Live Oak Bancshares Inc
NYSE:LOB
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Good day and thank you for standing by. Welcome to the Q4 2022 Live Oak Bancshares Inc. Earnings Conference Call. [Operator Instructions]
And I would now like to hand the conference over your speaker today Mr. Greg Seward, Chief Risk Officer and General Counsel. Sir please go ahead.
Thank you, and good morning, everyone. Welcome to Live Oak's fourth quarter 2022 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 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 referenced, including reconciliation of those measures to GAAP measures, can also be found in our SEC filings and in the presentation materials.
I will now turn the call over to James Mahan, our Chairman and Chief Executive Officer.
Thanks, Greg, and good morning to those dialing in today. If I had your job, bank analyst extraordinaire, my first question would be tell me about your loan loss provision.
Moving to the next slide, Michael, before we unpack the provision, in our last quarterly call, we talked about some very famous folks predicting a recession. So are the last two substantial increases in the provision a proxy for the future? Let's drill down.
Next slide. Let's go way back to pre CECL, the provision in 2018 and '19 was between $0 and $7 million, mainly in the $2 million to $5 million range. Then, in Q1 of 2020 we implemented CECL at the beginning of the pandemic. We were predictively conservative providing $10 million per quarter during the COVID peak. We were equally predictable as the government provided PPP funding and our provision came down in 2021 as you can see from the slide. The title of this slide is regression to the norm. We're about back to where we were three years ago as our allowance for credit losses are 2.2% of unguaranteed loans compared to 2.4% in 2019. We do not see the Q4 provision as a proxy for the future at this point in time.
Moving to slide 6. In the old days of running banks, we typically added to our loan loss reserves that which we charged off that quarter. Not anymore. As you can see our addition to the reserve has far exceeded actual net charge offs. BJ will be walking you through some calculations on how growth in the loan portfolio has a great deal to do with these differences.
Let's move to slide 7 Michael. As always back to credit quality and the underpinning of a building of a healthy allowance for loan losses. Once again soundness, profitability and growth in that order. So here are the facts. [Watch list] is down year-over-year, past dues are flat, non-accruals are down 10 bips. As we discussed last quarter surprisingly, of the total non-accruals at year end of $26 million over half or $15 million were paying as agreed. Charge offs in '21 were $9 million and $10.7 million in 2022. Deminimis on a loan book of $4.1 billion of unguaranteed paper.
Slide 8. Now that we have examined the past and reconciled the history of our loan loss reserve and our current credit quality ratios, what does the future look like? What better place to turn than our customers? I have known John Barlow for a long time. John started his data driven consultancy 43 years ago. We asked John and his team to ask our customers a number of questions about the future of their businesses. After a thorough review and list cleaning 4600 loan relationship customers were invited to participate in an online survey between late September and early November.
768 customers are 17% of the total respondents. As you can see from the slide, most were upbeat and over 60% thought they can grow their revenues in 2023. Nearly 25% of our customers planned to borrow money to finance that growth over the next 12 months.
Relative to customer challenges, difficulty in hiring and increased material and supply costs top the list. Half of our customers believe they are understaffed. Over the past 12 months most customers have increased their prices over 10%. Over the next five years, 25% of our customers believe they could sell their business. This doesn't feel like a recession, does it? Over to you BJ.
Thanks, Jeff. Good morning, everybody. Thanks again for joining us. Let's start on some full year 2022 highlights on slide 10. Earnings per share were $3.92. From a core earnings results perspective, they were driven by healthy production growth, $4 billion of production in the year leading to strong loan growth. This combined with net interest margin resiliency led to excellent net interest income growth.
And then of course, we had significant gains from successful exits of two ventures investments, which gave us the flexibility to moderate our guaranteed sales activity due to market dislocation, and continue investing in our people and technology while adding meaningful organic capital.
Put some numbers behind the highlights the full year 2022 net interest margin of $3.87 held up incredibly well ahead of expectations. This is a testament to the excellent discipline our lenders demonstrated to balance production and profitability along with the great work by our deposits team to manage the positive pricing in a very highly competitive, rapidly rising rate environment.
