Live Oak Bancshares Inc
NYSE:LOB
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Good day ladies and gentlemen and welcome to the Q3 2018 Live Oak Bancshares Inc. earnings conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will follow at that time. If anyone should require operator assistance, please press star then zero on your touchtone telephone. As a reminder, this call is being recorded.
I would now like to introduce your host for today’s conference, Greg Seward, General Counsel, Live Oak Bancshares. Please go ahead.
Thank you and good morning everyone. Welcome to Live Oak’s third quarter 2018 earnings conference call. We are webcasting live over the internet and this call is being recorded. To access the call over the internet and review the presentation materials and commentary that we will reference on the call, please visit our website at investor.liveoakbank.com and go to today’s call on our event calendar for supporting materials. Our third quarter earnings release is also available on our website.
Before we get started, I would like to caution you that we may make forward-looking statements during today’s call that are subject to risks and uncertainties. Factors that may cause actual results to differ materially from our expectations are detailed in the materials accompanying this call and in our SEC filings. We do not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of today’s call. Information about any non-GAAP financial measures references, including reconciliation of those measures to GAAP measures, can also be found in our SEC filings.
I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.
Greg, thanks, and good morning. I am now on Slide 3, today’s agenda. We’re going to talk a little bit about a hurricane that hit Wilmington, I’m going to give you a brief tech update - we’re very happy that SunTrust has made an investment in Apiture. We’ve been getting questions recently about concentration risk, so sticking with our standard of soundness, profitability and growth, in that order, we’re going to talk a little bit about that. I’m going to give you my view of a rather interesting quarter, and then proud to introduce our new partner, Huntley Garriott, and he will give you his thoughts on our business.
Moving on to Slide 4, Hurricane Matthew came through here two years ago, 2016. Our IT team led by Thomas Hill said enough is enough. We spent the last 24 months moving to a cloud only infrastructure and thankfully completed that effort on the 18th of July this year, and then it was game time as Hurricane Florence hit on the 14th of September.
Greg, I’m moving to Slide 5. One of our guiding principles here, if you have followed us over the years, is we treat every customer like the only customer in the bank. I rather think that some of our customers in Alaska or Hawaii may not have known that there was a hurricane in North Carolina, but for almost two weeks we were in disaster recovery mode. Over 300 of our folks evacuated. We took 700 customer calls, fulfilled 360 support tickets, we approved $94 million in loans and close 39 of those. Sadly maybe, August was the best lead month we’ve ever had and then the hurricane hit and we were down 9% year over year, but we’re making a comeback.
Moving on to Slide 6 and a brief tech update, and Neil may clean this up in the Q&A, mid next year we intend to be in the market with a combination of everything Finxact, Apiture and Payrailz to offer a fully API first environment. As we’ve mentioned earlier in the agenda, SunTrust invested in Apiture in a meaningful way. I will remind you that Apiture today has 549 bank customers, 487 of those are under a billion dollars, seven only are above $5 billion, so the 11th largest bank making a statement they agree with our philosophy of business is very important.
Lastly I’ll tell you, and I will certainly admit that I have never been involved since the early days of putting the first bank on the internet in a software project that was on time or on budget, but folks, this one’s difference. Every 30 days I spend a two-hour luncheon with three developers, hands-on keyboard folks, and the degree with which they can write code and put product in the market is unlike anything they’ve ever seen on the Amazon Web Services platform.
Let’s talk a little bit about credit quality, as we always do on every call. Greg, I’m now moving to Slide No. 7. Charge-offs were up a bit - $2.3 million, nine relationships in six verticals. I went back and took at look at charge-offs from inception, so from 2007 until today we have net charge-offs in this bank of about $17.5 million and we have originated $2.650 billion of unguaranteed credit. Also took a look at our loan loss reserve compared to other every $3 billion to $5 billion bank in the United States, so we at 164 compare quite favorably with the peer group of 129. I always talk about a strong capital position, so our unguaranteed non-performing loans grew a little bit from about $12 million this quarter to $13 million. I will remind you we have $477 million of capital at the holding company and $377 million of capital at the bank.
