Live Oak Bancshares Inc

NYSE:LOB

Earnings Call Transcript 2019-Q1

[Operator]

Good day, ladies and gentlemen, and welcome to the Live Oak Bancshares' Quarter 1 2019 Earnings Conference Call. (Operator Instructions) As a reminder, today's conference is being recorded.

I would now like to turn the call over to Greg Seward, General Counsel of Live Oak Bancshares. You may begin.

[Gregory Seward, executive]

Thank you, and good morning, everyone. Welcome to Live Oak's first 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 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 the 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.

[James Mahan, executive]

Thanks, Greg, and good morning to our shareholders. I'm excited about today's agenda. We're going to talk a little bit about, as we always do, the quality of our loan portfolio. Really excited about some things Huntley has been doing relative to expense management. And for the second quarter, really focus on our new business model and sharing with you how excited we are about that change.

So moving on to Slide 4, and kind of jumping in front of a couple of issues that we know are going to come up. One is the increase in nonaccruals. So it is true, nonaccruals are up over the last 5 quarters from $7 million to about $20 million. We told you about a year ago that we had a challenge a little bit in our turkey business. I'm glad to report today that that's looking quite a bit better and maybe even look forward over the next few quarters of that coming off that list.

We exchanged that for a $3 million hotel challenge, a $3 million chicken challenge and $1 million ABL challenge. The $1 million ABL challenge has paid off. But let's just take this up a level, right? So 20-ish trending down maybe a little bit. Let's look at the Texas ratio on Slide 4. So this bank's Texas ratio is about half our peer group.

Moving on to Slide 5. One of the regulators, the FDIC's favorite slide is this one, which is classified assets to Tier 1 capital plus the reserve. And I'm told by these folks over these last many years that they get a wee bit nervous at about 35%, so we're a 7th of that. They get really nervous at 50% and so were about a 10th of that.

And then kind of my favorite slide, Slide 6, shows our capital compared to the unguaranteed risk that we take on behalf of you, our shareholders. And you could see that that modified capital ratio is about 3x what a normal bank is today. So bottom line is we feel awfully good about the quality of the portfolio and, Steve may have a comment or 2 in the Q&A on that.

Now let's move to Slide 7 and talk about expenses. So if you go back 2 years ago, our net interest income was about $15 million a quarter, now it's $30 million. So we've doubled it in 2 years. Our expenses, 2 years ago about $33 million. This quarter about $38 million. And if you really drill down over the last 3 quarters and take out the nonrecurring stuff, it's about $38 million, $38 million and $38 million. And Huntley has done a wonderful job in the 3 quarters he been -- he's been here. I walk around and they say, good morning, Chip, I'm expense minded. Good afternoon, Chip, I'm expense minded. Hey, I'm staying at Motel 6, Chip. I'm really excited about that.

So will that stay the same? Probably not, because if it's -- as we move to Slide 7, we are -- and we think about how we built this business. So we did have the de novo period of '08 to fundamentally May of '15 we started 7 verticals in those many years. The next couple of years we started 6 and we've been really busy the last 2 years and we started 14 verticals.

The last of which -- we went into business with a gentleman from Durham, North Carolina with a great deal of experience in the venture space. Venture space at Square 1 and at Silicon Valley Bank. And I'm sure, many of you on the call heard that 2 weeks ago Signature Bank did a 24 person liftout in that industry. So something's going on there and you can monitor us in that space a bit as well.

And I think the thing that really excites me is we're pretty meticulous about pipelines, proposal, through closing. And last April our pipeline was $1.3 billion and today it's about $2 billion. So we're beginning to hit on all cylinders at the -- in our core business with the theory of verticality.

But on Slide 8, also importantly, the work that Kay Anderson has done on the -- for us over the past year or so. So these, it occurred to us that this was an R&D project 3 years ago, so maybe of the 4,800 SBA lenders in the country, they don't all work here. So are we a culture? Are we a platform? Are we technology? So these 14 folks have joined us. I see that John Randall just reached his 1 year anniversary and did about $20 million worth of business. So is that past a proxy for the future for all these folks? I don't know. I'd like to think so, so all is going extremely well there.

So just my last little comment, and those for -- I think is Slide 9, before I turn this over to Huntley. And that is we are not an origination play anymore, folks. I repeat, we are not an origination play. So don't look for quarter-over-quarter originations. So if we just take a look at Q4 and Q1. In Q4, we increased our loan portfolio $253 million. Our average spread was 4.56%. Our tax rate is 10%.

