Live Oak Bancshares, Inc. (LOB) Q4 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Live Oak Bancshares, Inc. Fourth Quarter 2016 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 follow at that time. [Operator Instructions] And 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 of Live Oak Bancshares. Sir, you may begin.

Thank you and good morning, everyone. Welcome to Live Oak's fourth 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 fourth 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. We are going to go through a couple of slides this morning. I will start on the slide that say, what we are excited about. And let me tell you what I'm excited about. Let me unpack this for you, it's not only 2016, it's really what's happened over the past couple of years. So, in 2014, we did about $850 million worth of originations, we are in the origination business issue. We did a $1.537 billion, so we almost doubled originations last couple of years. Net interest income almost tripled from $15 million to $43 million. Servicing revenue last 24 months was up 60% from $13 million to $21 million, so recurring revenue over doubled from $28 million to $64 million, while our net gain on sale dollars were up 50% from $50 million to $75 million. So our core business, net recurring revenue plus gain on sale dollars almost doubled from $78 million to about $140 million. Now let's look at expenses. I have taken out of expenses non-operating stuff like non-recurring executive comp, a loss of about $1.5 million on an airplane, and so you can see if you look at just the core earnings of the business, the past 24 months, we're up 64% from about $28 million to about $46 million. I'm really excited about that. It should not be lost on those on the call that at 12/31/2016 we had about $100 million of fully-funded government guaranteed loans on book, that is a 20% risk-weighted asset and further diversification of the model and creating more recurring revenue. I am now moving to the slide that says renewable energy. I want to talk about that as we did on the last call, but just a minute before we go back to the operating leverage of this business. We learned in January of last year that surprisingly the United States government extended the investment tax credit for solar energy. So, we got in to the business. We now do small size utility scale solar facilities. These are 1 to 25 megawatt projects. So in terms of dollars, that's $1 million to $5 million. The off-taker is an investment grade utility. That's good news or bad news? Good news, credit's great obviously, the rate of utility, lower interest rates, which mean lower gain on sale of dollars and lower premiums which Brett will touch on a bit later. The other good news is, all the power revenue flow through our bank. So, we kind of go where it's messy, right. This is not the SBA, this is not 7(a), this is United States Department of Agriculture and a little known, what they call the REAP Renewable Energy for America Program. These loans are 70% to 80% guaranteed by the United States government. We were excited that we did about $100 million worth of business in Q4. You should not model that, this is a bit of a food fight in this business at the end of the year as people rush for tax credits. So, we do have a robust pipeline and once again we're excited about the diversification. I'm now moving on to the Slide which say, Live Oak clean energy financing, which is kind of an extension of that knowledge base. So, we've formed a sub at the holding company. We have not been a very efficient relative to paying taxes over the last 8 years at Live Oak Bank. We are a 41.5% taxpayer. 35% of that goes to the United States Government. So, as we got into this business, we thought, well maybe we could help our chicken farmers, maybe we could put solar panels on all the chicken houses of our chicken farmers. Regrettably, in the Southeast, power is cheap, so upon further research, we found out that power is not cheap in the Northeastern part of the United States, so we have a very robust pipeline of putting our panels in the northeast and selling that power to municipalities. So, again a rated utility so to speak or municipality and full face of credit means the asset quality is stellar. Once again model diversification. So, back to the origination business on the next slide, record loan originations, so let's look back five years and see where this business is, coming to 2012 we did $400-ish million in originations and this year a bit over $1.5 billion, so almost quadrupled the business, yielding a 39% compounded annual rate of return. So, how did we do in terms of originations as we broke out last time kind of the old guys and the new guys? So, the legacy verticals will include the best vet space, healthcare which is mainly dental, loans to dentist, independent pharmacist, funeral directors, investment advisors, family entertainment centers and chickens. So, those guys did about $1.1 billion in originations. The new guys; wine and craft beverage, self-storage, independent insurance agents, hotels, renewables which we just discussed and government contractors did almost $0.5 billion worth of originations. Moving on to the leverageable side, let's look at the facts. So, the facts are, the old guys generated about $128 million with revenues on $23 million worth of expenses. The new guys just continuing to get started generated only $17 million worth of revenues on $9.4 million in expense. So, is the past a proxy for the future? If I look at the new guys, can they do $1 billion worth of originations at cruise altitude? Maybe, probably not, but close. So, that would be exciting if they did. One caveat there is, two of the stellar performers in that group, hotels and self storage, take a while between 2.5 and 3 years to monetize that asset, once you factor in permitting and construction and lease-up and all those sorts of things. So, I guess the bottom-line before I turn it over to Neil to talk about technology in the deposit side of our balance sheet, we are comfortable next year with $1.8 billion to $1.9 billion. That's my understanding that analyst estimates are about $0.90 and we're comfortable with that as well for 2017. Neil?

