Live Oak Bancshares, Inc. (LOB) Q2 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Q2 2017 Live Oak Bancshares Incorporated Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to Mr. Greg Seward, General Counsel for Live Oak Bancshares. Sir, the podium is yours.

Thank you, and good morning, everyone. Welcome to Live Oak’s second 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 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. Let’s review today’s brief agenda. I’m on Slide 3. I’m going to kick things off and talk about our past investments and how they’re beginning to produce results. This is primarily in the origination business. And given that growth, I want to talk a little bit about safety and soundness and then conclude with a current discussion of our renewable energy business. And then I’m going to turn it over to the newest member of our management team, Scott Custer, and he may have a comment or two on what he thinks about this place and the – it says six months here, but in the four months that he’s been with us. And then he’s going to focus on the right side of the balance sheet. And as always, Neil is going to talk about API banking technology and give you an update on our First Data joint venture. And Brett will bring us home with numbers. Moving on to Slide 4. Yes, we have increased originations in this business from 2012 to 2016, 39% compounded annual growth rate, and had a rather robust first half, growing the business 65%. And as I prepare for this call, I thought about someone potentially new to the story and looking at a bank that trades at 4 times tangible book and this growth rate and said, my gracious, what in the world is going on here? So moving on to the next slide, let’s talk about safety and soundness before we talk about the left side of the balance sheet. So since inception, we’ve originated $6.44 billion, 80% of that guaranteed by the governments, about $4.8 billion. And we’ve had cumulative net charge-offs since May of 2007 of $12.1 million. And now a little peek under the cover of government guaranteed lending. So we have submitted to the United States Government 66 loans since inception, totaling $13.1 million. And we’ve had one loan, as they say, in that business in Washington, D.C. repaired or denied. And I actually put the wrong number here. So that one loan was repaired by $28,000. And then if you take a look from the federal banking regulator standpoint, I’m told that the classified assets to total tangible capital ratio of 40% gathers their attention. I’m also told that at 20%, they’re relatively happy. And as you can see, our classified assets to total capital is 7%. So that’s $12.2 million divided by total tangible capital of $175 million at the bank level. Dropping to the bottom of Slide 5, you can see comparisons to Live Oak Bank to $2 billion to $5 billion banks in our peer group. So 30- to 89-day past dues, 24 bps compared to 38; non-accruals, 34 bps, about half the peer. Greater than 30-day past dues plus non-accruals, 58, again about half the peer. And then we’re 25% superior in the Texas ratio. So back to the theory of verticality and discussing, as we do every call, the operating leverage of our business. Let’s see if the past is a proxy for the future. So from 2008 to 2014, what we have basically called Live Oak 1.0, revealing the vet space, the health care space, which is primarily dental, independent pharmacies, death care, investment advisory, family entertainment and the chicken business. 2015 to 2016, we entered into the wine and craft space, self-storage, independent insurances, hotels, renewable energy and GovCon. I’m looking across the table at my friend and longtime colleague, Neil Underwood, who always likes to talk about organic growth in the vertical. It just doesn’t happen, folks. So when you model it, don’t think that way. We’ve been in the vet space for 10 years. That’s about $150 million origination vertical for us year in and year out. The chicken business is highly cyclical and highly commoditized. This year, we’ll probably do $100 million less than we did two years ago. That said, we’re extremely excited about 2.0 growing from $138 million last year to $471 million this year. And really excited about 3.0, the new stuff. Going to talk a minute about tax credit lending. We were really, really fortunate to go into business with Scott Preiser who has 35 years in the equipment leasing business. So for the first time, think horizontal. Looks like we have early traction in the chicken business, the pharmacy business and potentially all the stainless steel and the wine and craft space. Really excited about being in the early education services business. So think about childcare from zero to five years old. Partnerships with Primrose and Goddard look very promising. Then in the senior care business now for about 90 days. So think about private pay in two buckets, assisted living, that’s real estate business basically, and the services business and home health care. Again, all private pay. Let me take a minute and talk about the last two. So we ran into a couple of folks that have experience horizontally in calling on small private equity firms and boutique investment banks. So they’re putting a layer of debt in front of common equity and preferred equity. So can we sell that business across our verticals? We think we can. We also ran into a really interesting gentleman that has experience in lending SBA money to CPAs, so we’re attacking the professional services space. You may also let your mind wander and say there are 4,800 SBA lenders in this country. Last year, 2,500 banks made an SBA loan. In the past five years, 4,000 banks made an SBA loan. So given our technology and our reputation in the SBA lending space, are we a platform to attract these folks? Now certainly, if someone has a franchise in the convenience store space, the gas station space, we wouldn’t be interested. And we are not abandoning our theory of verticality, but we may be coming home to more folks like the M&A and professional services space. So back to the leverage on Slide 7, the operating leverage of the model. So you can see the 1.0 group generated in the first half $65 million in revs. This includes interest income on unguaranteed paper gain-on-sale dollars and servicing income. So yes, we’ve been in the vet space for 10 years. And yes, we service probably, I guess, $800 million or $900 million of vet paper generating $8 million in revenues. It’s going to take time for the 2.0 group to catch up and for the 3.0 to catch up. But the business model is on full display, probably for the first time this quarter, and I think you’ll begin to see that. Lastly, before I turn it over to Scott, just a word or two on renewable energy. We kind of view this as an extension of the investment portfolio. These offtakers are rated credits both in the lending area and the leasing area. Just a word about loans. So in the past 12 months, we’ve closed, we say, $250 million here. It’s probably closer to $300 million in loans. The pipeline is extremely robust, and we have run into wonderful challenges and having some customers approach our legal limit. And Brett is going to talk a little bit about how we’ve been successful in laying out some unguaranteed paper to continue to service this space. Lastly, in the leasing area, Live Oak Clean Energy Financing is a business. It is not financial – it is not a financial engineering tax equity play. As you know, the investment tax credit tied to solar is 30% today through 2019. It ratches down to 26% in 2020, 22% in 2021 and 10% thereafter where the numbers effectively don’t work. Year-to-date as of this moment, we closed about $43 million of leases, driving our effective tax rate into the single digit, which we expect for many years to come. And in order to continue to service this space, we have to have partners. We need to run our balance sheet from larger banks, and we have several banks that we’re about to close a deal with in that area. So we can continue to service what is now a very robust eight figure pipeline. And with that, Scott, why don’t you take over and talk a little bit about the deposit business and anything else on your mind?

