Live Oak Bancshares, Inc. (LOB) Q1 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Live Oak Bancshares, Inc., First Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct the question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this call is being recorded. I would now like to turn the call over to Greg Seward, General Counsel. You may begin.

Thank you, and good morning, everyone. Welcome to Live Oak's first quarter 2017 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 first 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 excited about 2017 and we're particularly excited about Q1, which is historically a slow quarter for us. Originations this year were up 65% year-over-year, $285 million in 2016, $469 million in 2017 and we did these through new verticals, new products. We are no longer a one-trick 7a pony; we are now in the 504 and USDA business. And we also acquired a new business, a title agency in St. Pete, Florida that helps us close loans faster. We're very excited about our renewable energy business. We got into the lending business last year; we did $100 million in Q4, and that gave us the knowledge to get in the investment tax credit leasing business. We have been a 41% taxpayer since inception and this fundamentally is a means to an end. This allows us to continue to make the after-tax dollars that we've talked about in the past, while building a portfolio of 7a guaranteed paper. We affectionately call this the treasure chest at Live Oak Bank, giving us more and more recurring revenue. So this year, internally, our recurring expenses will exceed recurring revenue by about $47 million, and over time we would march to parity there, all of which allows us the flexibility to fix the problem, build-out a next-gen fully digital experience for the 28 million small businesses in this country. Moving on to Slide 4, we have said since inception that this is a 15% year-over-year growth business. We've been fortunate the last five years to exceed that at 39% and certainly Q1 was phenomenal. Moving on to Slide 5, we'd like to talk about the operating leverage of this business, and let me just take a minute and focus on that. So the legacy verticals, which we call in this Slide 5 1.0, generated $256 million in originations, I will remind you they did $1.1 billion last year, as steady as she goes there. 2.0 did $194 million in Q1 versus $441 million for the year last year. I will remind you that self-storage is a delayed monetization at about 2.5 years and hotels, the same; some of that is 7a, but again mostly 504. Moving on to Slide 6, focusing again on the operating leverage, the 1.0 group generated $32 million in revenues. This would include total interest income, gain on sale dollars, servicing income versus an expense base of about $6 million. Compared to the 2.0 group – again, fully baked overhead at about $3.5 million, so more efficient than the seven legacy verticals, but generating only $11 million in revenues, which we expect to grow dramatically as some of those projects complete. And so moving onto Slide 7, what is the object of the exercise? That is, as we say, to treat every customer like the only customer in the bank, and for these last seven years, writing code on the force.com platform and partnering with our sister software company nCino, we think we have largely solved that, solved the approval process and the funding process in a fully digital manner. And we must keep that franchise in place and continue to grow it, and we're excited about the addition of Scott Custer to do that. Neil then needs to move on and is moving on daily to solve the problem on the right side of the balance sheet, and this is infinitely more complex as we rely on legacy software companies and partnerships that must be carved in order to achieve the end game. So, Neil, over to you.

Thanks, Chip, and good morning, everyone. We're excited to formalize what really we've been doing at Live Oak Bank for some time. Chip just shared with you the nCino story. Live Oak Bancshares will continue to make minor investments in companies that solve the problem. We're going to be doing this with a strong investor ecosystem, the very sophisticated folks like Insight Venture Partners, First Data, and even partner banks that also share the vision that Chip just outlined. These companies will have common characteristics, things like proven leadership. That's perhaps the most important one. Folks that have done it before, been there, done that, and have actually created companies and either sold them or taken them public. They will also share open API-based architectures, as well as be deployed on new cloud operating systems, such as force.com and AWS, and the benefit of that is a lower total cost of ownership by orders of magnitude. As you'll see on Slide 8, we've outlined some of these companies, and these have been in the filings, but the Company like DefenseStorm, we invested about $1.5 million, have about a 9% equity stake, about three years ago and this is a big data meets cybersecurity company, all around loss prevention. As of December, we closed down on around with Finxact, backing the Sanchez brothers, Frank Sanchez, formerly of Sanchez Competing, which sold to FIS to focus on a core banking system all on the AWS platform. So in closing, relative to Live Oak Bancshares, all these will have minimum balance-sheet impact, but are massively strategic, and our plan is to become a nationwide fully digital business bank. Brett, over to you.

