Live Oak Bancshares Inc
NYSE:LOB
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Good day, ladies and gentlemen. And welcome to the Quarter Four 2018 Live Oak Bancshares Incorporated 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. [Operator Instructions] As a reminder, this will be recorded.
I would now like to introduce your host for today's conference, Greg Seward, General Counsel, Live Oak Bancshares. Please go ahead, Sir.
Thank you and good morning everyone. Welcome to Live Oak's fourth 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 fourth 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, thank you and thank everyone for joining today. I think we passed Huntley's first 100 days at our bank recently, and he is so excited to tell you about what's going on. We're going to start off today with Huntley and then Brett is going to have a few things to say and then Steve Smits, our Chief Credit Officer and Neil Underwood and I will back clean up in the Q&A session, if necessary. Huntley?
Great, thank Greg and Chip and thank you all for joining. Hopefully you had a chance to see the earnings release and the CFO supplement that we put out on our website. Overall, we feel really good about the fourth quarter and the progress that we've made in 2018. We're also confident where we stand heading into 2019 and we're excited about the opportunities ahead of us. We continue to find attractive opportunities to lend capital small businesses across the nation, and we have a highly efficient deposit platform with a clear roadmap for lower cost deposit strategies.
We also continue to invest in the technology. We believe is critical to succeed in a rapidly evolving industry. Financially, as you can see on slide 3, we grew our loan portfolio by 25% over the course of the year despite selling almost a $1 billion of loans. This balance sheet growth led to a 34% increase in recurring revenue and with an increased focus on expense management drove significant operating leverage. As we outlined in December, we've migrated our financing model to hold more loans on our balance sheet with an expectation of holding $2 of our guaranteed loans for every $1 we sell.
In the fourth quarter, approximately $240 million and fully funded guaranteed loans became eligible for sale and we sold just over $100 million of that. So we kept roughly 56%. And while it was good to see the secondary market overall firm up a bit from the trough in Q3, we continue to believe holding the majority of our production, creates the most long-term shareholder value. With strong capital liquidity, we expect to continue to hold more of our loans and as we start 2019, we are yet to sell any loans given the government shutdown, and we'll catch up a little bit more on that later.
Page 5 highlights the trends in our increasing recurring revenue and the growth relative to our expense base. As we mentioned last quarter, we're taking a closer look at controlling our noninterest expense. The reduction in fourth quarter noninterest expense was largely driven by a profit share reversal, but we continue to be mindful across the board and where we invest and where we can save. Overall, we believe we have the right team and infrastructure in place to continue the growth in recurring revenues. And generate incremental operating leverage. But we continue to believe our people and our culture are competitive advantages for us, so we'll be careful not to jeopardize that with short-term expense cuts.
Despite our shift towards more consistent earnings profile, we continue to see the impact of volatility in our quarterly results as a function of loan sales. In the quarter, we saw favorable servicing asset revaluation offset partially by some pipeline hedging in our gain on sale. Brett will go into more details on those in a couple minutes.
Page 6 shows the power of our franchise demonstrated by the almost $500 million of high quality small business loans we made in the fourth quarter, which was well diversified across verticals and product. No vertical represented more than 15% of our origination and non SBA lending was 36% of our total production. Despite increased competition in many of our verticals, we continue to find good opportunity to lend while keeping our credit standards high. We launched six new industry verticals in 2018. We hired small business lenders across the country, and we continue to be impressed with those pipelines and the production that they're putting on.
We're also extremely pleased with the geography --with the geographic footprint that these people are creating, and the ability that we have to see deals both across our verticals and in M&A markets generally. In terms of credit, we're pretty measured in our assessment with metrics that remain solid overall as seen on page 7. Our charge-offs were modest $1.2 million and our non-performing assets and classified assets recognizing that we're starting from a pretty low base, were both up modestly, but we booked a $6.8 million provision which was partially a function of growth, partially a function of incremental modeling precision and partially a conservative appreciation for the environment we're in.
