Live Oak Bancshares Inc

NYSE:LOB

Earnings Call Transcript 2021-Q1

[Operator]

Good day, ladies and gentlemen, and welcome to the First Quarter 2021 Live Oak Bancshares Incorporated Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions]

As a reminder, this conference call is being recorded.

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

[Greg Seward, EVP and General Counsel]

Thank you. Good morning, everyone. Welcome to Live Oak's First Quarter of 2021 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 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 arrive 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 and in the presentation materials and commentary.

I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.

[Chip Mahan, Chairman and CEO]

Thanks, Greg. And good morning and welcome to our Q1 earnings call. As you can see from the agenda before you, we are kicking off today's call with a tribute to our Co-Founder, Kel Landis, who passed away on January 2. Your Board proudly created the Kel Landis Student Excellence Fund at his beloved University of North Carolina Kenan-Flagler Business School. We love you, Kel.

Some things never change. Once again, Huntley and I will attempt to unpack a healthy and yes noisy quarter. As I try to put myself in your position as to what really matters as the pandemic and government assistance to small businesses winds down, Steve Smits and I are going to discuss the COVID effect on our customer base and a brief look ahead.

We shall then turn our attention to Q1 loan originations and what loan growth looks like for the rest of the year as most other banks report a decline in loans outstanding and net interest margins. Trust me, that is not our challenge. Neil Underwood will provide a brief update on Live Oak Venture investments as well as what he sees through his Canapi lens. Lastly, back to the noise, before I turn it over to Huntley for greater detail, I'm going to focus on the metric that means the most to me, the core earnings of this business, which is a brief examination of our pre-tax pre-provision income.

So Steve, just about a year ago, the world was pretty bleak. And as I recall, you and your colleagues were predicting potential dire circumstances and maybe even losses of over $100 million. You quickly moved to isolate six of our verticals and disclosed that the current state of play in each quarter. Two questions for you. Number one, what losses have we taken from the COVID 6? And secondly, what have been the COVID losses in the rest of the bank?

[Steve Smits, Chief Credit Officer]

Thank you, Chip.

Yes, there certainly was a great deal of uncertainty. I was probably in the $34 million loss expectation in the early days, but today, we've taken $11.6 million in charges related to COVID. However $9.8 million of that was related to our hotel markdown. So if you exclude the hotels, we've charged off $1.7 million in loans that are directly a result of COVID stress. And of that, $1.2 million was in the COVID 6 industries and only $600,000 has been in the non-COVID industry. I do think it's important to note however that we've already reserved an additional $5 million on top of that for loans that were impacted by COVID. They may ultimately turn into charge-offs, but we're working very closely with them. We've also reserved another $10.8 million for loans that are experiencing some level of stress due to COVID, but I'm pretty cautiously optimistic as they are trending favorably today, so the expectation is we can avoid losses on most of this.

[Chip Mahan, Chairman and CEO]

So, Steve, clearly, we will be adding reserves for growth. But what does your crystal ball say about charge-offs for the rest of the year?

[Steve Smits, Chief Credit Officer]

Well, businesses still are not completely out of the woods and we do need to be prepared for potential surprises. Based on what I know today, I'm expecting charge-offs for the remainder of the year to be more reflective of pre-COVID levels. As I mentioned, we continue to work with borrowers still experiencing stress due to COVID, but at the same time, we're seeing a notable gain in credit quality across the rest of our portfolio. Many businesses are actually stronger today than they were pre-COVID and that's thanks in large part to the government programs.

[Chip Mahan, Chairman and CEO]

So Steve, our reserve plus fair value mark on our total held for investment unguaranteed loan portfolio was right at $70 million at the end of the quarter or 2.6% of unguaranteed loans down slightly from year-end to 3%. How do you look at reserves post-COVID?

[Steve Smits, Chief Credit Officer]

So Chip, I see reserves trending towards pre-COVID period levels as a percentage of loans and then barring any surprises, I'd expect that we'll see that trend over the next several quarters.

[Chip Mahan, Chairman and CEO]

So two of your verticals in the COVID 6, the restaurants and wine and craft beverage may get assistance from the Restaurant Rehabilitation Fund as administered by the Small Business Administration. It's my understanding that there is a pool out there of about $28 million for both restaurants and related businesses. We've heard that the calculation that goes something like this. 2019 revenues less 2020 revenues less PPP 1.0, less PPP 2.0, equals grant money. How do you see that?

[Steve Smits, Chief Credit Officer]

So if the program funds remain available, there is a small number of our most impacted restaurant bars that actually will see really significant benefits from the program. Now, the good news is that our portfolio in our quick-serve restaurants have actually fared really well, thanks to their delivery and their drive-through services. They may not even need a grant. Now, with regards to our wine and craft borrowers, this program can be very meaningful to our really our smallest breweries who have historically relied pretty heavily on on-site sales in tap rooms, for example. So again, barring funds being available for the program, we're pretty optimistic that our most in-need borrowers can see a significant benefit from this program.