So if you do the math, that's about $10 million in recurring revenue and if we keep expenses reasonably in line, as we just discussed, then you're increasing -- and your profit is $0.25 per share. And then we did it again in Q1, $244 million, 4.44% spread, 10% tax rate and another $10 million or $0.24 a share.

So that's my view of this business from a high level. Now, Huntley will be drilling down on many other things.

[Huntley Garriott, executive]

Thanks, Chip. As we indicated in our year-end results, 2019 will be a bit of a transitional year for us and we feel like we're off to a great start in that. We focused on -- on the core strategies of increasing recurring revenue by prudently growing the balance sheet, mindful of expenses and then continuing to invest in our platform.

And as you can see on Slide 11, some of the highlights from the first quarter. Chip mentioned our loan portfolio up 28% year-over-year, assets topped $4 billion. And we accomplished that by holding significantly more of our eligible loan production on our balance sheet. And so our recurring revenue is up, as you can see. And as Chip mentioned, we've been working really hard to keep expenses effectively flat year-over-year.

If you look at the lending side in a little more detail, so we said on our last call, we thought we could grow the balance sheet by $1 billion this year. In Q1, loan portfolio is up by almost $250 million and overall assets close to $400 million. So we're off to a really good start from that perspective.

At the bottom of the page you can see the production numbers, and as Chip mentioned, we think the story really is about the assets on the balance sheet. And so we're focusing as much on how we keep our customers on our balance sheet as we are the production numbers. But we do feel like the overall momentum is really good. Our pipeline is at all-time highs and so we think we'll continue to be able to grow this balance sheet.

If you look in a little more detail of our portfolio, on the left-hand side it just show that we continue to remain credibly well diversified across our verticals. We really don't have any individual verticals that stand out from a production perspective or concentration perspective. And then on the right-hand side you'll see the mix of what we're doing in terms of 7(a) production versus the USDA and conventional.

In the first quarter, we saw a little bit less real estate and solar projects financed, which we think we will make up over the course of the year. So you see a little more 7(a) in the mix than what we've seen sort of historically. But we still feel really good about the opportunities in the conventional space, as we sort of expand those filters beyond our traditional 7(a) focus.

Really quick reminder of the diversity and granularity of the portfolio. We're across 25 different industry verticals now, across 50 states, 4,000 borrowers. We anticipate our average exposures may creep up a little bit as we expand into some more conventional lending. But they are still going to remain really, really granular.

Chip talked about the credit stats, so we won't spend too much time on these. On Slide 15, you can see the headline numbers here. This is all still really well within our expectations. You know, the ratios have ticked up modestly a little bit as the portfolio ages and Chip talked about a couple of loans that made up the bulk of the increase in the nonaccruals. But we really don't see any systemic weakness across any specific areas of the portfolio as we sit here.

So moving to the deposit side, the story remains consistent, really good growth across the portfolio. We're at 40,000 retail accounts now. And that portfolio is up meaningfully 12% quarter-over-quarter. The retention rates look really good. And the overall operating efficiency still remains around 12 basis points. So we think this is a really efficient source of funding for us. And, yes, the market is competitive. You can see the increase in our cost of funds, down the bottom of the page. But there was also a pretty sizable CD maturity in the first quarter that bumped up some of those rates a little more than probably usual.

We continue to work hard on the technology side. We'll talk about that in a little bit to attract lower cost deposits. We are excited, though, that we've onboarded our first 2 Banking as a Service partnerships, which will start out small, but we think there's a lot of opportunity to use our technology in that space as well.

So if you migrate from the balance sheet to the income statement, Chip talked about the increase in our recurring revenues and our net interest income growth that's up $2 million quarter-over-quarter. Our margin did decline from 3.72% to 3.63% as deposit costs increases outpaced the loan yields. We did increase our liquidity portfolio. We added some duration to the balance sheet which hurt our margin a little bit, but we think it's overall good for our positioning. And given expectations for a flat debt environment, we expect margin to stay relatively stable for the remainder of the year, maybe dip down a little in the second quarter and then rebound, but pretty flat over the year.

So as we've increased the recurring revenue, the other thing that we've done is we've reduced the dependence on the volatile earnings that we've talked about. And so you'll see on this Slide 18 that both the servicing asset as a percentage of our capital is reducing, and then the gain on sale as well. So despite premiums that are actually rebounding and are up a bit from the from the troughs of last year, we're obviously, selling a lot less loans and generating a lot less gain on sale. And that servicing asset we expect to continue to migrate down as a percentage of our balance sheet.

