Live Oak Bancshares Inc
NYSE:LOB
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Ladies and gentlemen, thank you for standing by and welcome to the Live Oak Bancshares Incorporated Third Quarter 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] I would now like to hand the conference to your speaker today, Greg Seward General Counsel of Live Oak Bancshares. Please go ahead, sir.
Thank you and good morning everyone. Welcome to Live Oak's Third Quarter 2019 Earnings Conference Call. We are webcasting live over the Internet and this call is being recorded. To access the call over the Internet and review the presentation materials and commentary that we will reference on the call, please visit our website at investor.liveoakbank.com and go to today's call on our event calendar for supporting materials. Our third quarter earnings release is also available on our website.
Before we get started today, 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 referenced including reconciliation of those measures to GAAP measures can also be found in our SEC filings. I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.
Good morning and thanks Greg. As I was thinking about how to kick off the call this morning, I thought of that thing [ph]. The beat goes, life is about doing what you say you're going to do and we've done that for four straight quarters. But there is a lot to unpack here and hopefully at the end of the call, we will convince you as we believe our sales that this is the best quarter in our history.
I'm going to talk a little bit about high growth in recurring revenues, we always kick off talking about safety soundness and strong credit quality, but I really want to try to convince you what the real earnings of your bank are and that which should stay at holding company activities. And then Huntley will clean up everything's toward the end.
So let's move on to Slide 4. There is a lot here, so obviously, we're very proud of almost 50% growth in the loan portfolio year-over-year. What we affectionately call the treasure chest is up from the beginning of our strategic pivot from a couple of $100 million today to almost $850 million almost 4X increase there.
Net interest income year-over-year is up $10 million and as I went back and looked at expenses a year ago taking out $2.6 million of goodwill impairment. Expenses are up about $4 million bucks. So, year-over-year on the quarter, up about $6 million, [indiscernible] is $24 million, which is about $0.58 a share, not bad. We're excited about that and even though we changed the business model and don't really focus as much as we used to on quarter-over-quarter loan production, we were excited about $562 million of production this quarter almost a record and still highly confident that we will originate a couple of billion dollars on this $4.5 billion chassis, which again makes this bank unique. I don't think you can find anybody else that can do that. I also want to draw your attention to the last little line there that says growth in eligible sale guaranteed loans. So this is the growth in the treasure chest, running about $150 million quarter-over-quarter. Hold that thought, I'm going to come back to that in just a second.
Moving on to the next slide that we show every quarter, Slide number 5, as you can see since the change of our business model, roughly four quarters ago were adding somewhere between $250 million and $300 million a quarter and high quality mostly government guaranteed loans. Spreads have held even though rates are declining 444 for this quarter. So we tax effect this at 20% and come up with $2.32 million in earnings or $0.06 a share for the quarter and since the change in the model. The column on the right as to $0.24 a share or almost a $1 a year not bad in recurring earnings.
Moving on to the next slide. Really excited on Slide 6 to let you peak in the door of Live Oak's credit quality sausage factory. So let me tell you how this works. We soon will have 45 young folks out of college and what we call our business advisory group picking up financial statements every 90 days from all of our customers, totaling about 4500 customers. Today 92% of our customers have given us the financial statement within the last 12 months and it's almost that within the last 90 days. So here's what happens. Steve Smith and his team have a watch list meeting every quarter on every loan in the bank. We have 26 verticals. We know more about these industries in almost any other bank in the country and it does not take much to get a ticket to Steve's non-accrual club. So if you drop down to the line and this is non-performing loans to bank Tier 1 capital plus the 8 triple-L, you will see that a year ago that 3.3% equal $13 million of non-performing loans.
Today it's 20% or 4.1%. 41% of those loans are current, there are 82 loans in that group. $4 million of that of the Turkey loans we talked about in Q1 and I'm happy to report that half of those houses have birds and are being leased by very well capitalized integrator and the other half of those houses are in the [indiscernible] business all paying as agreed.