[Chip Mahan, Chairman and CEO]

So let's move on to the site visit slide. Thank you, Micah. There it is. I call this our stand by our customer slide. We try to treat every customer like the only customer in the bank. And when you're in a jam, we're going to be there for you. So the support Steve's lack of charge-offs through the pandemic in the last four months, we made in the pandemic 121 site visits to these folks and the losses predicted, as Steve just did, are rather de minimis. So when you know this mess outright, we generated about $100 million in fees including spread income from PPP, and the losses were just like we discussed.

So, let's move on to the next slide. Let's focus on originations and growth. So how did it go first quarter? So we did originate and closed $1.180 billion in loans, $672 million was non-PPP, $508 million was PPP. So that reconciles the $1.180 billion. In addition to that, so far in the month of April, we've closed another $280 million. So $280 million plus $672 million gives us the $952 million for the year, which is just about $1 billion. And if you add the $508 million in PPP, that gets you to $1.460 billion or about $1.5 billion. Things are good.

Moving on to the next slide. So we rarely do this and we're not going to disclose actual dollars from that, but what you have here is a bifurcation of our pipe. So proposal to underwriting is the blue and credit approval to closing is the green. Both are up 60% year-over-year. Just another word, I had the wonderful circumstance yesterday afternoon to spend about an hour with our closers.

And to say that we're burning the midnight oil and attempting to keep up with this volume and treat every customer like the only customer in the bank would be an understatement. I also had the chance to visually zoom in and meet six new closers. And another six new are coming on in the middle of May. So in the last couple of quarters, we've added five lending officers, 13 underwriters, 25 closers, 16 servicers for a total of 59. So when the business is there, we're going to go get it.

Moving on to the next slide. This is our diversification slide and the trend continues. One of these quarters we're going to make loans in all 50 states, 45 ain't too bad for 90 days. And it looks like that our new verticals after 2017 are gaining on our legacy verticals late at $280 million versus almost $400 million by the legacy verticals.

Neil, talk to us about investments inside the holding company and some of these valuations that you're seeing at Canapi, brother.

[Neil Underwood, President and Director]

Well, certainly, touch on it in a bit. But first on out, like you just stated, only to say that things are tracking nicely and a lot of the Ventures portfolio, most importantly, the software is actually really working. We've had for years, as you guys know, Huntley will give you the Live Oak Bank update, but in terms of the companies themselves, they are experiencing greater market adoption, net new logos with larger annual contract values.

Cloud-based and API first are proving themselves out, offering better customer experiences, more optimal economics, really lowering the total cost of ownership. All these companies continue to raise capital at appreciating values. In fact, two of these companies you see in the state are in a raise currently. As a reminder, the thesis of Live Oak Bancshares was to leverage the collective R&D budgets of all of these companies, re-architecting bank infrastructure, which we all know is many decades old. Equity appreciation is certainly nice that's secondary to our first - to being first out with the new cloud-based tech.

Switching gears to Canapi, last quarter we finally closed out the fund totaling $660 million with 40 bank LPs, the ABA and the ICBA. And the thesis of working here as well as we continue to win deals away from blue-chip Silicon Valley venture funds. Most notably in Q1, we led $130 million-rounded Notarize alongside CapitalG, which as you know it's Google's venture arm. Notarize digitizes the notary workflow bringing gig economy notaries together with large enterprises and their clients.

What is even bigger than that in our view, we think of Notarize as the Uber of trusts. In terms of the market, we are indeed gypsying this massive valuations, it's super frothy out there. One thing that we're able to do though is actually invest at good valuations, given our limited partner base for the 40 banks, the ICBA and ABA and that's super exciting to us. We're able to get access to good deals where maybe others won't. We're also able to wedge ourselves in where there is not a formal round, we can actually go in, and given our LP base, so strategic, create around and create an event.

And again, just back to Live Oak, how Canapi affects Live Oak. In our role at Canapi, we define success by surfacing the best in fintech and sharing with the Live Oak product teams. Economics are also very real in the fund structure, but they too are secondary. Huntley, over to you.

[Chip Mahan, Chairman and CEO]

No, I got one more slide, Neil, but that's a good job, buddy.

[Neil Underwood, President and Director]

Oh, over to you.

[Chip Mahan, Chairman and CEO]

Yes, yes. So my last slide. It is my most important slide and I'm going to attempt to make a case that the $24 million of pre-tax pre-provision income in Q1 really ought to be closer to the $30 million. And you know, Huntley, I was thinking about this earlier today. I have been in this business almost 50 years, 48 years, and I am convinced myself that you almost have to be a Certified Public Accountant to actually understand a bank income statement.

So I'm going to read something that Jennifer Demba wrote last night, talking about $3 million of the $6 million of adjustments that I'm recommending that you focus on. She says, "As of Q1 2021, Live Oak will not elect fair value for the unguaranteed retained portion of all new government guaranteed loans sold. This decision reduces volatility and drives more predictable revenue for LOB. Under the fair value option, the unguaranteed retained portion is revalued each quarter.

