Live Oak Bancshares Inc

NYSE:LOB

Earnings Call Transcript 2024-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to the Q2 2024 Live Oak Bancshares Earnings Conference Call. [Operator Instructions] This call is being recorded on Thursday, July 25, 2024. I would now like to turn the conference over to Greg Seward, General Counsel and Chief Risk Officer.

[Gregory Seward, executive]

Thank you. Good morning, everyone. Welcome to Live Oak's second quarter 2024 earnings conference call. We are webcasting live over the Internet, and this call is being awarded. To access the call over the Internet and review the presentation materials that we will reference on the call, please visit our website at investor.liveoakbank.com and go to the Events and Presentations tab for supporting materials. Our second quarter earnings release is also available on our website. Before we get started, I'd like to caution you that we may make forward-looking statements during today's call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings. We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today's call. Information about any non-GAAP financial measures referenced, including reconciliation of those measures to GAAP measures, can also be found in our SEC filings and in the presentation materials. I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.

[James Mahan, executive]

Good morning, everyone, and we're excited to tell you about our second quarter performance. Firstly, to use a baseball analogy, I'm instituting a line of change. Appropriately, BJ Losch, our President, will be our lead-off batter today, while Phifer, our CFO, will be on deck; and even more appropriately, I will be in the hole to wrap things up before the Q&A. BJ?

[William C. (BJ) Losch III, executive]

Thanks, Chip. Good morning, everybody. Let's start on Slide 4 and 5 together. Second quarter results, as I hope you've been able to take a look at, are reflective of significant efforts by everyone across the company here at Live Oak to grow our business profitably, and very importantly, control what we can control. And it showed up this quarter certainly in strong EPS and PPNR on both a reported and adjusted basis in healthy loan and deposit growth, higher production and activity and continued credit quality. That's what we'll demonstrate over the next several minutes. Momentum is building across numerous parts of the company. On the lending front, our teams delivered exceptional production and balance sheet growth results and healthy spreads in the quarter. And yet, approvals are up 30% from this time last year and pipelines are still near all-time highs, both of which bode well for continued growth. As you can see on Slide 6, our focus on the basics, growing revenues faster than expenses, while still investing in good costs such as new lenders, verticals, products and technology has resulted in exponential PPNR growth, up 33% on revenue growth of 11% on an adjusted basis since Q2 of last year. Our credit quality continues to be a hallmark. The result, as you can see on Slide 7, is very healthy reserve levels, low levels of charge-offs and significant reserve building, well in excess of charge-offs. Importantly, with our disciplined credit box, deep understanding of the government guaranteed lending process and an unmatched in-depth servicing and watch list process, results in an ability to get ahead of borrower stress. And as we've discussed previously, we are proactive with provisioning for growth, for changes in portfolio performance and for impairments of specific loans when warranted. So we are well reserved if charge-offs occur. Turning to Slide 8. While I'm certainly pleased with this quarter's results, as a growth company, I'm much more excited about where we're headed. Checking balances, which were immaterial 6 months ago, crested $125 million in the quarter and continue to build. Our new small dollar SBA lending effort is ramping up quickly and will be a meaningful contributor to our results over time. Our brand and reputation continues to attract and retain the highest quality talent. And we continue to heavily invest in the future through innovative technology and partnerships. The flywheel is definitely turning at Live Oak and our ongoing opportunities to serve more of America's small businesses are vast. So with a big thank you to all Live Oakers and our customers for a strong quarter, I'll turn it over to Walt for some more highlights.

[Walter Phifer, executive]