Now Greg, we’re going to move to Slide 8. I would call this the lack of concentration slide one. What we have here is unguaranteed exposure per customer by state, so the darker the color, the more the exposure. You can see we follow the population in the United States - California is our biggest state, followed by Texas and Florida, and North Carolina ranks in there uncharacteristically. If you look at the circular chart to the right, you can see equal dispersion per areas of the country from 36% in the southeast to 23% in the west and 13% in the northeast, and so it goes.
Moving to Slide 9, Greg, this is our second lack of concentration slide, so to speak. This slide shows concentration of unguaranteed exposure by customer in an industry, and again the darker the color the higher the concentration risk. If you look at hotels, you say my gracious, you’re taking $3.2 million of risk per customer compared to 320 in your largest group, which is healthcare? Well, not really. Those are almost all FILO for loans carrying a loan to value ratio of around 50%. Then if you look at the other large group there, that would be renewable energy, those are about $3.9 million of exposure per developer, which also doesn’t mean anything because the primary credit risk here is that of a rated utility off-taker, so I think relative to concern of concentration risk, we can move that off the table.
Let’s talk a little bit about this Aaron Deer write-up this morning, Noisy Quarter, and I agree. We got out of the title insurance business and that’s a one-time charge of $2.7 million. Typically we’d provide for about $2.5 million per quarter in a loan loss provision. This quarter, we were positive mainly because of our family entertainment division. We’ve been in that business about five years. We’ve been providing about a 7% loan loss provision per loan, and we’ve had no problems, evidence a positive reversal, so to speak, of $250,000 or so.
Then we get what we love to call around here the Christmas package per quarter of opening up the servicing asset reval we typically provide in these times for about $5 million, and it was roughly twice that, because as you can see below that, the secondary market has re-priced substantially. We actually look at this, as you see in our press release, at some many millions per loans sold, so that has moved from about 110,000 per million down to around 80,000 or 85,000. There are those CEOs in other SBA banks that tend to think that market is coming back. We will not model it that way. We will kind of stay the course under current market conditions.
But on a more positive note, let’s just forget about the quarter for a minute and let’s look at the year to date. The last piece of Slide No. 10 is recurring revenue, so I’ve added net interest income and servicing revenue. So far this year, that’s been a little over $100 million compared to about $74 million last year, or a $27 million recurring revenue increase, or 37% compared to expenses going up about 20%.
In moving to my last slide before I get the pleasure of introducing Huntley to you for the first time, I would still, as we said last quarter, believe that we’re more or less in the la-la land of credit. We will commit to you every time these words, always - soundness, profitability and growth, in that order. We will not chase poor pricing and we will stick to our credit standards.
I thought I’d give you just a brief view of what is in the market quickly. Top three bank, did a loan 25 years, 537 SBA. Same bank, 10-year loan, 439 conventional. Top 15 bank did a loan, 100% financing, 5.4%, 20-year am, 15-year balloon. Local bank, high 4s to a dentist, 20-year am, 15-year balloon. Top three bank, vet, 4.25 fixed for 20, 100% financing. We will not do that. I repeat, we will not do that, therefore our originations will be off a bit from what we thought. We should close the year in the $1.7 billion to $1.8 billion, not in the $2 billion plus or minus range as we had previously reported. We still contend that a properly priced 7(a) loan is the finest loan any bank can make, and we’re proud that we’re the largest SBA lender in the country. You probably will see a press release today or tomorrow that we received an award from the USDA. We’re the USDA Lender of the Year, and I frankly think, to the last point, that this is all a blessing. We have the ability to put on the books more predictable revenues, less gain on sale dependency, and less volatile changes in our servicing asset.
I will remind you that two years ago, Neil and his team spent over 18 months and untold millions of dollars writing 65 calls to [indiscernible], the results of which is we won the Best Online Account Opening Bank in the country from the bank rate monitor folks which would give us theoretically the ability, if we wanted to, to portfolio maybe up to $2 billion. Now, we’re not going to do that. It’s going to be a loan by loan surgical strike, and Huntley, I’m proud to call a partner, is going to give you his observations of this bank.
Thanks Chip. After listening to a couple dozen earnings calls each quarter for the last two decades, it’s strange to be on this side of the microphone, but I’ve been at the bank for a little over a month now, joining just as the hurricane arrived, and I have to say it was really inspiring to see the people here at Live Oak and how they stepped up in the face of that storm.