Our adjusted net interest income growth was up 31% year-over-year on that $4 billion of loan production and 24% loan growth ex-PPP along with 25% deposit growth. This balance sheet growth was made even stronger by the guaranteed loans we did not sell. While gain on sale income was down meaningfully from last year due to secondary market dynamics that income was not last forever. Those loans that we kept will be a strong tailwind to our balance sheet and NII growth in 2023.
As Chip said, credit quality remains quite strong, despite the uncertainty of the economic outlook. And of course, our history of successful incubation and investment in FinTech ventures again served us well, generating significant gains in organic capital for future growth. All of this led to significant tangible book value per share growth as well 12% year-over-year.
And as we look at slide 11, we also know that our 2022 results had a lot of moving parts that didn't make it easy for investors. A few comments on these as we head into 2023. I'll make five quick points. Number one, PPP loans and associated impacts are immaterial at this point and won't be a factor going forward. Number two, while we will continue to mark our servicing asset each quarter as required, we are working on ways to better forecast and minimize its impact on our quarterly results.
Number three, while we will continue to make tax credit investments when attractive, we are modifying our strategy to lessen the earnings volatility associated with those investments. Number four, we plan to keep gain on sale income as a percentage of total revenues more in current ranges, which will afford us additional flexibility and stronger recurring spread income growth. And number five while we continue to find our existing Live Oak and canopy ventures investments attractive, and we'll continue to make further investments we are not currently anticipating any exits in the near term.
Turning into slide 13. Let's take a quick look at Q4 '22 performance, where you see our adjusted results and the notable items that make up those adjustments. Adjusted PPNR was down 12% quarter-to-quarter as continued strong net interest income growth of 4% linked quarter was offset by lower gain on sale income and continued investment in people and technology.
As Chip discussed earlier, our credit remains quite healthy. We did build our provision proactively in anticipation of a potential recession in '23. I'll get into credit trends a little bit more fully in a few minutes.
Turning to slide 14. We generated almost $1.2 billion of loan production in the quarter and $4 billion for the year. You see, our loan originations remain quite diverse across our multiple areas, with particular strength in numerous small business verticals and our middle market sponsor finance vertical.
In energy and infrastructure solar remains quite strong, while bio-energy lending was down from last year. Both of those verticals should benefit from the clean energy incentives in the recently passed Inflation Reduction Act. Breaking down the components of revenue on slide 15, we see very strong and encouraging revenue trends particularly in net interest income. While linked quarter revenue was down modestly as continued NII growth was offset by lower gain on sale income, total revenue growth was up 16% year-over-year, even with significantly lower gain on sale income, thanks to 31% year-over-year growth in net interest income.
Given the fact we held more loans on the balance sheet and expect to continue to healthy NIM we are optimistic about continued strong NII growth in 2023. Secondary market for SBA and USDA fixed rate sales remain unattractive and pricing for variable rate SBA is recovering but still not quite at normalized levels. So we expect to continue to hold more assets on the balance sheet. Again, it's important to understand that lower gain on sale income is not income that is permanently lost, we simply earn it over time in the form of spread income. And because of the flexibility we have with strong capital and liquidity levels, we are more than happy to hold these high quality assets, and we will remain patient with secondary market sales until further normalization.
Digging deeper into net interest margin trends on slide 16. Margin again held strong in Q4 at 3.76% and for the full year at 3.87% versus last year's 3.86%. While we still expect some downward pressure as deposit competition shows no signs of easing we continue to be very encouraged by the resiliency of our margin due the excellent work by our lenders in adjusting loan pricing commensurate with market funding costs.
Turning to expenses on slide 17. We have been incredibly pleased with the quality of talent that has joined Live Oak in our various groups across the company. We have now largely worked through our hiring bubble to right size our lenders support to accommodate the significant step up in production and balance sheet growth over the past two years. And in addition, as we have discussed, we accelerated our technology hiring in 2022 thanks to the FinTech gain that is now also largely complete. So going forward, while we will continue to be opportunistic on hiring, particularly for revenue producers, we expect to see our expense growth moderate considerably into 2023 and significantly improve our operating leverage and PPNR growth going forward.