Thanks, Chip. I – Chip asked if I’d just say something about my – I’m in my fourth month now at Live Oak. And what have I learned, what are my impressions at Live Oak and what I would say is it’s a pretty simple thing and it reiterates what Chip just said. It’s a business model that works. It’s built around discipline, staying in the lanes of traffic that we know, the principle of verticality and having real subject matter experts in each of our verticals that add value to our customers. When we get into a vertical, we become known in that industry. We become known as a value-added financial partner. And when you become known as that, you get business. And I think the loan origination statistics that Chip just went over are evidence of that. But just as we have a great loan origination engine, we’ve been doing great work on the deposit side of the balance sheet as well and ensuring that we are able to fund ourselves today and for the years to come. And you’ll see on Slide 9, as far as the Q2 deposit growth, which is exceptional in and of itself, $233 million, 14% growth in the quarter and 26% year-to-date growth speaks to just the velocity of the deposit origination business. You see the statistics there. Maybe more importantly and more encouraging is what you see on the left side of that slide, our year-to-date savings origination. And when we say year-to-date, it’s not a long period of time. We launched our new savings product on June 21. So we had nine whole days in the quarter to add to our deposit. So in that $233 million, there’s not much of that $82 million that we’ve already generated in our new savings product. We’re opening 37 accounts a day. Average balance, $54,000 per account, picking up at right at $2 million in new deposit business a day. And if you believe that momentum creates momentum, we’ve got the chance to continue to add to that. So I think new daily deposit accounts will continue to grow, and I believe the average deposit size will grow as well. And for a person like me who’s – spend most of his life in a traditional bank and you look at typical branch measures of deposits per day, deposit accounts per day or deposits per FTE, those numbers, and we’ve only been at it a month, will stack up way ahead of any kind of branch delivery in terms of deposits per day, new account origination per day. And I think the momentum there will be seen as we go through the coming months. So excited about that. And then just to finish up, I mean, we’re not really done there. We’ve got new products on the horizon, all supported by great technology that’s being advanced every day. Neil is the best there is at that, and so I should stop talking and let him tell you that.