Thank you, BJ. Good morning, everyone. As BJ just provided a high level overview of the quarter, I'll spend the next few pages focusing on additional context on trends related to our balance sheet growth, key revenue and expense components and credit. Slide 11 highlights our loan originations by vertical and business unit. As BJ mentioned, we had a strong quarter of loan originations in Q2 with approximately $1.2 billion of loans closed. This is 45% higher than Q1 and is our second largest quarter in bank history. 2 items to note on this page. The first is on the bubble chart on the left. Approximately 60% of our verticals have had a year-to-date loan origination volume at or above prior year levels. The second is the strong performance by our SBB's specialty business units in Q2 2024 compared to Q2 2023. You can see this on the bottom right-hand side of the page as the Q2 2024 originations for Small Business Banking and Specialty are up 30% and 88% year-over-year respectively. Our Energy & Infrastructure business unit has had a slow start in the first half of 2024 due to delays in loan closing timeline, yet that team has closed approximately $80 million of loans thus far in Q3 and the pipeline remains strong. Slide 12 illustrates the strength and consistency of our balance sheet group over the past 5 quarters. While many banks across the industry are seeing minimal, if any, loan growth, our loan balances were up 3% linked quarter and 14% compared to the prior year and this growth is net of our loan sales and participations activity. Deposit growth is fueled by our customer deposit platform, specifically our business deposits, which are up 8% linked quarter and 29% compared to prior year. This is an outstanding story given how competitive the customer deposit market is today with many banks across the industry struggling to grow or even maintain their deposit base, especially their non-interest-bearing deposits. Slide 13 gives a little more detail on our quarter-over-quarter loan growth by component. The key takeaway from this page is that prior to our typical sales and participations activity, our loan portfolio growth was 7%. That's right, 7%, linked quarter as new fully funding originations and construction loans continue to drive balance growth. Slide 14, untaxed and net interest income, NIM and yield trends. Our net interest income increased 1% linked quarter and is up 80% compared to Q2 2023. This is primarily driven by our loan growth. Our net interest margin compressed 5 basis points quarter-over-quarter due to a full quarter of interest expense related to $100 million term loan added at the end of Q1 for growth capital of the bank. Absent this borrowing, our net interest margin would have been flat quarter-over-quarter. That's a great outcome. Now there are things we can't control and things that we can control. Some things we can't control are when the Fed will reduce rates [indiscernible] the competitiveness of the deposit market or other macroeconomic or political impact. Now these type of things will certainly have an impact on the slope of our NIM trajectory, yet we feel really good about the things we can control, all of which will help our NIM performance going forward. As I just mentioned, our loan growth momentum and pipeline remains robust. Growth will be an essential component of our net interest income and NIM expansion. We continue to demonstrate good pricing discipline on new loan originations, averaging prime plus 60 basis points or 9.1% in Q2, thus remaining accretive to our loan portfolio yield, which currently averages 7.79%. And our increase in cost of funds since Q2 2023 has largely been driven by maturing CDs renewing into a higher priced offering. You can see in the middle of the page the substantial headwinds this has generated in 2023 and 2024 as that portfolio is approximately 26% of our deposits. The fact that we have been able to maintain our margin over the last 5 quarters with this level of volume repricing as those significant increases is a great outcome. These headwinds have slowed in Q2 2024 and we expect our CD portfolio repricing to provide tailwinds over time once the Fed reduces rates. Quarter-over-quarter fee income is outlined on Slide 15. We sold $250 million in Q2 2024 for an average premium of 6%, largely in line with Q2 2023. 2 important things to note on our Q2 sales volume. We sold our first batch of small loan SBA 7(a) to only $9 million in loans sold for an average premium of 11%. We continue to be excited about the profitability opportunity on small loan front. The other items to note is given the improvement in the secondary market in general, we were also able to sell approximately $40 million of seasoned loans that were previously under water, another great outcome for the quarter. Turning to expenses on Slide 16. Our Q2 2024 expenses of $78 million were flat linked quarter and increased 3% compared to Q2 2023. Our teams have shown great expense discipline over the last year, even while adding 20 growth-oriented FTEs in our lending verticals, 5 FTEs in our treasury management department to support our business checking initiative and continuing to invest in the technology side of the house. As we have been over the last 5 quarters, we remain focused on adding good costs where needed, while continuing to identify expense efficiencies where possible, so we can continue the positive PPNR trends that BJ just spoke of. Key credit trends are included on Slide 17. We continue to be pleased with the performance of our credit portfolio and what has been a challenging environment. Our Q2 $12 million provision was primarily due to loan growth, what we refer to as good provision. And our linked quarter credit trends are generally favorable with non-accruals and classified asset ratio is trending downwards. As you can see in the top left graph, our over 30 days past dues were up linked quarter. This was largely a result of 2 loans with a total of $15 million of unguaranteed balances. We are currently unconcerned about further deterioration of those loans at this time. Given our highly attractive portfolio characteristics and our significant credit monitoring activity, as outlined in our last call, we remain confident in our reserve and the portfolio's credit strength. Lastly, Slide 18 highlights our capital strength, which remains positioned well to support our growth going forward. Overall, as BJ said, it was a fantastic quarter. We are very pleased with the outcome and we are looking forward to the continued momentum. I will now turn it over to Chip to add his final comments before Q&A.