So we are hopeful that at $4 million will bump off shortly getting us back toward the 13 almost a year ago. In addition to that, we have five loans that are over 30 days past due. That $640,000 bucks, I don't think there is a bank in the country that can say that. Now trying to make another interesting point on the last line, so I exchanged some emails with some analysts yesterday about the Silicon Valley Bank, in California. Many of you know that bank. Well, you probably know that their warrant portfolio over the past 30 years has more or less covered total credit losses.
We have our own version of that kind of. If you look at the growth in our Treasure Chest of about $150 million a quarter and let's just look at the last quarter of $158 million and let's not apply what we sold loans for last quarter at $95,000 per million. Let's just cut that in half and say, we were able to sell those loans at $50,000 per million that $7.5 million certainly is more than the $7.2 million in the loan loss provision this quarter, which Steve may in the Q&A section, have more to say. So it's nice to have that arrow in your quiver in the event of material adverse change in the economy.
Now to the punch line. Let's go to the next Slide 7, let's dig deep here, we need to help you. So if you look at the far right column, year-to-date pre-tax income of $14.5 million. Over half of that is deducted in the noise below. So let's attack each one of those. Live Oak Ventures year-to-date positive million bucks.
Let's jump to Slide 8 quickly and talk about our investments in FinXact, Payrailz, DefenseStorm, Greenlight and a small company here and in Wellington [ph]. So in the past two and half, three years nearly we've invested $17 million and both on the equity and cost method we are carrying those investments little bit less than that. Last round of financing indicates that our equity interest in those businesses are worth about $56 million or a $40 million gain.
I will remind you, the two of those companies are pre-revenue FinXact and Payrailz at $180 million post and $100 million post in recent financing, whereas we're not predicting the dramatic success of Ensino [ph] we highly confident that these investments will continue to gain value for you, our liable shareholders.
So let's go back to Slide 7 and look at Canapi. Canapi as you know is, is our effort with Team Ludwig [ph] to do a roughly $500 million FinTech fund. We're confident that that will be approved by the SBA here quite shortly and simply put that $5 million in losses next year should turn into $5 million in gains. As Neil and his team move over to that business which we will get half of the 2020 revenues. Apiture is in a separate line item. As many of you know, our roughly 50/50 partner there First Data sold to Fiserv. Fiserv is not in the business of holding minority shares and we are actively seeking wonderful partners to replace them. That $1.5 million in loss this quarter is likely to go up as we invest in the future there. So if you look at the bottom line of what we're trying to tell you and why I believe this is the best quarter in our history, that pre-tax pre-provision number on the bottom has grown 58% since Q1 until today. So you owners of the bank soon to be -- continue to be the number one small business bank in the country, that should be your focus and we can explain all the other things in the future, as I just have.
So just lastly before I hand it over to Huntley, what else is unique about us? I asked some of our guys yesterday to just pull banks our size, roughly $5 billion to $10 billion banks, and to get into this club, you had to make at least 15% on common equity. And you can see the average inside ownership of those banks is about 8%. Our General Counsel made me put down now, which is publicly available for Live Oak at 26%, but the real number is about 32%. We had other friends and family that are not in the public data. So with that, Huntley, tidy things up please, sir.
All right. Thanks. Chip. You’re always a hard act to follow. I'm going to provide some more detail across four main themes: business momentum, credit, expenses and then finish with a few thoughts on our technology road map. So Page 11, the highlights. You've seen the format before. Continued momentum across the franchise, loans up 9% linked quarter, manager’s income up 11% linked quarter. We’re three full quarters into our strategic decision to hold more loans. We've stayed on track retaining roughly two-thirds of our eligible production. And we still have $3 billion of loans that we've sold and are servicing on behalf of others, and as they continue to migrate back on our balance sheet quarter-over-quarter, as Chip mentioned, we're adding $2 million to $3 million of core earnings, each quarter.
Turning to Page 12 on the lending side. The story remains really positive. Chip mentioned $562 million of production, but more importantly, we continue to make great loans to great small businesses every day. Our vertical expertise truly differentiates us in the market, and we've seen early success from our general strategy in the M&A space. Our pipeline remains robust at about $2 billion and we continue to find new ways to reach customers in some of our more established verticals, and our newest verticals continue to build really nicely. The portfolio remains incredibly diversified and granular. In the quarter, we made over 300 loans across almost 30 industry verticals in 43 states with an average balance of $1.7 million.