Therefore, the legacy portfolio of loans at fair value will remain subject to quarterly fair value adjustments. Not electing fair value generally results in a larger discount on the retained loan portion and decreasing net gain on sale revenue. The discount is subsequently accreted into interest income over the remaining life of the loan."

To many, that will sound like gobbledygook. Let me see if I can unpack that. In relatively good times, we say we can sell a loan for about $100,000 per million. Under this new change, that $100,000 will go to $20,000.

And the $20,000 will be accreted into income over the life of the loan or if prepaid accreted instantly. So you can change your forecast by that amount over the entire portfolio going forward. This gives us, as Jennifer says, more predictable earnings. For the quarter, that was about $3 million. So if we recorded like we historically recorded, that $24 million would be $27 million. The other $3 million are legal fees, which are non-recurring, we certainly hope, in the not-too-distant future relative to a previously disclosed lawsuit.

And here to really drill down on all those details is our President, Huntley Garriott.

[Huntley Garriott, President, Live Oak Banking Company]

Thanks, Chip.

Before we get into the numbers, I want to spend just a minute on what's been and continues to be a pretty intense last year for our small business customers, all of our employees and the communities that we serve more broadly. Our focus has been and will remain to take care of those customers, to take care of our people, and to try to serve as an agent of change in those communities. So the areas of focus are the same, as Chip said, hopefully, we're emerging from this pandemic and we're all looking forward to some easier times, but we continue to stay focused.

So on the balance sheet on page 13, the overall growth trends remain really strong. Loans - loan growth up 33% year-over-year, excluding PPP. 5.5% linked quarter, driven by the strong loan originations that Chip referenced coupled with slower prepayment speeds as borrowers enjoyed some of the additional subsidies from the SBA. The eligible-for-sale portfolio continue to build, although at a bit of a more measured pace than last year.

On the income side, overall with provision down, fair value is moving in the right direction and the tailwind from PPP, the headline earnings number of $0.88 feels really solid. Breaking down those key drivers, we talked about loan origination. When you combine that with NIM expansionthat drove strong growth in net interest income, both year-over-year and linked quarter.

Net gain on sale was impacted by the change in accounting that we're going to talk about, and expenses are up with a few unusual items that we'll unpack as well. Bottom line, the adjusted pre-tax pre-provision earnings number ex PPP, as Chip referenced, up over 35% year-over-year, down a bit from Q4, but that still feels really good. And the growth rate of that is what's really going to be important. And we anticipate the net interest income continues to grow, non-interest income and expenses remain relatively stable for the year.

So as Chip alluded in his remarks, there's always seems to be a few moving pieces in the quarter and this one is no different. I thought I'll run through four of them. The good news is two of those items are ones that where we think we're going to reduce the noise. And then PPP, we all hope is behind us. So maybe three of these, we don't need to spend a lot of time with on the go-forward. In April, the last tranche of the market price RSUs vested. We talked about those in December. We had two more tranches of those that vested in the first quarter and then finalized those. So those are behind us. Going forward, we'll use the more traditional time-vested RSUs to continue to reward our people and those have a more predictable impact on earnings.

And then on the accounting side, as Chip referenced, we began the effort to reduce the amount of loans that we measure at fair value. And historically given the reliance on the guaranteed loan sales, fair value accounting made sense. As we transform this balance sheet and reduce the amount of loans we sell, electing to carry these newly original loan - originated loans at historical cost will reduce volatility and drive more predictable revenue.

But as Chip referenced and as Brett talks about in the CFO highlights, that result is typically a reduction in the upfront gain on sale. And that then is reflected in the carrying value of the portion of loans, so we actually end up with a higher yield and higher net interest income going forward. The end result, the cash flow is the exact same, the timing is different, less volatility. And again, that was about $2.7 million for the quarter and going forward.

Another quarter and another PPP program to navigate. Again, our team just did an extraordinary job standing up another set of systems and workflows, $500 million got into the hands of over 4,000 customers, so just really proud of the work there. We think that this program, 1.0 and 2.0 did exactly what it was designed to do. Steve mentioned how it helped our customers, but just helped countless borrowers and small businesses get to the other side of this, so we're all hopeful this is the last of these programs as we look forward. And that as these flow through earnings again, that volatility will subside.

And then finally, the other noteworthy event, we re-entered into the investment tax credit market, which supports our renewable energy lending. These investments are generally in solar projects, expected IRR of about 20% and they also oftentimes help fuel our relationship in our lending business. But the income statement geography is a little unusual. The benefit run through the tax line and then there is a corresponding increase in non-interest expense. So you see those numbers as well. They - it's a great investment, great projects, and but they show up in some interesting places.

So, we got more detail on page 15 on the market priced RSUs. I don't think we need to go into those here in too much more detail. Q1 - sorry, Q2, we have that last tranche about 100,000 shares that we settled and that will have a little bit more modest impact on the income statement and balance sheet in the next quarter and will be done. So page 17, detailed numbers on PPP, again originated just over $500 million in the second draw, generated a bit more than $21 million in deferred fees.

