Q3 2022 Live Oak Bancshares Inc Earnings Call

October 27, 2022

Yeah.

Thank you for standing by and welcome to live Oak Bancshares third quarter 2022 earnings Conference call. At this time all participants are in a listen only mode. After the speaker presentation. There will be a question and answer session to ask a question. During the session you will need to press star one one on Youtube.

Telephone I would now like to hand, the conference over to General Counsel and Chief Risk Officer at live Oak Bank, Greg Seward. Please go ahead.

Thank you and good morning, everyone. Welcome to live Oak's third quarter 2020 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 <unk> Dot Com and go to today's call on our event calendar for supporting.

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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, 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.

Thanks, Greg and good morning, all I will kick off todays earnings call, describing how we think about capital and a potentially declining economy.

Followed by BJ on results and we'll close with Huntley, describing how we operate the business and where we are going.

Let's move to the next slide.

Here's some household names, indicating a recession may be around the corner.

Those sales battened down the hatches Goldman CEO says, there's a good chance for a recession and Jamie Diamond says a recession is likely in the next six to nine months.

Next slide.

Certainly the world is not coming to an end. It is our belief that capital is king in any environment. Therefore, a properly managed balance sheet yields a flight to quality.

For our customers, our folks and you our shareholders.

None of US has a crystal ball there is little doubt that uncertainty is everywhere from runaway inflation to higher interest rates to an unsettling political environment and we could go on and on.

The truth is we operate one of the most highly leveraged.

And the baseball business by adding 400 gets you to enter all the thing.

Making 60% of your shots in basketball does the same thing.

And our business, making good loans over 99% of the time.

Is essential.

Sure.

Let's talk about recessions on the next slide.

Reflecting on the recessions that I have lived through one glaringly comes to mind and that is the third from the bottom of the recession in the early two thousands.

We were number 25 for takeoff.

My company's market cap was higher than deltas, and we were losing $60 million a year.

Could that possibly be.

I met with the ABN Amro team at the airport for an hour took the same playing back to Atlanta and called an emergency Board meeting in the next several weeks, we raised over $300 million.

From our customers that were using our software and not from Wall Street.

Then the dot com crash without that capital I'm not sure the company would have survived.

Recessions provide lessons learned.

We are often asked how will your small business customers handle a downturn.

How will your origination engine operate.

If the past is a proxy for the future how have we manage your balance sheet. These past 14 years.

Let's take a look at that on the next slide organic growth in our equity account is accelerating.

So let me unpack this slide for you a bit if you will follow the blue boxes above the timeline you can see that since inception, we have grown considerably while absorbing a little dilution.

Bank was capitalized in 2008 with $13 million. Shortly thereafter, we issued $5 million and preferred stock followed by the sale of 24, 9% of the business in 2014 to Wellington asset management, while we converted from an S to a C Corp.

A $50 million dividend was paid to the original shareholders, thereby recouping their original investment plus some.

Along the way, we created in snow and spun off at 65% ownership in the early days to existing shareholders.

From inception, we have raised $243 million.

And the shareholders' equity at the end of Q3 was a little over $800 million.

Note the Blue line from our Fintech investments had a great deal to do with our non dilutive capital generation. So let's examine that on the next slide.

Here's a bit more color on our fintech profits.

Since 2015, we have invested $52 million in all companies noted above.

We have received $163 million in cash from the exits of Finfet and pay rails and the sale of $15 million of Greenlight shares at a cost basis of $1 million.

In addition, the value of all other private companies totaled $158 million based on the last round of financing.

Our confidence of Investor support at those levels notwithstanding current market conditions.

Moving on to the next slide.

Just as we did last quarter, we would like to reiterate just how good we are at lending to small businesses.

The average charge off ratio for other SBA lenders is over 13 times ours, while 66% of the $20 billion in loans, we have originated since inception.

And within the SBA 708 program.

So.

If we have proven that we can grow the business organically in a unique way are there other arrows in our quiver if economic challenges arrive.

Let's move to the capital slide.

The conservative nature of this slide goes beyond the tier one capital ratio of 13, 2%.

Our adjusted capital ratio, which equals tier one capital plus allowance for credit losses, plus the fair value Mark divided by our and guaranteed loan exposure equals an unprecedented 22, 9%.

