Good day, ladies and gentlemen. And welcome to the Second Quarter 2019 Live Oak Bancshares Earnings Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Greg Seward, General Counsel, Live Oak Bancshares. Mr. Seward, you may begin.

Thank you. And good morning, everyone. Welcome to Live Oak's second quarter 2019 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 and commentary that we will reference on the call, please visit our website at investor.liveoakbank.com and go to today's call on our Event Calendar for supporting materials. 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.

Greg, thanks. And good morning all dialing in today. I just have a few brief comments before turning over the call to Huntley for much more detail. And I would direct you to look at the great job that Brett Caines did in his CFO highlights. I had a chance to read those a few days ago and I thought, "hmmm, boring." We just kind of did what we said we're going to do. We layered in more recurring revenue. And I even thought about not having this call today. But then, this is ridiculous. Enough is enough. This stock is a bargain. It's cheap. We're trading at 1.3x tangible book. And the world, the world defined as the $4 billion to $4.5 billion banks, are trading at 1.5x tangible book. So, I will ask you shareholders at the top of this presentation, what $4 billion bank has this asset quality generating engine. So, Q1, we did a little under $400 million. Q2, $525 million. We are highly confident we'll exceed $2 billion for the year. What $4 billion bank has $673 million of floating rate government-guaranteed paper, which you could put a mark on that as $50 million to $60 million. Let's talk about funding. Everybody on this call – or many on this call know Tom Brown. You read his weekly report. And I read last week's report with great interest as he talked about the famous Bank of America and how Brian Moynihan has done a wonderful job of bringing his cost of fund deposits from 300 basis points to 150 basis points. I then went to the investor relations BofA quarterly release. And it's impossible. You've got the global bank. You've got the consumer bank. So, I went to SNL Securities to find their cost of…

Thanks, Chip. Always a hard act to follow. Look, overall, a really strong quarter. And as we dive into the details, you'll see momentum in each of the kind of the three core strategies that we laid out, which, namely, increasing recurring revenue in a prudent manner, being mindful of expenses and investing in our platform. We knew 2019 will be a transitional year and this quarter demonstrates just the result of a lot of hard work from the entire team. And we run through the details, we're hitting on the benchmarks that we aim to achieve and things feel really good across the franchise. So, on slide 8, all the key metrics that we've shown are all green, which is a good color. Loan portfolio up 35% year-over-year. Assets topping $4 billion, over $4.2 billion. As we stated before, we're doing this by holding significantly more of our eligible loan production on the balance sheet and we continue to make high-quality loans across the franchise. We said earlier in the year, our stated goal was to grow assets by $1 billion this year, and we're well on our way with the assets up over $600 million for the first half of the year. So, we're kind of doing what we said we're going to do. And you can see the impact on operating leverage with net interest income and loan servicing revenue up over 20% and expenses, quarterly basis, roughly flat. So, if you turn to slide nine, our lending franchise, and you guys have seen this slide. We continue to add to the places that we're investing. And the expansion of our verticals has been key to our growth, but we're really seeing solid contribution from the more mature verticals as well. The majority of our teams are…

No, let's go.

Thank you. [Operator Instructions]. Our first question comes from the line of Jennifer Demba with SunTrust. Your line is now open.

Thank you. Good morning.

Good morning, Jennifer.

A few questions. You mentioned you'd hired a venture banking team. Just wondering if you could give us some more detail there on what kind of loans you're looking for in that segment, whether it be by size or type or sub-segment? And then, I have a question on kind of how much hiring you've done over the last three months and what the pipeline looks like in the next bit?

So, Huntley, why don't you take the front end of that. And then, certainly, relative to the credit box, Steve, if you want to weigh in on that, please feel free to do so.

Sure. So, in the venture space, we brought in a team, like we said, five people out of Silicon Valley, the old Square 1. And the thesis that we have is not dissimilar to the thesis we have in a lot of our small business lending verticals that there are niches of places that are perhaps a little under-penetrated or underappreciated. In venture, there is a lot of capital and a lot of talent that are flooding to the coasts, that are flooding to the New York market, the Boston market, the San Francisco market, the LA market. And we think that some of the second-tier markets, just like in our small business lending, have some really interesting companies and opportunities that aren't necessarily as well covered. And so, the smaller end of the market, which can be a couple million dollar relationship, $5 million or $10 million relationship, those, we think, are right in the sweet spot. And those that are in some markets that have a lot of innovation going on, but maybe aren't quite as heavily penetrated. And as you know, that business, you sort of lead with making good credit decisions, but there can be an interesting deposit opportunity that comes along with that as well in terms of cash management that we're building as well. So, I don't know, Steve, do you want to make any comment about sort of how we're thinking about the credits?

Taking a very disciplined strategic approach, we've put a lot of work into developing the policies already. So, a lot of forward work before launching the team has been put in place. We do feel that there is an opportunity, as Huntley mentioned, and it also starts with hiring the right people. So, we feel pretty good about some very seasoned folks in the space that we brought on board with Live Oak, which I think is the second part of your question. So, I'll turn it over to you guys to talk about.