Over the course of the quarter through amortization and forgiveness, we recognized about $19 million through net interest income. We ended the quarter with about $1.5 billion outstanding in PPP loans and about $33.7 million of deferred fees remaining on the balance sheet. So forgiveness continues to roll along. We're about 50% complete with the first tranche balances and now we've got the second to add to that as well, but that's going well.

So, turning the franchise highlights, we've really already touched on all of this. Solid loan originations, balance sheet growth, margin, and that's the recipe for net interest income growth. On the credit side, as Steve described, we really feel good about what we're seeing and the opportunities that we're seeing for new originations in the market. And from everything we can see, it feels like we'll keep this momentum up. We've hired a handful of new lenders already this year and we're circling around a couple of new verticals that we hope to update you all on in the next quarter. So continue to demonstrate really the power of our of our lending franchise as it relates to small businesses.

So on the loan sales, the market continues to strengthen throughout the first quarter. And we touched on the accounting election, so we don't need to go into that in more detail. We did choose to sell a little bit more paper into this market strength. And then also, we elected to sell some fixed rate loans that manage the balance sheet and the interest rate risk a bit. Those fixed rate loans had a bit lower premiums than the typical floaters. So when you look at our total gain per million, it's down over $30,000 per million. And that's a little more than half of that is from the accounting change and then from that mix shift.

On the USDA side, we did have some loans that closed late in the quarter that we weren't able to sell before quarter end. But that market remains really strong and we'll continue to be active there. And overall, as you can see on page 20, we remained pretty close to our targets selling about a 35% of the loans that become eligible on the SBA side and most all of the USDA loans. So again, that can bounce around on any given quarter, but our long-term targets remain the same. And then the bottom of page 20, you can see the loan portfolio and the amount of fair value loans that we have and our intention to have less of those as we choose not to elect fair value going forward.

So turning to expenses, a few items to unpack here. Page 21 has the headline number and trends, and then back in the appendix on 35, you've got some details worth noting, namely the $3.1 million in investment tax credit. Impairment is in there. There's $900,000, which is an impairment charge on a solar project that's taken longer to get out of the ground than we would like. So, think of that more on the credit side. And then the $2.6 million for the market priced RSUs, all of those gets you to an adjusted number around $53 million, which we think is a tad more of the number that we think about. Chip mentioned that there is elevated professional services legal fees in there and then there is a severance of about $750,000 in there. So when you net all of that out, you can compare that to an adjusted number of about $48 million in the fourth quarter.

Chip mentioned the growth that we're seeing on the lending side, the balance sheet side, and we've been working hard to keep up with that growth operationally and hiring. Over the course of last year, we just ran incredibly lean. So, we've invested a bit more across the franchise. Now as you look forward, that $53 million number should probably stay around there, maybe drift up to about the mid 50s on a quarterly expense going forward when you take out the tax equity investments.

On the deposits side, just a really, really solid story. The franchise here feels a little bit like GARCH-style investing, so growth at reasonable prices. 64,000 accounts opened. That's $4.8 billion of retail deposits, which is up from $4.3 billion at the end of the year. All of that, we pay 60 to 65 basis points and all the new money and we just dropped rates another five basis points for the majority of our products today.

I think we still have a little more room likely to tick down over the course of the year. Retention rates have been high on the savings account, given the overall liquidity trends. You see our mix has shifted away from CDs, more into savings, which we like. And the cost to operate the franchise is still under 10 basis points, even with some investment on the checking side. So $850 million were priced over the last quarter, another $2 billion are pricing in the next 12 months. We expect to continue to enjoy the benefits of this operating environment for our deposit model.

Turning to margin, the stated net interest margin jumped almost 50 basis points, largely driven by PPP, but also the lowering deposit costs we just talked about. But on an adjusted basis, we enjoyed a 13-basis point increase in margin to 3.46%, even with the spike in liquidity that happened in the quarter, given the strong deposit trends and some lending activity that pushed into Q2. So loan yields remained steady holding around 5.4%, and we expect that margin, ex PPP, to continue to trend up through the balance of the year.

So Chip talked about the metric that we stay laser-focused on this adjusted pre-tax pre-provision income without PPP. And there isn't ever one single metric that you can rely on. But given all the moving parts of the strategy, this one we do stay anchored to. You've got the details on page 25. On 26, we have a waterfall that just shows the changes year-over-year of the key drivers and then the linked quarter as well.

The year-over-year trend, 27% growth driven largely by that net interest income and then on the linked quarter we've talked about continue to have really good growth in net interest income and then some of the items that we've sort of already talked about that got that number down. Again that growth in that going forward is where we're really focused and feel good that we'll continue to be able to generate that.