Almost 60% of our origination were SBA 7A, so that continues to tick down a little bit as our more diversified products that continue to offer us opportunities outside of that SBA program. While we continue to see competition across all our markets, we have successfully maintained our discipline with stable pricing and we haven't relaxed any of our credit standards. To remind folks, our portfolio remains really granular with over 5,000 borrowers now in over two dozen industries and across 50 states and a handful of territories. We only have three loans with balances greater than $10 million. We’ve put a lot of energy into building out our capital market capabilities, which allows us to finance larger opportunities while maintaining the granularity of our portfolio.
So turn to credit on Page 14. I think Chip covered it really well. But I'll provide a few additional thoughts. Overall, our loan portfolio remains very healthy. Charge-offs and non-performers continue to remain well within our expectations. In the quarter, we had two loans that made up 60% of our $2.3 million of charge-offs. Our criticized and classified loans did increase as a percentage of loans in the quarter, but that was largely due to a single well-secured ABL loan that tripped the covenant, and has since corrected. Largely as a result of that watch list increase, our provision is up this quarter to just over $7 million roughly, a third of that is the result of two loans: one that I mentioned that's already course corrected and another where we're actively working on a potential sale and have a chance of becoming fully recovered there. So the result of that if the provision covers charge-off by more than 3x and the allowance continues to increase as a percentage of our loans.
So interesting side note, as we do all of our work around CECL modeling, I’d actually suggest that upon implementation it may in fact reduce some of the volatility that we see in our quarterly provisioning. So I'll go on record with the first positive statement about the new accounting methodology.
So overall, we continue to see a strong performance across the portfolio with no signs of any broad macro deterioration. We remain vigilant given uncertain political and economic environment. We have a couple of industry areas and we continue to stay focused, given some of the market competition, craft beverage, family entertainment and pharmacy. And a lot of folks have been watching the restaurant industry. We've got a tiny, tiny portfolio there. So not much to worry about.
Turning to the funding side, the deposit platform continues to operate really efficiently. We've got just shy of $3 billion of retail deposits across 46,000 accounts now. The market for savings and CDs were pretty rational among the major players as the Fed cut rates twice in the quarter, our consumer savings accounts currently are paying 2%, that's down 30 basis points in the quarter. Our CD book will take a few quarters to roll down the curve. So we're seeing maturing CDs roll-off in the 270 to 280 range and re-pricing around 230. So there's real pickup there. Our largest maturity role will be in Q1 with over $700 million maturing. So the margin will take a little bit of time to recover after the rate cuts. So we ended the quarter with a margin ticking up a couple of basis points to 374, although the 50 basis points of rate cuts will hit our floating rate book starting in October 1. So that's going to affect our margin in the fourth quarter. It’ll likely land somewhere in the 350 to 360 range. We’ll still end the year in the 360s range that we indicated, and we expect margin to rebound as we head into next year with all that CD re-pricing.
So the fee income side, the secondary market remains strong for loan sales. Servicing revenue continues to run off in line with the decline in the servicing asset, so kind of as expected there.
Turning to expenses overall, we remain really disciplined in our spending, while continuing to invest in growth in both the bank and the technology side. Salaries and benefits are up as we continue to recruit franchise players across the organization. And on the lending side, we've added some more general SBA lenders and some venture banking folks, and we’ve continued to build out our technology team.
There are two noteworthy items in the quarter that really shouldn’t repeat themselves. One is we had $1.2 million of loan repurchase expense related to the turkey loans that we've been talking about for a few quarters now. So bringing those back onto the balance sheet. And then we've had just over $1 million in expenses associated with the formation of Canapi and the ongoing Apiture negotiations. The Canapi expenses show up in some salaries, and professional services and data processing, the Apiture side of things really mostly in professional services. Both Canapi and Apiture remain important strategically for us. We expect to have definitive updates on both of those before year-end. So while there's always some other gives and takes in the expense line, adjusting for those two brings us right at the $40 million guidance that we've been talking about since the beginning of the year.