Few more points on credit trends on slide 18. As Chip discussed earlier, credit metrics remain quite strong. We continue to actively monitor the existing portfolio and do not currently see any glaring weak spots. Net charge offs and non-accruals remain quite low. 30 day past dues remain low as well. In fact, the Q4 dollar amount of $19 million you see in the upper right is down to only about $3 million as of yesterday.
Yet we grew the provision well in excess of the $1.4 million of net charge offs we experienced in Q4 and as you can see in the upper left 40% of that provision was due to strong balance sheet growth. To me that's good provision. 55% of the growth was continued proactivity in building appropriate reserves for a less certain outlook and regressing to the norm. With what we see combined with a conservative outlook we currently feel very well positioned with our current reserve coverage and levels.
Slide 19 shows the advantages of the Live Oak business model. Having 42% of year total loan portfolio government guaranteed a stronger net interest margin than most and reserves over twice the industry average is quite new unique and comforting. Add to that our overall capital strength on slide 20, we believe we're credibly well-positioned to thrive in whatever environment lies ahead.
With that, I'll turn it over to Huntley for a little more color on our outlook and areas of focus for '23. Huntley.
Thanks BJ. I'll try to wrap all this up on page 22. Despite what was admittedly a noisy quarter and the continued sort of macro uncertainty as we head into 2023, with a lot of momentum from day one of Live Oak you've heard Chip articulate our priorities as a company safety and soundness, profitability and growth in that order. And we remain committed to that. Our balance sheet as BJ, went through was really well-positioned with ample capital, significant loan loss reserves and the flexibility that we required to support our growth. Our loan portfolio remains healthy and we're committed to staying close to our existing small business borrowers, and we're optimistic as they navigate a slower growth economy. That said, we still see tremendous opportunity to continue to lend prudently, especially if history repeats itself and lenders pull back from small businesses in choppier times.
In 2022, we demonstrated our ability to maintain our net interest margin despite the rapidly rising rate environment, and that coupled with continued loan growth to position us for significant net interest income growth. As BJ mentioned, we've been spending a lot of time focusing on how to reduce the volatility in our earnings to make your jobs as investors easier to see our core fundamentals and expect to demonstrate that in 2023 as well.
On the expense side, our team is firmly in place as we start the year, and our headcount growth will dramatically slow versus the last couple years. Our lending franchise is stronger than ever. Our technology teams fully built out with clear roadmap. And we're seeing tangible efficiency gains in both our technology investments and our operational improvements. All that should allow our revenue growth to significantly outpace our expense growth, and result in strong PPNR growth throughout the year.
On the technology front, you'll see continued improvements in origination and servicing platforms designed to speed up our lending process and improve our customer experience. You'll also see our embedded banking developer portal that will drive customer acquisition and deeper banking relationships through software providers that serve small businesses.
I'll wrap up with a topic that I'm sure you've all been waiting for an update on checking. As you all know, we currently have a checking product in the lower end of the small business market with about 2000 accounts. But it doesn't have all the capabilities that we need to serve our core customers; the veterinarians, the professional services firms and the rest of small business America that require some version of entitlements and money movement.
In the next couple of weeks, we're going to onboard our first customer on our fully functional business checking account that's complete with treasury management capabilities and that will allow us to serve all of our existing small business clients and the broader small business market as well. It's been a long wait for everyone. But we're excited to finally prove our ability to drive low cost deposit growth at Live Oak. We remain laser focused on our mission to become America's small business bank, and we look forward to translating that into predictable earnings growth throughout 2023.
With that, let's turn it over to questions.
Thank you. [Operator Instructions] Our first question will come from Steven Alexopoulos from JPMorgan. Your line is open.
Hey, good morning, everybody.
Hi Steve.