[James Mahan, executive]

Thanks, Walt. Thanks, BJ. How do you hold us accountable, right? I've been thinking about that and reflecting on the last several years. And as I look back, yes, PPP interesting, we generated $80 million of fee income. Yes, we invested $13 million in Finxact and got back $135 million and we've sold the business to Fiserv. Yes, we invested about $3 million to $4 million in Payrails and got back about $35 million. And then we invested that money. We were a bit behind. Renato today has 130 folks. We needed to beef up cyber. We needed to beef up data. He is constantly extending our moat, reference to the Express products, more to come there. So where does that actually leave us? And how do you -- how should you hold us accountable? Bank accountants create in my judgment a lot of mumbo-jumbo. For instance, typical list of adjustments to revenues, any PPP-related impacts, servicing asset revals, volumes accounted for under fair value option impacts, any one-time gains from sale of fixed assets, like this quarter we sold an airplane and had a gain of $6 million or $7 million. Any gains from investment portfolio sales, fintech investment activities, valuations and realized gains and losses from sales, non-cash gains and losses from investments in venture funds. Now let's move to the expense side. Non-routine employee bonuses related to fintech gains, impairments or losses from sales of long-term fixed assets, renewable energy tax credit impairments and wrapping up with litigation settlement expenses. You need to take all that noise out to see how this business is doing. So I thought it would be interesting to go back 12 months. So from 6/30/2023 to 6/30/2024, what were the operating earnings of this business with all that noise out, $174 million. What was it the previous 12 months, 6/30/2022 to 6/30/2023, $137 million. I don't know any other bank that increases operating earnings 27% year-over-year. And to me and lastly, the most exciting thing, BJ alluded to the wonderful origination quarter that we had, which matched our previous high, which was Q4 of 2022. We left Q4 of 2022 with a pipeline of $2.4 billion. Today, it's $3.6 billion. So those good costs and those revenue producers that have finally learned the Live Oak way are out there generating high quality loans. And with that, we will be happy to entertain questions.

[Operator]

[Operator Instructions] Your first question comes from David Feaster with Raymond James.

[David Feaster, analyst]

Maybe just following up on kind of, Chip, your last commentary, just talking about the origination strength here on the line. Could you talk about how much of the strength that you're seeing is from maybe improving demand versus share gains? And just kind of the composition of the line and where are you seeing the most opportunities today?

[William C. (BJ) Losch III, executive]

Yes. So I'll start, David, it's BJ. We're seeing it across the board, which feels really, really good. First quarter was a little bit lighter than what we would have wanted. Even though pipelines were significant and approvals were significant, we didn't see the pull through that we had wanted in the first quarter. Not only did that come through in the second, but as Chip talked about, as I talked about, pipelines going forward, most importantly, are still healthy. So I think it's a combination of a few things. One is, certainly, our lenders are excellent at what they do. They're constantly talking to customers, their referral sources, activities and they want to win. And they want to do more loans and do more business for our customers. So obviously, that is priority #1. I think #2 though is, with the Fed making more and more noise about rates kind of being at their peak for sure and inevitably coming down sooner rather than later, I think we're starting to see more optimism and more activities -- more activity across our different verticals such that buyers and sellers are more willing to come together and get deals done. So we're really pleased about that. One more thing I'll mention, I think Walt, maybe hit on it a little bit. Our Small Business Banking verticals and our Specialty Finance business have had a great quarter. And our Energy & Infrastructure business was down from last year. They had a lighter first quarter as well, but their pipeline is significant and they closed almost $100 million in the first month and a half of this quarter. So the pipeline is there, the pipeline is growing. So when we get E&I back where we know it can be, along with the great performance of our other 2 businesses, we're really -- feeling really good about the outlook.