I’m supported by a great dev team. So thanks, Scott. Just a few words on technology. As Scott mentioned, we continue to grow the platform by adding new products like personal savings, and we’re really pleased with that progress. In Q3, we’ll add operational enhanced to the platform and roll out new features such as mobile and business savings. We continue to work very closely with First Data, leveraging our technology assets, and we’re tracking on all of our projects. As previously discussed, the joint venture is set to close at the end of this quarter. As I mentioned earlier, our dev team is hitting on all cylinders and innovative products will continue to be released throughout the year. Brett, over to you.

Thanks, Neil. We’re very pleased with our second quarter earnings of $0.27 per share, which bring our after-tax ROA to nearly 2%. We’re equally excited about record loan and lease originations of $586 million, representing a 25% increase over the prior quarter and 64% over last year’s second quarter. Our loan and lease originations were a nice blend of mature and newer verticals with renewable energy loans contributing just under $70 million of the $586 million. Renewable energy lending is seasonal, and we do not expect to repeat this faulty origination volume in the third quarter. Our Q3 originations are likely to be more in line with originations in the first quarter of this year. This will definitely bounce back in Q4, and we will achieve the upper end of our target range of $1.8 billion to $1.9 billion for the year. The success of our strategy to reduce earnings volatility and create longer-term revenue streams by retaining more fully funded guaranteed loans on balance sheet was once again on full display in the second quarter. Our total loan portfolio grew 66% in the past year to $1.7 billion, providing steady recurring interest revenues. Based on the note amount, guaranteed loans held for sale grew to $1 billion in Q2 compared to $639 million one year ago. This value includes guaranteed loans that are part of our hold strategy as well as our construction loans which cannot be sold until disbursements are complete. Our combined recurring revenue sources of net interest income and servicing revenue comprised 55% of our total revenue in the second quarter. Recurring revenue increased to $24.6 million, a 64% increase over Q2 2016. Net interest income grew by 85% over the same quarter a year ago to $18.4 million, driven by the significant growth in the loan portfolio combined with a rising net interest margin. The margin grew by 16 basis points in the last quarter alone to 3.92% as the rise in yields on our loan portfolio outpaced that on our funding sources. Recall that just over 60% of our own book loan portfolio reprices on a quarterly basis using a prime rate. Of our 2017 year-to-date originations of just over $1 billion, approximately 75% are quarterly adjusting. Our outstanding servicing portfolio of SBA and the USDA guaranteed loans sold in the secondary market amounted to $2.52 billion and yielded $6.2 million servicing revenue, an increase of 22% from Q2 2016. The total servicing asset value at quarter end was approximately $53.7 million after a revaluation loss of $1.2 million in Q2. This was an improvement from last quarter’s loss of $2 million. Our deposit base continued its upward ascent, growing to $1.87 billion at June 30. This is an increase of $233 million over the prior quarter and a $731 million increase above a year ago. Our success in gathering deposits has been important to the execution of our hold strategy as fewer guaranteed loans need to be liquidated in a given quarter compared to our historical operations. Guaranteed loan sales totaled $204 million in the second quarter compared to $136 million a year ago and virtually unchanged versus last quarter. Overall, premiums have remained very strong in light of rising rates. The net gain on sale of guaranteed loans was $18.7 million or approximately $92,000 of revenue for each million sold, which was slightly above last quarter’s average premium. As we have stated previously, the sale of the guaranteed portion of USDA loans results in premiums lower than our historical SBA loan sale averages. And the mix of loans sold has more to do with premium variability from one quarter to the next. In Q2, approximately 47% of the loans sold or $96 million were USDA loans. They received an average net gain on sale of approximately $76,000 per million, an improvement over last quarter. In addition, we sold at par just under $16 million of unguaranteed portions of USDA loans originated by the renewable energy vertical in order to reduce internal concentration levels. Turning to credit quality. Net charge-offs in Q2 declined to $190,000 from $1.5 million in the first quarter, resulting in an annualized loss rate on average loans held for investment of a mere 7 basis points compared to 63 basis points in the first quarter. Overall, our credit performance remains very strong. At quarter end, the unguaranteed exposure of nonperforming loans and foreclosed assets of $3.9 million declined slightly from the prior quarter. As a percent of total assets, unguaranteed nonperforming loans and foreclosures were 18 basis points, down from 19 basis points a year ago. Provision expense totaled $1.6 million in the second quarter, well above net charge-offs, as we added to our loan loss allowance to accommodate the strong loan growth. Non-interest expense totaled $33.3 million in the second quarter, an increase of 33% over the same quarter a year ago and nearly unchanged from last quarter with an increase of just over $300,000. The full quarter inclusion of Reltco amounted to $2.4 million in operating expense in the second quarter. Salaries and benefits continue to comprise the largest portion of our non-interest expense and increased to $18 million from $15.4 million for the second quarter of 2016. However, growth in salaries and benefits have been relatively flat over the past four quarters. As we mentioned in the first quarter call, with the full inclusion of Reltco, this current level of non-interest expense should be considered as a natural base going forward. As we have said in the past, 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. Renewable energy leasing continues to do well with $24 million of operating leases originated in the second quarter, which contributed to incremental investment-type credit to the bottom line. As a result, our effective tax rate for the second quarter was 4%, thus bringing our year-to-date effective rate to 7%. As a reminder, under current rules, we are entitled to about a 30% tax credit on our total lease origination, which is generally spread over the year as it is earned. We expect to be able to maintain an effective tax rate of less than 10% for the full year of 2017. These tax credits derive from a core business activity and provide an added source of capital that we can opportunistically put to use for a variety of initiatives within the company. This concludes my comments. Thanks for dialing in this morning, and we’ll now open the call for questions.

