Live Oak Bancshares Inc
NYSE:LOB
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Ladies and gentlemen, thank you for standing by and welcome to the Fourth Quarter 2019 Live Oak Bancshares Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] I would now like to hand the conference over 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 fourth 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 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 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.
Thanks, Greg and good morning all. So I am going to kick off today’s call and reflect on our accomplishments over the last 4 years, discuss our excitement about this year and then we are going to have some fun and put ourselves in your shoes and discuss our views of the community bank of the future versus other bank stocks you can own. Then Neil is going to explain how we are going to accomplish this from a technical standpoint before Huntley takes us home on the bank’s financial performance in 2019.
Moving to Slide 3, whereas we are tickled the depth of this year’s results here at Live Oak we often refer to marathons and not sprints. It was fun for us to go back and reflect on our first full year as a public company, 2016 that was, so beginning in 2016 we grew assets almost fivefold until the end of this year. The capital account over doubled from $200 million to over $530 million. Recurring dependable revenue quadrupled from about $40 million to almost $170 million, while non-interest expense was up 130% in the 4-year period. Well, by the way and along the way, we originated $7 billion of mostly government guaranteed loans. We sold $3 billion to avoid dilution and charged off just $14 million in 4 years compared to I think almost $55 million to the loan loss reserve.
Moving to Slide 4, we are proud to show this slide every quarter. The loan portfolio grew 43%. Credit quality improved. Net interest income was up 32%. And most importantly, we grew the government guaranteed book from $357 million to almost $1 billion. As a shareholder, you should view that as a credit quality buffer. We were excited to continue to grow that into this year about $90 million which was off a bit. USDA was behind a little bit this quarter. And as we think about originations in the future we are happy when we originated about $2 billion of loans in ‘19 and we think that would rather increase 10% plus in 2020.
Moving on to Slide 5, another recurring earnings call slide and the beat goes on. So this quarter we owned $269 million in high-quality loans. The spread was a bit less as we suffered a couple of down rate challenges there as we all know. So, we have put a nickel a share EPS on the books this quarter when annualized at $0.20, last quarter was $0.25. So, we charge on to $1 a share of wonderful recurring EPS.
Moving to Slide 6, the credit quality slide, again, good news on safety and soundness, charge-offs were $1 million less in ‘19 than ‘18, that’s $3.8 million versus $4.8 million. Non-performers as a percent of Tier 1 capital in the loan loss reserve declined to 3.6% in line with our historical norms. And this is a bit frustrating. It’s rumored out there that you people talk and there is talk that you are number 1 SBA lender in the country will lead the league when a recession occurs. I am here to tell you today that, that cannot be further from the truth. Until CECL, we typically went into each vertical and the theory of verticality range. So, we use SBA’s historic loss ratio for all their banks and at the end of 4 years, we true it up with our actual losses. In so doing, we added back $12 million over the last 4 or 5 years to the loan loss reserve doing it this way. This will no longer be the case in the future with CECL and Steve Smits, our Chief Credit Officer is here this morning and he can certainly talk about that in the Q&A here shortly.
Now, in preparing for this call, I will try to put – we try to put ourselves in your shoes. So you only have three options today. You are consuming data and you are trying to decide whether you are going to buy more Live Oak shares, sell Live Oak shares or hold on to what you got. So, what would be your alternative? So, we did some work on the traditional community bank and whether you want to buy that stock or hold on to ours. So, let’s talk a little bit about the bank of the future versus the past. So in preparation for this call, again have some fun and looked at 15 investor presentations of banks roughly our value, of banks that traded between 1.40 a tangible book and 1.80 a tangible book. And for those of you that are professional bank stock analysts shocking that all investor presentations were exactly the same. There was a little math of the location of offices. Section 2 talked about a diversified loan portfolio, single-family residential think of real estate, CRE think of real estate, multifamily, real estate again, construction and land development on real estate, some C&I loans, very little consumer from a dollar standpoint. Then we had to go to the deposit mix, lower cost of funds back to the branches.
So if you go to Slide 9 and in the tiny front that you can’t read, there are 10 banks represented here. They had an average number of almost 40 branches. They had 250, more than we do, roughly the same net interest margin, very little discussion on the cost to operate those branches, which we estimate between 1% and 2% which would need to be a deduct from that 363. Let’s focus on the rubber really meets the road. So, you have a real estate play in a geographic area with a traditional community bank and you are paying 1.60 a book for that company versus 1.44 a book for our company and we grow in almost 7x their rate in a diverse high-quality asset what Huntley is going to describe later.