[David Feaster, analyst]

That's great. And maybe touching on the expense side. You guys have done a great job controlling expenses. Could you just touch on kind of what you guys are seeing? I know you're continually investing, but are we just being a bit more discerning with growth projects or are we at the point where we can just scale-up and leverage the existing infrastructure that you've already built? I'm just kind of curious, how to think about -- how does that play into the [indiscernible] expense growth as we go forward? It sounds like it should be slowing.

[William C. (BJ) Losch III, executive]

Yes, David, I'll add some color and then Walt can jump in as well. You may recall, over the last couple of years, we talked about different things, Chip alluded to it from the Finxact gains that we had. We accelerated coming out of the pandemic production growth, but needed to catch-up on lender support growth, underwriters, closers, servicers, et cetera. We did that. We then accelerated our technology investments in '22 and a little bit in the first half of '23 to again try to accelerate where our growth would be. So we put a significant amount of expenses ahead of revenue over the last 24 months, I'd say. Here, we've kind of gotten to the point where we've got the expense infrastructure in place across our businesses that we need to grow. We've just got to put the revenue apparatus on it, and that's exactly what you're seeing. Our revenue is up 9% on an adjusted basis, as Chip showed over the last 12 months on only 1% expense growth. About 90%-ish or so of the incremental people that we're adding right now are in revenue-producing spots in our organization and we want that to continue. We have really good infrastructure and support to be able to scale this business now because of the hard work of people over the last 24 months. And so now we're in a position to be able to provide much more operating leverage on that expense base than we had been previously.

[Walter Phifer, executive]

And Dave, I'll just add on quickly to what BJ just mentioned. Now we've been really fortunate that our company has embraced this challenge of how we think about expenses. And there you can definitely grow your expenses and we'll inherently have growth in our expenses because we're a growth organization and that's what we're about, for all the reasons BJ just mentioned. But there are other opportunities across the company where we can look supplying efficiencies as well. So thus far, in 2024, we found a really nice balance between the 2, growing and investing. I wouldn't say, we're slowing down on any technology or growth initiative whatsoever. I think if anything, it's the opposite. We're trying to progress as quickly as we can. But we continue to look for other ways to -- across our lines, across our business units to find expense reductions when we can as well. And that's a good, healthy expense discipline that we really demonstrated over the last 12 months.

[David Feaster, analyst]

That's great. And then last one for me. Just great to hear the commentary on deposit costs stabilizing. It sounds like we're starting to see some opportunity to even -- the CD repricing is behind us and you're seeing a lot of success on the core deposit front from the business customers. I'm just kind of curious, would you expect the funding costs start to decline, I guess, if you can continue to this kind of success with the business clients and we could maybe be set-up for approaching a pretty material inflection point in the margin? And how quickly do you expect to be able to reprice those business clients in a potential downrate scenario?

[Walter Phifer, executive]

Yes, I'll start and then BJ could jump in. Great question, David. I appreciate that. Look, I think ultimately, we're going to control what we can control, right? We have a really good problem right now and that problem is we're growing. And I'd say problem with a smile because I think that's not something many other banks are seeing. So we're going to price accordingly and we're going to really see what the competitive market does here going forward. There are things I'd like to say, like I mentioned that we can't control. We don't know what they're going to do. Well, ultimately, a 330 margin with our level of growth over the last 12 months feels pretty good. And I think if we can maintain that going forward, we'll be just high.

[William C. (BJ) Losch III, executive]

Just one thing, David, on your first question to BJ, sorry to back up. BJ does such a wonderful job operating this bank and I get to spend probably 2 or 3 days a week at least on the road with customers. And certainly, in our SBA business, in our 35 verticals, when Steve designs the credit box and tells the lending officers what the credit box is, it's kind of banking 101. Am I approved and when are you going to give me the money. So these lending officers know exactly what to say to these borrowers. On the other side, in our sponsor business yesterday in the Northeast, I had a chance to visit with a firm that has about $3 billion in assets under management and does business for a lot of banks, it's got the brand firms. So you guys are difficult. We never have to worry about the loan committee. We never have to worry about going back and forth. You guys give us an answer and it's always direct and we get to move along with our customer and book the deal. So I think it's like banking 101, David.

