Live Oak Bancshares Inc

NASDAQ:LOB

Earnings Call Transcript 2018-Q2

[Operator]

Good day, ladies and gentlemen, and welcome to the Second Quarter 2018 Live Oak Bancshares Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

I would like to introduce your host for today's conference, Mr. Greg Seward, General Counsel of Live Oak Bancshares. Sir, please go ahead.

[Gregory Seward, executive]

Thank you, and good morning, everyone. Welcome to the Live Oak's Second Quarter 2018 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 are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed on 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.

[James Mahan, executive]

Good morning, all, and Brett's going to kick us off with a few highlights and some comments on restricted stock awards.

[S. Caines, executive]

Thanks, Chip. I assume most of you have already seen my commentary on the quarter, along with the earnings release. As you can see, we had a fantastic quarter compared to last year's with the dramatic increase in pre-tax earnings.

Our loan and lease portfolio continued its substantial growth which, in turn, is driving the steady rise in recurring revenue. We also continue to diversify our loan products, thereby reducing our dependency on SBA origination.

As referenced in the posted documents, we did see NIM compression in Q2 compared to Q1 as we continue to hold a higher average liquidity throughout the second quarter as a result of the positive ramp up during Q1.

The increased liquidity profile was the product of our strategic plan, as we discussed in the last earnings call.

Going forward, we should see improved NIM as our loan portfolio continues robust growth and approximately 80% of our loan portfolio will reprice within the next year.

Finally, referencing Slide 4. I would like to touch upon or remind you of an item that may be of interest. Related to $2.1 million retention and stock performance awards issued in 2016, that vest on our stock price reaches to $34 per share for 20 consecutive trading days, and we've traded in the low 30s for a while now and reached the record price just this week of $32.95. We want to walk you through the potential effect of such an occurrence.

If the share price reaches $34 for the earlier mentioned period, you will see an increase in noninterest expense as a result of that event beyond what has already been incurred. As of June 30, there was roughly $10 million in remaining expense to incur on these stock awards.

However, after consideration of tax impact of these awards, net income would increase by $5.4 million due to the tax benefit derived from the fair value of the shares awarded and expense incurred. Also, the addition of the 2.1 million shares to the share count would not materially impact EPS in the coming quarters as the discontinuation of the quarterly stock compensation expense for these grants offset the impact of the share dilution.

Having updated you on these items, I'll now turn the call back over to Chip.

[James Mahan, executive]

Brett, thanks for that rather complex review of those what we affectionately call here the 34s. More to come on that in a minute.

So moving on the Slide 6. Our normal and customary theory of verticality, just a comment or 2. We are running behind, as you can see, from last year of $1.55 billion compared to $889 million. As of this moment in time, we're a $1.1 billion last year and $990 million this year, so we're gaining on them so to speak.

And I would just tell you that the SBA hit us in the tummy a wee bit, 100% financing is gone. You now must have 10% equity that used to be that a seller could issue a note and get interest paid after the end of 2 years. That has been reduced to 5% and cannot be paid interest until the SBA loan has been paid off fundamentally right back to the 10% equity rule. And that has hurt us in the chicken business, the healthcare business and the vet business.

Help is on the way. If you look at the bottom of that slide, I will remind you that about a year ago, putting it in the R&D category, we cut Kay Anderson loose on the 4,800 SBA lenders that do not work here.

If you go to Slide 7, Greg, you could see that she has been victorious. The facts are these: for fiscal year ending September 30, last year, 1,978 banks did $25.5 billion of 7a paper. That's an average of $12.8 million per bank from various headhunters that we run into from time-to-time. It is our understanding that the average SBA lender does under $5 million of production. These highly trained lenders have been attracted, not only to our technology platform, but our culture. And as you can see, they have 17 years SBA lending experience, an average historical production of over $22 million. So we expect that to kick in on top of our theory of verticality. We got a new vertical today. Proud to announce that we're in the contracting business. So this would be HVAC electrical and plumbers, both installation and mainly, the attraction is the recurring revenue service agreements and there's no bank in that space.

And now just a, I guess, a wee departure and just, I guess, the commercial banker in me always thinking about soundness, profitability and growth in that order. And thinking about now, our 22 verticals and the American dream and the only thing that matters to our customers is free cash flow. So I thought I'd look at our business in terms of free cash flow. Adding back, as you see in the appendix, stock option expense, depreciation, pre-provision, which I'll get to on the next slide and adding back the subsidiary, Reltco. So back to soundness and making a case to look at our business pre-provision. It's interesting to note that since inception these last 10 years, we have -- we've originated a little over $8 billion loans, so that's $2 billion of unguaranteed paper.