The addition of implied pre tax value of Fintech investments Mark to market adds another $158 million to the frenzy.

Excess capital is freedom.

And flexibility.

Let's move to the continuous cycle next slide.

So what does all this mean.

If the downturn occurs and credit losses began bank credit officers typically react and underwriting guidelines change dramatically.

This is always created an enormous opportunity for us to not only stand by our existing customers, but allows us to actively seek new opportunities as the competition pulls flat back.

Again.

Any of this occurs there will be a flight to quality and we will be in the thick of it.

Oh, that's tough results.

Excellent. Thanks chip good morning, everybody.

I'll start with the quarter highlights on slide 13.

And as you can see our earnings per share were <unk> 96.

Driven by strong net interest income and loan growth, which we'll talk about a little bit more and of course, the previously announced pay rail gain.

Net interest margin of 384 held up very well again in the quarter declining just five basis points from the second quarter. Despite 150 basis points of rate hikes. During the third quarter. Our net interest income growth Youll see us up 26% year over year on 23%.

Loan growth loan production again churn to $1 billion and pipelines are still near all time highs and credit quality remains quite strong despite the uncertainty of the economic outlook.

Our core business performance, along with continued success with our ventures investing.

Kipp highlighted continues to add significant tangible book value per share at 15% year over year.

The other one I'll quickly highlight is the renewable energy tax credit impairment as we've had a few of these over the last several quarters. These investments are a good thing and a net positive when we make these investments the accounting treatment is to impair a substantial portion of it immediately which flows through the <unk>.

<unk> this is more than offset by a larger reduction to our tax expense and effective tax rate over the course of the same year that is why we adjust out the expense when looking at adjusted PNR or pre tax earnings and also why our effective tax rate is lower than statutory rates.

We will continue to have more of these investments from time to time, including one in the fourth quarter that we currently estimate to be about $12 million.

Adjusted <unk> was up 21% due to strong net interest income growth of 5% linked quarter and higher fee income driven by $9 million of gain on sale income versus $5 million in Q2, which more than offset continued investment in people and technology.

As I said earlier credit remains quite healthy while our allowance for credit loss reserve coverage stayed steady overall at 123 basis points net charge offs were actually lower in the quarter totaling $1 7 million provision was up quarter to quarter due to strong loan growth along with portfolio on macro.

Economic changes as we proactively look ahead to a potentially less benign credit environment.

Breaking down the components of revenue on slide 15, Youll see total revenue growth up 12% year over year, despite significantly lower gain on sale income thanks to 26% year over year growth in net interest income as we discussed on last quarter's call we've seen secondary market dynamics for guarantee.

<unk> sales shifting rapidly due to the current aggressive fed rate tightening cycle as you know we moderated sales in the second quarter and this quarter, we saw modestly better opportunities and SBA variable rate sales, but the market for fixed rate sales remains unattractive again.

Want to understand that this income is not permanently lost we simply earn it over time in the form of spread income as evidenced by our strong loan in net interest income growth.

Turning to slide 16, you'll see our loan originations remained diverse across our multiple verticals with particular strength in both some of our most established small business verticals, such as vets investment advisors in agriculture.

And in some newer verticals such as our SBA General lending group and our middle market sponsor Finance group and energy and infrastructure solar remains quite strong NY bio energy lending is down from last year. Both of these should benefit significantly going forward due to the clean energy incentives in the recently.

Inflation reduction Act.

Balance sheet trends look great as discussed on slides 17 and 18.

And as you can see on slide 19.

And as I mentioned earlier, the net interest margin again held strong at 384, and while we still expect some compression as the fed continues to raise rates rapidly. We continue to be encouraged by the resiliency of the margin.

Our lenders have done a great job adjusting loan pricing upwards with market funding costs and our deposits team has continued to fund our growth with disciplined yet competitive pricing with betas remaining just under our assumed range of 70%.

Turning to expenses on slide 20, we've been incredibly pleased with the quality of talent that has joined live oak and our various groups across the company going forward, while our need for talent will continue as we grow we've largely worked through our hiring bubble to rightsize, our lender support to accommodate our significant step up in.

Production post pandemic and then in addition, as we have discussed we accelerated our technology hiring this year. Thanks to the fins that gain that is also largely completely going forward. We will continue to be opportunistic on hiring particularly for revenue producers, but we expect to see our expense growth.