Lastly, you'll note our tax expense is up in the quarter as we curtailed our investment in the energy tax credits. Those renewable energy lease investments, they really front-load the economic benefit through those tax credits, and given some of the market dynamics there, we’ve scaled back our activity there. So all in all, we remain on track towards our profitability goals as a scale and earnings power of our franchise makes its way back onto our balance sheet and our income statement.
So if you look at Page 20, we’ll talk about technology just for a minute because our pioneering work continues. And I use this image because the banking industry continues to face a fundamental challenge: the largest banks are pouring incredible amounts of money into technology. And the majority of the industry is reliant upon their core technology providers to innovate on their behalf really. And at the same time, we see these challenger banks who are building some pretty cool products that the banking industry should be offering to their customers, like integrated expense controls, reporting features, elegant new account openings and API based integrations. So our goal is to change all that, right? And as we've said, building from sort of the cloud up a new technology stack and we're more confident than ever that the ecosystem that we're building will allow us to design and innovate products and solutions for our core small business customers, and then for our companies that we’re invested in to provide those to the banking industry at large.
So just an update on our build-out of our deposit products: our first debit cards are live and being tested right now. As we've said in previous quarters, we’ll continue to build the infrastructure through this year and we'll expect to see results in our financial statements heading into 2020. As we finalize plans for next year, you're going to largely see the same story on the lending side, namely continued addition of high quality loans and recurring revenues. But you're also going to see the culmination of our technology roadmap that's going to allow us to drive these innovative products, and build deeper customer relationships and continue on our path to reinvent how banking is done.
So with that, let's open it up to questions.
Thank you. [Operator Instructions] Our first question comes from Aaron Deer with Sandler O'Neill & Partners. Your line is now open.
Hi, good morning everyone.
Morning, Aaron.
I guess starting with the credit, the -- I was curious about the loan repurchase that you made in the quarter. It sounds like that was for the turkey loans. What was the volume of the actual loans that were repurchased and is the 1.8 -- I think it was 1.8 and maybe it was less, but was the purchase amount associated with that that was expensed in the quarter, should we think about that as being a loan loss on those repurchases and is that repurchase what drove the non-performers higher in the quarter?
Hey, Aaron. This is Brett. Regarding the repurchases, that -- as Huntley indicated, that was $1.2 million when -- and then those are all guaranteed dollars. When a loan needs some sort of modification that's installed in the secondary market, typically you work with the investors to try to make those modifications. If the investor’s not interested in modifying the note, the way a lot of things the things that should be modified to help the borrowers survive, we have the authority to repurchase those from secondary market. So those were borrowed back on book during the third quarter. And when those came back just the nature of those loans, the way they're structured with -- for payments back from the turkey farms, those are annual pay. When you repurchase the loan, you bring the investor current on interest. So that was the bulk of that extent. That expense line as shown in our P&L did increase1.8. The other increase there, a lot of that is associated with just general growth and the owned book guarantee portfolio where we pay the roughly 50 basis points for the ongoing guarantee. And I believe that was the second part of your question.
But Brett, just to be clear, so that borrower was paying as agreed and we took that interest and applied it to principal, and that's the gap. Correct?
Yes. Those lines are non-accrual on our book. So all payments being made by the borrowers, which were being made, we’re going to pay on principal rather than interest.
That’s my point. And then we had to true that up and that’s the negative. Correct?
And then to -- I think there was another part of that question about non-performing and maybe you were asking [indiscernible].
Yes, was bringing those loans back on the book, is that what drove the non-performers higher or was it other credits that drove that higher?
So this is Steve Smits. Yes, that was part of what drove it up, coupled about nine relationships actually went to non-accrual this quarter, some actually were rehabilitated, went back to accruing, some refinanced and paid off, but a good portion of that was actually bringing that guaranteed portion back on book.
Okay. And then obviously the loan pricing has not been exhibited in the -- well the loan re-pricing that we would expect to see here come through in the fourth quarter wasn't exhibited in the third quarter margin. Can you give us a sense of what the -- what percentage of the portfolio I guess do you expect to re-price this quarter and where do you expect loan yields to end or average loan yields to be in the fourth quarter relative to the third quarter?