Cumulative 10 year net charge offs, $15 million. I will remind you that our loan loss reserve today is $30 million, twice that. Average debt service coverage ratio in the portfolios is 2:1. FICO, 754. Trailing 12 months charge offs, 25 bps. Texas ratio is under 3%. And as always, I'll remind you, the holding company has $463 million of capital; add to that a loan loss reserve of $30 million; add to that the treasure chest, which show would generate another $30 million of capital, so that's $523 million of capital. On unguaranteed paper of $1.4 billion, so that's in excess of 35%, if you do the math on that. And our average exposure per customer is right at 300,000.

So if you go to the next slide, Slide 8. You'll see, if we kind of look at ourselves, again, notwithstanding we're a bank, I clearly understand as long as we stay within the rules, we can issue deposits and raise cash. But if we were like our customers, I think we'd look at it this way. So what is the earnings power of this business? So if you do those add backs that I mentioned a minute ago, you can see that the compounded growth of adjusted non-GAAP pretax earnings is 31% from '15 to '17, and we jumped from $28 million to $48 million or 69% year-over-year first half of '18 versus first half of '17.

So why do I talk about it? Well, the reason is, we have a very profitable business that's growing. And you are going to see more of the same. So yes, we took his company public almost exactly 3 years ago at '17. And these 34 stock grants are going to kick in shortly.

And as you can see on Slide 9 that our average stock awards outstanding as a percent of common stock these last 5 years, about 10% or about equal to these SaaS based companies. So are we a bank? Are we a technology company? Everybody asks that all the time. And you can see that normal customary banks are about a tenth of that. So as we continue to extend this platform and this culture and certainly excited about the arrival in the fall of Huntley Garriott, you'll see more of these so-called 34s, certainly not 34, but certainly much higher than that. And as we go back and talk about the bank and the technology, Scott, why don't you talk a little bit about the bank and then, Neil, you can take us home with the technology piece.

[Scott Custer, executive]

Sure. Good morning. Thanks, Chip. And as Chip and Brett have already touched on, the bank had an exceptionally strong second quarter and the level of business model is not just alive and well, it is a unique business model and really one that, I think, stands alone in terms of if you look our across the industry and it's really hard to compare it to anybody. So as we think about it, we really look and see how we're doing ourselves.

And Slide 10 is a slide we've shown you in the past, but it really shows the -- I think what's inside the business model, and that's the operating leverage that exists. And Chip has already touched on production. In some of our more mature verticals, production sort of flattened out. But even as productions flattened out, revenue inside those verticals has not and revenue growth continues to occur. We're holding more paper on balance sheet, as we've talked about in the past. Loan servicing revenue continues to grow there, and all that occurring on a really fixed cost expense base in those mature verticals. And so you see the operating leverage and verticals. 1.0, which are our mature verticals. And then as you move across the page, what that really tells you is the best is still yet to come for verticals 2.0, 3.0 and beyond. And so as those verticals begin to mature, as we -- as they begin to see the same type of effect as our more mature ones, you'll see just enhanced leverage in the business and creating a consistent earning stream that will come from that.

And Slide 11 shows really where we're going with that in the revenue. The core revenue growth now in this company is significant. The ability to hold more on balance sheet, creating 38% recurring revenue growth, year-over-year, the balance sheet growing at a 35% clip. Chip referenced the capital position we have. So we can continue to grow into that capital nicely, and you see that occurring on Slide 11.

Slide 12. When we talked about last quarter, we talked about the power of the deposit platform more from an origination standpoint. We had such a great quarter that we probably felt it a bit this quarter in our margin as the liquidity of the company really was exceptionally strong, and some of that was intentional. This quarter managing pricing a bit more tightly. Still, new originations were about $250 million. But what I really call your attention to on this page is the fact that often times, when you're a bank like us, you might say, well, all we're doing is competing on price. And I would argue that that's not the case. When you look at $344 million worth of CD, CDs that were maturing in a almost an 80% renewal rate. Our consumer savings has got almost a 95% retention rate. That doesn't happen just because you have an attractive price. In fact, if you take a look at our price compared to others, we're well down the list. Yet, we're retaining almost 100% of our new savings accounts. And as you know that the experience customers have here is exceptional. The deposit experience just as those that our -- the experience for our loan customers is. and I think that, that bodes well for how we'll be able to manage deposits, our funding cost and our growth rate going forward.

With that, over to you, Neil.

[Neil Underwood, executive]

Thanks, Scott. I pulled this next slide from actually last earnings call, and this falls into the bucket of driving low-cost deposits with low deposit beta that scale, and we are proud to announce that Live Oak Bank is the first bank in the world, live and in production, on the things like next-gen core, build API first and completely cloud native. So 1 of those 2 last terms mean scale, flexibility and speed on H1. Scale being on the things that core will allow us to scale up, not just to millions of accounts but the 10s of millions of accounts at a very low operational cost.

