Live Oak Bancshares, Inc. (NASDAQ:LOB) Q3 2023 Earnings Call Transcript

Live Oak Bancshares, Inc. (NASDAQ:LOB) Q3 2023 Earnings Call Transcript October 26, 2023

Operator: Good morning, ladies and gentlemen, and welcome to the Live Oak Bancshares Q3 Earnings Conference Call. At this time, all lines are in listen-only mode. Following the presentation, we will conduct a question-and-answer session. [Operator’s Instructions] This call is being recorded on Thursday, October 26, 2023. I would now like to turn the conference over to Greg Seward, General Counsel and Chief Risk Officer. Please go ahead.

Greg Seward: Thank you and good morning, everyone. Welcome to Live Oak’s third quarter 2023 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 the Events & Presentations tab for supporting materials. Our third 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.

A woman holding a checkbook and standing in front of a bank location.

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 Chip Mahan, our Chairman and Chief Executive Officer.

Chip Mahan: Good morning to all on the call, and thanks, Greg. We’re going to start on slide 4. In an effort to support BJ’s reporting of a very fine quarter, I’m going to cover five views of the future at Live Oak Bank. First, as always we lead with the quality of our loan book, revealing more data than usual and reintroducing you to our unique secret weapon. Secondly, I like the hand we’ve dealt ourselves as the historic banking business has challenges with infrastructure fixed costs. Third, we shall be aggressive in hiring high-quality revenue producers. Fourth, the building out of our Community Bank of the future has predictably taken longer and been more costly than we thought. We want to remind this audience how we’re going to pay for it.

Lastly, a quick slide describing the true operating earnings of our business and the corresponding achievements in operating leverage. Moving to slide 5, beginning with credit quality. Moving from left to right at the top, nothing doing on past dues over 30 days less than it was eight quarters ago. On the non-accrual slide top right, over the last four quarters non-accrual loans deducting those borrowers that were paying as agreed, were 25 basis points, 47 basis points, 77 basis points and declined to 64 basis points at the end of this quarter. On the bottom left classified loans or risk grade six loans divided by total unguaranteed loans was less than eight quarters ago. Bottom right the section is what we call our regulator slide classified assets to Tier 1 capital plus the lower loss reserve is up slightly but virtually unchanged over the last two years.

Some will remember this as the closely watched Texas ratio during the recession. Moving to slide 6. Let’s take a look at the Q3 provision and charge-offs. We charged off our total exposure or $8 million on the shared national credit fraud influence loan that we discussed last quarter when we itemized a specific $6 million reserve. Normal charge-offs for the quarter would have been $2 million or about one-fifth of our provision. The combination of our conservative CECL calculations along with consistent growth in our loan book has built a loan loss reserve of $121 million or 1.56% of loans held for investment. More importantly, our unguaranteed reserve to unguaranteed loans to leases is 2.32% or 76 basis points higher. Many analysts on this call have told us we have never been through a recession.

And because we lend to small businesses, the investment community expects our customers to be at the tip of the spear. Well, now you have the data to draw your own conclusion. Moving to slide 7. Let me remind you of our secret weapon. Managing asset quality begins with caring about each customer and providing the resources to do so every day. There are 49 of 62 folks on this slide that comprise our business analyst group. These folks are responsible for analyzing our customers’ financial statement every 90 days. So, back to a potential recession. Workouts are an art, not a science knowledge and data are paramount. We have more data and understanding of what’s going on with our customers’ business than any bank in the country. Our theory of verticality combines with our early warning system to provide a solution whether it’s M&A advice or using industry benchmarks to provide them a definitive plan for success.

So moving to slide 8. So what’s happened to the banking business recently? Rates are up 550 bps and non-interest-bearing deposits are fleeing our industry. Here is a brief deep dive on comparing our business model to larger banks with a more traditional model of gathering deposits through retail branches. On the left side of the slide, the large banks have lost 5% of their noninterest-bearing checking accounts, from 30% to 25% in the last 12 months. In total $429 billion of noninterest-bearing deposits have left or shifted into interest-bearing deposits at JPM, the Bank of America, Wells, Citi, Truist, P&C and US Bank again since Q3 of 2022. Their average interest-bearing cost of funds has risen almost 2% over the last year. On the other hand, we strive to pay our deposit customers a market rate while maintaining a net interest margin that it’s almost 100 bps higher at 3.37% compared to $2.67.