As we think about our portfolio from a macro perspective, we're cognizant of the impact that rising rates may have on our borrowers, two-thirds of which a floating rate loans, as well as expected credit trends as our portfolio ages. On a more granular level, we have seen a bit of softness in a couple of our verticals but overall we remain confident in credit process and our portfolio as a whole. Page 8 illustrates the granularity of our portfolio across both industry and geography, which serves as a natural diversification.
On the deposit side, we continue to have success growing our online savings and CD portfolios with balances up over 50% year-over-year. The market remains competitive as we've seen in the roughly 70 basis point increase in our cost of retail deposits over the year, but the business remains extremely efficient with only 13 basis points of direct expenses to run the entire platform. We're confident that in 2019 the technology investments we've made over the last several years will allow us to introduce new deposit products including checking accounts and deliver them across multiple channels including to our small business customers and through banking as a service partnerships.
As we kick off 2019, we remain laser focused on a couple of key objectives. Continuing to find opportunities to expand the breadth of our small business banking platform through people, verticals and products. As we continue to expand our product offering to include deposits and payments we will be better positioned to leverage our vertical expertise and migrate to a true small business bank. We're also focused on finalizing the infrastructure investment we have made to migrate ourselves to a fully cloud-based open API Bank and begin to recognize the benefit through lower costs and newer products, which allow us execute our low cost deposit strategy.
The roadmap as laid out on slide 10 identifies banking as service partnerships, new user experiences, checking accounts, core migration and deposit and loan integration all on the critical path this year. As we have in the past, we'll continue to look at ways to partner with fintech companies and other banks to build an ecosystem that will foster incremental innovation and growth. For those of you that saw the investor slide deck we posted our website in December, we laid out a series of metrics that we believe are indicative of high-performing banks, and that we believe we're on a path to deliver.
We'll continue to see some volatility in our quarterly results as we transition to a more recurring revenue model, but on slide 11 we lay out our progress in achieving this. Key to this progression will be our ability to continue to generate high-quality loan growth and increase the recurring revenue that we've talked about. Our preliminary outlook for 2019 has us growing our balance sheet by about $1 billion with a stable to improving NIM depending on the interest rate environment and modest expense growth, all of which should continue to generate recurring revenue operating leverage.
Before I turn it over to Brett, I'd be remiss if we didn't talk a little bit about the government shutdown that's current in its 33rd day. With the SBA and USDA program closed and certain government contracts held up, we're impacted in three primary ways. The first is our inability to secure new guarantees on SBA and USDA loans. The second is the inability to sell these loans into the capital markets, and third is our relatively modest portfolio of loans in the government contracting sector, which have been impacted by government contract spending. If anything this government shutdown further reinforces our decision to diversify our origination mix and decrease reliance on gain on sale, as we've been unable to sell any loans in the first quarter of the year.
But heading into the end of last year, we're able to look forward and secure guarantees for a visible pipeline. And we're confident that with a balance sheet and liquidity to operate without an open loan markets --open loan sale market. While we feel secure in our financial strength here on the government shutdown, we do know that the impact that this shutdown has on a lot of small businesses and a lot of Americans. And we're working hard every day to provide capital to our clients both current and prospective that they need to run their business. For everyone's sake, we hope that this gets resolved quickly.
I'll now turn it over to Brett to provide some more details on some specific financial items in the quarter.
Thanks Huntley. Good morning, everyone. I'll be referencing slide 13 for comments related to the financials. Our earnings per share total $0.26 for the fourth quarter and $1.24 for the full year. Our new strategy was on full display this quarter with a healthy increase in recurring revenues and less reliance on gain on sale. For those of you that have had a chance to read my commentary on the quarter that accompany that release, you are likely very familiar with the details of our performance. As such I will focus my comments on the more notable trends in the quarter.