Really the flexibility, API will allow us to integrate best of breed third-party systems. And speed and time to market, given it's an open model, we can innovate at a very rapid pace. So when complete, Live Oak will partner with fintechs, allowing them to use our digital platform with the ultimate goal of accessing low cost of funds with low deposit betas, again, at scale. Just a note, though, we are live with friends and family so it's a smaller set of accounts and we'll continue to launch incremental lead throughout the year. And I think this will position us relative to next year to be able to seek out these fintechs and these deposit channel partners en masse.

The other 2 systems, by the way, that we are implementing, I'll give you updates on those as they come, are Apiture and Payrailz. So we hope, the digital banking platform will position Live Oak singularly in the market to these fintech partners and again, offer our people cost deposit at scale.

Chip, back to you.

[James Mahan, executive]

Thanks, Neil. [ Miko ], Greg will certainly entertain questions.

[Operator]

[Operator Instructions] Our first question is going to be from the line of Aaron Deer with Sandler O'Neill.

[Aaron Deer, analyst]

Chip, it seems like you had a nice rebound in the production volumes this past quarter and you sound pretty optimistic on the outlook there. Last quarter, you kind of suggested plus or minus 5% of $2 billion for the full year production. Is that still kind of a good target?

[James Mahan, executive]

Yes. I'm looking at Scott, and he's nodding his head. Yes, we're good with that.

[Aaron Deer, analyst]

Okay. And with the production this past quarter, what percentage of the -- or maybe what dollar amount of that was not government guaranteed paper? And then in what verticals and kind of what was the average size of that nongovernment guaranteed origination?

[S. Caines, executive]

Yes. Aaron, this is Brett. So roughly, I guess, just under 40% was non-SBA, between 35% and 40% was non-SBA. The bulk of that was via the USDA program. Roughly -- or a little over 1/3 of our loan origination in Q2 were via the [ OTA ] program.

[Aaron Deer, analyst]

Okay. It's -- I gather then that that's largely solar then? Is that what mostly USDA stuff is? Or is it the traditional ag as well?

[S. Caines, executive]

No. It is the vast majority, 90-plus percent is up for the renewable energy lending vertical.

[Aaron Deer, analyst]

Okay. And then, Brett, maybe 2. Just given the excess liquidity and the impact that, that's had on the margin over the past couple quarters. As you look to get that deployed and, obviously, have the added dynamic of rising deposit costs but also some pretty substantial repricing on the loan book, how do you see the margin behaving here over the next couple of quarters? And where might we see that get back to by the fourth quarter?

[S. Caines, executive]

Yes. So we certainly see NIM improving throughout the remainder of the year, beginning next quarter. As we referenced earlier, roughly 80% of our one portfolio will reprice within the next year. And in July, at the beginning of July after the Fed increase in June, 75 -- between 75% and 80% of the portfolio actually repriced. Then as well -- so you have that significant repricing on the loan portfolio side and that combined with our -- the liability side of the balance sheet, our deposit betas have been trending sort of around the 50% mark. So that obviously nice. So those 2 things combined, we do see NIM improving as the year goes on, certainly above 3.5%, I would think, for Q3 and maybe growing favorably from there.

[Aaron Deer, analyst]

Okay. That's helpful. And then lastly, on the gain on sale. As you're kind of looking at the volumes that are going to be ready to take out to the secondary market over the next couple of quarters and kind of what that mix of loans is, what kind of sale volumes do you anticipate and what kind of market pricing do you expect to get there? Do you think we can get back to the $90,000 or $110,000 per million? Or are we probably going to stay down here closer to the $80,000 given the mix?

[S. Caines, executive]

Given the mix, I don't necessarily think we're going be back up around $100,000. Our anticipated mix for Q3 and Q4, I'd definitely -- I'd see it being above the level we've seen on Q2. That said, I think in terms of the other part of your question, our -- so sold volumes will likely take down a touch from Q2. We did have a record volume sold in Q2. I don't see it setting another record in Q3.

[Operator]

And our next question comes from the line of Jennifer Demba with SunTrust.

[Jennifer Demba, analyst]

Question on nonperforming loans. I realize they're still at low levels, but just wondering if there was any discernible trend in the increase this quarter. And then my second question is on capital. Just how are you feeling about capital levels? And any capital needs you think you might have over the next 12 to 24 months?

[James Mahan, executive]

What was the -- I didn't catch the first question.

[S. Caines, executive]

Nonperforming loan trend.

[James Mahan, executive]

Steve, you want to comment on that?