[Walter Phifer, executive]

David, I'll just add one more quick thing going back to the deposit dynamics. There's something that Walt has on his deposit slide that I think it's pretty important and insightful. About half of our loan portfolio is variable rate, but almost 3/4 of our deposit portfolio will reprice in less than a year. So when the Fed does start to reduce rates, there will probably be a little bit of treading water because our loan portfolio is coming down a little bit quicker than the deposit portfolio. But once we start to get past the first quarter or two, the majority of our deposits will -- our deposit costs will be coming down more quickly and we believe that we'll start to see NIM expansion over time to levels that we expect we can generate from this business model.

[Operator]

Next question comes from Tim Switzer at KBW.

[Timothy Switzer, analyst]

Can I ask a quick clarification real quick. Did you say 25% of your deposits reprice within a year or quarter?

[Walter Phifer, executive]

So over the next 12 months, we'll have -- it's roughly about 76%. So you have our liquid savings portfolio and then you have our CD portfolio that takes time just to migrate through the maturity schedule, it's roughly about 1/4 of that CD maturity. 1/4 of that city portfolio matures each quarter over the next 12 months, as you've seen over the last 12 months.

[William C. (BJ) Losch III, executive]

Well, I think, Tim, to add to in Walt's initial comments, you were talking about how over 25% of our entire deposit portfolio repriced because of CD maturities. Almost 200 basis points higher at the beginning, 150 basis points through the middle of to end of last year and we still held -- we held the margins flat and we grew our net interest income by 8% year-over-year. So I think we're just incredibly pleased with the pricing discipline that our lenders have had and the activity that they've generated to continue our loan growth and the discipline that our deposits team has had to manage that large repricing and still maintain our margins.

[Timothy Switzer, analyst]

Okay, that's helpful. And could you guys talk about the secondary market demand in the SBA space? Is it -- did the rate movement help at all? And do you think lower rates will help improve going forward? And then have you started to see some rising competition generally in SBA from other banks who are kind of trying to diversify their loan exposures?

[Walter Phifer, executive]

Tim, this is Walt. I'll start with the secondary market. The rates helped or at least the outlook of what the fiscal you do has helped. Really, what we're starting to see there is the assumption that when Fed cut rates, prepayment rates, both voluntary and involuntary will slow, obviously, depending on why the Fed is cutting rates and if they do it in a disciplined fashion. So that has definitely helped as well as our spreads continue to be competitive, especially on the small loans probably could be ranges anywhere from 5 plus 1.5 to 5 plus 4. So broadly speaking, expectations for the Fed have helped. The treasury curve coming down has helped. And then just continued high demand from investors for those SBA pools that they start taking downward rate protection and alternatives to cash. So I'll start with that one. And then, I'm sorry, the second question was...

[Timothy Switzer, analyst]

Are you seeing any more competition from other banks in the SBA?

[Walter Phifer, executive]

Yes. So on the competition side, I think it's pretty much the same, right? I think every industry is very different and every industry has their own competitive pressures. And so we actually get this question a lot of what banks are we seeing out in the market? And my answer always is what industry you're looking at. But really, no, I wouldn't say we've seen any migration or any more competition pretty much across the spectrum. It seems to be the same players.

[William C. (BJ) Losch III, executive]

Tim, one more thing I'll mention on secondary markets. I'm particularly proud of this because it speaks to what our lenders are doing to balance production growth and doing the right thing for the customer and being disciplined on pricing. We generally don't like to sell any SBA guaranteed loans that are less than a 105 premium by and large, because we think it makes more sense to hold those than it does to sell those at those levels. And over the last -- over the previous 4 quarters, what we were generating in terms of production was anywhere between 30% to 50% of what we were producing of SBA guaranteed was going to yield a 105 or greater. This works for -- it was 70%. So in addition to whatever the pricing dynamics are going on in the marketplace, our people are producing loans that give us the optionality to either keep or sell for very attractive profitability metrics. So I'm really pleased at how our lenders and how our business are really kind of turning over to Rubik's Cube to give us as much optionality as we can.

[James Mahan, executive]

And BJ, I think in the small dollar in the Express situation where we're not having to take many times all the way collateral, and we can close these loans much more quickly and we're seeing pricing in that area of...