Brett, hang on just a second. I got to say one thing here that our General Counsel is asking me to say. It is not lost on us that our growth has continued to put pressure on our capital ratios. We regularly evaluate our capital position and our business outlook and will consider available options, including going to the capital markets if we think action is appropriate. And now we can open it to questions. Is the operator there?

Thank you. [Operator Instructions] And our first question comes from the line of Jennifer Demba from SunTrust Robinson. Ma’am, your line is now open.

Thank you. Good morning. Nice quarter. Do you think that there could be upside to your loan production target this year? And if so, would it primarily come from renewable energy? Or are there other sources that are showing particular strength right now?

So Brett, as I recall, we said in the fourth quarter last year we were comfortable with originations this year being $1.8 billion to $1.9 billion.

Correct, that’s right. Yes.

So Jennifer, we do what we call a quarterly business review, which just concluded this week. And our guys are – I would say that we’re comfortable with $1.9 billion. The second half is typically better than the first half. And maybe our folks are sandbagging us, but the number is not much higher than the upper end of that range. So I think we should stick with that.

Okay, great. And Scott, could you elaborate? You guys started the personal savings product recently. Can you just elaborate on what other types of products you expect to roll out in the next 6 months to 12 months?

Really, I appreciate you asking me the question, but I’m going to defer to my partner, Neil, because really the savings product is something that he’d worked on for a long time. And he is the driving force behind all of the product, new product development at Live Oak and can give you a much better answer on that.

Yes, I’m happy to do it, Jennifer. So I would say that we are going to continue to roll out products. I mentioned earlier mobile and business savings being two specific products that you’ll see this quarter. However, we still think that the personal savings product will be the biggest one in terms of asset generation. We do and are – we do intend and are going to roll out checking. However, another opportunity has presented itself that’s too premature to talk about right now with First Data that we might pursue before then. We’re very close, by the way, with checking. It’s just we are realistic about the volumes of low-cost deposits that put on with the checking’s product. The upside is we have verticality. We can go hard at verticals with checking. But as you take a look at our growth, which is not insignificant, we need to think of low-cost deposits and scale like that, too. So it’ll have to be one or the other, this new cool thing that may take up checking or checking. You just happened to catch us right at the time where we’re planning. So that’s – but you can count on business savings and count on mobile coming out this Q.

Thanks so much,

[Operator Instructions] Our next question comes from the line of Aaron Deer from Sandler O’Neill. Your line is now open.

Hey, good morning guys.

Hey Aaron.