[Steven Smits, executive]

Yes, certainly. This is Steve Smits, Chief Credit Officer. So no concerning trends. More loans. More stories. I will point out that in the nonaccruals this quarter, there was -- several years ago, we did a group of turkey farms, the only turkey farms that we have in our portfolio. Those farms that planted, they feed into has gone through a change in integrator. So the new integrator will have a model, at least for the foreseeable future, that is less dense, which means less birds means less revenues. So we placed those loans on nonaccrual. It'll be a process that we're going to work through most likely. It looks like today, we'll probably restructure the debt to help the farmers be able to pay back the debt based on the revenues that they're going to have for right now. So there may be some restructuring of debt but that's a notable portion, approximately $4 million of what you see in nonaccrual. Basically, they have to stop GAAP to stop the interest and then work with those farmers on the debt restructure.

[James Mahan, executive]

Steve, I think it's worthy to note. So back to who we are on that particular situation, Jenny. So as you recall, Don Jackson 4, 5 years ago joined -- 6 years ago joined our board. He invested a substantial amount of his personal capital in our bank. He is the former CEO of Pilgrim's Pride. It just so happens that the integrator in California that bought this business is run by someone that used to work for him. So even though he is retired from our board, he instantly jumped into action. We met the new owner, and I would say that we are reasonably highly confident that these loans will be paid with a bump in the night, as Steve mentioned. But being able to understand an industry as deeply as we do has been most helpful when things like this go bump in the night. Relative to capital, we have plenty of capital. And looking forward to deploying what -- depending on your perspective, $100 million of excess capital.

[Jennifer Demba, analyst]

How do you feel about your efforts thus far to diversify the loan portfolio away from SBA lending to some degree? Are you on track, above plan, below plan? And how are you seeing -- a lot of banks have -- now that the competition has intensified in the last few quarters. So what are your thoughts there?

[James Mahan, executive]

Yes. And Scott can weigh in on this, too. Look, so yes, for 10 years, we've been an SBA 7a bank with average exposure at 300,000 per customer, and that's exactly what it is today. So we challenge our lenders all day every day to say, like, so you're in 22 verticals, what do you think the SBA 7a loans as a percent of all loans in that industry are? Less than 1/10 of 1%? Probably. So if you know everything there is to know about an industry, show us more, right. So I think Scott and I are of like mind on this. We're happy with the legal limit of $60 million or $70 million to look at $5 million to $15 million deals. Certainly not like -- at this point in the cycle, the crazy competition making 4.5% 20 year fixed rate loans to veterinarians or dentists. We're not interested in that. But we are looking at other interesting differing credits. And Scott, you may want to talk a little bit about the ABL initiative and any other thoughts you have on this matter.

[Scott Custer, executive]

Well, you're right. I mean, I think one thing we don't do is we don't compete on price. So we're not going to get in the game that others have gotten into about just chasing deals and doing things that are just priced way below where they should be. We are going to compete with our business model, using -- as this Chip said, using the existing expertise we have and find new and different ways to lend money to companies in the industries we're very comfortable with. As it relates to trying to diversify the loan book, we're doing that. We're doing some conventional commercial real estate lending now and not in a big way but doing some of that. We're easing our way into the asset base lending business, also another conventional loan product. And you -- and Brett, sorry, referenced the USDA while it's a government guaranteed program, it's different than the SBA. And we're very active there and that's a very important part of what we're doing. So the fact that almost 40% of our loans were not SBA loans is a telling statistic. And I think you'll continue to see that diversification.

[Jennifer Demba, analyst]

My last question is on expenses. Brett, thanks for the guidance on the stock comp expense. Any other discernible trends we might be in expenses over the next couple of quarters that are of note?

[S. Caines, executive]

Probably nothing of note. And I would probably encourage you guys to get an idea of the expense base. I would encourage you guys to take a look at our GAAP to non-GAAP reconciliation table in the back of the earnings release. I know it's -- not only that's another side to look at but I think it does provide a good base expense for modeling by really identifying the, sort of one timers.

[Operator]

And we have a follow-up question from the line of Aaron Deer with Sandler O'Neill.

[Aaron Deer, analyst]

I just wanted to follow up on the energy business to go to the leasing side and the impact that, that's having on tax. Brett, you gave some good guidance in terms of your expectation for the tax for in the back half of this year. I was just -- as you look out to 2019, I'm curious how active you intend to remain in that business. And what kind of tax rate you might expect as a result for next year?

[S. Caines, executive]

Yes. We think in 2019, the solar panel leasing program and the resulting investment type credit still make good sense for Live Oak. And for that -- or because of that, we think you'll see an effective tax rate not dissimilar from 2018. For 2018, we've said, leasing will -- effective the tax rate into 2019 that might be mid-single-digit but in that ballpark. But point being, we feel like it's an effort that we continue to do and can trust through 2019.

[Operator]

And I'm showing no further questions at this time. And I'd like to turn the conference back over to Chip Mahan for closing remarks.

[James Mahan, executive]

Thank you, ma'am. Thanks for everyone attending the call. And we'll see you next quarter.

[Operator]

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.