I want to start so BJ, you guided the NIM several quarters ago to 3.50%, 3.75% for the fourth quarter, you are 3.76%. I think you won both showcases with that forecast. What do you see is the range one year from now 4Q ‘23?
Yes, I think, I would probably still say the 3.50% is 3.75% and hopefully, again under promise and over deliver. As I talked about earlier, I feel really good about how quickly our lenders adjusted loan pricing and still put up record loan production as well. So it's not like we sacrificed quantity for profitability. So very pleased with that. The deposit pricing was very well managed by our team in the first half of 2022. And then it significantly ramped up in the back half and shows no signs of slowing.
So I do expect in 2023, particularly in the first half of the year to see downward pressure on the NIM as it relates to deposit pricing. Because we won't see quite as much loan repricing that was helpful to us. But in the back half of the year, I see us continuing to build our margin as potentially the Fed stops raising rates and rates in general are more stable. So still feel really good about the margin and our ability to produce. So happy with what we've seen so far.
BJ if the Fed does not cut rates the way the market thinks and they move up a couple more hikes and then pauses you'd still think NIM can hold in that range? Or is it really contingent on seeing rate cuts the back half?
Now, it's a good question. We essentially are assuming what the market forward curve looks like. So another two or three Fed moves of 25 basis points, and then a cut either late December '23 or early 2024. So our margin assumptions for '23 really don't have any rate cut that would have a meaningful impact.
Okay, that's helpful. And then to follow up on the comments around dialing down the expense growth. Can you help us think about what's a reasonable range for 2023?
Good question, Steve. Look I think if you look back in 2021, that's really in that sort of post pandemic or sort of capital flows and our lending volumes, really stair stepped up. And so we hired a bunch of lender support to keep up with of that opportunity. And then into 2022 it was really in the technology side, where we really invested heavily and we talked about that as it relates to some of the gains that we had that allowed us to accelerate that both of those are really in place.
And so I think that if you thought about from a headcount perspective, we may still grow a little bit, but it'll be certainly less than 10% across the board. And that's assuming that our production still looks like it'll be at or above where we came in last year with everything we see right now. And that's obviously the driver, the largest driver of our expenses is on the people side.
So are you saying only high single digit is that about what you're implying?
If you look at '21 to '22, so take out kind of some of the noise or the one times that kind of thing we had about 25% expense growth from '21 to '22. I would see that more in the mid teens range this year, as we put more of that investment in people and technology to work.
Yes, I think Steve, the other way to think about it is we had a lot of growth throughout last year. So looking at Q4 and that sort of core expense number, I think will be in high single digits or mid single digits of growth over that kind of call it less than 10% growth on that number, but to BJ's point that'll translate year-over-year higher, just given the ramp up over the course of last year.
Steve I think the only thing that could upset that right is back to your earlier point, right? If this is a true recession and if the credit guys end up running these banks and if there are opportunities to hire other lending officers, we will be in that hunt. But that is not suitable at this time.
Yes. If I could squeeze in one last one, just on credit, did the commentary around a small number of relationships you talked about impacting credit quality, anything to read into there? Any industry one offs? Just give a little bit of color there? Thanks.
Steve, this is Steve Smith Chief Credit Officer. No systemic or anything to read into it. I would say that's based on a handful of relationships that are going through some turmoil with their management teams still paying as agreed. However, we opted to reserve against those, because it will be potentially navigating some uncertain times. And so I don't suspect that that is going to turn into losses. But it's kind of a conservative approach. Let's reserve against that. Because and see if these management issues with our borrowers escalate, we'll be prepared and ready for it. So it's kind of a conservative approach, but not anything systemic that jumps out these are unrelated issues.
Got it. Okay. Thanks for taking my questions.
Thank you.
Thank you. [Operator Instructions] Our next question will come from Crispin Love of Piper Sandler. Your line is open.