Right into 2023.

Credit trends as I discussed on slide 21, the great having 43% of your total loan portfolio of government guaranteed as both a great comfort and great responsibility that we take very seriously non accruals and past dues remain at historic lows as to net charge offs, but we know there are clouds on.

On the horizon. So we will continue to be proactive with our outreach to existing customers. We have strict well established concentration limits for higher risk portfolios and verticals and we're doing stress testing on those portfolios with various recession scenarios to anticipate impacts so to recap production topped to one.

Pipelines are strong balance sheet is profitable and growing guaranteed loan sales opportunities are modestly improved but still muted expense growth is moderating credit quality is great and our ventures investments have and should continue to provide us with organic capital and optionality so with that.

I'll turn it over to Hunter East Huntley for some additional color on the business a J. Thanks P. J I'm going to wrap up today by focusing on three questions. The first is our small business is doing overall the second is what's the opportunity for us at live oak to serve them and then third what are we doing to address that.

We got a lot of questions about the overall health of small business, given where we sit and three years ago. We started a quarterly survey of small businesses along with Barlow Associates is one of the preeminent research firms serving small businesses and we wanted to share a bit of information from their most recent survey to give you a sense of how small businesses are.

Filling but also it indicates some of the opportunity that we have to serve them.

People say that we're at the tip of the spear as it relates to small business America and if thats. The case, so far small businesses are waging a pretty impressive battle. So on page 23, you can see the overall sentiment certainly has deteriorated, which shouldnt come as any surprise, although interestingly it looks as if views on the economy may have.

Bottomed out recently, although they still remains decidedly negative expectations of the financial performance of companies have also deteriorated, but remain more positive than views of the overall economy. It is clear that the majority of small business is expect to slowdown and are positioning themselves for a weakening economy.

And Thats still in contrast, as chip and Vijay referenced with our current credit performance, which remains outstanding.

Looking at the right hand side of this page, we see that only 20% of the surveyed small businesses applied for credit in the past year, and if you drill down a layer deeper into that data youll see that the majority of those that applied applied for working capital not the growth capital that we typically provide.

So the opportunity for us to serve small businesses with working capital products and deposits can dramatically expand our addressable market.

You've likely heard the term silver tsunami referenced the generational shift among small business owners occurring in the U S. On the bottom right you can see that almost a third of small business owners expected transition ownership of their company in the next five years. These change of control transaction Theyre right in our wheelhouse, both for lending, but also an opportunity to change primary.

And our relationships and while the uncertainty in the economy and volatility in the markets has put some of these transactions on hold we believe the overall macro trend of small business acquisitions will continue to provide a significant opportunities.

Anecdotally across our portfolio, we hear a consistent set of concerns labor market inflation supply chain being at the top of the list and while we see overall sentiment more cautiously. We also witness everyday that resilience C and entrepreneurial spirit of our small business owners as they navigate this cycle.

So what's the opportunity for us turning to page 24, the SBA data says, there's 32 million small businesses in the U S. But we know the majority of these are very small solo printer businesses. We look at our primary market is the roughly 6 million small businesses in the U S that have between two and 500 employees.

To generate on average a $110 million of revenue each.

Currently across our small business lending, our savings and our and our new checking businesses. We serve about 17000 small business customers. So you can see our market share is pretty tiny, but if you add to that very few of our customers do we actually have multiple products with our repeat customers and you can see.

Despite being pretty good at what we do we still have a lot of runway to better serve small businesses and deepen these relationships.

So what are we doing to address this.

On slide 25.

<unk> seen over the last year expense growth related to hiring not only in new lenders, but also in folks needed to support the process and while we still we will be opportunistic on new hires were in a really good place overall and you can see the production numbers.

Our pipelines reflect that.

Yes.

You'll also see the head count expense growth as BJ mentioned are going to slow down into next year.

We're also in the process of finalizing the migration to a new loan origination platform still leveraging salesforce and <unk>, but with some pretty high powered enhancements that we felt in house. The new platform is designed to further reduce application to funding cycle time improve efficiency and deliver a best in class portal for our customers and partners, we're already observing some enhanced.

<unk> in key areas and we're excited about what we can accomplish on modern architecture the.

The timing of this couldnt be better as it allows us to better react to potential changes in the SBA programs that are being contemplated.