Chip mentioned the expense side. Here's a little more detail just in the last 5 quarters of what we've done. It's a really good story. There's a few moving parts that are probably worth mentioning. The headline number which is flat to Q1 and down from the points in the rest of last year. And the trend of expenses to assets is moving really, really nicely. We did get a benefit in the quarter from trading out of an older airplane and that helped us, but there were also some onetime legal fees related to Canapi and some severance numbers, and that sort of offset that.

I think most importantly, though, this quarter really reflect a lot of hard work across virtually every line item, as Chip mentioned. It's travel, it's marketing, it's technology, it's facilities, it's everybody really just digging in and making really good decisions and being good stewards of our dollars. So as we move forward we'll continue to stay really focused on that, but we're also going to continue to invest in the platform and that's finding great people and that technology and we're not going to let up on that, because we continue to see really, really good growth opportunities.

So on the technology front you've heard us talk about the infrastructure builds for a while now. And it's been probably a 3-year journey as we've looked to rebuild parts of the core and how all these pieces plug in together. And I think we're getting to a really interesting point. We continue to build all of this ecosystem. In order to put this all together it takes more than a dozen different partners all coming together and so it's been probably harder than we even anticipated. But we've got a great set of partners that we've been working with, some of which we're invested in, and it all is coming together.

I think what's exciting to us is, as the roadmap becomes clear of just delivering on the checking accounts, the savings and CDs, our mind then begins to move quickly to what can we do that's new and innovative and differentiated, and that's where the fun really begins. I think, this year really is the infrastructure build and next year and 2020 you'll really see the benefits of lower cost deposits starting to hit our income statement.

So in summary, we laid out a set of metrics at the beginning of the year that we thought high performing banks should achieve and that we want get to. And so we'll show you where we are, and we'll show you that on a quarterly basis. And we recognized we've still got a lot of work to do. And -- but we're just going to keep our heads down. We did it this quarter. We'll continue to do it each quarter, delivering on our strategic priorities.

So I think with that let's turn it over to questions. Victor?

[Operator]

(Operator Instructions) Our first question comes from the line of Jennifer Demba from SunTrust.

[Jennifer Demba, analyst]

So could we talk about -- that Slide 20, by the way is very helpful on your deck. Can you just talk about where the checking account platform is and when you're at looking at rolling out? And then I have a couple of other questions.

[James Mahan, executive]

Neil, why don't you take that one, buddy?

[Neil Underwood, executive]

Well, sure will, thanks. Jennifer, the Finxact core continues to track. And I think we told you the checking account would be Q3 of this year and we're still tracking to that. It's -- to Huntley's previous point, putting in Payrailz, which is one company that we own, Apiture and Finxact, we've learned a lot from. But right now we're tracking. So we're excited about it. It's -- we're calling it [MVP], which will have everything from integrated merchants to small business checking and the like. And again, to Huntley's point, we think we'll do some really interesting things, including integrated loans and such at the end of this year and into next.

[Jennifer Demba, analyst]

And could you guys talk about -- assuming a stable economy -- relatively stable economy, when do you think you could be approaching the profitability metrics you're aiming for?

[Huntley Garriott, executive]

Yes. Look it's a good question. I think if you look at the balance sheet number, we're at $4 billion right now. We put out here $7 billion to $8 billion we think gets us into where the math suggests that these numbers will all fall in line. If we're putting $1 billion a year on this year, it's going to take us a few years. We're optimistic that as the platform grows, that we can even grow more quickly. We haven't put any numbers on that yet. And then as the deposit side, you know, can accelerate that as well once we start to get those really rolling. But both of those things, we're not putting specific timelines on those yet.

[Jennifer Demba, analyst]

And what kind of budget do you have, Huntley, for new hires? It looks like you've taken advantage of some opportunities. How aggressive can you get and still stay focused on expense controls?

[James Mahan, executive]

Jennifer right here before the NBA draft, I know maybe you don't follow that stuff, there's something called lottery picks, right -- and first rounders. So I don't think that this bank will ever turn away talent. So how many folks can we hire relative to general lenders? I mean, a number of these folks come from different banks. We're still in the market there. I mentioned the venture space a minute ago is becoming very interesting to us hourly. So we're just going -- we're going to take -- we're going to -- we will hire the best talent if it's out there.