Thanks, Neil. Good morning, everyone. We are very pleased with our first quarter earnings of $0.17 per share, which also included $0.01 per share of M&A expenses related to RELTCO. It was a well-rounded performance across the board. Our originations and loan sales were very strong, coming off record-setting fourth-quarter volumes. We closed out the first quarter with $175 million guaranteed dollars retained on the balance sheet as part of our strategy to build our loan portfolio. Consequently, our recurring revenues have increased substantially. Our net interest margin rose sharply, by 68 basis points over the prior quarter, due to the repricing nature of our loan portfolio and the profitable redeployment of excess liquidity. Our effective tax rate for the first quarter came in at 11.5%, significantly lower than our historical rate of 40%-plus. Due to our success in the renewable energy space with solar panel lease originations of approximately $19 million, I'll speak more to that in a moment. As Chip referenced, we historically experience a decline in originations in the first quarter of each year. The falloff this year was less dramatic, with production declining just under 9% from record Q4 production to $469 million, which was 65% above the prior-year level. As mentioned, we continue to employ our strategy of holding more fully funded guaranteed loans on balance sheet to reduce volatility and create longer-term revenue streams. You can see in the selected financial data section of our earnings release that the guaranteed portion of loans held for sale, based on the net amount, grew to $866 million in Q1, compared to $542 million one-year ago. This value includes our construction loans, which cannot be sold until disbursements are complete. Our total loan portfolio grew 78% in the past year to $1.5 billion, providing meaningful recurring interest revenues. Our combined recurring revenue sources of net interest income and servicing revenue increased to $21.6 million, an increase of nearly 60% over the same quarter a year ago. Net interest income grew by 80% over the prior-year quarter to $15.6 million as we successfully deployed excess liquidity and enjoyed increased spreads on our variable-rate loans. This resulted in our net interest margin increasing to 3.76% for Q1. Recall that more than half of our loan portfolio re-prices on a quarterly basis using the prime rate. The rates for interest-bearing liabilities are relatively stable from the prior quarter. First quarter servicing revenue from our solar blend portfolio increased to $5.9 million on $2.4 billion of SBA and USDA loans outstanding in the secondary market. Recall that sold USDA loans carry a 40 basis point servicing fee compared to the standard 100 basis points for SBA loans. The total servicing asset value at quarter end was just under $54 million after a revaluation loss of $2 million in Q1, which was less than last quarter. Loan sales totaled $208 million in the first quarter, compared to $156 million a year ago. The net gain on sale of loans was $19 million or approximately $91,000 of revenue for each million sold. As we discussed in the last call, the sale of the guaranteed portion of USDA loans results in premiums lower than our historical SBA loan sales averages, largely due to their comparatively lower yields. Despite this, we consider this a high-return asset as a fully funded closing and can thus be sold immediately and also come with a guarantee. In the first quarter, approximately 30% of the loans sold, or $61 million, were USDA loans and received an average net gain on sale around $70,000 per million sold, showing substantial improvement over the average premium last quarter. The prime rate change last December did not significantly impact the premiums in the secondary market during Q1, as it had been well anticipated. Similarly, we