Moving deposit accounts digitally has become exponentially easier for all banks. Evidence the $43 billion that exited SVB during March Madness. We choose not to estimate the cost of their branch system to collect those deposits. Most folks think it’s about 2%. For those interested in what our customers think of our branchless business model Claire Parker would be delighted to shoot the link to an online video interview conducted recently by a third party. Moving to slide 9. All on this call have seen these reports of layoffs asset sales in an effort to shrink the balance sheet in anticipation of more stringent capital requirements as well as declining loan portfolio balances. Many times the fear of recession leads to tightening credit standards, which leads to unhappy lending officers many of which will suffer incentive compensation declines.

Our model, our credit quality standards, and our excess capital allow us to be incredibly active for the best of the best when others are pulling in their horse. Slide 10, while our sales team has not grown headcount over the last several quarters they’ve done an amazing job in continuing to grow our loan book over $2 billion over the last two years in a very difficult banking environment. Again, we will seek to extend our feet on the street as the competition retrenches. Slide 11, as further confirmation of our efforts in growing our business through innovation I thought I would show you our investment in building our cloud-based API first next-gen technologies. Over the past two years, we have grown our tech staff by 60 high-quality engineers.

Our vision of building out a bespoke bank by industry has played a large part in attracting this level of talent. Outstanding engineers must believe in the dream. They completely understand our customer base and that the largest banks in the land tend to focus on everything, but the small business owner that operates an under $5 million revenue business. In addition, many have firsthand information of the sizable technical debt that those banks must overcome. On the left-hand side of the slide, I wanted to remind you of how we’re supporting and maintaining these 119 folks. Our venture pre-tax gains over the past several years has amounted to over $0.25 billion after providing $20 million in bonuses to our folks and to our community, Slide 12.

Before I turn it over to BJ for more color on this slide, it’s working. Ours is the business model of the future. We are trying to show you the true operating earnings of our business by taking out the noise here. Expenses have flattened and recurring revenue is on the rise. BJ over to you.

BJ Losch: Excellent. Thank you, Chip, and good morning to everybody. Let’s start on slide 14, with a high-level earnings summary of the quarter and it was quite a good one for us here at Live Oak. The key commitments we made about what we would do in Q3 such as margin performance, continued loan growth stable credit quality and moderating expenses were all delivered. And while we cannot predict what the economic outlook might bring the actions we took in the first quarter, our performance in both the last two quarters and the ongoing strength of our business model have set us on a strong path towards continued earnings and customer growth over the next several quarters. Put some numbers to it. In Q3, we earned $0.88, while aided by a positive change in estimate related to our servicing asset and fair value loans PPNR, excluding that $15 million impact grew nicely again this quarter driven by strong net interest income growth and good expense management.

In addition, our credit quality remains strong. Loan production was up almost $1.1 billion from $860 million in the second quarter as closing activity was spicier than it had been in the first half of the year and pipelines continue to be very healthy. Deposit growth was intentionally moderate this quarter as we soaked up some of the excess liquidity, we had built coming out of March. Very importantly, however, our business customer deposits our primary focus were up 12% linked-quarter. Since March, we have grown business deposits 36% or $1 billion and have done so without increasing our rates paid on business savings and we continue to see strong inflows great performance by our teams and a testament to our brand. As discussed in April, we believe that Q2 would mark the bottom for net interest margin and we’re pleased to see that our margin was 3.37% in Q3, up from 3.29% in the second quarter.

Even more importantly, net interest income at $89 million is up almost $7 million or 9% from last quarter, owing to strong loan growth and disciplined loan and deposit pricing by our teams. I’ll get into a bit more detail on the reasons for our NIM resiliency in the positive net interest income growth in a few minutes. But in short, it’s due to the excellent efforts by our lenders, along with our deposit and treasury teams to remain both competitive with our customer offerings and disciplined with our pricing. Fee income was improved linked quarter on a core basis with relatively steady gain on sale premiums. Expenses declined again quarter-over-quarter. And while we expect continued discipline here as Chip said, we’re a growing company, which will continue to invest in good costs, which are those that support continued revenue growth.

