try to get into how quickly this balance sheet is going to be growing. Are you going to be adding by my math maybe $300 million of loans onto the balance sheet per quarter or just can you help me frame how fast the balance sheet is going to be growing?

Brett, take that one.

Yes. Jefferson, we’re estimating that by year-end our total loan portfolio, so inclusive of what we have coded as HFI, what we have coded now as HFS, the construction fund up any loans that are going to be rolling off, we think our total loan balance at year-end is going to be between $1.35 billion and $1.45 billion. At the end of Q2 we were just a touch over $1 billion. So that’s $350 million to $450 million of growth in the next two quarters, over the next two quarters.

All right. So adding, so let’s call it maybe adding $200 million a quarter roughly possibly?

Yes, that’s correct.

And with that, so you have, I don’t know, so I guess that would take your TCE, you could do that for six quarters, maybe $100 million of excess capital or more, so that could possibly go six quarters? Is that, am I thinking about this correctly, how this, if you just ran this indefinitely, I guess you couldn’t really do this indefinitely with this amount of sales on capital, I don’t think.

Well, so what we’ve modeled and have become comfortable with given our internal generation of capital through retained earnings, we are currently comfortable with the 25% hold of what we feel is available or what we think is going to be available for sale in any quarter. So modeling it out, we’re comfortable with our current amount of excess capital plus equity through retained earnings that that’s an appropriate match for us.

Okay, I wasn’t doing the annual retained earnings in as of yet. On the SBA piece I guess on the chicken loans, the loans that aren’t getting a good valuation, your losses are relatively low. Would you contemplate actually adding doing these loans as not SBA loans and just adding these to your balance sheet as a small business loan that is not an SBA?

Maybe; I was just looking. Our total construction portfolio today is $860 million and the chickens are $359 million of that. And it does get a little messy, so you’ve uncovered the fat underbelly of daily discussions. So my official answer would be maybe.

Okay. I had one more but I can’t think of what it is right now, so I’ll get back into queue. I appreciate it, guys.

Next question is from Doug Mewhirter of SunTrust. Your line is open.

Hi, good morning. I just had a few follow-up questions. First, with your loan origination guidance that you just bumped up, which is obviously very impressive, have you considered the current overall industry capacity for 7a loans? I know that I think in the fall it has to get re-upped every year because the industry is growing so fast that it hits federal limits. I don’t know if you had, what your level of comfort that you will have enough headroom to grow into that this year, for this fiscal year rather.

Doug, that’s a really good question. And I would say having met with 41 senators and congressmen over the last 12 to 18 months that the small business administration is as well placed politically as it has been maybe ever. We are quite fortunate that Steve Smits, our current Chief Credit Officer who you heard from a minute ago, is the former head of the Office of Capital Access. So that’s really the position that runs the agency certainly the administrator is a cabinet level position, mainly a political position. But the person that runs the agency is in that seat which Steve had. So Steve, why don’t you comment on Doug’s question?

Yes, Doug, thank you. This is Steve. So when I headed up the Office of Capital Access a number of years ago I will say that it was almost a daily job of mine just to stay in touch with the legislators and work with the agency. And typically the SBA has always been a very good place in a non-partisan way. It’s a unique year this year. I will say that it was evidenced with the increase in the program last year to $28 billion which I think speaks to the commitment from our lawmakers on this program and the good that it does. So we feel pretty good about it. We know that there’s, we all know a lot is happening this year and we stay in touch with it and watch it. But we still feel very, very good. We had very good conversations on Capitol Hill and with the agency, as well, that we feel pretty positive in the direction that it’s going. That’s about as much as I can add.

Okay, thanks. That’s a very helpful answer. I had two follow-up kind of technical-type questions. First, Brett, just a classification question more for my education. When you have, when you originate a construction loan can you, and let’s say as soon as you originate you decide that you want to, you’re going to end up retaining it even though it’s guaranteed. As that loan funds, can you only move it to held for investment until it’s fully funded or can you put whatever value it’s marked at held for investment if you decide to hold it on your balance sheet from the start?

So I will break it up into two pieces. I guess the first piece, in the construction portfolio consider we have a conventional loan in there, non-SBA loan. Given our recent strategy change on unguaranteed which would apply to conventional loans as well, that loan would be categorized as HFI from the day the note closes all the way through the construction period that the funds advancement period and remain held for sale after that. Considering a 7a loan you have the guaranteed, unguaranteed portion. That unguaranteed portion now is going to be HFI. We do not have the intent to sell those any longer. The guaranteed portion is classified as held for sale. Primarily that is a function of our determination on a quarterly basis what the most appropriate loans are for us to hold within that quarter. So it’s not, so the intent is to sell those based on that ongoing analysis of what it makes sense to hold. And I think one point of clarification that I should make and this relates back to Jefferson’s question a little bit. So in any quarter what becomes available to sell, meaning the loans are fully funded or have rolled out of the construction phase so that they are able to be sold, we are selling 75%, a proposed roughly 75% of that amount and holding 25% of that amount. What becomes available for sale, not everything that is available for sale.

Okay, that actually makes sense. My last question again it’s a little bit more in the weeds maybe, Steve can answer it, about credit. And you’ve had some pretty impressive credits statistics, although have you looked, I’m sure you have, but what does the vintage the recent vintage performance look like? Because obviously you’ve had the denominator on your calculations, charge-off calculations is increasing very rapidly. So I was wondering if the more recent vintages seem to have very similar early delinquency stats as your more seasoned vintages?

So Chip, do you want me to handle this? This is Steve.

Yes, please do.