Thanks Chip. Quick deposits update for you. I'll be referencing the slide titled robust new deposits generation. We closed up the year very strong over $500 million in net new deposits and a blended cost of funds of 113 basis points. Most notably, in Q4 we released our new deposits platform to production. As December of last year, all net new deposit customers are now enrolling online and with the new technology. We will continue to launch additional services to production from pilot throughout the first half of the year, including API-enabled features, such as business money market and business checking. Brett, over to you.

Thanks Neil, and thanks everyone that's dialed in this morning. You may recall in the third quarter earnings call, we had now a record setting quarter for loan origination of $381 million. We are very excited that we set a new record in the fourth quarter of $515 million, a 35% increase over third quarter 2016 and a 56% increase ever fourth quarter 2015. As Chip referenced, this linked quarter growth was driven largely by entrance into the renewable energy space with the utilization of the USDA loans program for solar farms. For the quarter, our recent decision to reduce volatility and create more predictable and longer term revenue streams by retaining more loans in the balance sheet was once again on display. Our recurring revenue sources of net interest income and servicing revenue increased to $18 million, a 40% increase over the same quarter a year ago. The net interest income component of our recurring revenue stream for the fourth quarter increased $4 million from the same quarter one year ago to $12.4 million, a 46% increase. This increase was driven by a significant growth in total loans of 71% over the fourth quarter of 2015, to a yearend amount of $1.3 billion, but revenue growth from increase loan balances was mitigated by the yield on loans in our renewable energy vertical, which is substantially lower than our historical and other new vertical. Of the $1.3 billion in loans just under 67% is represented by the unguaranteed portions of SBA loans and conventional loans, not too dissimilar from the mix at yearend 2015. Our net interest margin declined to 3.08% in the fourth quarter largely due to the growth in renewable energy loans which typically carry a lower rate. Cash balances normalized in the latter part of the fourth quarter as the excess funds raised in the third quarter, we'll put to use as plan to support record loan origination. In light of our initiative to hold more guaranteed loans on book, we still had a record quarter for guaranteed loans sales of $260 million, compared to $220 million one year ago, thus providing cash to fund lending activities in addition to new deposits gathered. This was largely driven by the production within the renewable energy vertical. For the year loan sales rose 19% to $762 million exceeding our previous target of $700 million to $725 million. The net gain on sale of loans in the fourth quarter was $22.5 million or approximately $87,000 of revenue for each million dollars of loan sold versus $20.8 million a year ago at approximately $95,000 per million sold. The premium and consequently the gain per million, declined from Q3 2016 and from one year ago, primarily as a function of the introduction of renewable energy loans, which comprised 23% of the sold volume in the fourth quarter and received a net gain of sale in the lows 50s per million dollar sold. This is obviously different than secondary market premiums received on our other loans, but not unexpected as indicated in our comments about these loans in the third quarter earnings call. The premiums were however lower than we anticipated, but do not in anyway, undermine, the financial benefit of our entrance into renewable energy lending. This vertical operates more sufficiently with a very low expense base required to support it and generate large volumes of loans with a very high origination amount per loan. Additionally, we fill our knowledge and experiences in this industry, will provide us with other profitable avenues to bolster the bottom line of the company, such as the solar tax credit investments the Company made in the fourth quarter that netted at $0.06 per share gain. Another notable benefit of the anticipated 2017 volume of renewable energy loans, is its positive impact on the overall percentage of loans that fully-fund at closing. Our recent communications to you have