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Q3 2016 · Earnings Call Transcript

Oct 30, 2016

Executives

Greg Seward - General Counsel Chip Mahan - Chairman and CEO Brett Caines - CFO Neil Underwood - President Steve Smits - CCO

Analysts

Aaron Deer - Sandler O'Neill Jefferson Harralson - KBW Jennifer Demba - SunTrust

Operator

Good day, ladies and gentlemen, and welcome to the Live Oak Bancshares, Inc Third Quarter 2016 Earnings Conference Call and Webcast. 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] And as a reminder, this conference call is being recorded.

I would now like to turn the conference call over to your, Greg Seward, General Counsel of Live Oak Bank. Sir, please ahead.

Greg Seward

Thank you and good morning, everyone. Welcome to Live Oak's third quarter 2016 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 Web site at investor.LiveOakBank.com and follow the links from there.

Our third quarter earnings release is also available on our Web site. 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. I will now turn the call over to Chip Mahan, our Chairman and Chief Executive Officer.

Chip Mahan

Thanks, Greg. We are pleased with our Q3 results for several reasons.

Number one, year-to-date, year-over-year total revenues increased from $76 million to $101 million or a 32% increase. On slide one, the originations are up 24% for nine months ending September 30, '16 versus '15 or $828 million to $1.022 billion.

On slide two, our efforts to create a more predictable business model is working. Net interest income plus servicing revenue less loan servicing asset revaluation cost grew 67% year-to-date, year-over-year from $24.6 million last year to $40.9 million this year.

On slide three, growth in non-interest expense less stock-based comp expense for restricted stock awards has slowed dramatically from Q1 to Q3 each of the last two years. The actual drop was from 22.9% growth in non-interest expense to 9.9% this year.

On the fourth slide, our thesis of combining entrepreneurial bankers with domain experts, and allowing them to operate their own business provides leverage atypical in the banking business. Slide four again shows that our six legacy verticals, veterinary, healthcare, independent pharmacies, death care, investment advisors, family entertainment, and chicken business originated $806 million in loans for the first nine months of 2016, while the new wine and craft beverage, self storage, independent insurance agents, the hotel division, renewable energy, and government contracting generated $217 million in new loans.

The estimated operating cost is identified in slide five, which is $21.9 million for the vintage group versus $30,200 per $1 million of loans originated for the newbies. Mature verticals generated $78.9 million, and revenues net of operating costs, versus fundamentally a breakeven situation for the new verticals.

Now let me take a minute and talk about two of our newest groups, renewable energy and government contracting. The recently launched renewable energy lending vertical conforms to Live Oak's history of targeting low-default industries.

The vertical focuses on utility scale solar facilities with capacities of one to 25 megawatts. Virtually all of Live Oak's solar facility customers sell power to investment grade buyers under long-term power purchase agreements.

The vertical utilizes a United States Department of Agriculture loan guarantee program to help finance energy-efficient upgrades in newly constructed renewable energy system. Live Oak is pleased to be part of this solution to provide clear, renewable energy, while producing economic development and job growth in disadvantaged communities across America.

Secondly, lending money to small business government contractors plays to our strengths. It allows us to leverage data, domain expertise, robust servicing, and technology in a market segment where the government awards $90 billion annually to rough 150,000 potential borrowers.

We see the combination of business acquisition financing with asset-based lending as a competitive advantage and an excellent way to capture core deposits. As we put together our 2017 budget, we can see that the 2015 and 2016 group begin to move toward maturity, and now it's time to begin to search for new growth opportunities in other verticals.

Neil, over to you.

Neil Underwood

Thanks, Chip. First, let's talk funding.

We've been very pleased with the changes to our funding model in 2016. With our online CD campaign, we have opened nearly 6,000 new accounts totaling $442 million in deposits at an acquisition expense of $0.66 for every $1,000 in deposits.

The portfolio rate remains roughly 1.1%. This is higher than the industry average, but our cost of funds is offset by our branchless environment, driving down operational expenses.

Additionally, our customer experience keeps driving market-leading retention rates, which is currently 74% as a rollover rate based upon a 13-month curve. As originally planned, we expect the launch of Acorn Business Checking in Q1, 2017, which will leverage our expanding customer base, and drive down our overall cost of funds.

On the lending front we've got exciting news to report. While still abiding by rigid traditional credit standards, we are experiencing triple-digit year-over-year growth in this market segment.

Perhaps more importantly, we are experiencing a 5X efficiency factor, meaning we can originate five small loans at the same cost structure as one big loan. We are now proving that a bank can indeed be as efficient an originator as an alternative lender, but take advantage of a stable proven cost of funds.

While the growth is significant I'd like to remind you this is still smaller relative to overall Live Oak Bank production. We look forward to an exciting 2017 as we rollout new loan products and new deposit products.