Turning to the deposit side, we're particularly excited about the success, we've had generating business savings and Cds with over 10000 customers now and over $1 8 billion and deposits. It is becoming increasingly important part of our funding and almost 30% of our total deposits, but also a critical component of our customer acquisition.

<unk>.

As we entered into more products and services, we have a growing base of customers to better serve.

So the wait is finally over we officially have a checking account in the market.

This product offers balanced protection improved account funding Nextgen Bill pay and Quickbooks integration among other features.

And our marketing efforts have really just started but we're seeing on average 40 to 50, new accounts a day and we currently sit at over 300 accounts and about $10 million imbalances. So we're off to a good start.

While this product serves the smaller end of the small business market. Our next milestone is to deliver a treasury management product, which we expect in Q1 that will allow us to serve the upper end of our customer base as well. We're also excited about the start of our first specialty deposit vertical serving 10 31 exchanges and we ended the quarter with about 60.

And checking balances and we're actually close to a $100 million already as we move into the fourth quarter.

So a couple of big wins on the technology front, but we're certainly not slowing down bringing our entire platform together on modern architecture anchored by our modern things at core remains our top priority.

We believe that'll open up incredible opportunities for us in areas like embedded banking customer insights and payments.

In the short term, we'll continue to deliver Treasury management capability, it's working capital solutions and our initial embedded banking partnerships.

Where does that leave us on page 26, and I think P. J sum this up well our lending platform solid credit quality is excellent. Although we remain vigilant and are certainly not declaring victory.

Secondary markets are strong enough to support our balance sheet.

We remain a premier destination to work in both banking and in financial technology.

Our deposit businesses are starting to yield tangible results and we remain confident in our technology strategy. Both on the investing and the software development fronts. As we continue to build the small business bank of the future so with that let's move to questions.

As a reminder to ask a question you will need to press star one one on your telephone again Thats Star one wanted to ask a question. Please standby, while we compile the Q&A roster.

Our first question come from the line of Steven Alexopoulos of J P. Morgan Your line is open that Steven.

Hey, good morning, everyone.

Good morning, Steve.

To start so first on the cost of deposits. If we look the cost of interest bearing deposits is around one 5% in the quarter. If we look at your online rates. It looks like it's between $2 75 to $3 75. So first how quick does the overall cost of interest bearing deposits move into that range.

Do you expect more incremental funding has come from the online savings right, which is the lower end are born from Cds, which is the upper end.

Hey, Steve Good morning, its BJ.

Yes.

Our team has really really done a great job managing deposit.

Deposit rates up through.

Through this this point it started off slow in terms of beta as we all would have imagine, but it's significantly heated up probably in the last four quarters, what helped in terms of our overall deposit costs.

Both last quarter and this quarter is that a lot of the big moves in rates.

From the fed happened towards the latter part of the quarter, which meant that there was not nearly as big of an impact on the overall portfolio in the quarter.

As you would have expected I think now with the fed moving earlier in the quarter going into the fourth.

As well as what they did in the third youre going to start to see our portfolio cost.

Move more towards where our spot rates are today.

In terms of the mix.

We still believe that savings is really where we're seeing most of the volume.

We have had and tried some attractive offers more in the 12 to 24 month range on the CD side, but there hasnt just been a lot of appetite for that given how rapidly online savings rates have been going up so.

We certainly expect deposit cost to continue to rise but on the.

Left side of the balance sheet loan yields we are very very pleased with what our lending officers have been able to do to adjust quickly. We're seeing loan yields really start to move October 1st.

Was a big deal for us because thats when our quarterly adjusting loans of which we have a quite a bit.

Just up a 150 basis points.

So our loan yields are keeping up with our deposit costs growing and Thats why.

We've been able to do such a good job on holding the net interest margin and we expect that to continue.

So P J, if we stay with that.

Previously we talked about on these calls $3 50, 375 NIM for the fourth quarter. How are you trending in that range could you frame for us what to what.

'twenty three could look like.

Good NIM bottom.

Yes, so as we said last quarter.

Expected more to be at the higher end of the range.

Still feel very good about that.

Based on again, what I'll just.

<unk> talked about a little bit as rates.

As the fed stops its tightening cycle or at least slows it down significantly.

We think that our net interest margin starts to stabilize as well.

And again, because we're cycling through and readjusting, our loan yields in particular to.