Yeah. So, on the people front, I'll put it in two categories. So, on the technology side, as Chip mentioned, about 50 people at the end of 2017 headed down the street to Apiture and we've been pretty slow to back fill that. Over the course of this year, we've been a little more intentional and have put probably a dozen people into that to really enhance the effort there. And so, that should lead to more product innovation, design ability, things like that. On the lending side, the venture team, we talked about, I think we might add a few more there. We are being really selective. This isn't a land grab in that space. It's a very intentional view of folks that can help us build kind of in the category we're looking for. On the generalist side, that's an interesting question because we continue to see resumes kind of coming in probably at an accelerating pace. And there's a lot of really interesting markets that we're not in right now. In the Northeast, we're not in Boston. We're not in D.C. or Philly in the Mid-Atlantic. There's a lot of places that are big markets. And to think that you can put somebody in those markets that has relationships and can do $30 million or $40 million or $50 million a year of production per person is not a stretch. And so, we are being selective about who they are. They've got to fit culturally. They've got to have – their experience has to be in specific types of credits that we like. They have to be in – brought those business in by themselves and not through a branch network. And so, the bar is high, but I think you'll continue to see us make progress in building that team. And then, we continue to look at other verticals as well. What we call emerging markets isn't slowing down either. And in niches that we think are interesting and where there's expertise, you may see us continue to add on in that space as well.

One more question. Your credit quality continues to be excellent. We are seeing costs, net charge-offs and provision, problem loans go up for the industry. Some more than others. What is a reasonable level of what you would call normalized net charge-offs for your business mix right now in your view?

Steve, why don't you take that one, partner?

I'm not going to give you a number. I just really can't. That would be foolhardy. What I will tell you is, as you see in the recent trends in the portfolio, that is how I feel. I feel like we're very stable and cautiously optimistic. I feel really good right now about the portfolio. We do stress for scenarios of changing economic conditions and always think about that and plan for it. I feel that we've provisioned correctly. I feel really good about that. And you probably can see that I tend to lean towards provisioning for an expectation that there's going to be a cycle that we're going to go through and we're going to lead into it in a good place. But to give you an actual figure, I feel really good with where we are. We have room for some more losses that we could take, but I don't see them right now but we think about that all the time.

Yeah. The other part of that question is, what are we seeing? We've got 4,000 small businesses that we look at every day in terms of how they are performing across 30 industries, across 50 states. And to Steve's point, we are very sort of cognizant of what's going on, but we're not seeing macro degradation, right? And so, have certain folks in the quarter had selective misses in credit? Sure. We think the granularity really helps that idiosyncratic losses. But as we sit here, we're not really seeing any macro real degradation. I think when I got to the bank and sat down with Chip and Steve and David Lucht and others, they said, look, we think that, through a cycle, we could see as much as 1% losses in the portfolio, and that's sort of how they think about it. And, obviously, haven't seen anywhere near that in this portfolio over the last decade and don't see any reasons why it would go that way. So, I think to Steve's point, it's hard to put a number as to where we expect it to go because we're taking a pretty conservative approach around it.

Thank you.

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

Good morning, everyone.

Good morning.

I appreciate your guidance on margin expectations. Just trying to understand some of the dynamics behind that. I guess, first, on the asset side with loans, can you give us an update in terms of what percentage of the loan book is tied to prime and kind of the reset timing on that, so we kind of understand how that's going to behave if we do get a couple of rate cuts from the Fed? And then, on the funding side, obviously, you guys are maybe pushing a little less hard on deposit campaigns recently. I saw you guys had ticked down your CD rates a little. Do you suppose that you will continue to let loan growth outpace deposit growth and deploy some of that liquidity that you've previously built that could also give some added support to the margin?

Yeah, great question.

Brett, that's right up your alley.

Thanks, Chip. Yeah, to address your first question, Aaron, our current portfolio, just about – or just under 70% of that is on an adjustment period tied to prime that's less than annually adjusting most of that. Call it, roughly 65% is quarterly adjusting. And then, we have some other either monthly or annual adjusters in there that bump that up to a little above 65%. And then, while we're originating, it's a similar story, but we've seen just from a competition standpoint the need for some fixed rate. So, our new originations still tied to prime, you're looking at something closer to low 60s, maybe 60% that adjust on those time frames less than annually. And I guess continuing on into your second question, as it relates to the loan-to-deposit ratio, I think we just continue to be really mindful of our liquidity profile, just being in a position where we have a strong, robust liquidity base that is there when we need it. And you're correct, yes, we did use some of that liquidity in Q2. I don't necessarily see steps like that going forward. I probably would view it more as kind of leveling it out, kind of maintaining where we are. We think that's a good base for now. And, of course, that could change as the environment changes going forward.

And then, on the deposit side, look, I think we've got a very fair offering for our customers. We have not been at the top of the leader board, as you've seen. And we continue to get nice flows of deposits. So, I don't think we need to either red line or necessarily track the top couple of folks that come in and out of a market in various campaigns. And like I said, it's been probably a little more rational around pricing, and we'll see. We have not seen this amount of direct deposits in the market in a Fed cut environment yet, right? And the last time this happened, ING was probably the only player really in the game. And so, it's going to be real interesting. Some of the big guys have already started to make some moves on the savings side. And you want to just see how we react, right? So, that's, obviously, going to be the swing factor as it relates to our margin, the Fed cuts.