believe the March increase will have very little effect on market pricing in the second quarter as it was likewise baked in. Recall our mix of loans sold, fixed versus variable, currently have the greater impact on our gain-on-sale margin than does market pricing. Turning to credit quality, net charge-offs of $1.5 million resulted in an annualized 63 basis point loss rate on the average loans held for investment in the quarter. This is an increase from the fourth quarter ratio of 39 basis points, but overall credit quality remains in fine shape. At quarter end, the unguaranteed exposure of non-performing loans and foreclosed assets declined to $4 million, compared to $5 million in the prior quarter. As a percent of total assets, non-performing loans in foreclosures were 20 basis points, down from 23 basis points a year ago. Improvements in industry-specific credit metrics used for newer verticals, as well as Live Oak-specific metrics offset reserves associated with the growing loan portfolio, resulted in a provision expense of $1.5 million in the first quarter. Non-interest expense totaled $33 million in the first quarter and contained a number of incremental costs related to the acquisition and inclusion of RELTCO within our Company. M&A-related expenses of $516,000 were incurred in the first quarter. The normal operating expenses of RELTCO amounted to $1.2 million for the first two months in the quarter that they were part of the Company. Other non-routine expenses totaling $1.2 million in Q1 included a loss on the trade-in of an aircraft and expenditures made regarding charitable and benevolence initiatives. Salaries and employee benefits increased to $18.7 million from $12.7 million for the first quarter of 2016 as a result of staffing and infrastructure demands, consistent with the growth of the business platform and inclusion of the RELTCO salary base. Total stock-based compensation expense in the first quarter of 2017 was $1.8 million, compared to $4.4 million for the fourth quarter, as the larger expenses associated with the previously disclosed stock awards in 2016 concluded in the fourth quarter. We view this first quarter level of non-interest expense as more or less a natural base in the coming quarters, given the inclusion of RELTCO for a full quarter going forward, along with the ongoing costs related to intangible asset amortization and fair value adjustments related towards purchase. There will also be increased depreciation expenses from the recent purchase of two aircraft. In general, as a growth company we will continue to invest in initiatives that capitalize on our competitive advantages and position us for superior long-term performance. As stated earlier, we significantly lowered our effective tax rate this quarter to 11.5%. We view our improved tax rate as a function of the sustainable, ongoing operation of our renewable energy activities. We have a strong team focused on and a strong pipeline of solar panel leases that will provide investment tax credits for the foreseeable future. This is a business we've been building since the second quarter of 2016, alongside our renewable energy lending vertical. Unlike the lending vertical, Live Oak's ownership and subsequent leasing of solar panels allows the Company to receive the investment tax credits. We view this as a core business and an integral part of our profit generation, independent of where it comes in on the income statement. Irrespective of the $874,000 tax benefit from ASU-201609, we do expect this lower effective tax rate to be sustainable via our solar panel leasing business and to be an added source of capital that we can opportunistically put to use for a variety of initiatives within the Company. This concludes my comments. We would like to thank everyone that has dialed in today and open the call for questions.