Thanks. And good morning, everyone. First one is on SBA gain on sale margin. So they were at 5% in the quarter well below recent quarters. But you did sell more SBA in the fourth quarter than you did in the third. So I'm just, can you speak a little bit to your strategy there? And why you didn't balance sheet more loans in the fourth quarter similar to what you did in the second quarter? And then just your expectations for selling versus holding on the balance sheet in early 2023?
Sure, Crispin. Hey it's BJ. One thing that has been particularly surprising and impressive about what our lenders have been able to accomplish is the beginning of the year, about 30% to 35% of our production was variable rate. So 65% to 70% was fixed rate. And that obviously was as we talked about difficult to sell. By the end of the year, we were over 50% variable rate in terms of the production that we were booking. Variable rate market was still relatively healthy from a gain on sale perspective. And so we had more capacity and more eligible loans for sale that were attractive to investors.
So as we looked at where we would want to manage interest rate risk, what kind of balance sheet we wanted, and what kind of gains that we felt we could take in the fourth quarter from SBA sales, we decided to sell a little bit more of the variable knowing that we had quite a bit of it on the balance sheet already. So that was part of the math there.
Okay, thanks, BJ. That's helpful. And then do you have any early reads on the first quarter for margins? Have they begun to form a little bit? Or do you expect a little bit more of the same for near term trends?
Yes, so I'd say that the variable rate SBA market continues to heal. It's probably still a couple 100 basis points from “normal levels”, but there's -- there's healthy activity and there's buying if we choose to be in the market and sell. USDA and SBA fixed rate product is still virtually nonexistent from a buying perspective. So we'll be holding those.
So like I said at the opening, we're just expecting pretty muted activity from a gain on sale perspective in the first half of the year and hoping it opens up in the second half. But one of the thing I did say that I wanted to reiterate now that we've got our gain on sale as a percentage of quarterly revenue somewhere in that 7% to 10% revenue range and gives us a total revenue mix of let's say around 80% spread income 20% fee income versus historically over the last couple years, we've been more 70/30.
I think that's actually a pretty good place for us to be. It minimizes our gain on sale and frankly, reliance on gain on sale every quarter, allows us more flexibility to sell more if we see attractive pricing, sell less if we want to hold more. But then importantly, it gives us much more recurring revenue through NII and balance sheet growth, which we think is certainly more predictable and obviously attractive to us and to investors. So this has actually given us an opportunity to kind of reset what our gain on sales strategy is and grow more balance sheet.
Thank you, BJ. I appreciate that. And then just one last one for me. Kind of dovetailing off your last point, but I'm just curious what your outlook is on loan and origination growth. In the past several quarters ago, you talked about kind of longer term trends of 15% origination growth. Do you think levels like that is still attainable right now or do you think growth like that needs to come down given the current environment?
Do you mean balance sheet or origination [indiscernible] Crispin?
Origination, but also looking for both as well?
Yes.
Yes. So on the origination side we continue to add lenders last year and I think we have the franchise in place to do that. So we did $4 billion of total origination last year to think that we could grow that 15% in sort of a normal environment seems quite reasonable. I think we're obviously being pretty conservative right now looking at the implications of a slowing economy, interest rates, construction costs largely M&A market, things like that.
So we feel good right now, kind of, at where we are or up. But certainly the franchise is in place to do that sort of 15%. And as we look at just the overall size of the market, the overall trends in the silver tsunamis and the transition of ownership, as Chip talked about, it still feels like there's just a ton of opportunity for us to continue to expand the lending franchise. We're just going to do it really prudently as we kind of look and see what 2023 looks like.
Thanks Huntley. Thanks for taking my questions.
Yes.
Thank you. [Operator Instructions] Our next question will come from Michael Perito of KBW. Your line is open.
Hey, guys, good morning. Thanks for taking my questions. I wanted to start a kind of two bigger picture questions. One just on how are you guys thinking about, there has been some discussion on this call about expense with moderating positive operating leverage, NIM having some more pressure, but then hopefully stabilizing kind of taking it on to soar here. I mean, what's the updated thoughts you guys have on kind of structurally what the targeted ROE should be for this business. I mean, you guys are now growing the balance sheet a bit more, maybe there's a little less gain on sale.