Now, let’s talk about the state of play today and maybe the state of play tomorrow. So earlier this year, Penny Crosman from the American Banker interviewed Adam Dell who is the Founder and CEO of Clarity Money bought by Goldman and this gentlemen runs the Goldman and Marcus product. And she says in several recent article headlines, it is reported you see banks are screwed, did that come out a little stronger than you intended? Adam says yes, the text of my comments were not relayed in the press, my comment really was around the notion of the empowerment of the consumer and how important it is that banks appreciate the greet, which the consumer is now empowered to understand the value they are getting from their financial relationship. Historically, if you are an average consumer in the U.S., it is very difficult to understand the fees that you paid in your bank, the interest rate they pay you for deposits. That lack of transparency is a thing of the past. And the consumers now have to have a wide array of tools available to them to understand the financial arrangement they have with their bank. And then he goes on to say and I just love this, love it. Inertia is the most harming of ailments that base the consumer who is healing to address financial well being.
Now, this is consumer focused or small business focused, but if you move to Slide 10. So what is the state of play today? Right, so if you look at the box at the bottom and you think about a small business and you think about a veterinarian and we do business with a 1,000 of them. She has a checking account, most likely a money market account or a savings account. She probably funds her business with a personal credit card or maybe a business credit card. And if she is lucky, she has a line of credit from a bank. So, let’s unpack that. How do we use an industry? How do those banks that you have an opportunity to pay 1.60 a book versus us at 1.40 a book? Well, on the checking account, kind of screw Adam’s words, monthly fees, transaction fees, NSF fees, wire fees, BofA fees, 3 bps on a savings account, we pick 200 bps, credit cards are always 18%, line of credit who knows. All of these systems are run separately and they don’t talk to each other. Neil is going to describe how in a next-gen core processing system with our ecosystem we can bring this all together in one account.
So, at the end of the day, to doctor so and so, if you have $0 to $5,000, we might not pay you anything, $5,000 to $15,000 we might pay you 1%, over $25,000 we might pay you 2%. If you need the bar, we are not going to lend it to you at 18%, we are going to be fair. I know yes, there will be cash back and rewards and all those sort of things and if in fact we can do that understanding at only 2% of small business has moved their banking account today, our research indicates that with this account, it might be substantially higher. Might we bring our cost of funds down, substantially, 25 bps, 50 bps, 75 bps on a $5 billion bank, that’s meaningful. Neil, takeover.
Thanks Chip. To your point, as you have been following the Live Oak Bancshares, you know that one of our core theme centers around financial services technology. This next slide is a reminder of our fin-tech investing over the years. And as you can see, we have been pretty busy. From the spinout of nCino to the joint venture with Apiture to Live Oak Bancshares in assembling strategics, investing and mission-critical banking applications, we feel Live Oak Bank is on the forefront of digital transformation. We are excited to announce our journey continues in this latest endeavor, Canapi, which you might have read about, a fin-tech venture fund built by bankers for bankers.
Turning on to the next slide, this close to $600 million fin-tech fund is unique and that the limited partners are highly progressive banks who are deeply interested in understanding the fin-tech landscape. LPs include 30 regional and super regional banks as well as the ABA and ICBA. While we think this is a major milestone for the industry, the benefits of Live Oak Bank are significant. In addition to fee-based income connected to the fund that also receives carry, which comes with the long-term harvesting of the fund, but even more strategically we get to see every fin-tech deal in the market with unprecedented clarity and we feel this will keep Live Oak Bank on the leading edge of digital transformation.
Turning the page on to the numbers, as you can see we broke up the fin-tech activities into three buckets for greater clarity: Apiture, Live Oak Ventures and Canapi. Given our ownership in Apiture, we follow equity method accounting. And while we do not consolidate Apiture, our pro rata portion of the losses, do flow through our income statement. As you can see, we are investing heavily in the platform and will continue to invest in 2020. At Live Oak Ventures, we had a relatively neutral year where write-ups of one company’s valuation offset the flow-through losses of the others. We feel this neutrality will continue in 2020 and beyond. And lastly, at Canapi, we are excited. Given the funds approval in Q4, we began to receive fee-based income which will continue through the fund’s 10-year existence. This is an offset to expenses that that already existed in the business and will be a net positive to the income statement.