[Operator Instructions] Our first question comes from Jennifer Demba of SunTrust. Your line is open.

Thank you. Good morning.

Good morning, Jennifer.

Can you just talk about the timing around formalizing your investing in these other companies within the ecosystem?

I would say that it is ongoing, so we have invested today, as Neil pointed out, in DefenseStorm, Finxact, working on a couple more, and I would reiterate – and I think we disclosed all this that the Board allocated $10 million to Live Oak Ventures, and to date we've invested how much?

Not close to that.

Nowhere close, so these are very small bets, and if you kind of think back on the nCino experience, incredibly leverageable opportunities from an economic gain standpoint, but, again, the object of the exercise is to solve the problem in a next-gen fashion, as Neil mentioned, open APIs and all that other stuff.

Jennifer, this is Neil. Just to add to that, while our investments are minimal, those partners that I identified in aggregate make meaningful investments into these companies, so they have the capital required to develop the solution and solve the problem.

And we require all the managers that have actually done this before to commit a substantial portion of their liquid net worth in the project as well.

Thank you. That's helpful. And can you just talk about your pipeline in terms of new industry verticals in terms of lending? And are you likely to make any other kind of ad hoc acquisitions, like the title agency one, over the next one to two years?

Well, if you go to Slide 5, I failed to talk a little bit about Live Oak 3.0. So we are incredibly excited about Jody Murphey's leasing business, the solar panel leasing business. So I kind of view that as vertical 15 and probably will react to the upper end of the originations in our historic vertical. So, we have – I don't know how many of our 15 verticals do well over $100 million a year, but we would expect that business to be in that area. The one that I failed to mention is the first horizontal effort that we had. We hired an incredibly talented guy with 35 years of experience in the equipment leasing business and we're going to try to offer those products and services horizontally to certainly not all of our verticals, the IA a business wouldn't be in the equipment leasing business, but we're excited about that. Educational services is our newest one, off to a resounding start. We think that will at cruise altitude be one of our better performers. Relative to your question about acquisitions, probably not. We've found that every time we acquire another business, every other business has an interesting culture. We're awfully proud of what we have built here. What we've found in the St. Pete area is a very like-minded, driven individual that we expect to do about 1,000 loans for us this year. We tested their capabilities for almost 12 months during the due diligence period because many times, Jennifer, as you know, in these complex SBA loans with 150 documents and real estate loans, the long pole in the tent is the title policy, so we didn't want excuses coming from outside sources. We wanted to bring that in house to create a – speed is our weapon customer experience.

Okay. Thank you. Can I ask one more question, just on your space needs over the next one to two years? Can you just kind of give us an update on where you are that, where you are on your real estate and office needs?

Yes. It seems like every time we build a building, it's full, so we're oversubscribed here in Wilmington today. We're contemplating the acquisition of more land and building more buildings as we continue to march down the path of success, and I think some of these businesses that Neil is involved in will actually end up moving to Wilmington as well, where we can have Neil oversee the integration of all that software.

Thank you very much.

Our next question comes from Aaron Deer of Sandler O'Neill. Your line is open.

Hey, good morning everyone.

Hey, Aaron good morning.

I wanted to start on the solar leasing business because it seems like that seems to be kind of having an outsized influence on the income statement particularly on the tax line here. Can you talk about the – or maybe give an example, if you do $1 million solar panel deal. Can you tell me what percentage of that comes back through interest income? What the cost is in terms of depreciation and what the exact benefit is to the tax line or any other income statement lines that are impacted by that?

We have Jody Murphey in the room who runs that business. I'm going to start that off by saying that one thing that attracted us here, notwithstanding what's going on in Washington, is this solar tax credit thing that was passed a little over a year and a half ago has a step down feature. So in 2019, the tax credit remains 30%; it steps down to 26% in 2020, 22% in 2021 and 10% each year thereafter. We rather look at this as a loan and, Jody, you may want to tackle Aaron's question.

Sure. So on a typical $1 million lease, it's a 30% investment tax credit that is dollar-for-dollar, so you receive the day that the project goes into commercial operation, you receive – you’re able to claim a $300,000 tax credit on that $1 million outlay. Through this year, through projects that are completed by 2018, those projects also qualify for bonus depreciation of 50% on an 85% basis after ITC. Just with the ITC and the bonus depreciation and normal depreciation on the asset, you receive about 48% of your capital back in year one on the investment, so about $480,000 of cash comes back on a $1 million outlay, irrespective of any lease payments that come in. So as far as from an interest standpoint, we don't make an interest per se on the actual lease stream payments. We make that through the tax benefit, which every project is different depending on the timing, but your after-tax return is somewhere between, depending on the term, 6.5% to 9%.

Okay. So you are purchasing them, then the lessee is paying you lease payments on that, correct?

That's correct.

That's not recognized through interest income?

It would be in the loan and lease income section on our income statement, Aaron. So it will be part of that in that interest income or I guess what nets down the net interest income line item.

Okay. And then with more of your loans coming on fully funded, how much of that is – I guess does that reflect the lending to more existing solar facilities or can you kind of talk about what the dynamic is there that's generating more loans that come on fully funded?