I thought I’d start with a few initial observations about Live Oak and then address a couple of specific topics that we’ve been focused on here at the bank. My initial thoughts here at Live Oak are consistent with what attracted me here in the first place - it’s a remarkable franchise and I think one that’s really unique in my experience in banking. It’s an incredibly talented group of folks with a real culture of innovation and the proven ability to leverage technology.
As you can see on Slide 12, Live Oak started largely as a mono line SBA 7 lender utilizing the SBA guarantee program to fund the majority of the loan production and a model based on vertical domain expertise and efficient workflow technology. Ten years later, as Chip mentioned, we’re proud to report we finished the SBA fiscal year in the number one position for lending. As we look ahead, we’ll continue to build out new industry verticals where we see opportunities, and continue to augment that team with the best general small business lenders in the country. The folks that we’ve brought on board already are world class and have meaningful pipelines that will help drive originations in 2019 and beyond.
Diversifying the business was the next phase in the company’s evolution, building out expertise in conventional lending. Across ABL, CRE and leasing, the non-SBA originations currently comprise 37% of our total origination volume this past quarter. The total loans that we manage, both on the balance sheet and those that we service on behalf of others, is $5.6 billion, which is up over 20% year over year and represents just under 4,000 small business customers. While originations of $1.3 billion year to date are down a bit from last year and short of our expectations, we remain really proud of our accomplishments, especially given the level of competition that we see in the market. As Chip says time and again, we’re not going to stretch on credit or terms, so our people are working even harder to find good loans.
We’ve also continued to develop our deposit platform as well as launched a wealth management offering, and we have and will continue to reduce our reliance on gain on sale using our balance sheet more to retain loans and increasing recurring revenues. As this company has always done, we’ll continue to develop new technologies, and the next chapter of that progression will open up exciting new opportunities on both sides of the balance sheet, developing transaction accounts on a real time, low-cost core, and partner banking opportunities that will allow us to better serve customers.
You can see on the next couple slides quickly recurring revenues continue to grow nicely, and so does the managed loan portfolio.
On the lending slide on Page 15, we continue to be pleased with the efficiency of our deposit platform. The combination of lower than forecasted origination volume and faster prepayment speeds led us to a smaller balance sheet than we had anticipated for closing the quarter and a higher loan sale percentage relative to origination. With less balance sheet growth than we had forecasted, we’re able to keep deposit betas low and still maintain our balances. That said, in the quarter we did originate nearly 3,500 new accounts, bringing our total deposit accounts to more than 30,000, which is more than double the level from a year ago with minimal additional resources added.
A couple topics that we’re focused on here at the bank, and the first one I’d like to address that’s getting a lot of attention in the market is how we think about selling our loans versus holding them on balance sheet. From the inception of this company a decade ago, selling eligible loans to the SBA 7(a) program allowed Live Oak to access the lowest cost of capital available and provided the bank with the ability to scale in the least dilutive manner. As the bank grew, it built capital and developed funding capabilities to retain more loans on balance sheet and reduce its cost of capital in the process. This quarter saw an increased softness in the secondary market for SBA loans, significant premium declines, prepayment speeds increased in tandem with rising rates and a flat yield curve. The shortening of duration depressed premium pricing, and you couple that with market competition that reduced spreads and that further pressured secondary pricing. On top of that, the number of buyers pulled back from the secondary market during the quarter while there was a significant amount of supply of loan sales. All that came together to reduce the gain on sale in the quarter. It also had an impact on the servicing asset, as Chip mentioned.
We really believe that the market is under-pricing these assets right now, but we also think it’s going to take time for the technical factors to run their course. For those of you who know Bob Judge, you know that we have an incredible asset in his expertise and insights into the secondary market and we’ll continue to monitor this market very closely.