Aaron, this is Brett. So our own book portfolio just a touch over 60%, I believe it’s 62% re-prices on a quarterly or more frequent basis. We have a couple of monthly adjusting lines. But as of October 1, that's when roughly 60% of our portfolio will re-price based on those -- or did re-price based on those Q3 Fed cuts.
Okay. And then I'm trying to understand too the negative fee income related to some of the start-up investments. Can you give us a sense of how long do we expect this situation to be the case and when we can expect some improvement on that front?
It’ll be a while. I mean Neil is here with me, right, you're referring to Live Oak venture investments, right Aaron?
Presumably, yes. The slides that you guys presented this morning would have been helpful last night in trying to understand some of some of this, but it's -- but yes, I mean the degree to which we've seen some changes there I guess is a little surprising to me.
Well in ventures this quarter, Greenlight completed a round of financing at a $200 million valuation, right Neil? And we picked up $3.7 million on that, which offset both cost method and equity method write downs in the other businesses and that's why we’ll split that out in the future and talk about more of those.
Yes. I mean and just so you no Aaron, that was always in the income statement. We are just now breaking it out to demonstrate the difference between operating income and some of these investments. Again the Canapi should be -- I think as you look out over the years, Canapi in that income statement should be kind of net neutral. So that goes away given future revenue that's going to hit the income statement. And who knows how to project the warrant options that Chip talks, and as we go out and raise more capital or write-offs that happened there, there'll be some probably chalkiness there. The OpEx that floats through the income statement banks that some of these others is something that we’ll continue until we sell down. But again if we continue the offsets are, as we continue to raise capital at higher valuations and/or these companies continue to grow, that there'll be an offset for them as well.
Okay. I guess, I mean the equity method losses last year were maybe run in between $50 million to $100 million a quarter, and this year they're more closer to $2 million a quarter. And so I'm just, it sounds to me like that's going to continue to be the case for a while.
Yes that's specifically at mature and I would view that we certainly don't want to take on anymore. So again, we should see that is those as relatively, as you project this out relatively flat. And we'll talk about this in this next financing around, we will on a little bit bigger portion in the successive round at the bank. And so you'll see some of that flow through to the income statement, but at a minimum we're going to continue to break it out for you so that you can see and track and we're going to be cognizant of it.
All right. And then with the, solar investment in the leasing business, I guess you gave some guidance in terms of what the impact that's going to have on the tax rate for this year. Just as we look out to next year, is that, are you curtailing that indefinitely. I guess, particularly now that the benefit of those investments is going to be declining and what does that mean for the income and expenses related to, I guess the equipment expense on the expense side and the lease income on the revenue side, are those going to flat line at this point. And then what do prospectively expect, this your tax rate to look like in 2020 as a result.
Aaron, this is Brett. I'll start out adjusting the income statement pre-tax question. So the way those leases are structured any expenses associated with those is nearly net it out with the lease income. I think you're looking at a neutral pre-tax income statement impact just based on what is existing in incoming lease payment and then related to the forward path. We're in a bit of I'd say assessment mode for 2020. Putting a lot of fold into continue to layer in that assets, of course there is DTA considerations. As Tommy mentioned in his comments, there is market dynamics considerations, all these things that we're thinking about going into 2020. We did provide a bit of guidance in the CFL highlight related to where we think our tax rate will be for this year. And I'd say, more to come on 2020 at this point.
I'll just add one, more thought because know these are a relatively small investments. If you think about them like loans $5 million or $10 million of these lease projects will move the needle in a quarter because you take all of the accelerated tax credits upfront and then you end up with as Brett mentioned in asset that where the expenses in the income kind of offset each other. So, you end up making if it's an asset that has a I'll make us of an 8% total sort of yield for the life of the project, you will end up taking most of the income through the first period in the interest expense. So it's a little bit of a front-end loaded period. So we're trying to make sure we like the product where the market is, changes in tax rules, et cetera, but recognize that it does swing the income statement, a bit more than if we made that equivalent amount of loans for example.