Actually very good. I slice and dice and dig and dig and you’ve hit on something that I focus on very closely. And I focus on the watch list because our watch list would be an early indicator of some stress even before. And what is important to point out on our watch list is we’re a little different. We are very conservative. We place things on watch early and it takes a long time for us to pull them off. So what’s interesting is my risk grade thoughts if we’ve got an eight-stage, so those are really the watch credits, 98.77% of them are not past due on payments. So, we’re putting them on there, early for all kinds of things. A lot of this is construction delays or we’re not seeing the sales that they expected to see. What I will say is that the vintage loans are performing very, very well. So I don’t see any early indicators that would give me pause. I also, it’s amazing but it lines up where as I look at our watch list the category of type of loans that we’re watching closely tend to be expansion projects. And the interesting thing about it is the expansion loans while we put them on watch, they actually have really strong success stories. There are very, very few actually end up being charged off. So that proves that actually when you watch them closely, you put some training wheels, you stay in touch with them they tend to actually do very well. We see the same thing also on the more recent vintage years. We’re seeing more of the expansion projects and these are unforeseen delay in construction or extra cost overruns or capitalization. So if I say anything out of all of this digging is that we take a hyper focus on making sure that our small business borrowers are appropriately capitalized out of the gate. Because that seems to be the area that we do see. It has nothing to do with the core business or metrics or their business plan. It seems to making sure that the projects have the proper capital necessary to get them through the ramp-ups. But, again, it looks pretty favorable. In fact, my watch list is growing at a slower clip than the portfolio is growing. So I do track that very closely, as well. I look for anything that is going to give me a little forward indication of what’s going on with the early loans.

Thank you. Next question is a follow-up from Jefferson Harralson of KBW. Your line is open.

Thanks. I have two questions. One is you guys mentioned that you are transitioning morphing into a national small business bank. I feel like there is a lot of things maybe going on to create that. I know you hired the gentleman from BHG recently. So can you maybe talk about the things you would need to do to make that morph, to the extent you’re ready to disclose them, to make that morph happen? And also I know it’s not happened yet but can you comment on the audit that is coming from the SBA on the chicken loans and if that’s having any impact on your business? Thanks.

So Jefferson, two really great questions. Steve can certainly comment on the chicken audit first. Neil, as he does that, why don’t you contemplate what fundamentally is the complete build-out, open API, next-gen, fully digital small business bank that you’ve been working on for some time. And in so doing, I know you touched on this in your canned comments about the e-lending piece which has been in the marketplace for roughly a year, but let’s complete the cycle on the liability side of the balance sheet. So Steve, why don’t you take the IG thing?

Okay, so just for folks on the call what that is in reference to is the Office of Inspector General that lays out their agenda over the next quarters or year. One of the areas that they are going to look at is the poultry industry. And, of course, us being the largest participant in providing SBA loans to poultry industry. That would certainly be something that we would be focused on. We’re very comfortable. We’ve got a great relationship with the agency. We’re very proactive with them. Communication chain is great. We have had audits and they have all been stellar. So we’re very, very comfortable with what we’re doing. So we would expect when you see a new lender enter a space that that would be something the IG, if I was with the IG I would also want to take a look and make sure that what we’re doing is meeting the spirit of the program and following the rules. So we do welcome that. It’s, again, we’ve had no communication with the IG but we’re certainly willing to provide and we actually sometimes like to because we’re pretty proud of what we’re doing. So, again, not to be unexpected, it makes perfect sense when you look at a new player for a particular industry with a program that they should take a look at that. And we’re more than willing to look at that and again we’ve never had issues with our compliance and feel pretty comfortable on that front.

And the next question, hey, Jefferson, how’s it going. Neil here. So it’s a pretty tall order to say we’re going to be the nation’s premier small business digital bank. So I will break it up into two pieces, loans and deposits and a little history here. You guys recall that last year we rolled out our e-lending product and as I said earlier that continues to grow and meet expectations. We think it will probably beat expectations when we continue to roll out the next new products, as I mentioned Fast Fund Conventional. And you hit it on the head, the BHG resource is going to be the first of many new hires on that front to really build that out. Kind of higher-yielding conventional products. And the exciting thing on the deposits front is effectively leveraging the digital platform to offer up things like we said which were new account opening, account aggregation, categorization but the most important thing is how we’re offering it up. Obviously going direct to our small businesses, our 4,000 small businesses and growing is a key part of that strategy. But really looking at channels, new channels, think of white labeling deposit services through channel partners, we really think we can get some economies of scale they are both in deposits and incremental fee-based income. So it’s easy to go after 4,000 vets, dentists and pharmacists but if we go after one channel partner that might have 1 million customers because they have the desire to leverage our API structure that we think can be a pretty massive accelerator. So that’s what we mean. Do you want to add anything to that?

The only thing I would add to that is, Jefferson, it is not lost on us that we have loans to 900 veterinarians and there are 80,000 of them. So the Veterinary Information Network is a kind of Facebook for vets, you’ve got to be a vet to sign on. So once we launch the full suite of deposit products we will market to those folks that don’t need to borrow money inside our verticals.

All right, that makes sense. I could think of a lot of different companies that would be interested in I think white labeling that type of product. It sounds pretty exciting. All right. Thanks guys.

One example, by the way, as you are out there looking at it, just real quick, Fidor Bank did a deal with Telefonica in Germany that really interests us. And we’ll have that kind of capability. So dig into that one a little bit.

Thank you. This ends the Q&A portion of today’s conference. I would like to turn the call over to Chip Mahan for any closing remarks.

Just want to thank everybody for participating. Sorry, we went a bit long this time and hopefully next quarter we will have less moving parts. Thank you very much.

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may now disconnect. Have a wonderful day.