Sure. And then, Huntley, you've talked about some of the new deposit products that you're testing now and hoping to bring online next year. Can you give us maybe some specifics in terms of what types of products those are and what types of customers they'll be targeting?

Yeah. So, this is going to sound really novel, but we are going to have a checking account. But, look, I think we think about it much more as an operating account, as a payment account and as a checking account. And our first view is, what actually do small businesses need to run their business and how do they think about payments and funding and the like? And we will go into some of our verticals that we've been in for a long time where we see a need. We will have integrations into places where they do business, so we can present information. Pretty intuitive, pretty simple interfaces. And, look, this is going to be an evolution. We'll come out of the gate with something that will be pretty consistent and we hope better than what the industry has, but our ability to innovate and integrate from that is pretty boundless. And that's where we think the real momentum is going to come, is to build specific use case products for customer segments. And so, the community of veterinarians or the community of another industry vertical where we can actually design some real use cases for them, and that's where we think we're going to make the most progress.

Okay, that's great. And then, one last question. With respect to your innovation efforts, I believe you guys are still kind of in the midst of your gradual conversion to the Finxact core. I was hoping maybe you'd give us an update on that. And then, what kind of cost saves might be applicable as you move away from your prior core vendor?

Neil, why don't you take that one?

Hey, Aaron. How is it going? Yeah. So, as we mentioned before, trading out a core is something you don't want to do in a big bang approach. So, we have, for the past six months, been in friends and family. We are pretty excited because we're going to make the full commitment in Q4 whereby every net new account will actually go on to Finxact core. And every net new savings and CD account will go in the core. And then, shortly thereafter, following up with, as Huntley said, not just the checking account, but a very different checking account and one that we feel we can represent to the market with no branches. So, super excited about the progress that we're making thus far. But also to Huntley's point, we're integrating not just Finxact, but 16 other vendors all on next gen platforms. And so, when we look at the competition out there, we're not necessarily looking at the big six or our peers, we're looking at a lot of the new fintech entrants that are coming in. So, again, certainly making progress.

Okay. And then, when that eventual transition does happen in its entirety, what kind of cost saves might stem from that?

The real answer is, I don't know. We're still looking. Nor does Finxact because they haven't – we're the first bank that – we're running on it. We have a pricing schedule set that's materially different than our current core provider and materially beneficial, but we'll be able to properly answer that one probably when we're actually live and in production.

Sure. Okay, great. Thanks.

Our next question comes from the line of Christopher Marinac with Janney Montgomery Scott. Your line is now open.

Thanks. Good morning. Wanted to follow-up on the criticized asset ratio in the slides. Does that 05/27 compare with a much larger number if we went back five years and anything relatable as we went back kind of in the crisis years? I just kind of want to relate that to where you've been and just kind of get that comparison in your favor.

Steve?

Yeah. It's lower. That's a really healthy number. I would say it's lower even compared to where we were in the past.

Industry data would suggest that maybe we're a third of the level we used to be just five years ago. And then, of course, the numbers aren't really comparable to the crisis years because the classifieds and criticized weren't disclosed. But just curious if you had any ballpark guesses. So, that's helpful, Steve. Thanks. And then, my follow-up was just – back to the deposit cost conversation that Huntley was on a minute ago. The brokered market came down a lot in April, May and June. And I'm curious, does that relate at all to how your pricing may play out the next couple of quarters?

Brett, do you have a view on that? And then, Huntley, certainly weigh in.

Yeah. Hey, Chris. Yeah, I think that both move together. I don't think the way we priced retail is necessarily a result of what the brokered market is doing or anything like that even though they have been moving in a similar direction. To Huntley's prepared comments, we have seen rates come down sort of across the board on the brokered end of the retail side, probably in anticipation of some moves the Fed may make. And it's really hard to say what's going to happen going forward. I think competition, as we've said on prior calls, will continue to be a factor that we have to be mindful of. And whether or not a Fed cut is already priced in to what we're seeing now, that's anybody's guess. But we've certainly been pleasantly surprised at how – rates for the market we compete in on the retail side, we've been pleasantly surprised at how rates have responded recently.

And look, the fact that brokered funding can be now competitive or even inside in some cases where we're funding in the retail market is great. It's never going to be a huge part of our balance sheet, but it certainly makes our tactical decisions easier as we think about pricing of certain products and our need to help fund the growth of the business, right? So, it's a benefit, for sure.

Great. That's helpful. It just seems that perhaps the Fed cut could be a competitive opening for you and that's kind of what I'm curious about.

Yeah.

Very well. Thank you, guys.

Thank you. This concludes today's question-and-answer session. I would now like to turn the call back to Chip Mahan for any further remarks.

We just want to thank everyone for joining us today. We look forward to talking to you again in 90 days. Thank you very much.

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