been that approximately 40% of loans originated with fully-fund at closing, which make them immediately eligible for sale. In 2017, we forecast an upward shift such that approximately 50% to 55% of production with fully-fund at closing. The servicing revenue from our sold loan portfolio increased to $5.7 million for the fourth quarter compared to $4.4 million for the fourth quarter 2015, a 29% increase. This servicing revenue arose from a weighted average servicing fee of 1.04% on $2.2 billion of SBA guaranteed dollar outstanding in the secondary market. USDA secondary market sales resulting from our renewable energy vertical contributed minimally to the fourth quarter servicing revenue due to their newness and a 40 basis points servicing fee compared to the standard 100 basis points of servicing fee for SBA loan. The total servicing asset value at quarter end was $52 million after revaluation loss of $3.3 million for the quarter compared to a $3.4 million loss in the third quarter. Annualizing the fourth quarter's net charge-off of $813,000, results in a 39 basis point of loss rate on the average loans held for investment in the quarter. This is a decline from the third quarter ratio of 51 basis points. At quarter end, the unguaranteed exposure of nonperforming loans and foreclosed assets was $5 million compared to $3.7 million at the end of the third quarter. As a percent of total assets, nonperforming loans in foreclosures were 29 basis points, representing an increase compared to our prior fourth quarter average in the late 20s. The credit performance and growth in the portfolio resulted in a provision expense of $3.8 million in the fourth quarter, well above net charge-off levels and unchanged from the third quarter's provision expense. Non-interest income totaled $32.4 million in the fourth quarter, the special RSU awards referenced in our earnings release and in past earning calls contributed $3.4 million to this amount, and was the last charge of this magnitude associated with these specific awards. Two other non-recent expense transactions in the fourth quarter worth noting are the impairment loss on one aircraft of $1.4 million, which was sold this month with no additional losses incurred and a $3.2 million impairment loss on renewable energy tax credit investments of $4.6 million in the fourth quarter. Investment of this type, generate a return primarily through the realization of federal and state income tax credits and other tax benefit, and as a result impairment of the investment amount is recognized in conjunction with the realization of related tax benefit. This investment generated $5.5 million in tax savings for 2016, and resulting impairment loss for a net benefit of $0.06 per share in the fourth quarter. There will be a final loss net of additional tax benefits taken on the investment throughout 2017 of approximately $660,000. Again, our involvement in the renewable energy space opened up this opportunity for us to leverage our lending expertise and underwriting. With the adjustment for the special RSU expense in both the third and fourth quarters of $3.4 million, the tax credit investment write-down and the impairment loss for the aircraft, non-GAAP adjusted non-interest expense grew just over $500,000 from the third quarter, a modest increase given our growth and supportive of our previous quarterly comments, that expenses incurred in these quarters were to build infrastructure for expected growth and new initiatives. We do expect to see growth in non-interest expense in 2017 as we continue to bring portions of the legal process associated with our loan closings in-house, as well as other activities to streamline the loan closing process. Our investment in new verticals in 2017 and ongoing technology projects. All-in-all, we are very pleased with the solid performance in Q4 and 2016 as a whole. We look forward to a strong 2017 with loan and lease origination in excess of $1.8 billion as Chip referenced and capitalizing on all the opportunities afforded us by our unique business model. We'd like to thank everyone that has dialed in today and will entertain any questions you may have.

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

Hey good morning everyone. Chip you mentioned with the solar that is part of your interest in getting into the business was the expansion of tax credit. How long is the extension on that, and is there any risk that that could be eliminated by executive order?