Provision declined modestly with the vast majority of net charge-offs like Chip said from a credit previously impaired and largely reserved for and the majority of the provision build came from net new loan growth, which I believe is good provision. Let’s turn to our net interest income and margin trends on slide 16. As we’ve discussed in prior calls, we expected to see downward pressure on the NIM in the first half of the year, because of the accelerated deposit repricing from the Fed’s rate increase cycle and that would be more rapid than the loan repricing. But in the back half of the year, as our loan repricing flowed through the balance sheet and the Fed neared the end of its rate increase cycle, we would expect NIM expansion. All of those things are still true.

We’ve been able to both grow deposits and hold savings rates very steady since March, due to our already strong rate offering. Loan repricing tailwinds continue as our lenders remain disciplined with new production yields. We expect loan pricing discipline to remain strong, but deposit competition to continue increasing. Overall, however, while the trajectory may not be linear quarter-to-quarter, we do expect steady NIM expansion and net interest income improvement over the next several quarters. A few highlights to point out. First, on the deposit side. You see that we again provided information on both Live Oak and the top digital competitors, as it relates to pricing in betas. Even though the Fed’s move 50 bps since mid-March, we were already in a highly competitive position to attract customer deposits, particularly on the business side, such that we continue to see healthy deposit growth, while holding very steady on savings rates and our through-the-cycle beta of 70% is exactly what we’ve communicated all along as our expectation.

It is modestly better than that on the business side. Now let’s take a look at the loan side. Our loan yields have been moving up nicely as you can see in the table, but hadn’t been moving nearly as rapidly as deposit betas. That dynamic is shifting. Two points we’ve made on loan yields in the last two quarters continue to hold true. Number one, loan production yields are currently being booked at rates much higher than the portfolio rates, see the $8.93 on new loan production yields in the upper right of the slide versus the 7.52% on portfolio loan yields in the upper right of the table. And number two, the majority of our variable rate loans are quarterly, not monthly adjusting. This means that unlike deposit rate changes, which happened intra-quarter, we don’t see intra-quarter increases in loan yields.

They move up the full change in the prime rate over the prior quarter on the first day of the following quarter. So as of October 1, our quarterly adjusting loans saw another 25 basis point increase in rate, owing to the 25 basis point July Fed move. And about 47% of our total loan portfolio is variable rate and almost 90% of our current production is variable rate that will certainly help. Therefore as our newer loan yields replace older loans over time, our portfolio yields will continue to rise, supporting continued stabilization then improvement in our net spread. On the deposit side, we’ve been able to see continuing strong customer deposit growth, however, while we have fully expected upward pricing pressure for traditional banks, we have been a bit surprised by the aggressive consumer savings pricing we’ve seen from top digital competitors.

Time will tell if this continues and it’s a trend we are monitoring closely. So what does all this mean for the NIM? Same as what we believe the last two quarters, have seen a large change in direction from the Fed or an economic shock, both of which are entirely possible given the geopolitical environment. We have hopefully seen the bottom for our NIM and we should continue to see steady margin expansion over the next several quarters. It may not be linear improvement quarter-to-quarter, but should be generally up and to the right over time. This remains an uncertain environment. So let me be very clear and transparent with our current assumptions here. First, we are assuming no further Fed rate increases and remain on hold through at least the first half of 2024.

Second, deposit pricing will remain highly competitive from both traditional banks and digital competitors. And if it gets more competitive we will respond accordingly to support continued growth. Third, healthy loan growth continues on pace with current pricing. And fourth, no further major industry disruption related to deposits or liquidity. So to recap, we saw expected NIM expansion in Q3, and we’re particularly pleased with the net interest income improvement we’ve seen. Turning to Slide 17. Our loan production in the quarter was again diverse across multiple areas with particular strength in our specialty health care and middle market sponsor, solar, senior care, educational services, self-storage and general lending verticals. As Chip talked about others are pulling back on lending, but we expect to see good opportunities for new business going forward.