Brett, over to you.

Brett Caines

Thanks, Neil. Good morning everyone.

The third quarter was marked by record-setting loan originations of $381 million, an increase of a robust 26% over the third quarter of 2015. As Chip referenced, this has been driven by growth in both our legacy verticals as well as in the newer verticals that began production in 2015 and 2016.

Our combined recurring revenue streams of net interest income and servicing revenue benefited from this increase in origination, rising to $17 million for the quarter, a 61% increase over a year ago, the net interest income component increased by $5 million from one year ago to $11.6 million, a 75% increase. We are already starting to see the benefits of our recent decision to diversify our revenue streams from the historical gain-on-sale revenue concentration by retaining more of our loans on the balance sheet.

In future periods, we would expect greater consistency in growth in our more stable revenue streams with less reliance on market-sensitive sources. Total loans on book at quarter end increased to $1.1 billion, a 58% increase over Q3 2015.

Of the $1.1 billion in loans, approximately $735 million represents the unguaranteed portion of SBA loans and conventional loans. This is an increase of 11% in unguaranteed loans from the prior quarter amount of $660 million.

Cash balances were high at quarter end as we raised funds in anticipation of Q4's loan production, and also settled a large volume of loan sales at quarter end. In total, we settled $211 million in guaranteed loan sales in the third quarter, which included $38 million in loans that were sold but did not settle in Q2, as we discussed during last quarter's call.

The corresponding net gain on sales in the second quarter was $21.8 million or approximately $104,000 of revenue for each $1 million of loans sold, versus $15.4 million a year ago at approximately $105,000 per million sold. The net gain on sale was well above last quarter's amount of $14.6 million before the average premium decline from the 107 level primarily is a function of the mix of loans.

Overall, pricing in the secondary market has remained fairly steady when comparing loans with similar characteristics, largely due to the continuation of low interest rates that have kept prepayments low on a historical basis. Regarding the on-book [ph] construction portfolio, the guaranteed portion of the note amount for loans in the construction stage increased to $692 million from $499 million one year ago, a 39% increase.

Remember, these loans are eligible for sale only when fully funded, and therefore represent pinup earnings not reflected in our financial statements. Expanding on Chip's discussion of our renewable energy vertical, we expect to begin selling USDA loans in Q4.

We have not yet sold any USDA loans in the secondary market, and are therefore unsure of the timing required to settle. While we anticipate these loans will receive lower premiums compared to our traditional SBA 7(a) loan sales and will likely lower our combined gain per million in Q4 as a result of this new mix of sold bonds.

They will serve to this overall sale volumes and related revenue. We are also increasing our forecast to the amount sold in 2016 to a range of 700 to $725 million, which indicates a sold loan volume of between 200 and $225 million in the fourth quarter with sale premiums averaging roughly in the low to mid 90s for the above reasons assuming otherwise stable market conditions.

The resulting total loan portfolio on balance sheet is estimated to be approximately $1.3 billion by year end. The servicing revenue from our sold loan portfolio increased to $5.9 million for the third quarter compared to $4.2 million for the third quarter of 2015, a 39% increase.

This servicing revenue arose from a weighted average servicing fee of 1.05% on $2.1 billion guaranteed dollars outstanding in the secondary market. The servicing asset value at quarter end was 49.7 million after a revaluation loss of 3.4 million for the quarter compared to a 1.6 million loss in the second quarter.

Third quarter net charge-offs equated to an annualized 51 basis point of average loans held for investment. The majority of the $937,000 in charge offs for the quarter was concentrated in a single relationship.

This is an isolated occurrence in the context of our long history of stellar credit performance and is not indicative of any fundamental weakening of the loan portfolio. At quarter end, the unguaranteed exposure of nonperforming loans and foreclosed assets was $3.6 million compared to 2.6 million at June 30th 2016.

As a present of total assets, non-performing loans in foreclosures were 22 basis points, fairly consistent with the past four quarters. The credit performance and growth in the portfolio resulted in a provision expense of $3.8 million in the third quarter.

Non-interest expense totaled $27.2 million in the third quarter. The special RSU award, Chip mentioned, contributed $3.4 million to this amount.

As a reminder, there will another and the final $3.4 million charge associated with these specific awards in the fourth quarter. Excluding the special RSU expense in both the second and third quarters, non-GAAP adjusted NIE grew less than $1 million from the link quarter as we adjusted recent expansion in various initiatives near conclusion.

Compared to the third quarter of 2015, non-GAAP adjusted NIE grew 5.8 million or 32% as a result of increasing loan demand and multiple newer initiatives of the company over the past year. We do expect to see some additional growth in non-interest expense in the coming quarters as we discussed during the Q2 earnings call.