The ultimate decision of whether we sell or hold a loan has a number of considerations, but primarily it’s a relative cost of capital or NPV discussion. As we sit here today, the NPV analysis suggests that in many cases, holding loans makes more economic sense than selling, so as Chip referenced, you should expect to see us sell less loans into this market and retain more on our balance sheet. Notwithstanding the market dynamics, holding more loans and migrating to a more recurring revenue model is a strategy you’ve heard Live Oak talk about for a while. Recent events will only accelerate that transition. The good news is we have both the capital and the funding to manage this shift, and while we recognize that this will reduce near term earnings as we reduce the reliance on gain on sale, we’re confident it’s the right long term decision for shareholders. You heard Chip say that the 7(a) loan is the greatest piece of paper a bank can originate, and he’s right. That statement is true regardless of whether that loan is sold into the secondary market or held on our balance sheet.
The second topic I wanted to address is expenses. As Chip described, we’re clearly in a competitive part of the lending cycle. You see that in our origination volumes, you see that in our prepayment speeds, and while we still feel really good about the origination capabilities, we’re not going to chase the market. When you couple that slower growth environment with some softness in the capital markets, it makes sense for us to increase our focus on expense management. I don’t think we’re going to come out with any hard numbers of dollar savings or any clever acronyms, but you should expect us to focus more on how we can add more operating leverage through thoughtful expense control, continued automation of manual processes, and continuing to grow into our existing franchise.
We’ve spent years building an infrastructure that supports our goals of serving the small business community and reshaping the financial technology landscape. We remain more committed to those goals than ever but intend to achieve them through the scalability of our model. We have the best small business banking platform in the nation and don’t intend to do anything that would compromise that.
Thirty days into the role, here are the things I’m most focused on. Number one, continuing to find ways to serve more small businesses without compromising our key principles of safety and soundness. Number two, continuing to expand our product set and serve a broader array of customers within the verticals and markets - in the near term, that will be additional conventional lending; in the medium term, transaction and payment accounts and platform banking partnerships. Three, focusing on controlling expenses while we build recurring revenues that demonstrate the operating leverage in our model. In all aspects of our business, we’ll remain disciplined as we navigate the current environment and remain optimistic that we’ll continue to create value for shareholders. I couldn’t be more excited to be part of this organization and think we have a really bright future ahead of us.
Chip, if there’s anything to add, otherwise we can turn it over to questions.
Let’s do that.
[Operator instructions]
Our first question comes from the line of Jennifer Demba with SunTrust. Your line is now open.
Thank you, good morning.
Morning, Jennifer.
Huntley, welcome to the company.
Thank you.
Look forward to working with you. Question first of all on the competition you’re seeing in small business lending and probably other conventional lending as well. Can you give us a little bit more color on where you’re seeing the most intensity there?
Yes, I think it’s broad based, right - you’ve got the large banks that are playing in various spaces or verticals, and largely they tend to be some of the more established customers with track records where they’re willing to compete on price more than on structure and term, so there are credits where we just look at it and say from a return perspective, people are starting to do some things that don’t make sense for us and we’ll draw lines there. I think maybe Steve, you can jump in too.
And Steve, I know that--Steve Smits is with us here, our Chief Credit Officer, and I know that our lending officers are making a lot of proposals and a lot of times losing and kind of spinning, so you may want to comment on some of that.
Correct. This is Steve Smits, Chief Credit Officer. We do see competition coming from across all of our verticals, but what sticks out to me is healthcare is always a very competitive space. Competition comes from conventional lenders that are offering pricing and leverage that we don’t think are sound decisions for the long term, so we’re going to be very disciplined about not following that down, so that is certainly an area that we see a great deal of competition.
In addition, some of our--you know, self storage, for example, will see some challenges with the cost of the projects escalating due to cost of materials, for example, that may be impacted - steel impacted by tariffs, for example, makes the projects less feasible right now until pricing comes down to make that more sensitive. Some of that is delayed projects due to costs prohibiting feasibility.
Okay. With this lower production expectation, what is the NIM outlook over the next few quarters? Are you still expecting NIM expansion?
Hi Jennifer, this is Brett. I would say just in short, when we think about NIM at least going into next quarter, I’d say flat to up would be the best estimate right now. As Huntley and Chip both mentioned, looking more strategically at holding higher volumes of loans on balance sheet, and of course that means additional funding through deposits as we rely less on funding through those loan sales.