You know that's a really good question, and I asked that myself yesterday and I was yet to have the answer. The answer to your first question is 2021, and I do not know whether it's an act of Congress or an executive order, that fact it would go away. We should research that.

Then on the gain on sales, I was wondering, Brett maybe if you could give us kind of a breakout in terms of what the premiums were in the quarter between the USDA versus what premiums were on the SBA and if there were any other factors just in terms of the secondary market demand or the types of loans that were sold in a quarter that changed from prior quarters, just some of the different moving parts that were in there?

Sure. So, UDSA loans have originated in the renewable energy vertical. Those – that gain on sale was in the low 50s, between 50,000 and 55,000 for every million that was sold. And those loans, they typically get a lower rate and they are also for the most part five year adjustable, or as we call them internally fake five [ph]. Also the USDA market, secondary market is quite a bit smaller than the 7(a) secondary market, so size also impacts the premiums as we want to receive. The 7(a) secondary market, the average gain on sale there was in the mid to high 90s, so slight drop from Q3 above was higher than Q4 of 2015. There, for the most part, there is – in the fourth quarter of any year and then especially in December of any year, premiums do go down towards year end. We did have a lot of sales that occurred in December. I think that is part of the reason that 7(a) loans were in the mid to high-90s rather than low-100 that we had been seeing. Related to the rate increase that occurred in December, for the most part heading into December, anyway maybe early in Q4, we did so like people started adjusting or buyer starting adjusting a little bit for that that, fed move. So we think all that played into the premiums we saw in Q4.

Then with respect to the tax credit investments, Could you give – it sounds like you gave a number with respect to maybe what the amortization or the operating cost of that's going to be in 2016 or in 2017 as well as the tax benefit that you might expect to realize that might still be available too?

So I think there is a little confusion there. I think what you were saying was, that the renewable energy lending division is very efficient in terms of number of folks generating high quality paper. That's the lending division. The sub at the holding company that's in – we are going to actually lease panels is something entirely different. But we also think that will be very efficient from non-efficiency standpoint.

But I think Aaron, were you referencing the investment type credit that we…

Yes.

Net of the $0.06 per share? Yes. So, the tax benefit on that has been realized. It was realized in Q4. There is an additional expense that we will take in 2017 and throughout the – for the full year that expense totals, is roughly in the $650,000 to $660,000 range. We have not yet determined how that will be spread out over 2017. We have two different accounting approaches that we're looking at, could be that a large amount was taken in Q1 and then smaller amount in Q2, Q3, Q4, or it could be – but it's a relatively small amount in the scheme of things.

And do you anticipate, spinning any more of these tax advantage strategies?

Not right now, not of this type. We felt like it was a good endeavor or good thing to do in Q4 as it rounds out a lot of our thinking in the renewable energy space, but…

We won't need to, because the leasing company is going to do fine.

Thanks for taking my questions. I'll get back in the queue.

Thank you. And our next question comes from the line of Jennifer Demba of SunTrust. Your line is now open.

Thank you good morning. Two questions, first, Chip have you, has Live Oak gotten any benefit from the reputational damage at Wells over the last several months? Can you see the tangible benefit there on the SBA 7(a).

No. I would say no. I mean you know Wells is the number one SBA lender in the country, we're two. I don't think it's highly likely that we will pass them in the not too distant future, but… No, their business model is for their SBA lenders to healthy input print lender so to speak, so very different from the theory of verticality that we adopted. So, I really don't see anything. Neil, do you?

Hey Jennifer, no, I really don't. I think any of the growth that you see is based upon all of our organic endeavors and really hadn't seen us fight to that market situation.

Okay. And second question, in terms of the newer verdict, you've given us some loans origination guidance for 2017. How do you think the mix of loans is going to change versus – by vertical versus last year?