We’re open for business and focused on growing our revenue-generating capabilities. We’ve already talked enough about deposit growth and pricing dynamics. So let’s move on to Slide 19 take a look at non-interest income trends. Our SBA sales activity and gain on sale premiums were pretty steady in Q3 not much new to report. The gain on sale at roughly 8% to 12% of quarterly total revenue feels like the right range for us. Over the last two years, we have intentionally reduced our reliance on gain on sale income to both improve the consistency of our revenue by shifting to more net interest income and to provide more flexibility. In addition the USDA secondary market has been nonexistent for six quarters now. Eventually that will change and that will provide us with technique used to estimate the fair value of our servicing asset and the mark on our held-for-sale loan portfolio.

And so as a result we made a onetime adjustment to both the servicing asset and the fair value portfolio. Going forward, there will be continued variability as these assets are revalued quarterly but we believe that these revisions are more representative of the value of the portfolios. Turning to expenses on Slide 20. We’re doing just as we said we would do. We’re moderating our expense growth while continuing to grow revenues. And going forward we will always be opportunistic with hiring revenue producers but we are smartly managing our expense growth. We’re confident in our ability to consistently grow our PPNR and improve our efficiency ratio over the next several quarters. Our expenses were down linked quarter. And as you can see we have held salary and employee levels steady for the past several quarters even while continuing to invest in next-generation technology.

One item, I will mention, as I wrap up expenses, which also relates to the variability in the tax rate. As you have seen over the last few years we will from time to time invest in investment tax credits related to solar projects. These tax credit impairments show up as a non-interest expense in a given quarter but they’re more than offset in the tax expense line over the course of the year resulting in an overall net benefit after tax earnings. That is why you will see much variability in our effective tax rate from quarter-to-quarter and you saw it again this quarter with only a 7% tax rate. In Q4, we expect one of those investment tax credit investments to hit non-interest expense for about $16 million but it will ultimately lead to an effective tax rate for the full year 2023 of about 10% so a net positive to us overall.

Turning to credit trends on Slide 21. As Chip discussed earlier credit metrics remain strong. We continue to actively monitor the existing portfolio and don’t currently see any significant weak spots. Past dues are low non-accruals remain quite manageable as well. And as you can see the credit quality trends across all our three major business segments are healthy. As expected in the current environment we moved some more loans to non-accrual status during the quarter. But on the bottom left of the slide you’ll see a five-quarter trend of our non-accruals and see that they’re still at very manageable levels. Provisioning again was healthy largely driven by what I call good provision for new loan growth. Our reserves on guaranteed loans as Chip said remain almost twice as high as the industry average and 40% of our total loan portfolio is government guaranteed.

Slide 22 shows our overall capital strength, which continues to give us great ability to continue providing growth capital to our small business customers and comfort that we are well positioned to thrive in whatever environment lies ahead. So to wrap up on Slide 23, I really like our position at Live Oak over the long term. Our revenue growth has a strong upward bias our loan production engine and reduced reliance on secondary market sales is producing solid double-digit loan growth. That loan growth coupled with strong new loan nation yields and deposit rates that are already at market is leading to growing net interest income and expanding margins, and we are in the very early innings of attracting checking accounts which will be a tailwind to building longer-term customer relationships and lowering funding costs for years to come.

We’ve already made smart investments in lender support and technology over the last few years. So while our expenses will grow commensurate with a growing company, that is adding what I call good costs such as new lenders and they should increase as we grow over the next several years. Credit quality is strong. And we expect it to hold up very well on a relative basis in whatever credit environment we might face. And again having 40% of our portfolio government guaranteed when the industry is about 1/10 of that, provides great comfort and confidence. Finally and most importantly, we have got the best mission inspired people and culture in the industry serving America’s small businesses. With that, we’re happy to take questions.

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Q&A Session

Operator: Thank you. [Operator Instruction] Your first question comes from Brandon King from Truist Securities. Please go ahead.

Brandon King: Hey. Good morning.

Chip Mahan: Hey Brandon.

Brandon King: So I wanted to start on expenses. They were down quarter-over-quarter and FTEs were down as well. But how are you thinking about growth next year excluding the tax credit impairments. I know in 2023 as mentioned mid-teens was, kind of the target. But kind of how are you thinking about expense growth next year any details around that?