I guess, a follow-up on your comment, Chip, regarding the capital exploration. Is there a specific capital ratio that you guys look at as you’re kind of looking out over the coming quarters and a prospective growth where you would imagine a specific capital ratio, get in, where you decide that’s the time to raise?

Yes, I’ll take that one, Aaron. This is Brett. I would probably answer that just by saying that we’re in constant dialogue with our board on what levels of capital we think are appropriate, giving different business initiatives we’re trying, different strategies such as the hold strategy. I don’t think it’s lost on anyone that those guaranteed loans or holding in themselves are a very strong source of capital. So decisions around continuing that strategy for recurring revenue and raising additional capital to support that, those are constant conversations we’re having. I’m probably not going to throw out a capital ratio target that we say we’ll stick to forever. I’ll just say that we evaluate that and it changes every time depending on what different things we’re doing.

Aaron, if you could see our General Counsel here, so Greg Seward has been with us for two years. He was one of like 200 lawyers in Capital One. And he’s got daggers in his eyes looking at us trying to be careful on answers. So we ought to probably move on to something else.

Fair enough. Following up, Brett, you mentioned the volume of loans that repriced. I heard a couple of numbers, 60% and 75%. I missed the delineation between those two figures. Could you elaborate?

Yes. Just the existing loan portfolio on book, in excess of 60% of that volume, we’ll reprice on a quarterly basis based on the prime rate. And just in comparison, what we have – the loans that we’ve originated in the first half of 2017 have been closer to 75% quarterly adjusting based on the prime rate. So what we’re – the quarterly adjusting loans by percentage that we’re putting on book is greater than the quarterly adjusting loans currently on book.

Okay. And just to make sure I understand that because my understanding was that a lot of the loans are – have like five-year resets. And so – but this obviously – these are suggesting that the bulk of the book resets every quarter?

Yes, more than half of the book resets every quarter. And you are correct, we do have a pretty solid volume of variable rate loans that reset on a five-year basis, hence, this emphasis on the word quarterly in the previous comments.

Sure, okay. And then the question on – I know you guys are retaining more and more on the balance sheet. But with respect to the SBA loan sales, I know there’s some changes that have been proposed or put forward on the pooling guidelines. And I was wondering if that – given your mix of kind of longer-dated loans that fit into those pools, will that change in the guidelines, have an impact on what you would expect to get in terms of your pricing on those?

Yes, those changes – the – we’re probably looking at the way that could impact our secondary market pricing. Essentially, what it would do is make certain loans more difficult to get into a pool based on their remaining term or the – their maturity. And for us, given our strong origination volume, in a lot of cases, we’re generating enough volumes of loans that what we’re putting out to sell is, a lot of times, there’s already sort of a ready-made pool there. In cases where we have a very strange maturity, call it an eight-year maturity, you no longer can clump that into – or I guess, under the proposal, you would no longer be able to get that into a 10-year pool. So really, odd maturities like that will likely get a lower premium if the buyer wanted to put that into a pool. But some of our longer maturity stuff, given just our production volumes, we, in a lot of cases, are able to generate enough bulk ourselves that there’s a pool ready to go when we sell those individual lines.

And I think the bottom line is if there’s some fussiness within a pool, we’ll just keep it.

Yes. And it could also be a candidate for hold strategy.

And then a question on the tax guidance. Brett, you said likely to be under 10%. Just it was particularly low this quarter. If I recall correctly, there’s a limitation on how much of the federal tax you can offset through these credits and I’m just wondering too how that plays into your guidance there and if that can in fact put a limit on the amount of production that you do in the leasing space.

Yes, the less than 10% type comment, that is on a GAAP basis. Limitations are on a cash basis. You still remit to the IRS I believe 75% of what would otherwise be due. And after that, you’re creating a DTA. And I guess I’ll go back to a comment similar to my capital ratio comment in that we’re assessing flat level of DTA where we want to take on, and that will certainly factor into our decisions of the amount of solar panel leasing that we will engage in.

Okay. Good stuff. Thanks guys for – I appreciate taking my questions.

Thanks Aaron.

And I’m currently showing no further questions. And I would like to turn the call back to Chip Mahan for any further remarks.

Thanks to everyone for dialing in, and we’ll see you next quarter.