To the market and funding costs, we think the margin stabilizes at into 2023, depending on when the fed stops raising rates, we could start to see it modestly moving up again.

Got you okay.

And then finally for me on the expenses just following up on that slide indicating that spending requirements are moderating a bit I mean, the growth rate's been very elevated on expenses could you help us think about what's a reasonable growth rate of expenses from here.

Yes. So if you look at adjusted expenses, 30% year over year because of our.

Bubble I think that that should come down by.

At least 25% if not more in terms of the rate of growth.

And so we still see very healthy.

Our revenue growth both from net interest income as we just talked about but then.

Into 2023, starting to see further normalization on the gain on sale. So strong revenues far outpacing the expense, but the expense will moderate.

Okay. Thanks for taking my questions.

Thank you our next question.

Comes from the line of Crispin Love with Piper Sandler Your line is open Crispin love.

Thanks, Good morning, everyone.

First on the venture portfolio, you've had some nice exits from M&A year to date, but I'm just curious how youre looking at the at our full portfolio Chip you made some comments earlier in the call that make it seem like you're confident in the current valuations there because I'm just curious what the key reasons for that is that VC backed companies broadly are seeing.

So Neil Underwood has joined US on the call and Neal just got back from money 2024 days' worth of what is the current state of the Fintech business I.

I think my comments Neil to turn this over to you more about.

How will we know these companies when we know the other investors on those boards and how they seem to be at least from my perspective recently very supportive.

Current valuation in some of these valuations are as much as a year old. So why don't you take that and maybe say a word about the future.

Sure first of all the reason we were out there.

As you guys know canopy in LIBOR ventures are two of our investment.

Vehicles, and fueling top of funnel for live Oak ventures is equally as important to us looking at extending canopy and so when you look at live Oak ventures, I think chip nail that it's really the quality of the investors around the table.

And the timing for which we got into these investments many of these investments we've gotten we've gotten into many many years ago.

<unk>.

The last valuations are.

Can actually can actually stand up.

Clearly there has been.

A discount across the board on mostly what we see are mostly the BDC heavy heavy discounts. If you recall our strategy is around b to b.

Selling to banks bank infrastructure payments Tech and so forth, which has held up pretty strong from a from a revenue perspective and a growth perspective.

Thanks, <unk> I appreciate the color there and then just one more on the interest bearing deposits.

Vijay you're able to give any color on what spot rates currently are for deposits.

You mean, just what.

Savings rates are in those types of things.

So I'm kind of like what Youre seeing right now.

We are.

So really where we're at in terms of online deposit rates for savings is more.

More in the two and a quarter range is what we're seeing for the more established online banks.

Moving up pretty quickly I think.

Today.

Actually its higher after our recent moves so $2 75.

Today, <unk> and Thats kind of where some of the largest <unk>.

Online players are and one year CD rates more in the $3 75 range.

Alright. Thank you I appreciate you taking my questions.

Sure.

Thank you.

Our next question comes from Michael Perito BW. Your line is open Mike Perito.

Hey, good morning, Thanks for taking my questions.

Hi, Mike.

I wanted to start on the business checking launch so.

Customers are already up to <unk> hundred it sounds like from the 70% 75 at the end of the quarter. I mean, do you guys have a sense of like what the average balances on these deposits that are coming over as we tried to frame.

Frame our growth opportunity here over a realistic time periods.

Yes, Mike sure. So we've got about $10 million and balance across 1300 account. So they are in the $5 to $10000. The majority of them are in the 5% to $10000 range. So like we said the smaller end of small business right now.

And that's what we're seeing I think as we as we go to market.

Ideally start to push up a bit.

With that but like we said on the call.

It doesn't have the treasury management capability and some of the largest small businesses need and will be coming at that end of the market in the first quarter, which we think is where we will get to some of the more significant balances in the market.

This is the marketing like kind of.

Branding and sales effort need to change at all as you try to make that transition or or is it pretty.

Okay.

And across both customer basis, it's more just the product capability that needs to evolve as you target the bigger businesses.

Yes, I mean look at the marketing itself is pretty is pretty.

Consistent across our brand and who we serve.

And certain verticals will be able to go a lot deeper with a broader product set and do some more targeted marketing in sort of building out these community banks in some of these verticals that we've spoken of.