So turning to the balance sheet, still feels pretty fortress-like with strong amount of government guaranteed assets on the balance sheet, excess liquidity, solid capital ratios. The Tier 1 leverage ratio ticked back up in the quarter after dropping a bit last year. We're seeing right about 8.50% on the Tier 1 leverage ratio, which feels really comfortable now and we think that's going to continue to tick up over the course of the year.

All in all, we feel really good about the performance metrics, recognize some of them are influenced a bit by provision or fair value adjustments. What we did on this page that you'll see new at the bottom of the page, we added a couple of growth metrics, because we think that as we achieve high performance and demonstrate that, it comes in three categories: safety and soundness, as Chip and Steve talked about; profitability that we've been showing here; and then growth. And we feel really good about what we can deliver on the growth side with safety and soundness, and profitability in focus.

So a quick update on the technology stack. We are live with our pilot of checking accounts. That's going really well. Between that and all the new business savings and CDs that we book on the new platform, we have almost 2,000 customers and over $150 million on that core. That's in addition to the $1.5 billion of PPP loans that are on that core.

So we put almost $100 million of new deposits on the platform since year-end. We'll continue to expand the checking pilot into general availability and we're planning on converting our 64,000 deposit customers in Q3. We're just laser-focused on getting that right and then adding on features and functionality that we've talked about that we think are going to be really unique for small businesses.

I'm going to close with a quick note on our ESG efforts. I would encourage you all, if you haven't seen the impact update in our Annual Report. We've got some great information in there. And we recognize that we and all companies and business leaders and all of us play a key role in driving forward efforts of diversity, inclusion and climate change.

And while there's always more we can do and that we will do, we're really proud of our accomplishments and initiatives, as it relates to our employees, our Board, serving the communities that we are in and then the small businesses that we serve across the nation, plus our renewable energy efforts just feel like they continue to have great tailwinds and some changes in administration and government-backed that will make that even more impactful. So we know many of you are increasingly focused on the topic as well and look forward to sharing incremental data, but also having increased dialogue with you guys on this front.

So with that, head to questions?

[Chip Mahan, Chairman and CEO]

Let's do it.

[Operator]

[Operator Instructions] Your first question comes from Jennifer Demba with Truist Securities.

[Jennifer Demba, Truist Securities]

I've got a few questions. Number one, Chip and Huntley, what do you see as the biggest risks to your budget and earnings expectations in '21 right now?

[Chip Mahan, Chairman and CEO]

The biggest risk to our internal budget that you haven't seen.

[Steve Smits, Chief Credit Officer]

I mean, I would start and say prepayment speeds have been really favorable. And if we see a big spike in that in the back half of the year, that will move some of the fair value numbers around. And that's - again the budget numbers, that also could reduce the growth of the balance sheet a little bit. But that's maybe the one that's a little bit out of our control. But that would be the one that I think where that I look at, but you want to, Chip?

[Chip Mahan, Chairman and CEO]

I would say just examining the pipeline and originations, we still feel really good about what we told you last, $3 billion to $3.1 billion. And Steve, I've probably been with 40 customers the last 90 days. And I reaffirm what you say, it just - it doesn't seem like there are many big credit surprises out there to Jennifer's question. I think we're pretty much steady as she goes. You really did scrape. Yes.

[Steve Smits, Chief Credit Officer]

I agree.

[Jennifer Demba, Truist Securities]

Okay. Can you give us an update on where the lawsuit stand that you referenced in the press release?

[Huntley Garriott, President, Live Oak Banking Company]

Yes, Jennifer, it's Huntley. We put out the disclosure that we got and that's sort of all the update we got right now.

[Jennifer Demba, Truist Securities]

Okay. All right. In terms of legal fees, do you have any thoughts on what the legal fees might be for the rest of the year?

[Huntley Garriott, President, Live Oak Banking Company]

We'd always like to have lots of them.

[Jennifer Demba, Truist Securities]

Okay. Last question, the deposits continue to reprice down. How do you think about positioning the funding base for a different rate environment where certain funds are higher in the current funding mix is not as favorable for Live Oak?

[Huntley Garriott, President, Live Oak Banking Company]

Yes, look, that is why we're so laser-focused on building out a checking account and operating accounts, because we know that they have real advantages in a rising and higher rate environment. So we love what we're funding with now. And our goal is to be building out those checking accounts and operating accounts, so that if and when that cycle turns, we can capture that advantage.

[Jennifer Demba, Truist Securities]

Do you have any specific targets like, I want to - you want to get to X amount by the end of next year or something like that to share with us or can you give us any detail there?

[Chip Mahan, Chairman and CEO]

I think that's too early right now to do any of that.

[Huntley Garriott, President, Live Oak Banking Company]

Yes.

[Steve Smits, Chief Credit Officer]

We've said that we don't think it's going to have a lot of financial impact this year and we still stand by that. But if we get that right, if we start to look into next year, well, I think we can give some targets. As we look at our plan for next year, we still don't have that in there, and we still think that we've got a really solid sort of operating model, but we can start to give more detail on our expectations as that - as we get closer in the year.