During our last earnings call, we spoke about focusing our efforts to minimize noninterest expense growth going forward. Having spent several years building an infrastructure to support our goals of serving the small business community called transforming the financial technology landscape, we believe it is time to show the scalability of our model. However, you will likely surprised by our total noninterest expense of just over $32 million for the quarter. To level set that and expectations going forward that reduction is heavily driven by a $4.2 million reversal of accrued incentive compensation in Q4.
Combined with the absence of the quarterly accrual, it is nearly a $6 million swing from the prior quarter. We will have an incentive compensation program in place for 2019, and you can expect noninterest expense to return to a level more consistent with the second and third quarter of 2018. A second significant contributor to lower noninterest expense in Q4 was the savings arising from exiting the title insurance business in Q3 of 2018. Our focus going forward is to mitigate expense growth.
Regarding noninterest income, there was a favorable swing in the servicing asset revaluation in the fourth quarter which benefited from improvements in the secondary market for loan sales. The benchmark premium rates have improved 1.5% to 2% compared to the end of the third quarter when premiums reached their low point for 2018. This market improvement offset the ongoing amortization of the service portfolio. As we have implemented our strategy to hold 50% to 75% of the loans that become eligible to sell, the gain per $1 million that we experience on loan sales can be substantially different from the overall secondary market as we hold our most valuable loans.
Despite the improving secondary market, we reported a gain per $1 million of $60,000 a decline from the third quarter. This was largely driven by changes in the fair value of exchange-traded interest rate lock commitment where we experienced a net loss of $1.8 million in the fourth quarter which in turn impacted the gain per $1 million by $18,000. Excluding this, the gain per $1 million for guarantee loans sold was just over $77,000 reflecting the improvement in the secondary market.
Finally, our provision expense totaled $6.8 million for the fourth quarter. This is a material increase from the credit provision we booked in Q3 which benefited from an update to the historical loss experience for certain verticals consistent with our methodology for estimating the allowance. While total net charge-off decreased compared to the third quarter of 2018, the growth in the portfolio and selected credit performance metrics in certain individual verticals, primarily healthcare, pharmacy and hotels drove a higher provision.
This concludes my comments on some of the more impactful items for the quarter. As a reminder, we have fully embraced our strategy to hold more of our loans on book. As we said during the last call, there will be a period of reduced revenue as we move further away from a gain on sale dependents and replace those gains with a steadily building recurring revenue stream. We believe strongly in this path as it maximizes the potential of our business model, minimizes the volatility that frustrates us and many of you as well and extracts the greatest long-term value from assets we generate.
With that I'll turn it over to Chip for comment.
Thanks Brett. I'm on slide 14, just a couple of comments to wrap up here today. Brett and I got a call recently from an institutional investor that's kind of been in and out of our stock. And they were thinking that there is going to be a recession shortly. And that we being an SBA lender would lead that recession. So we went back and we looked at the data. We often say here for those that have been with us for 10 years - treat every customer like the only customer in the bank and we refer to marathons and not sprints.
So what do you have here? So the top 10 SBA lenders the last 10 years did $44 billion in loans, charged-off rate was a little over 1%. So if you take us out of that, we are obviously in the top 10. Charge-off rate goes to 1.19%. What is not on this slide is the default rate. The default rate in the second column would be 5.5%. So our default rate is 1.2% or 4.5x the industry's 4.5x where we are. And from the default standpoint, they're 6.5x. So I don't think we're going to be leading that.
Moving to the next slide. I tried to put myself in your shoes and say where is this company going? What have we got here? You've heard us talk about soundness, profitability and growth in that order. So I just looked at the loan servicing asset reval over the last five quarters compared to our income before tax. And you can see that it's all over the place. And fundamentally we're tired of it. With some of the changes in the secondary market, some of the changes at the SBA, we're just going to layer in recurring revenue, recurring revenue and recurring revenue. And it's going to take us a little time.
I was going to talk a little bit more about the loan loss provision, but I think we've covered that. And now we'd be happy to take questions.
[Operator Instructions]
And our first question comes from Jennifer Demba with the SunTrust. Your line is now open.