Maybe that weighs on a little near term. But just curious if there's any kind of profitability thoughts you're willing to provide, as you guys kind of look out over the next couple of years with what you know today in terms of what -- what you think is reasonable, or should be targeted for the type of business you're building?
Yes. That's a great question Mike. We talked about that a lot here. We've consistently grown our balance sheet north of 20% actually. I think over a sustained period of time, we still think that 15 plus percent balance sheet growth makes sense for us as a franchise as we look at sort of where we're going. The simple math says a 15 plus percent ROE allows you to sell fund that and continue to grow without having to sort of tap into capital markets which is nice. It creates a lot of sort of flexibility for us on that path.
As we look at our franchise a 15% ROE, I think is quite reasonable, especially as we start to turn the dial on the deposit side that we've been talking about and start layering and checking accounts which is a pretty capital efficient place to grow earnings by lowering our cost of funds. So we'd love to think that we could turn that dial to be 20% ROE and 20% grower that's sort of I think the optimistic case, but pretty reasonably think that a 15% ROE to support our growth is pretty reasonable. BJ if you have anything on that.
No. I think that's right. And kind of our arrow in the quiver so to speak is we were 50 if you normalize some of these onetime costs and the gains and all this we're a 15% to 20% ROE business today with a deposit platform, that is market rate. And as Huntley mentioned this is our year of checking, and really getting focused on that. And so over the next several years, as we continue to grow our business and build out a small business bank we are anticipating that funding cost is going to be a tailwind to us as we continue to improve profitability.
Got it, that's helpful, but it's fair to think that on a GAAP basis, there will be a process to build backups that's 50% right. I mean, it over the next year or two, as some of those initiatives take hold and rate stabilize, etc. Is that fair?
Yes. I think that's fair, Mike.
Okay. And that kind of dovetailing off that you guys kind of brought this up, but I think BJ, you mentioned that at this point you're not expecting any exits in 2023 on the venture side. And kind of from a timing perspective, it feels like 2022 will be a year where the balance sheet growth outpaces the ROE at least as it looks right now. So I'm just curious, all the capital front particularly with the mindset now of holding more your production. Could you also just maybe remind us eternally what you guys are thinking about in terms of the capitalization of the bank and what's kind of the target range? And if you were to go above or below that what would be kind of your priorities to right size that?
Yes. I think if you look at where we sit today kind of the common equity tier one ratio of 12.5% is quite solid where we have our binding constraint as we continue to grow is really more of the leverage side. And we are unique in that 40% of our loan book is government guaranteed. And so leverage is a little bit less relevant to us, but obviously, still an important and headline ratio.
So that's one that we continue to watch. We're at [9.3%] today from a holding company or bank shares perspective which still remains very healthy. Even if we grow the balance sheet faster than the retained earnings we still have a couple of years of runway before tier one leverage gets down at the bank shears level towards 7.5% or 7% range, in which case, we would probably have to think of something else absent more ventures gains. So we do have some runway as the balance sheet grows.
Very helpful. Thank you. Just lastly, for me, I know, it's hard, but any thoughts on a rage on the tax rate for next year BJ just given some of the credit activity you've done already? And is there any guardrails you could give us on that?
Yes. Sorry. Yes. I know that's a tough one. Honestly, a tough one for me too. I would say our statutory rate blended is going to be around 23%. I would use 20% as an effective tax rate to model. Now it's going to kind of go up and down quarter-to-quarter but that's probably the best range. If we are, if we do see attractive tax credit investments that we want to make that could certainly shift and be more positive, but right now 20 is probably the best place to land.
Okay, great. Thank you guys. I appreciate it.
Thanks Mike.
Thank you. And I'm seeing no further questions in the queue. I will now like to turn the conference back to Chip Mahan for closing remarks.
Well, this will be brief. See you in 90 days folks.
This concludes today's conference call. Thank you all for participating. You may now disconnect and have a pleasant day.