[Huntley Garriott, executive]

Yes. And I think the limit is on how many new areas we go after at one time, right? We do a lot of research and a lot of homework before we go into one. Once we go into one and we see the results we want, adding on to the -- finding the best people in those make sense. So it's hard to put, we budget a number of verticals and a number people in those verticals each year. But like Chip said, when we find market opportunities, we'll take advantage of them.

[Operator]

And our next question comes the line of Aaron Deer from Sandler O'Neill.

[Aaron Deer, analyst]

The -- Chip, notwithstanding the, I guess, what seemed like a little lighter production in the first quarter, you see -- you sound very optimistic about the pipeline and still being able to hit that $1 billion growth target for the balance sheet for the year. Can you give us a sense of how the hiring is playing out? And if there's maybe some of the legacy verticals that are hitting plateaus that's maybe keeping us from seeing greater acceleration in terms of the production volumes and balance sheet growth?

[James Mahan, executive]

Aaron, I'm sitting here and looking at Underwood and you remind me of Underwood. I mean when we started this business, all he wanted to talk about was organic growth per vertical year-over-year. And you just can't do that. For the first 10 years we were flat in the vet business at $150 million dollars per. And then the SBA did kick us in the teeth a little bit. Our chicken business is off substantially because of the 10% down payment rule. So we just can't really look at it that way. I think the exciting thing, and Huntley alluded to this a minute ago is, we are constantly in the market for new verticals. Our broadband vertical is on fire. Our entire renewable energy space is on fire at about 6 separate sub-segments.

So plugging along year-over-year, the death care business is doing a lot better this year than they did last year. That seems to be coming back a little bit. I mean, we can go over, but it's like we just want a lot of looks at the basket. If you add them all up, they're like 27 of them today, right. And we'll continue that pace and we'll continue to look for new lenders.

[Huntley Garriott, executive]

And the only thing I'd add to that is, in the first quarter some of the lumpier assets are solar, and we see [area] hotels. Pipelines are good. They just didn't close in the first quarter. So I think you might see a little bit of a catch up in those, just back to sort of their norms. But, I think, Chip said it exactly right. We actually feel pretty good about some of the legacy verticals are actually outperforming and the new stuff is really online.

[Aaron Deer, analyst]

And then give some color on the credit trends. Obviously, the NPLs doubled year-over-year. I think some of that is probably just normal seasoning within the portfolio as you guys grow as an institution. But what gives you the confidence that there aren't any trends of concern? And can you give us what the classified numbers were at period-end as compared to year-end?

[James Mahan, executive]

Yes. I think I kind of had a slide on that. Steve, you could speak to that. But I just would remind you like -- so this is the -- I looked at it this morning. So from 1/1/15 until today, we originated about $6 billion -- $6.1 billion. So if you look at $20 million worth of nonaccruals and a couple of isolated loans, and then you look at all the metrics I just showed you, it's really -- it's no cause for concern to us at this point. But Steve you can drill down a bit deeper on Aaron's question.

[Steven Smits, executive]

Yes, Aaron, this is Steve Smits. To answer your question, the classified assets, to Chip's point the slide that he was referencing was Slide 5, I believe. So a year ago, Q1 of '18 it was 3.3% of Tier 1 capital plus our provision. Today it's 5.68%. We often call that the examiner ratio. And again to Chip's point, typically you want to be under 35% and you want to have some strong reasonings if you're closer to 50%. So we're well under that. So, again, I think you're exactly right. The trends that we see are still -- we're talking about very low numbers. It's very consistent with an aging portfolio, especially in some of our more aged verticals.

And what gives me confidence, looking forward, is the quality of the credits that we've been decisioning over the past number of quarters. They're strong. The metrics look very good, and I think that's due to our brand. We're seeing more looks, and very strong credit. So I feel very good about what we're putting in and the numbers tend to be very low relative to the overall portfolio size.

[James Mahan, executive]

Well, and I would remind you too, Aaron. I know you know all this, right? So it doesn't take much for Smits to put loans in these different watch list categories. And I'm sure all of your banks say that. But what I don't think you're used to is the level of insider ownership that you have at this bank because all those folks around here that own shares of this bank want to be extremely conservative in this regard.

[Aaron Deer, analyst]

I appreciate that. The -- and then just trying to understand the margin outlook. Obviously, it sounded like there were some pretty big CD maturities this past quarter that drove the deposit costs higher. What's the -- what's the volume of CDs that are going to mature over the next few quarters? And what is the variance between those that are maturing and kind of where your current market rates are?