[Jennifer Demba, Truist Securities]

Okay, great. And you did a great job giving the filing information I think we need and the slide deck and in your monologues. Thanks.

[Chip Mahan, Chairman and CEO]

Thanks, Jennifer.

[Operator]

Your next question comes from Michael Perito with KBW.

[Michael Perito, KBW]

Hey, good morning, everybody. Thanks for taking my questions. Chip, like you, I'm a bit more of a plain English guy, so I was wondering if I could maybe just hash through a couple of these items to make sure I'm thinking about them the right way. And I wanted to start - so I mean, is it correct to assume that given the change on the fair value, I mean, on the incremental gain on sale, your margins are going to move down over the course of the balance of this year and then eventually sell down at a lower rate. Is that directionally correct or am I misinterpreting what's going to happen?

[Chip Mahan, Chairman and CEO]

I'm so excited that for the first time in over a year that Brett Caines is standing next to me to answer that question, six feet away.

[Brett Caines, CFO]

Hey, Mike. Yes, I think as we look going forward, it's going to look more similar to Q1. So if you take what you saw in 2020, probably in Q3 and Q4 of 2020, and as Chip mentioned, about a 20% reduction in gain on sale revenue given this accounting election that we've decided to make, that's probably a good forward way to look at it. I will reiterate what Huntley said, the secondary market right now is our premiums being paid are very, very favorable. And I think they're probably at an all-time high right now. So of course, the market impact which we cannot predict, that comes down, that was like more of a change downward compared to Q1. But just in a steady market, just the accounting election change is about a 20% drop in the expected revenue on gain on sale.

[Chip Mahan, Chairman and CEO]

We should have probably done this before, Michael. I mean, this is kind of like son of servicing asset reval, servicing at reval, down $9 million one quarter, up $5 million in the next. That's why we started holding a bunch of these loans. We've leveled in these loans. This is the same thing. We probably should have done it some time ago to give you more predictability.

[Brett Caines, CFO]

And then again just to reiterate, we do get all of those cash flows back over the life of the loan. And on booking the retained piece, probably about 100 basis points on average of incremental loan yield on that retained piece. So it's not an insignificant benefit over time in the net interest income line.

[Michael Perito, KBW]

Got it. So - and that there is income benefit to the margin over the life of the loan, near term, the big gain on sale margins will be more indicative of the first quarter than the back half of last year from an accounting perspective and then we'll have to make considerations for the environment and the demand for secondary loan sales over the course of the future. That seems to be the general gist?

[Steve Smits, Chief Credit Officer]

You nailed it? Yes.

[Michael Perito, KBW]

Okay. And then on the cost side, I was wondering, first, if you maybe could just talk a little bit about the pipeline for additional kind of renewable energy investments. And then maybe just spend a second to talk about kind of some of the risk factors we should be thinking about as you guys, I imagine, consider to do more of these? Is it any noticeably different than a typical tax credit type situation or anything else unique we should be thinking about?

[Huntley Garriott, President, Live Oak Banking Company]

Yes. So our - when we think about it, we want to - given the geography of the income statement, we'll be mindful of sort of capacity to do these relative to taxable income. That also drives the timing with which that you can recognize and that drives the IRR. So we'll do - maybe we can give you a bit more color about sort of capacity, but I think, think of it in the context of what we did in this situation relative to our taxable income.

So we'll continue to look to do a little bit on a programmatic basis. Nothing and I don't have any giant spikes, but we'll try to continue to do something similar to this. And they can be a bit lumpy. These projects take a while to get together. So close one in one quarter, one in the next quarter, maybe a little bit lumpy.

We're going to try to avoid that. From a credit perspective, Steve, you can pile in. We like these projects from a repayment perspective. The project needs to stay operational in order to secure the tax benefits from the program. So your real risk is that you can't operate the program and we've been in the business long enough to feel comfortable that even if something were to happen with an operator, you can find another operator and keep the lights on. So, but I don't know, Steve, on the credit side, do you have any thoughts?

[Steve Smits, Chief Credit Officer]

You're exactly right. It - our experience in this space is incredibly important. We've learned a great deal over the years. We've refined our servicing. We have the proper controls in place. So we feel pretty comfortable that we can identify good projects, learn from those projects in order to make smart investments on that side of the equation. So that all comes together.

[Chip Mahan, Chairman and CEO]

Brett, do you have anything to add, brother?

[Brett Caines, CFO]

Yes, I would say, Mike, as you're thinking about and all of you, as you're thinking about modeling in these type Fed investments, probably the simplest way to think about it is take a look at what you're forecasting for pre-tax income. And our investments right all for the probably around 10% of that number and then that helps us target a tax rate kind of in the mid-teens.