BJ Losch: Yeah. Sure Brandon. It’s BJ. Like I said, like Chip said at the front, we’re a growing company and we’re always going to be in the market for what I call good costs. Costs that are going to help us generate revenue in the future, whether that’s hiring new lenders or creating additional technologies that are going to be better for our customers and building relationships. So we did have the bubbles of expense growth I would say in 2021 and 2022 related to lender support in particular and technology. That obviously has moderated this year. So, mid-teens to, actually in the 20%, 25% range, we’re kind of the norm in 2021 and 2022. I would see it as much lower than that going forward but still at a pretty healthy clip as we continue to support revenue growth.

Brandon King: Got it. So I would say high-single digits and lower is kind of a better gauge. Is that fair to say?

Chip Mahan: It’s certainly less than mid-teens. How about that?

Brandon King: There you go. Okay. Okay. Got it. Okay. And then on the net interest margin, I appreciate the commentary around that and expertise for expansion going forward. I know the 350 has been mentioned before, do you think you can get there in the fourth quarter just given what you’re seeing as far as deposit competition in rates in loan repricing?

Chip Mahan: So I kind of if you read between the lines and some of my comments. I basically said I’m highly confident that our margin is up and to the right over the next several quarters but it won’t necessarily be linear. So said a different way in the fourth quarter, given what we’ve been seeing in deposit competition particularly from top digital competitors, it’s been quite surprising. We would have thought that that would have moderated but it hasn’t. So we still have an upward bias we believe to the margin and net interest income, but it will depend in the fourth quarter on how proactive we need to be repricing the deposit portfolio giving competition to support our loan growth. So I’m still very confident in our abilities to expand the margin. But again it will be based on what near-term deposit competition looks like.

Brandon King: Okay. And just a follow-up to that any thoughts to maybe leaning more into that business customer deposits since that’s seen for strong growth as opposed to maybe not competing as much for those consumer deposits?

BJ Losch: Yeah, great question. If you go back in time, I think around 2018, the vast majority well over 90% of our deposits were consumer very, very little were business. And over the last five years we intentionally have shifted that such that, I think it actually was last quarter that we tipped over 50% business savings deposits versus consumer savings. So it’s been a very intentional shift towards small businesses and providing them very competitive rates in building that book. So with that said we continue to emphasize our business savings product offerings and operating accounts to build business account relationships. We will use consumer more as an opportunistic funding toggle if you will. It’s a bit more competitive than the small business deposit industry might be. And so we’ll continue to try to optimize both those portfolios as we grow.

Chip Mahan: And BJ I think on that point, right, certainly our growth in business segments over the last call it 18 months or so does not a trend make, but it certainly seems that it’s less volatile like consumers are a little more rate sensitive and a little more flighty and the stability of our business savings book seems to be much more predictable.

BJ Losch: Yes. That is certainly true. So whenever we can build a loan and deposit relationship that certainly helps I think our Live Oak brand as a small business certainly helps. And our rates for business savings are literally at the top of the industry. And there’s quite a bit more competition from a variety of other competitors, traditional and digital on the consumer side. So yes that’s why we focus on small business side a bit more.

Brandon King: Great. Thanks for taking my questions.

Chip Mahan: Thanks Brandon.

Operator: Your next question comes from Michael Perito from ABW. Please go ahead.

Chip Mahan: Hi, Mike.

Michael Perito: Hey, guys, good morning. How are you?

BJ Losch: Good.

Michael Perito: I wanted to just dissect the margin question a bit further. And BJ, I think I pretty much have a good handle on it. I was just curious if maybe you could give us an indication I think you mentioned in October, the loan yields kind of readjusted higher. And I was wondering if you could maybe just give us an indication of where the margin was in October just as we think about the starting point moving forward with those — with the loan yield adjustment?

BJ Losch: I’d say the margin in October was largely the same as where we were in September maybe a modest step-up because of that repricing of the loan yields. So if you think about it Mike 47% of our loan book is variable rate not all of that is the quarterly adjusting. We do have some sulfur-based loans in there. But generally speaking you can look at our loan yields in the third quarter and then adjusted for 40% of the portfolio being variable rates. So that’s helpful. But we also moved late in the quarter, consumer savings up from $4 to $4.15 and so that has somewhat of an offset as well. So largely the same, but we’ll have to see how again deposit competition heats up or not in the fourth and beyond.