So, moving on to the next slide and connecting it to Chip’s one account concept, why would we go through all this pain over the years investing, incubating companies, starting funds, it really takes a ton of energy. And to us it’s quite simple. It all comes down to the customer. The customer now demands more superior customer journey and digital journey and this is demonstrated by the millions of customers flocking to fin-techs. Sadly, we feel the banking sector is broken with old software and old tools and somebody has to fix it, why not us? So, as you can see by this picture, we deconstructed the entire stack, created, incubated and invested in an entirely new approach, with new companies and this has been difficult. And yes, it’s taken longer than we had expected. But the platform will last for decades to come and allow us to bring new products to the market, just like the one account that Chip referred to earlier. In addition, the scrappy approach has had a little effect on our income statement. If anything, we benefited from the write-ups associated with our equity investments over the years. And lastly, I am excited to say that after a 3-year build, including an entirely new core ecosystem, we are rolling out first products with limited availability this quarter and general availability next quarter. And certainly, we would invite you to open up the new account as we feel the experience will set the new standard. Huntley, over to you.
Thanks, Neil. Thanks, Chip. Turning to the bank on Slide 17, we are extremely proud of the accomplishments of the bank this past year, which is a direct result of the dedication of our entire team and Q4 really punctuated just a great overall year. We knew that by holding more of our loans in our balance sheet we reduced our near-term earnings, but that will result in a stronger franchise.
As you can see over the course of the year, we grew our loan portfolio by ever 40% and ended the year with a balance sheet of $4.8 billion. And we stay true to our strategy of holding 65% of our government guaranteed [indiscernible]. Our net interest grew 3% in the year despite three rate cuts in the year. And we remain disciplined on the expense side despite providing over $2 billion of credit to over 1,100 small businesses nationwide and working to build the next generation of technology in banking.
On Slide 18, the lending franchise was strong across the board last year with our $2 billion originations spread across geography and industry. As you can see, our more established vertical continued to perform level and the newer verticals are maturing nicely. Overall, small business activity remains solid throughout the year despite SBA volumes being down industry-wide. In the SBA space, in 7a lending, we are proud once again to be the nation’s largest SBA lender this year extending our lead in that category, the testament to our model which combines deep vertical expertise and efficient technology platform and the dedication of our people to serve the nation’s small business owners and entrepreneurs. We also ended the year on top of the USDA lending list, which is an area where we continue to see a lot of opportunity, especially with some of the changes in the recent farm bill.
As Chip mentioned, growth in the guaranteed portfolio slowed a bit in the fourth quarter as we originated less renewable energy in the quarter, which is really more timing issue than anything else. We are also methodically looking up-market, an opportunity to lend beyond our traditional government programs. A lot of people talk about the lower middle-market which seems like an increasingly competitive state to us, but we think there is a lot of opportunity in the upper little market, targeting companies and industries we understand with typically less than $5 million in EBITDA. While this strategy will modestly increase our average loan side, we aren’t going to compromise our commitment to diversification and granularity across the portfolio. For perspective, we still have no loans over $20 million in exposure and only a handful over $10 million. Overall, we continue to see great lending opportunities across our 33 verticals and our pipeline remains robust.
On Slide 19, we show our existing $3.6 billion loan portfolio and the diversification of it as well. 45% is government guarantee as Chip mentioned, which we think serves as a great source of continued capital and liquidity. It’s also worth noting is the $3 billion of loans that we service for others that puts our managed loan portfolio over $6.5 billion. Over time, we expect to replace the majority of those loans with loans on our balance sheet as we continue to work with our existing borrowers more proactively to keep them on our books.
Turning to credit, overall, our loan portfolio continues to perform very well and in line with our expectations as Chip mentioned. Non-performing loans and charge-offs were both slightly improved on the quarter and the watch list was basically flat. We remain guardedly optimistic in this late cycle economy and while we aren’t seeing any macro deterioration in the portfolio, we are cautious especially in places where competitive pressure is high like the craft beverage industry or where there are more cyclical concerns like hospitality. The obligatory CECL comments, as Chip mentioned, while the new methodology is certainly more sophisticated and is more weighted towards quantitative factors, we expect our allowance to stay roughly the same relative to historic levels and it largely leverages our existing models that we have in place that use SBA data and then migrating towards our own data.