What about a tax rate? You already gave some guidance for ’18, but what about next year, Brett? What are you thinking about?
I think we’re in a better position at this point to comment on 2019 than we were last year at this time commenting on 2018 with the impending or the potential back the for tax reform, so where we sit now in 2018, we have the ability to better predict and fine tune what we think our effective tax rate will be. I would say that it certainly would not be a negative effective tax rate like we saw in Q3 and sort of what we’re expecting to happen for the full year of 2018, so I would say just thinking about 2019, targeting somewhere in the high single or low double digits would be most appropriate.
I’m assuming Neil’s there. Can we just talk about Apiture so far, where you are, what inning you’re in, and how everything is going versus expectations?
Neil just got back last night late from the first ever [indiscernible] Apiture user group meeting.
I did. Hey Jennifer. I think trending positive. You know, the biggest thing that the SunTrust investment does is validate Apiture and its API-based solution to larger FIs. If you take a look at other players in the market, some of which that are public, their largest customer is around the $50 billion mark, and we think the solution set spans large FI all the way down to some of the smaller sub-billion dollar ones. I think that’s--when you think of scale, much of which we get from great platforms from Amazon Web Services, you think of scale and bookings and revenue certainly could change the trajectory of the value of Apiture over time.
More importantly from our perspective, it allows us greater investment in R&D and innovation, and given we’re the first user of the new open platform, we’re the benefactor of that.
Okay, one more question before I jump off. The provision was negative because you changed the methodology for the family entertainment sector. Do you have any other sectors that are maturing to the point where that will happen in 2019 before CECL is enacted in ’20?
Jennifer, this is Steve Smits again. No, we do not, so our model dictates that once we have our own historical data after several years, we flip from using industry data to our own internal data, so that was the result of what happened with family entertainment, because we have very strong performance in that area. We do not have verticals scheduled to have that same encounter before CECL is enacted in 2020.
And how is the CECL prep going?
CECL is going very well. We’ve been very proactive in working on our modeling and with the expectation to run tandem models throughout 2019 to be well ready for January 2020.
Thanks so much.
Thanks Jennifer.
Thank you. Our next question comes from the line of Aaron Deer with Sandler O’Neill + Partners. Your line is now open.
Hi, good morning everybody.
Morning, Aaron.
Chip, kudos to your team for getting through that hurricane so successfully; and Huntley, may I also say congratulations on your new gig with Live Oak.
Thanks.
I guess starting with the--well maybe let’s start with the growth outlook. I obviously hear as we head into year-end you’ve kind of dialed back the expectations, which makes sense given the environment; but with all the new verticals that you have added over the past year or two, as we look out to 2019, are you comfortable at this point giving any sort of guidance in terms of what sort of origination volumes we should expect next year?
Aaron, the answer to that would be no. That said, though, I will say that from the credit guys to the sales guys, we are really excited about the eight what we call general lenders that we have brought on board in the last six months or so. In addition to that, we have a couple of unnamed verticals that we’re working on that look like they could be really, really exciting.
But you know, as we look back at some of our more mature verticals, it is disappointing to see the level of competition, and I think what is happening here is that, frankly, other banks see us go to a vertical and they follow us, and then they go to trade shows and they follow us around. I guess that should be an indirect compliment.
But you know, I’m excited about next year. I think over the next 60 days as we drill down with the 22 verticals or whatever we have within the GMs and that group, we’ll come up with a number, and as we have every year since we’ve been public, we’ll probably let you know what that is in the next 90 days.
Okay. Then with respect to gain on sale, first maybe if you could give us the percentage of sales this quarter versus in the second quarter that were USDA versus SBA, if you have that?
Yes, USDA in the third quarter was a very small percentage of our total sales. We sold about $298 million in the secondary market. Around 40 of that was USDA, I’d say 10 to 13%, and Q3 USDA was a much more substantial portion of what we sold. As you know, [indiscernible] has that seasonality where we see the drop-off in originations in the third quarter and then that will tick back up in Q4.
Okay. It sounds like your internal analysis with Bob Judge and such is suggesting that--or at least you guys are taking the approach that we’re not going to get any sort of snap-back in the premiums, and if that’s the case, as you kind of re-think what you hold versus sell, if things do stay the same, can you give us a sense of what your outlook would be for loan sales over the next several quarters?