Thank you. Good morning. First question is about credit. You noted that you had seen softness in a couple of verticals. Can you elaborate on what you're seeing?
Steve Smits?
Jennifer, this is Steve Smits, Chief Credit Officer. How you doing? So some of the older verticals have pockets, some softness I would say nothing systemic more individual loans and that's just reflective of the age of the portfolio. I had mentioned in prior earnings calls pharmacy is an industry that we watch very closely. And these are predominantly around some of the older credits that have weathered the storm of changing business models and reimbursement rates and what-have-you and those are continued. I don't --they've been with us for a while and we work them through, but I would say nothing really systemic.
I'd say overall the portfolio is very healthy. We definitely see some trends but nothing alarming. And most I would classify as consistent with what we managed to and what we expect.
Okay and Huntley, you talked about the goals of diversifying the loan portfolio. You said like 36% of the loan growth and the quarter was from non-SBA products, non-guaranteed products. What's the ultimate goal there in terms of diversifying the loan mix?
Yes, Jennifer, great question. I don't think we have a set target in the sense that I think as we explore other opportunities. They have a naturally higher growth rate than what's in the SBA market that we've been in for 10 years. So I think you'll see the mix continue to shift away from the SBA naturally, but I don't think we're setting sort of a peg target that say it should be 50/50 or something like that.
Okay and I guess my other question would be on Apiture. What are the implications, if we know yet, of the merger between First Data and Fiserv? What does that mean for Apiture long-term, short-term?
Jennifer, Neil and I were talking about that before the call. And we've been in touch with Frank Bisignano and Chris Foskett. And I think it's just too early. I just --we just don't know.
Okay. I'm sorry one more question in terms of the timing of the new deposit product rollout. Neil, do you have any thoughts on best-case scenario, worst-case scenario in terms of timing?
Yes. I think, I'd say at latest the end of Q3, again, what we're trying to do relative to putting together a brand new core connected to a brand new cloud-based payments platform connected to Apiture are a recent spin out with the First Data. We feel pretty confident that things are on schedule and so if you're going to target something I'd say end of Q3.
Our next question comes from Aaron Deer with Sandler O'Neill. Your line is now open.
Hi, good morning, guys. My apologies if I ask a question that you guys have addressed. I hopped on little late, but I want to go back to the subject of credit. Just curious maybe give any additional color on what drove the higher classifieds and past dues? I know you mentioned pharmacies may be an area that you're watching more closely. Anything --any other color that you can give behind that? And then relatedly your reserve is at a pretty elevated level here, obviously, you've made a big provision this past quarter.
What's --with given methodology on that front is your expectation that the reserve is going to remain at this high level or could we see it start drifting back down again?
Yes, Aaron. This is Steve Smits again. So just a little, I'll take little granularity to the past dues to answer your first part of your question. What's inside that number is actually as Huntley had mentioned in his comments, we're starting from very low numbers in terms of units. So that actually consists of 13 total customers. It just so happens that there is a large hospitality that was administrative in nature. It was 504 that a modification needed to be processing time.
So I wouldn't --that wasn't a performance past due. That was simply a processing a modification or a loan extension which has been taken care of. Another hotel that was past due which was a little bit larger exposure but pretty heavily secured that they're working through. So I would say there wasn't any one vertical that dominated that number outside of a couple outliers in the past dues. The provision is a combination of growth, as well as we've made some precision to how we model the past dues which we think are going to create some consistency going forward and appropriate move. And that had an impact to the provision.
We're also coming off of, if you recall the quarter, where we actually gave some money back into provision. So that kind of magnified.
Steve, I didn't go over that last slide, Aaron. If you look at that last slide, the way we typically do this. Let's just take FEC as an example, right? So the SBA loss ratio for family entertainment centers is about 7%. So for four years that's what Steve does. He books a 4% industry average and at the end of four years, he trues it up with what happened to us. We had zero losses and zero past dues, so we put another $2.9 million back on the books. And it really doesn't matter because a year from now we're faced with CECL. And who knows how that's all going to shake out, right?