On the funding side, on Page 21, our direct deposit model continues to perform extremely well. Growth was in line with our expectations and our balance sheet needs for the quarter. Average balances were up about $200 million in total deposits and 500 and 1,500 new retail accounts, which brings our total to right at 50,000 retail accounts. Our digital platform remains highly scalable. As we said in the past, the lower cost to operate translate to higher rates for customers, which leads to other customer acquisition and there seems to be plenty of room for growth as the leading players in the space are many multiples larger than we are. Overall, the market for online savings and CDs has remained rationale. Most of the major digital banks remain within 10 to 15 basis points of each other. On the savings side, the Fed cut rates 3x in the back half of the year and we have re-priced our savings down a total of 45 basis points. We are still enjoying extremely low savings attrition rates and CD renewals are running all over 70%. With a stable Fed outlook, customer preference has shifted more towards CDs, which is good for us as we have $800 million of CDs rolling over in the first quarter, with an average rate rolling off of about 255 and rolling on at about 205, so about 50 basis points of pickup there.
Turning to the net interest income on Slide 22, net interest income grew nicely over the year despite three rate cuts in the back half of the year. Two of those cuts hit our loan book in Q4 causing NII to be roughly flat for the quarter despite almost 7% linked quarter increase in earning assets. Those rate cuts compressed our NIM to 355 for the quarter. Despite the continued competitive lending environment, loan spreads remained roughly flat during the quarter on our new loan production. Looking forward, we expect margin to be roughly flat in Q1 with the Q4 rate cut offset largely by CD rollover and the margin should trend up modestly from there over the course of 2020 assuming constant rate environment.
As we mentioned, we stayed true to our targets this year and sold roughly one-third of the government-guaranteed loans that became available-for-sale. As we typically sell all of our USDA production given the long fixed rate nature of the product, that means we sold only about a quarter of our eligible SBA loans. As the secondary market for 7a loans continue to strengthen throughout the year, we continue to evaluate our hold for sell decision and decided to make a slight revision to our targets. Going forward, we will continue to sell virtually all of our USDA production and target a third of our eligible SBA production. The effect will be relatively modest, but we will look at capitalize on the strong market and can serve a little bit more capital in the process.
On Slide 24, Chip referenced the growth in the company since the IPO. At that point, the servicing asset was over a quarter of the capital base of the company and the resulting earnings volatility was significant. Today, we sit with a servicing asset at 6.6% of capital and the impact of a quarterly revaluation is a fraction of what it used to be. We are getting close to the point where new production will offset the amortization and we expect the asset to stabilize in size as we go forward, but continue to decline as a percent of capital and earnings as we grow. On the expense side, we are really pleased with the story last year, especially relative to our growth in clients and balance sheet. Normalizing for the performance bonuses, expenses increased less than 5% year-over-year. While the fourth quarter saw an unusually large FDIC insurance assessment, it was offset by a reduction in some of our professional services cost largely with the completion of Canapi. We did increase our lending teams by about 25 people over the course of last year which we expect to help drive continued lending growth in 2020.
Given we knew we are managing this pivot year in earnings we delayed some hiring until the end of the year. So we will see a bit of a higher run-rate in 2020 in the expense side, but we will still see a significant operating leverage and will continue to remain focused on balancing expense discipline with investing to support the growth of our franchise. So summing it all up, we have shown this slide every quarter of the year and will continue to because you can see the progress we have made over the course of the year across the key metrics that we are looking at. In 2020, we will continue on the same course focusing on providing capital to small business owners, the doers of the economy. And with continued momentum in our core banking franchise, we will continue to focus on our future technology builds and delivering a new broad suite of products across the next generation infrastructure.
With that, Chip or Neil we can open up for questions.
Thank you. [Operator Instructions] Our first question comes from Jennifer Demba of SunTrust. Your line is now open.
Thank you. Good morning.
Good morning, Jennifer.
Hi. So you said you are pretty optimistic on the economy and credit quality, but you are being a little bit more cautious on hospitality and craft beverage, can you kind of expand on those thoughts?
Jennifer, this is Steve Smits. Happy to. Again, we are looking at – those are two examples of industries that we have got our eye on how competition, for example, may impact the craft beverage space making sure that if it’s impacting the revenues and really, it’s about just remaining disciplined in our credit decisions, businesses have solid plans and then we look closely at contingencies that the business has to deal with unexpected bumps, balance sheet strength, cash on the balance sheet, proven ability to raise equity when its needed global support, so just remaining very disciplined in that front. Hospitality again, seasonality, so where we focus on is strong projects, very disciplined loan-to-values, almost our entire portfolio, our loan-to-value is our less than 65%, I would say across the entire portfolio, our weighted loan-to-value is about 40%, 45%. So, we are very disciplined, very conservative in that space.
Have you seen any credit deterioration in either one of those loan buckets?