You know I think that the new guys are at cruise altitude so to speak. So, I see them remaining in that area of $1 billion, maybe a bit more as we say last year. And as we look at the newer folks, you know as I said, you know can they get to $1 billion? Maybe, you know I don't know how to really handicap that, but you know some of those folks are doing better than others, and there is some cyclicality in our business. Couple of years ago in the chicken business we did almost $400 million and you know in 2017 that number is going to be substantially less than that. We always get our share, but that is a highly cyclical business. I don't know, Neil, you got anything to add to that?

No, it's tough. I get your question, it's a good one. At some point in time maybe we look at a vintage type scenario, but for now we haven't done an analysis on a vertical by vertical basis of it, but the difference is – but Chip's point is, when you are in 15 verticals or growing – and growing, you've got pretty good diversities. You can take advantage of being cyclical over here by adding to some of our verticals are actually growing pretty significantly as well. And it derisks the numbers that we provided in the growth.

And I think just on that, I forgot to mention this, just real quick is, we paused, because I think we needed the pause after we started four or five new verticals and we're going to step our foot back on the gas this year and looking at two plus verticals, one of which we've already decided which is early development child care. There are many SBA lenders in that space, but there is no body as good as we are in terms of speed and taking care of the customers. So, we're pretty excited about that business.

Can I ask one more question?

Sure.

So you sold an aircraft, did you replace that?

We are in the process of doing that. We intend to keep – we're in the aviation business, we tend to keep three planes in the air totaling 600 hours a year. If you are making $1.8 billion in loans, so that's 150 loans a month-ish at $1 million each, and we have our folks to see every single customer and present that loan-to-loan committee.

Okay. Thank you.

[Operator Instructions] And we have showing a follow-up question from the line of Aaron Deer of Sandler O'Neill & Partners. Your line is now open.

Thanks for taking the additional follow-up here. Question on the compensation, as you look into 2017, I guess on a core basis, we ended last year at just close to about $14 million on the run rate for comp. As you look at kind of your new hiring that you might be doing in some of the new verticals, where do you see that line going?

Brett's thinking about it.

So, I would say with our addition of two new verticals, some of the items that we have planned, especially on the development side related to our deposit platform and further building out this end-to-end digital experience for our customers, that's deposit customers and loan customers. There will be a rise in non-interest expense. I mean well in non-interest expense and also base salaries, I'm very hesitant to give a number to guide to. I would say net of any stock compensation. You'd probably see a similar rise in base salaries as you saw from the end of 2015 to the end of 2016. We have a forecast for the number of people that – or the number of FTE that we believe that we will add in 2017, it's slightly or it's pretty much in line with what we added over the course of 2016 given some of the growth initiative that we have.

That's helpful and then, following onto that, Neil, maybe you can talk about the deposit initiative and maybe what kind of expectation you got for the deposit inflows that that might drive here in 2017?

You know we're going to keep a close eye on the cost of funds at 113 basis points and try to implement as we roll up, this is checking, implement that to our current customer base as well as expand it in vertical. You know, when you run the numbers, we have 4,000 growing to call it 6,000 on average account basis of 10,000 to 20,000, even still it doesn't put a dent in fully-funding the bank if you originate the $1.8 billion. So, we are looking at a channel strategy on the deposits fronts, and you probably read about some of this, where invested case study I can cite would be Silicon Valley and Stripe and you know the number of net new accounts that are opened, vis-à-vis Silicon Valley and Stripe relationship far outweigh perhaps some of the ones that are direct. So, we are – we have as of mid-last year to keep four hire sales team to go out and interact, we've got a nice pipeline, not ready to announce it yet. But in that case, and I'd actually send you to the Capital One site, they have rolled out a beta program on API banking. I'm glad that they've done it. I would like to have been first, but I'm glad they've done it, because it actually demonstrates the market a bit. So, we'll be rolling that out in the first half of the year as well.

Good stuff. Thanks guys. Appreciate the time.

Thank you. And I'm showing no further questions at this time. I would now like to turn the call over to Mr. Chip Mahan for closing remarks.

No closing remarks. Thanks for joining everyone and talk to you next quarter.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.