While we have now is a more call it a mass market small business product and we're kind of marketing that accordingly.

Okay and then.

10, 31 exchange balances of $60 million or are there any other.

Verticals.

Could.

Become a size that are on your radar that you can share with us at this point and then just secondly kind of as a backup to that just on the embedded finance side any.

Timing update someone.

Those numbers could start to really maybe impacted David the financials, a bit more of the growth opportunities there Robert.

Sure. So on the specialty deposit side, we are looking at a handful of the HOA space is one that we spend a fair amount of time on and.

It's obviously, a reasonably competitive marketplace, but trying to figure out exactly where our niche could be and where we can differentiate ourselves and have some ideas. There we've been spending some time on so that's probably the one that's the next closest behind $2 31.

And it's it actually dovetails into some of the work we're doing in embedded banking, we're looking at areas where software providers.

In a space may lead us to deposit opportunities and some specific industries that maybe we're not in so far and I think no ACO.

And it can be a nice example of that <unk>.

For an example, we should have pilots. We're in pilots now we've got a couple of small ones that are that are up and running but.

We think it's going to be into next year before we really start to see embedded banking numbers that move the needle on.

On our balance sheet.

Obviously, youre noninterest bearing mix is below where you'd like it to be right.

Are you guys thinking at all about where you think that mix can move next year or is there any kind of framework or guardrails around that you think thats reasonable that that we should be thinking about.

As you kind of like take everything you just said together Huntley you can think about all the growth opportunities cumulatively.

Yes, so I think we sit today it may be 3% of our deposit mix noninterest bearing which is negligible.

Next year, it moves up modestly, but not meaningfully maybe a couple of percentage points, but I think if we're sitting here five years from now.

Probably 10 times.

The size.

In terms of mix.

We're at today so.

I think what Huntley, just talked about with our <unk>.

Title.

Mass market small business type product rolling out early next quarter are larger.

Treasury management offering and then embedded.

Yes.

I really think that by the end of 2023, Youll really start to see some momentum, particularly from the first two and then embedded as it layers in over the next 12, 24, 36 months really driving our future growth and that shift in mix.

Great. Thanks, guys for spending some time on that and then just lastly for me maybe a question for chip, but just from a high level right. I mean, if you think about the second and third quarter.

We are in the last quarter, who knows what 2023 Hasnt store, but the last quarter of the 75 basis point fed hikes.

We move towards the end of the year here.

Curious how you guys as we think about next year and.

And kind of where the margin environment is hopefully a stabilization in the SBA secondary market. Once we're through these massive fed hikes.

Any updated thoughts on the balance between selling and holding loans as we look to next year, because it's been a little choppy or on a percentage basis recently.

Because of the environment just curious if there's any updated thoughts there that we should be mindful of.

Okay.

So I'll start that and you guys can add to that I mean.

<unk>.

We talk to our lending officers about and remember our lending ASO basis.

<unk> daily I mean, we've added.

12, 15 lending officers just this year, primarily in the SBA area.

And certainly the secondary market for fixed rate SBA paper has been a.

Bloodbath SaaS operation.

And so our lending officers are now.

Being quite successful on the variable rate side, because there are a number of borrowers out there, saying like this thing may term, maybe I should not take an 8% 25 year fixed rate, maybe advocate a low floater here.

And then the prices for those loans in the SBA secondary market has held up and are coming back quite nicely. So I think we're seeing more lending officers being more aggressive on a bit lower right, not two or two and a half or something.

Something slightly less than that and I think we will see that continue over the next several quarters you guys may want to add to that yes, as a matter of fact, we have chip.

Chip to your point over the last three quarters, we've seen.

Our percentage of variable rate production.

Double double over the last three quarters. So I think yes, there was a lot of demand for fixed and fixed adjusting production, but to your point customers are starting to maybe see the crest. Our lenders are doing an excellent job providing customers options and many times the customer wants to be.

<unk> rate option because near term the rate is lower and they also think that it could float down over the course of or the term of the loan. So all of that I think is pretty good on broadly just thinking about our.

Our gain on sale income and mix.

Though we didn't necessarily want to.

Tightening cycle to happen like it did we've gone from maybe 15 to as much as 20% of our income in any given quarter being gain on sale.

Down to about six six to eight.

We've.

Been intentionally moving that down as we've originated to hold more.