Yes Aaron, I think it’s hard to put a number on it. I will tell you that as we look at it, the 10-year sector has been a little more depressed than the 25-year, so we may be more likely to sell some of the longer paper or price just a little better from a risk management perspective as well and more likely to hold the shorter paper. But it ends up being--you know, it will be a little bit of a loan by loan, week by week analysis. I do think that we’re going to watch prepayment speeds really carefully and then watch how investors price those in. The interest rate environment and the curve shape will affect that some too, and then we just have a supply-demand imbalance and a bit of technicals that we’re going to watch. I think it’s safe to say it’s going to be more, significantly more on balance sheet, but I think it’s really hard to put a number on it as we sit here right now.
Okay. Brett, given that 75% of your loans re-price monthly or quarterly, I was surprised that we didn’t see a more material increase in the loan yields given the rate hikes that should have pulled through from March and June. Can you talk about your expectations for loan yields going forward?
Yes, the loan yield from Q2 to Q3 was somewhat depressed from what you would expect, given that 75 to 80% of our portfolio will re-price on a quarterly basis. That was depressed primarily as a result of some unguaranteed loan sales that we did for concentration reasons, and those unguaranteed sales when they occurred, any deferred calls associated with those loans hit--were deducted from yield immediately, so that led to that depressed growth there. That’s not an expectation for Q4 that we would see that type of depression on the normal adjustment that occurred at the beginning of October as a result of the September rate increase.
Okay, so that’s why, I guess, you have confidence that you expect loan yields to outpace your deposit re-pricing. I guess you guys still have a fair bit of liquidity on the balance sheet. Your guidance heading into the fourth quarter, it sounds like you said flattish to up a little, but might we not see a more material increase in the margin just given some of those favorable trends?
I would say I would approach it probably a little more cautiously, harkening back to the response to Jennifer’s question, in that as we evaluate what volume of loans we’re going to hold in Q4, that will impact what liquidity we need to go out and raise. In your modeling, I would say approach it a little more cautiously than a substantial increase.
Okay. Then lastly, if we can just explore the expense subject a little bit, I guess with the Reltco costs kind of dropping out of the--
Did we lose everybody?
--for both compensation and non-interest expense, and then how might that transpire through next year as you guys continue to make investments, but then have some offsetting savings from the new core processor?
Let me tee you up on that just real quick, Huntley. Aaron, I think what you’re going to see is we always talk about four verticals a year and hiring other platform lenders. Given the fact that some of our historic verticals are off year over year, we will have the ability to continue to grow those areas and repurpose people without hiring net new folks, and I know Huntley has got a lot of things that he wants to say about that as well.
Thanks Chip. I mean, if you rewind the clock and you said that we thought we were going to be plus or minus $2 billion origination this year, and as Chip mentioned, we’re coming in $1.7 billion to $1.8 billion, part of that is that the market’s competitive, and to Chip’s point we bid on and missed some deals, but we also have people that can do some other things. We’ve got a platform built to do $2 billion of origination, we come in short of that, we don’t think we need more people to go out and do that again next year. I think that’s--and then as you layer on those recurring revenues, the model starts to look really interesting.
The rest of it, I think is really just a much sort of careful line by line discussion and being really thoughtful about what we spend where. It’s nothing glamorous, but it’s just a lot of blocking and tackling and being really thoughtful about it.
Okay, so in terms of a run rate to build off of in the fourth quarter, we’re maybe looking at something around the $39 million level and then it sounds like maybe not a whole of additional investment needed in 2019?
Yes, this is Brett. I would agree with that - 39 or 40, and then as you model out the future, not seeing the non-interest expense base grow as it has in the past, really focusing just on scaling the model at this point.
Okay, terrific. Thanks for taking my questions.
Thanks Aaron.
Thank you. We have no further questions at this time. I would now like to turn the call back to Chip Mahan for closing remarks.
I thank you for that, and I thank everyone for dialing in, and we shall see you at year end.
Ladies and gentlemen, thank you for participating in today’s conference. This does conclude today’s program. You may all disconnect. Everyone have a great day.