[Michael Perito, KBW]

Got it. That's helpful. So that to take that all on the costs side, right, so I think, Huntley, you mentioned the adjusted - I think it was $53 million, obviously, there is still some elevated legal fees and that $53 million, that could hopefully drop off as the year progresses here. But then next quarter, there'll be some additional small hit on the RSUs on top of that $53 million. And then potentially in the back half of the year at some point, there could be some more impairment related to any additional renewable projects that, that could also possibly come in. Is that generally fair? Is there anything else significant beyond that, that you would highlight?

[Huntley Garriott, President, Live Oak Banking Company]

I think that feels good. Brett, do you…

[Brett Caines, CFO]

Yes, I think you nailed it.

[Michael Perito, KBW]

Okay. And then just what about growth rate, right? Because I feel like there is a dynamic here that obviously you guys are building platforms that are scalable and you're trying to leverage those economies of scale. But clearly there is, as you guys mentioned in your prepared remarks, there is a high need for investment as your bank grows significantly, right. So I mean, how should we think about kind of the cost growth dynamic as we think about adding talent and supporting growth, but also trying to leverage platforms that you built that are highly scalable?

[Chip Mahan, Chairman and CEO]

Well, I'll tell you the way I look at it. Huntley, you can add to this, right, pretty simple. If we can grow the loan portfolio of 15% and EPS 15% year-over-year, that's our goal. Hopefully, we can beat that a little bit, but that's what we say internally and that's what we shoot for.

[Huntley Garriott, President, Live Oak Banking Company]

Yes, I think on a balance sheet revenue 15% to 20%. And then if we can keep the expense side closer to 10%, then we're creating significant operating leverage. So those are kind of metrics again it gets a little lumpy, and - but 15% plus on the balance sheet and revenue side, and 10% plus - and 10% on the expense side, feels like a pretty good - pretty good numbers.

[Michael Perito, KBW]

Got it. Yes. No, I - the PPP isn't doing anyone any favors in terms of trying to model any of this out. But I appreciate all that commentary. Thank you, guys, for taking my questions.

[Chip Mahan, Chairman and CEO]

Thank you, Michael.

[Huntley Garriott, President, Live Oak Banking Company]

Yep.

[Operator]

Your next question comes from Steven Alexopoulos with JPMorgan.

[Alex Lau]

Good morning. This is Alex Lau on Steve - for Steve.

[Huntley Garriott, President, Live Oak Banking Company]

Hey, Alex.

[Alex Lau]

Hey. On your loan originations ex PPP of $670 million per quarter, this was a drop from the prior two quarters from around the $900 million range. Do you have some color on what drove the lower originations or was it more of a timing thing?

[Chip Mahan, Chairman and CEO]

It's more seasonal, Alex. That's what we tried to show in that slide. I can't remember the percentage we were up over last Q1. Q1s are a slow quarter. And we've made a little bit of a comeback and close to really large loan in April. But I think we're standing by what we said last quarter, $3 billion to $3.1 billion still feels pretty good. So you shouldn't view that the way you're viewing it, because Q1 is slow.

[Huntley Garriott, President, Live Oak Banking Company]

Yes.

[Alex Lau]

Understood. And I'm sorry if I missed this, but can you give some color on the uptick in non-performers in the quarter? Thanks.

[Steve Smits, Chief Credit Officer]

Yes, this is Steve. Several loans for which we've impaired over the quarter, but not anything significant. I mean, it was actually relatively small number of relationships. Most of them are tied into challenges that existed pre-COVID, where COVID just simply was not - didn't do them a favor. So, I put it in the category influenced by COVID, but had pre-existing challenges that we continue to work through.

[Alex Lau]

Thank you. And just last one, can you talk about how you're marketing the checking accounts? And do you have a target or a sense of the growth potential for the year? Thank you.

[Chip Mahan, Chairman and CEO]

Micah, do you want to talk about marketing, and then turn it over to Huntley since you're the marketing guy?

[Micah Davis, CMO]

Yes. So our focus now is to build the pilot out and get the system stable and ready to go. So we don't have any definitive plans yet or definitive budget to market it, but we feel word-of-mouth will be really good and existing customers will definitely want to purchase.

[Huntley Garriott, President, Live Oak Banking Company]

We'll start there and then our ultimate goal is to leverage partners for distribution and product enhancements through embedded banking. And so, this platform is easily integratable into other software, vertical software in other partners. So that distribution channel ultimately will be our strategy, when, as Micah said, we're ready to hit the accelerator.

[Chip Mahan, Chairman and CEO]

I think, Alex, too we are going to have an Investor Day when this pandemic goes away probably here in Wilmington, where we can describe to you as we've described to most of you in the past what all that means, what is the community [indiscernible] future. So we will March vertical by vertical to create a deposit experience embedded in what you need to operate your business from financial planning to credit books to tax to all these other things, practice management software in the platform.

We've been working on for four years with Finxact in the middle that allows us to do that. Cloud-native API first, but that is not something that we can drill down on one question on our earnings call. That's why we're going to invite all you folks to Wilmington, when things settle down from this damn disease.

[Alex Lau]

Thanks for all the color.

[Operator]

[Operator Instructions] Your next question comes from Chris Donat with Piper Sandler.