This increase will be related to bringing portions of the legal process associated with our loan closings in-house along with the preparation and investment involved in exploring new verticals to consider for 2017. Overall, we are encouraged by the solid performance in Q3 and are looking forward to a strong close out of 2016 in the fourth quarter.

We would like to thank everyone that has dialed into the call today, and we will now entertain any questions you may have.

Operator

[Operator Instructions] Our first question comes from Aaron Deer with Sandler O'Neill. Your line is open.

Aaron Deer

Hi, good morning everyone.

Chip Mahan

Good morning.

Aaron Deer

I guess, let me begin by saying -- our thoughts certainly got to the folks were still working through the aftereffects of Hurricane Matthew, but related to that I was curious to know what if any impacts the storm and its aftereffects had on your -- some of your borrowers, particularly the chicken farmers in terms of their flocks or structures and how that might be affecting their business cash flows and collateral, and how you are dealing with that?

Chip Mahan

I am going to -- Aaron, this is Chip, I am going to ask Steve to answer that question, and at the tail-end of the answer to that question, Steve also commented we were about -- our provision this quarter was a bit higher than we were used to and then wanted to get in front of that and chat about your view of the portfolio in general.

Steve Smits

Absolutely, thank you. Good question.

We were concerned most with our chicken borrowers. We actually reached out to every borrower.

Happy to report that there was only one borrower that had minor damage to his roof, one of his barns that didn't have a material impact in his operations. That's very good news.

We also reached out to the integrators to anticipate whether there will be any delays in picking up the chickens or the timing of the flocks, but happy to report that we fared very well. Don't expect to have any disruption from our borrowers related to Matthew.

So, that's a very good news. We also have not heard from other businesses that have been materially impacted.

We reach out to as many as we can, but the first calls were to our chicken borrowers for sure in affected areas. So that's good news.

Chip, you are right. The provision expense at $3.8 million, it's really -- its continued loan growth certainly is a major component to that.

Also as Brett had mentioned, we experienced the charge-off this quarter of $928,000, and as Brett also pointed out that that is centered primarily around one relationship, the healthcare relationship, due to -- I don't like comment on the specifics on a individual credits, but I can say that it was personal issues that translated into some challenges with this business that we have seen it. They are working very closely with the special assets group.

They are very cooperative, but again it's centered around that. I will point out as Bret had mentioned, and we can see it by the numbers that the -- if you annualize the charge-offs that we had experienced this quarter, it would be 51 basis points compared to the average help for investment, but I also would want to point that we are coming off of a very good several quarters with last quarter having an annualized net recovery.

So the actual trailing 12-month charge-off to net loans is 19 basis points, which has slightly improved from a year ago where it was 21 basis points.

Aaron Deer

Okay, that's all very helpful. Thank you.

And then, Brett you had -- if I heard you correctly the volume kind of drifted out for [indiscernible] guidance numbers, but maybe can you repeat what you said your expectations are for the gain on sale premium in the fourth quarter and it sounded like it was down. And if so, how much of that might be related to the sales of solar?

Brett Caines

Yes. So in Q4, we expect our guaranteed loan sales actually between 200 million and 225 million.

That is a little bit higher than the indication that we gave during last quarter's call. And the gain on sale, again, just to give the disclaimer that we always give anything in change in the secondary market is subject to interest rate move, which will affect the premiums that we received, but right now we are expecting a gain on sales premium somewhere in the low to mid 90s as the average for Q4.

Again, that will be down from Q3. Primarily that is a function of the volume of loans that we are expecting to sell related to these renewable energy products, which are USDA loans.

Those will command a lower premium and secondary market compared to our traditional quarterly adjusting 7(a) loans. So we are looking for that decline.

I don't -- I don't necessarily want to comment on the volume of that 225 million that's related to USDA, but in total that's what are expecting and then question of gaining some revenue from there.

Aaron Deer

Okay. That's helpful.

And then, just one last question from me on the capital front, you guys have been growing like gangbusters for several years, and I guess since the capital which you gained from the IPO you have been putting a lot of that to work, is it kind of watch the balance sheet grow and relative to capital generation, what's your thoughts on the potential made for capital to look out over the next or two to continue supporting your growth?

Brett Caines

Yes. Looking at capital, a lot of the model that we ran as we talked about holding more of our production portions of the guaranteed loans that we would have historically sold plus holding the majority if not all of our unguaranteed production, we have ran these models in anticipation of not needing additional capital going forward.

That's one of the reason which has made the strategic decision as we indicated in the last quarter's call to be in the range of guaranteed loan sale up to 25% of what -- what otherwise be available for sale.

Aaron Deer

Okay, great. Thanks for taking my questions.

Operator

Thank you. Our next question comes from Jefferson Harralson with KBW.

Your line is open.