Okay and then lastly on the capital front. TC ratio is coming down as the balance sheet. It's been growing at a pretty good clip here, obviously just got very strong capital levels. But if you continue to grow the balance sheet at this space at what point do you guys think you might need to come back to raise capital, particularly for not seen any material improvement in the profitability?
Somewhere down the road.
Yes. We expect to have material improvement in the profitability to help offset some of that, but we've got, a lot of capital now will continue to deploy and we think this is the best way to put it to work right now is through growth in the balance sheet. And if we're fortunate enough to continue to find great opportunities beyond that then we'll assess it.
Okay. I'll step back. Thanks.
Thank you. Our next question comes from Jennifer Demba with SunTrust. Your line is now open.
Huntley, what kind of expense growth do you expect next year and how many revenue producer hires have been made year-to-date?
So we are in the process of calibrating that next year. And I do think to some extent we're in a unique position where we're pretty fortunate, a lot of people like our platform. A lot of people would love to come join us and so we can modulate our growth and that obviously has a ripple effect on expenses, not only in the producers. But then in the amount of underwriters and credit and closing and everything else, you need to support that.
So that's a big. We have a variability around that will come back to folks and we sort of lay out our plans to finalize that for next year. I think that we've got, we believe we've got a lot of opportunity to continue to make great loans and to grow with the team we've got on the field right now. So I don't think you'll see us grow to the same extent that we have this year. I'm trying. I don't have the total number of producers that we've put on the team this year, but it's probably north of a dozen in less than 2000 if I had to guess.
I was going to say 15. If you just looked at the vertical and the generals would be somewhere in that area.
Okay. And Brett, what are we looking at in terms of a seasonal loan loss reserve adjustment at the beginning of next year?
I had a feeling you were going to ask about that, we aren’t planning to disclose adjustment based on CECL yet. We have been running the model in parallel with 2019. We feel really good about where we are, we're using the discounted cash flow method. Looking at all the inputs going into that there is a, one of the more material inputs that we're leaning on is forecasted levels of employment is kind of the economic variable. So a lot of work going into it. We're very pleased with our progress. As we've indicated in the prior calls and plans to adopt in January 1, 2020.
Okay. Question on credit quality, we've seen cracks from the banks here and there. Just wondering what you're seeing kind of, in terms of industry stress as you look at the Live Oak portfolio, just underneath, what we really can't see as outsiders?
We get asked that a lot. And I think appropriately. So given the geographic nationwide situation, Steve, you may want to comment on that.
So Jennifer this is Steve. So pay special attention to the industries that may be impacted in a slower growth economy. So and that's kind of where are kind of echo chips comments earlier about our servicing platform that's where it bodes us really well, our special assets group and our business analyst group servicers are best in class. So we strive to collect 100% financials from everybody and folks that don't provide us updated financials, we got, we visit them. So that gives me great confidence that our portfolio overall is risk rated really well and can react real quickly. So if you think about it, it's the industries that have discretionary spend tied to the revenues that we pay special attention to, entertainment centers that’s a very small portfolio for us. We have $40 million in total exposure but we focus on their topline revs and competition around them.
If the economy starts to see a slower growth our wine craft, it's really-- the breweries that we focus on because of the changing model and then we do what we do best. We provide resources consultants and others to help them adapt to the changing economy or their change in industries. So feel pretty good. And again, we are very anemically low levels, we expect to see 75 to 100 bps as far as losses and we're well below that’s we're in a really good position right now.
Okay, last question. Your loan originations have been really good last two quarters. I'm assuming you can get, if they can stay pretty strong, given you're hiring has been good and as you said the economy is still pretty good.
Yes. Jennifer, we feel, we feel really good. We've got our pipeline strong. Look, there's a lot of competition and we're not going to chase our tails here on pricing or structure. But as we sit here right now continues to feel like we've got really good momentum to keep making great loans.
Thank you.
Thank you. I'm not showing any further questions at this time, I would now like to turn the call back over to Chip Mahan for any further remarks.
Thank you all very much for attending. We will see in 90 days.
Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.