[Chris Donat, Piper Sandler]

Chip, I wanted to review a bit of your - the dialogue you had with Steve on slide five and the site visits. I liked what I heard about guardedly optimistic, but also recognize still not out of the woods. Can you just give us a little color on how you think the world might look as some of the beneficial impacts from PPP and various stimulus programs fade over time? Like you were just talking about in the last question, there are some businesses that were challenged before the pandemic.

I feel like there's going to be some cohort of businesses that really aren't able to bounce back robustly. But I don't know if that's going to mean much for your credit quality. So just trying to understand a bit how this unfolds for small businesses for credit quality as some of the help is withdrawn.

[Chip Mahan, Chairman and CEO]

So I'll start, because of Steve has to stay back and plant himself at the door of the ball, then I get to fly around and meet with customers, particularly ones that are challenged. So I think the programs, Chris, have worked. And I think that our lending officers did a great job of picking folks that had eye of the tiger. Now, there were a couple that just gave up and threw us the keys, but there weren't many.

And Steve basically alluded to the charge-offs earlier in his comments. So just simply put, with all this government money that's out there, the ones that want to fight are going to, I think, just be fine. I just don't see very many losses. I mean, whatever that total number you came up with a minute ago was de minimis compared to what we thought a year ago. And you may want to tag on to that.

[Steve Smits, Chief Credit Officer]

The government programs are wonderful.

[Chip Mahan, Chairman and CEO]

Yes.

[Steve Smits, Chief Credit Officer]

At the same time, we cannot become complacent. So it's not lost on the significant percentage of our borrowers that were receiving subsidy payments, for example, from the government. We could become very complacent with the payments coming in and lose sight of really what's going on with that business. So I talk about the surprises. We will - how do we minimize the surprises, the throwing in the keys. We call them the subsidy riders.

They're riding the subsidy payment, but their plan is to throw in the keys at the end after the government stops. So it's all about servicing to knowing your customer. We've talked about this in prior earnings calls. We put a stress mark on every one of our borrowers. As we sit today, 97% of the entire portfolio we have a stress mark. You can't put a stress mark unless you have talked to that customer, collected financial data, measured that financial data and assessed the stress. So we have a really good intel on how our borrowers are doing, which gives me great confidence. But I am aware that the March payment, 37% of our portfolio in terms of dollars had a subsidy payment made.

One data point is our payments are the fifth of each month, so we felt really, really good that most burned off in April. In addition, we see that stress mark from high to medium to low trending towards low. And those are based on real numbers. So what matters what does your balance sheet look like? Have you made the right thing? Have you received government support? Has that wound up on the balance sheet to give you some cushion as you get back on your feet? What does your credit look like? What is your status with your vendors? So we think about, well, what's the next shoe to drop. It's going to be are you in arrears with your vendors? Do you have some past rent that you're going to have to make up with? What's your strategy? What's your 13-week burn rate? We're looking at all of those really diligently. So we've invested pretty heavily on our servicing to get as good a feel as we can about what our portfolio looks like going forward. There will be surprises. I've talked about it. That's why we've got reserved for that. Hopefully, it doesn't turn into losses. But we feel that we've done everything we possibly can do to have a good feel for the health of our portfolio at this time.

[Chip Mahan, Chairman and CEO]

And I think the conclusion there, we'll stop talking here, as you know, we're just so unusual. We have plenty of capital, stated capital. And you got another $1.8 billion of government guaranteed loans and that's got a value of 150 plus million. You got all of Neil's Live Oak Ventures, that's another $150 million. And then basically the PPP numbers is close to $100 million as well, if you add up all the fees and the spread income, as I mentioned earlier in my comments, so we have a balance sheet that is way different than any other bank that you cover.

[Chris Donat, Piper Sandler]

Got it, okay. Thanks for all the color there. And then sort of related issue here as we think about the future. Just the pace of PPP round two originations, it felt like you guys started a little slower than others. And looks - just wondering what you - how you're thinking about second quarter or at least through May 31 for PPP originations?

[Steve Smits, Chief Credit Officer]

Yes, I think we've really focused, given everything else we have going on, on our existing customers in helping them through, and sort of got through that and are effectively done. I mean, there may be a few other little pieces that come, but effectively I think we served our customers that we could and feel good about that. So it was a big effort to stand that up again and in quite of the luxury of taking the entire company and turning towards it like we did a year ago. So - but I think for Q2 purposes, we're effectively - you shouldn't think about much new in the pipe.

[Chris Donat, Piper Sandler]

Got it. Okay. Thanks very much, gentlemen.

[Chip Mahan, Chairman and CEO]

Thanks, Chris.

[Operator]

All right. And I'm showing no further questions at this time. I will now like to turn the conference back to Chip Mahan, CEO.

[Chip Mahan, Chairman and CEO]

Thank you, ma'am. And thanks to everyone for attending and we'll see in 90 days.

[Operator]

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. Have a wonderful day. You may all disconnect.