[William C. (BJ) Losch III, executive]

It ranges from 1.11 to 1.17.

[James Mahan, executive]

Yes. And that's going to help too because that's going to pick-up dramatically for sure.

[Operator]

[Operator Instructions] Next question comes from Alex Lau at JPMorgan.

[Alex Lau, analyst]

I had a follow-up on the expenses. So with expenses flat in the first half of the year when you compare year-over-year, have you changed your expectations for your full year expense growth outlook from the high-single-digit to low-double-digit range?

[Walter Phifer, executive]

Alex, this is Walter. Look, I think the -- we continue to do what we can do on that front, like I mentioned, balancing, finding expense efficiencies, while you continue to invest in our growth organization and especially on revenue generator side. I think our expenses will continue to inherently grow, right? And I think if you take the last couple of quarters and you run rate those for the full year, add a growth expectation on top of that just given the focus on hiring new lenders and other support personnel to proactively aid our -- in terms of complexity, I think you'll get a pretty good expectation versus last year.

[William C. (BJ) Losch III, executive]

Yes. I would just add, Alex, that we're going to continue to look for new lenders, invest in technology, build our business. So we're not really concerned quarter-to-quarter on how much expense we're going to add ahead of revenues or expense growth. But with that said, if I were betting that, I would be optimistic about us being better than what we have talked about on expenses for the year.

[Alex Lau, analyst]

And Walt, just to confirm your comment earlier on the net interest margin, are you expecting to maintain the NIM in the 3.30%s range for the rest of the year or was there any change to the prior NIM outlook in the 3.50% to 3.75% range for year-end?

[Walter Phifer, executive]

Yes. No, I think the -- if we focus on the things we can control, which outline our pricing discipline, our growth, our pricing discipline on the deposit side too, I think that up into the right trajectory still applies. I think the slope of that trajectory will really depend on some of the things we can't control, right? That's the competitiveness of the deposits and the Fed. So I think that 3.50%-plus range still remains our target, right? And I think we'll navigate our way back there. The timing of that really depends on those things we can't control.

[William C. (BJ) Losch III, executive]

It's probably not in '24, Alex, it's probably into '25. Just thinking about the forward curve, what our business model is generating is moving us up into the right, but probably getting into the 3.50%-plus ranges some time next year.

[Alex Lau, analyst]

Got it. And is that also assuming rate cuts for the rest of the year?

[Walter Phifer, executive]

Yes. To migrate into that level, we would expect 1 or 2 cuts this year and then going to 3 or 4 cuts going into next year similar to what you see in the forward curve.

[Alex Lau, analyst]

And then just on the stronger loan production and pipeline your all-time highs in the second quarter, do you expect loans on balance sheet growth for the year to be in that low-double-digit range or is there a potential upside to that given the strong pipeline?

[Walter Phifer, executive]

Yes. I think that low-double-digit range feels right early on. I think the upside there really just depends on Q3 and Q4. We think we have the pipeline and the production to really have a strong second half. So I think kind of that expectation still applies right now.

[Alex Lau, analyst]

Got it. And just one follow-up on the comment on the tailwinds on the CD portfolio. How much of the CD book is repricing in the third quarter? And what are the rates of CDs rolling off and being replaced at?

[Walter Phifer, executive]

Yes, great question. So in Q3, Q3 is actually are the lightest of the 4 quarters in terms of CD maturities. So you'll roughly be somewhere between 15% to 20% of our customers' CD portfolio will reprice in Q3. Q4 is a large quarter as well as Q1. I think that the rate that it's rolling off on right now would be -- our current offering is about 5%, rolling off 5.20% to 5.25%, so you see a slight pick-up there. Again, that all depends on our growth and our funding needs, especially short-term CDs are one of the primary tactics that we use given the Fed uncertainty going into the second half.

[Operator]

We have no further questions. I will turn the call back over to Chip Mahan for closing comments.

[James Mahan, executive]

Well, we enjoyed being with you this morning, and we look forward to seeing you in the fall. Thanks for attending.

[Operator]

Ladies and gentlemen, this concludes your conference for today. We thank you for participating. And we ask that you please disconnect your lines.