[S. Caines, executive]

Yes. Hey, Aaron, this is Brett. Yes, we had a very large volume of CDs mature in Q1. That was in the mid $300 million range. For Q2, Q3 and Q4, that dipped down into the lower 200s. Q1 is always a really big repricing from a CDs standpoint, a big repricing CD maturity quarter. And then in Q1 of 2020, of course that's going to -- those maturities are going to jump back up again -- that number actually, that maturity number actually exceeds what we experienced this Q1. However, we could be in a very different rate environment at that point and it could be a much more favorable reprice in early 2020 compared to the unfavorable reprice this past quarter.

[Aaron Deer, analyst]

Then can you give us a sense of what the spread is between those that are maturing here in the second quarter and what the -- I know where your rates are today, but what those are that are maturing. What that rate was or will be?

[S. Caines, executive]

Yes, it really depends on what our appetite is for CD renewals. And fortunately with our portfolio we have great flexibility and being able to somewhat control that retention rate, we could in Q2 and Q3 focus more on really short term CDs rather than repricing the 12 months that mature, focusing on short term, and then maybe not repricing our entire savings portfolio. So our strategy regarding mix, I think, will be a more important driver than that rate adjustment.

[Aaron Deer, analyst]

And, Huntley, on the expenses, I'm glad to see that that's become such a focus. The -- I was hoping you might give a sense either in terms of what kind of a dollar amount run rate we might expect as we look out over the next couple quarters or if there's an efficiency ratio metric or something else that we can watch as a measure of your progress in minding that.

[Huntley Garriott, executive]

Yes. Look, I think the dollar amount is probably the best number as our profitability metrics have shifted. And so efficiency ratio is obviously high now. We do expect it to come down quarter-over-quarter. That expense to asset number, we also expect to come down. We are going to continue to invest in people. So does that number get closer to $40 million. It was hitting kind of around $38 million, that's probably not a bad number. We keep looking at places that we can be more efficient and then, candidly, reinvest that in great people. And so $40 million is probably a decent number. Love to try to hold the line a little below that, if we can, but it also depends on if we find lottery picks and we get a chance to bring them on, we're going to do that too. Thanks, Aaron.

[Operator]

And our next question comes a line of Christopher Marinac from FIG Partners.

[Christopher Marinac, analyst]

Brett, I want to follow up on your point you just made a minute ago about controlling the retention rate on CDs and renewals. Is taking on a slightly higher loan to deposit ratio one option that you have to therefore perhaps take less CDs and perhaps control your overall rate of deposits heading into the rest of the year?

[S. Caines, executive]

Yes. I think regarding a prudent and derisking our liability side a little bit, I think that loan to deposit ratio is what makes sense for us, given our deposit product mix. So I don't see increasing that ratio, at least in the near term, as a -- as sort of a realistic option for margin control or margin management. I will say as we approach year-end and more deposit products become available such as checking, then the comment I just made could certainly change.

[Christopher Marinac, analyst]

And I would imagine that the pace of deposit cost increases should slow maybe after second quarter. Is that a fair impression?

[S. Caines, executive]

I think that's probably a fair statement. I think the big unknown for us is what the competitive environment may be on the deposit side, certainly going into a flatter rate environment will help, but there's still that competition component to consider.

[Christopher Marinac, analyst]

And then last question just relative to the discussion earlier on asset quality. I mean your asset quality numbers with the slide information is very helpful, and they're still way lower than most banks and the industry at large. So is there a natural rate that as the economy ebbs and flows in future quarters that you may go a little higher than this, but you're still on a relative basis way less than the rest of the normal industry?

[James Mahan, executive]

Well, I think that's right, and Steve can comment, too. And Chris, you've known us for a long time. And there are days when I reflect upon when we started this business and then the massive recession that we had and how much fun it was going to all these shows that we go to, we were the only bank, because every bank and credit officer turned inward. So there is a wee bit of us that says, that might be fun again too. But that said, Steve, you can answer Chris's question.

[Steven Smits, executive]

So to answer the question, Chris, we managed to an expected loss rate for good times and benign times, which we could argue we've been in for quite a while, and we also manage and stress to more challenging economic times. And we feel very comfortable that the quality of our portfolio and the credits that we have will be inside of that. So we do look at that. It's to be expected, If you have more challenging times, small businesses will have some challenges. I will also add that historically, the health of our SBA franchise is important, because there tends to be opportunities in franchise lending. As the economy changes, i.e., you often see some stronger credits which tend to offset that for the new loans that we look at or originate.

[Operator]

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

[James Mahan, executive]

Thanks to all of our shareholders for dialing in, and we'll see you in 90 days.

[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.