Jefferson Harralson

Hi, thanks. I want to ask about the e-lending piece of it.

What thoughts [indiscernible] are you originating on the e-lending platform now? Are they non-SPA loans?

And if so, what percentage of your loan book is now not SPA?

Neil Underwood

Hey, Jefferson, Neil here. So we have actually made a leap from SPA7(a) to other types of loans.

Probably I can't give you the actual numbers there, but indeed we are launching products such as the SPA express which has a 50% guarantee, more importantly it has the up to depending on the loan size prime plus four yield. And in addition, what we are calling fast fund conventional which are look into higher yielding conventional products for loans under 350,000 vertical.

And I think the other thing I would add to that is these are still all loans in vertical. What we found is our marketing efforts are working wonderfully as we go down market as well as which you have obviously seen in the big loan market.

We understand the credits and it's -- from a customer acquisition cost perspective, which we compare ourselves we all lenders at least in this market segment, it's allowed us to scale much more efficiently.

Jefferson Harralson

Okay. Can you talk about is it consumer, is it commercial it's all commercial…

Neil Underwood

Yes, all small business loans from 75,000 is our minimum to 350,000 is the maximum; C&I, working capital for the most part, equipment.

Jefferson Harralson

Okay, all right. So I mean, although you may not be ready to talk about this I guess, can you talk about yields, your expected loss rates on this business?

Neil Underwood

I'll turn it over to Steve on the expected loss rate which we do expect to higher, but in terms of yield, yes, I would kind of rather wait because as you would know for the first year, they were all 7(a) loans which have implied maximum based on the SPA limits. So, we are just starting experience some of the higher yielding loans.

So, I would rather wait a little bit at time to get to that but I don't have that at my fingertips. Steve would you like to comment on the asset quality?

Steve Smits

Yes. So far the asset quality is excellent, we don't have any delinquencies.

Very early on, we did model this to expect a higher loss rate 2% if we were expecting a typical portfolio to be 1% we do expect this portfolio to be 2%.

Jefferson Harralson

Okay, thanks. And also, I know you guys hired a -- put a press release out that you hired a bankers healthcare group person, can you talk about is there a new initiative around healthcare that you are possibly ready to talk about?

Neil Underwood

Yes, well, will talk about in terms of really building out the sales culture around the online lending, the e-lending space, and actually not just limiting it to healthcare, applying that same kind of sales culture to other verticals as well. So, again, we -- as I mentioned, it's triple digit growth on 1.5 billion, it's not material, but at some point in time given that growth rate we expected to do to be a more significant portion of originations.

Jefferson Harralson

Right, and I'll ask one more for Brett on the other servicing assets revaluation, the 3.4 million; it's kind of large, did the change come in shortening of expected timeframes or duration of the asset or what -- worsening credit or what changed in the model for that big of an asset valuation change?

Brett Caines

Yes. That change was driven entirely by sort of the natural amortization rate of the portfolio.

And during one of the month, during Q3 we had a tick up in prepayment that was isolated in that one month, and we were made aware and saw that coming ahead of time, but as related to the secondary market as a whole performance of loans in secondary market and what premium we are currently seeing that have an impact on that revaluation loss. The market had been fairly stable.

That was entirely waited -- it was entirely related to the pay down of the portfolio and those servicing assets associated with those loans coming off.

Jefferson Harralson

Okay. Is there any way to forecast this number?

It should a smaller negative number going forward, is that what we should think about?

Brett Caines

As for now, I don't see any reason why you guys should change from what you had been using for the amortization of our portfolio, the amortization rate and the pay down rate. I think that still apply very well.

As I said, August was somewhat of san isolated month with a tick up. So I would say continue forecast in the way we have been forecasting.

Jefferson Harralson

Great. Thanks, guys.

Operator

Thank you. Our next question comes from Jennifer Demba with SunTrust.

Your line is open.

Jennifer Demba

Thank you. Good morning.

Just could you remind us what you are expecting in terms of non-interest expense growth for 2017, and how many verticals do you think you may be launching next year, would it be two or could it more?

Steve Smits

Good question, Jennifer. We are going to crank that engine back up.

We are in the process of doing that right now. We are going to approach it a bit differently than we've done in the past.

In the past, we would a domain expert. And then fully staff that group kind of day one in anticipation of future business.

This time we are going to be a bit more circumspect and try to match revenues with expenses. As to the number, I can't tell you the number.

I would say certainly two, but really wouldn't want to go beyond that. I mean four would be nice, but we just kind of take what the market gives us.

Jefferson Harralson

Thank you.

Operator

[Operator Instructions] And I am showing no further questions at this time, I would like to turn call back to Chip Mahan for closing remarks.

Chip Mahan

Well, we just thank everyone for attending the day and look forward to chatting after the first of the year.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect.

Everyone have a great day.

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