I would say Q1, as we said that amount that we were able to portfolio in line with our efforts to grow recurring revenue. That was a function of the investment tax credits that we were able to capture through the solar leasing activity. But the loans that make up those that are held, it's strongly influenced by what we're doing in the renewable energy lending space, as all of those loans are fully funded. Most of those we do sell, which means we can hold loans within some of our other verticals that we believe we receive a greater return on over time by having those on balance sheet, rather than selling them.

Okay. And then if we talked a little bit about the compensation and obviously it was up sharply, I know there were some outsized stock compensation expense in there, but what – and the RELTCO addition as well, which we'll see the full quarter of here in the second quarter. But is this a good run rate on the comp line at this point or will there be some drop-off in the second quarter built in, and what are the expectations there?

So you’re speaking specifically of the salary and benefits line?

Correct.

Yes, so I would say that's probably consistent with where we would be in the coming quarters. There were a couple of items in there, a one timer related to the acquisition of RELTCO, of course their existing the salary base that was in place when we acquired them, that will be ongoing, obviously, and it will be for three months, rather than two months, but there was a one-time expense in that selling benefits line as a result of that. And then a small portion of the charitable and benevolence initiatives that we mentioned, a small portion of that hit that salary and benefits line item as well. However that said, I do not think that the coming quarter’s run rate on salary and benefits will be too dissimilar from that number.

Well I mean so hang on that, Brett. I mean we paused about a year-ago and tried to catch up a little bit and now we're hitting the gas again on creating new verticals. So Kay Anderson runs the emerging markets effort and we certainly hope that she can add probably three more the rest of this year or let's just say over the next four quarters to the educational services business. So more expense building and some of those may be full funders, some may be longer-term construction projects. So we're going to continue to do what we've done in the past and invest in the future. And I will say this just on that issue a couple other things. So it was interesting the other day, Aaron. Our construction fee income in the chicken business more than covers our overhead in that business, now that that business is at cruise altitude. We also are bringing legal in house. So we'll have some more expenses upfront, because it became known to us that our customers pay outside counsel about $7 million a year. So we want – this is just like the title business. At a return, we want to control the process with our customer to go faster and more elegantly, I guess.

Okay. And then I know Neil is working hard in the APIs and on the funding side. It was interesting this quarter to see that the margin widened out as you guys saw the lift on both the loans, as well as deployment of cash into loans. Can you talk a little bit about expectations in terms of your current liquidity and funding needs as you look out to the second and third quarters and what kind of impact you expect that to have on the net interest margin?

Hey, Aaron. This is Neil here. So it was a good deposit generation quarter. We've raised about $107 million at a blended portfolio rate of 120 basis points. These new deposits are all being brought on by our new – the omni-channel. We called it Acorn before, but that platform. We do believe we are rolling out savings products that we believe we can offer at lower rates, but we do think the lag will have an impact over time. So I wouldn't – we at some point will have to start paying up. So I don't know the rate of the NIMs increasing will be the same as it was quarter-over-quarter this time.

And I also think, Neil on that issue like back to the $175 million in the treasure chest relative to liquidity, if we can build that over time not only building recurring revenue, but instant liquidity. And Caines, you could certainly comment on over a period of time diminution of value of 7A paper is not what most people think.

Yes, maybe just on that note, and this is something that we've tried to clarify in prior calls. When we talk about retaining guaranteed loans on book, it's really probably better to think of it as a revolving door. We'll hold or retain a loan for a period of time while it is providing value to the bank that is inconsistent with the value that we think we get in the secondary market. And that revolving door, as new loans are originated that loan easily could fall out of that stack, that value stack and be replaced by a newer loan origination. But we don't see very much decline in the value of paper within a 12-month timeframe of origination and sale.

Okay, great. Thanks for taking my questions, guys.

Thanks Aaron.

[Operator Instructions] End of Q&A

So we have no further questions. Thank you all for dialing into the Q1 call and look forward to chatting in 90 days.