Nothing that rises to a great concern, we have seen a handful of beer businesses that have had – are missing their arc on their planned revenue growth and that’s due to competition. Most of those are smaller credits, very manageable and we are taking a very – like we do, take a very proactive approach to dig into their plans and see what they are doing around that, but nothing that I would call a macro concern, but there are examples of at a micro level of businesses that are struggling a little bit to ramp up and we are keeping close eye on that.
Okay. Huntley, you said expense control would continue to be a focus, what’s your thought on hiring this year in terms of more producers, you said you might go up market a little bit? And as you look at the mix of loan growth over the next couple of years, how do you see it evolving 24% of your originations last year were conventional, how do you see that mix evolving over time?
Sure. I think we largely have the lending team on the field that we want right now and we are in like a bunch of great verticals. The generalist team is hitting their stride, a bunch of great markets. And so we pickup one or two here and there maybe, but I don’t think you will see us grow the lending side to the same extent that we did last year and we really love the team that we have got right now. In terms of the mix, we look at – we will make all the great 7a loans that we can find and we will continue to chase that as, I think just generally, but the relative size, the opportunity set for us in conventional is larger than it is in 7a. We do still think there is a lot on the USDA front that we can still do as we broaden out across all of the different programs they offer. And so we still think there is more upside in the USDA side. I think more of your incremental growth is likely to come from the conventional side though. They are also a little larger credit. So they will move the needle a little bit more on a relative basis.
Okay. And Neil, I think you said you are rolling out the new deposit product very soon here?
Yes, look, I said that, it takes longer, I am thinking of you, because it had to field your questions on the checking account many times. Rolling out the core in a banking environment takes more time than we expected. So what we are rolling out in Q1 is CD and phasings, on-boarding and servicing and that’s 80% and they were very close to the checking account they are after. I would rather not give you a date on the checking account, but know that a brand new web, mobile on-boarding servicing, CD savings personal and business offerings coming out, limited availability in Q1 and general availability in Q2.
Okay. So the checking account sounds like it’s probably the second half of the year event, is that fair?
That’s right.
Okay. Okay, thank you.
Thank you. And our next question comes from Aaron Deer of Piper Sandler. Your line is now open.
Hi, good morning everyone.
Good morning, Aaron.
Pardon me if you covered this, I got on the call late, but Neil, following up on your discussion there was a drop in the data processing cost, so I am wondering is that tied to the core conversion that you mentioned and is that – are we at a sustainable run-rate on data processing or are there other investments happen in there that’s going to cause that number to come back up?
Yes, I think so. So, I think it – I will turn it over to Brett, relative to that specifically. I think one I don’t know that we have actually seen the benefit of the core conversion and the financial impact there yet. So good news is there is probably more upside. Caines, what would you say there?
Yes, on the data processing side, Aaron, looking at Q4, I would say that’s more of a change in some of the third-party services we were using. There was some internal build-out that we were doing and that did not repeat in Q4 or came to completion in Q3.
Okay. And then also related to the discussion on the deposit products been introduced, is that – does the margin guidance that you provided in terms of some stability here in the first quarter and then some expansion as the year goes on? Does that incorporate the expectation for the deposit flows in these new products or could good success in those products drive even more expansion on the margin?
Well, I think certainly this is Brett. I think certainly success there would lead to upside from a margin standpoint. I do think there is a rollout period for when we have the ability to go after those deposits. So if you are thinking 2020, favorability there is probably going to be good as volumes of those types of accounts build.
But our margin guidance that we just talked about doesn’t have any benefit embedded in there.
Yes, steady state and there is upside.
Yes.
Okay. And then Brett, any – obviously as a pullback on the solar tax investments and the related credits there, if you didn’t already, could you give an update in your expectations for where the tax rate is likely to shake out here heading into 2020?
Yes. Well, I guess for starters, we continue to look heavily at investment in tax credit through solar panel leasing. As everyone knows that’s something that we did a good bit of in 2018 and also early in 2019 pulled back a little bit because of some of the economics. However, we are starting to see trends where that could turn favorable again. So still looking at heavily, it will probably be an update we give later on in the year, but for now, I think as far as your modeling is concerned, something similar to what we experienced in Q4 is the good run-rate going forward kind of in that 25% or just about 25% effective tax rate.
Okay, great. Thanks for taking my questions.
Thank you. And ladies and gentlemen, this does conclude our question-and-answer session. I would now like to turn the call back over to Chip Mahan, Chairman and CEO for any closing remarks.
We just thank everyone for attending. We will see you in 90 days from now.
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.