Fair enough. I guess along those lines, are you guys now running parallel and can you give any preliminary guidance on CECL expectations?
We're still evaluating CECL. I feel like we're pretty far along down the path getting ready for January 1st, 2020, but nothing to share on what we think that might going to be.
Okay. And then any guidance can give just in terms of what you're looking for in terms of origination for the year or maybe now given the new strategy maybe look at in terms of balance sheet growth for the year?
Yes. I think that's the right way to look at it, Aaron. And we, I said on the call, we think we can put add $1 billion of assets to the balance sheet this year. That comes largely from making new loans, but also we'll have increased flexibility to work with existing customers whether that's a refinance or adding new products. So but I think that's the right metric to look at and if we can put an extra $1 billion of assets on the balance sheet that's a pretty reasonable growth rate we think.
And then should we look for something similar to the fourth quarter level in terms of loan sales? I mean something around this $100 million volume or could that trend higher or lower from here? Any thoughts.
Well, we need the government to open first. That will help. I think it's a reasonable place, right. It'll depend on a couple factors, right. How many new loans we make and the mix of that? The previous loans have become fully funded and eligible for sale. And then the market conditions will factor into that too, but we ended up of the eligible loans holding 55% that's probably a little lower than what we kind of think long-term target is. But it feels like a pretty reasonable, be a pretty reasonable place.
Okay and then related to the government shutdown. You mentioned the three areas where that is impacting Live Oak. It seems--my guess is that if the government reopened tomorrow, you guys would probably have a backlog or stuff that you can push through and still get some loan sales made before quarter end but the longer this drags out, it seems like there's a greater likelihood that it's going to impact your, at least your first quarter results. Any sense on at what point the timing of this shutdown really starts to affect your results?
Yes. I probably put in a couple buckets, right. The first one is loan sales as you mentioned, right. And the question I think we're all still looking at here are pretty unprecedented is how many people rush to market the first year the government is open? And does it lead to inefficient pricing because some folks may be more compelled to sell than we are, right. And so we'll look at it and we'll see how the market opens up and if we're planned to sell, I'll make the couple hundred million like we did last quarter. We've still got plenty of time to do that. But you're right as the quarter compresses and more folks have more pent-up supply, we're just going to have to see how that plays out.
And I think the other side of things is that this goes on; does it impact our lending and our ability to commit capital to our borrowers? And we secured a lot of guarantees. We're working that through the pipeline. We're increasingly seeing opportunities to make good loans where there aren't existing guarantees in place now. We can't secure new ones, and we're evaluating those on a case-by-case basis. And there are ways that we can provide bridge financing and other things. And we're looking at all of those. That's a little more complicated than a traditional get the guarantee and move forward.
And so does that ultimately have some impact on us? Yes. But it's --we're working through it, and we're not sort of ready to call any meaningful change in the model at this point.
Okay and then just a couple last questions for Brett. Brett you mentioned to kind of use maybe the second, third quarter of last year as a guide on the operating expense run rate. Just want to confirm that I understood that correctly. And then secondly, any guidance can give on the 2019 effective tax rate expectation?
Yes, sure. Starting with the expense question, yes, I think I probably just reiterate the comments I previously made. A focus on expense control is definitely top of mind here. With that being scalability, it's not so much expense reduction as it is just looking at what we built and how to scale that in the most efficient way possible. So you did hear that correctly going into the 2019 at least for the first quarter I think noninterest expense will be back in line with where Q and Q3 of 2018 were. And then potentially or likely increasing through the year from there.
As far as the tax rate goes, we're looking at, obviously, in 2018, we had a credit tax rate which is --was not for where we had indicated previously where it would be, but looking at 2019, probably something in the mid to high single digits maybe low double digits kind of in that realm.
Thank you. And that does conclude today's question-and-answer session. I would now like to turn the call to Mr. Chip Mahan, CEO.
Thanks everyone for dialing in. We'll see you next quarter.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. And everyone have a great day.