But this has given us a step down opportunity if you will to kind of reset the base and.

Then b a lot more thoughtful about what we keep in what we sell.

And quite frankly gives us a lot more flexibility going forward to two.

<unk>.

Maximize our gain on sale across our different portfolios. So.

I think thats going to help us in terms of more consistent earnings going forward.

Awesome. Thank you guys for taking my questions I appreciate it.

Thank you Mike.

Thank you at this time I would like to turn the call back over to CEO chip Mahan for closing remarks, Sir.

Thanks to everyone for joining this morning's call and as always we will see you in 90 days.

This concludes today's conference call. Thank you for participating you may now disconnect.

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[music].

Okay.

Yes.

Thanks.

Yes.

Thank you.

Sure.

Yes.

Okay.

Yes.

Thank you.

Okay.

Telephone I would now like to hand, the conference over to General Counsel and Chief Risk Officer at live Oak Bank, Greg Seward. Please go ahead.

Thank you and good morning, everyone. Welcome to <unk> third quarter 2020 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 <unk> Dot Com and go to today's call on our event calendar for supporting.

<unk>, 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.

Thanks, Greg and good morning, all I will kick off todays earnings call, describing how we think about capital and a potentially declining economy.

Followed by BJ on the results and we'll close with Huntley, describing how we operate the business and where we are going.

Let's move to the next slide.

Here are some household names, indicating a recession may be around the corner.

<unk> says battened down the hatches Goldman CEO says, there's a good chance for a recession and Jamie Diamond says a recession is likely in the next six to nine months.

Next slide.

Certainly the world is not coming to an end. It is our belief that capital is king in any environment. Therefore, a properly managed balance sheet yields a flight to quality.

For our customers, our folks and you our shareholders.

None of US has a crystal ball there is little doubt that uncertainty is everywhere from runaway inflation to higher interest rates to an unsettling political environment and we could go on and on.

The truth is we operate one of the most highly leveraged.

The regulated businesses on the planet.

And the baseball business, adding 400 gets you to enter all thing.

Making 60% of your shops in basketball business same thing in.

And our business, making good loans over 99% of the time.

Is essential.

Just talk about recessions on the next slide.

Reflecting on the recessions that I have lived through one glaringly comes to mind and that is the third from the bottom of the recession in the early two thousands.

I had started and Internet banking software company in the late nineties and I was sitting on the runway at Atlanta's Hartsfield Airport and route to meet with the senior management team at the ABN Amro Bank in Amsterdam.

We were number 25 for take off <unk>.

<unk> company's market cap was higher than deltas, and we were losing $60 million a year.

Could that possibly be.

I met with ABN Amro team at the airport for an hour took the same playing back to Atlanta and called an emergency Board meeting in the next several weeks, we raised over $300 million from our customers that were using our software and not from Wall Street.

Then the <unk>.

Dot com crash without that capital I'm not sure the company would have survived.

Recessions provide lessons learned.

We are often asked how will your small business customers handle a downturn.

How will your origination engine operate.

If the past is a proxy for the future how have we manage your balance sheet. These past 14 years.

Let's take a look at that on the next slide organic growth in our equity account is accelerating.

So let me unpack this slide for you to bid if you will follow the blue boxes above the timeline you can see that.

Since inception, we have grown considerably while absorbing little dilution.

The bank was capitalized in 2008 with $13 million. Shortly thereafter, we issued $5 million and preferred stock followed by the sale of 24, 9% of the business in 2014 to Wellington asset management, while we converted from an S to a C Corp.

A $50 million dividend was paid to the original shareholders, thereby recouping their original investment plus some.

We then took the company public in the summer of 2015 and completed a secondary offering in the fall of 17.

Along the way, we created and see no and spun off at 65% ownership in the early days to existing shareholders.

From inception, we have raised $243 million.

And the shareholders' equity at the end of Q3 was a little over $800 million.

Note the Blue line from our Fintech investments had a great deal to do with our non dilutive capital generation. So let's examine that on the next slide.

Here's a bit more color on our Fintech province.

Since 2015, we have invested $52 million in all companies noted above.

We have received $163 million in cash from the exits of Finfet and pay rails and the sale of $15 million of Greenlight shares at a cost basis of $1 million.

In addition, the value of all other private companies totaled $158 million based on the last round of financing.

Our confidence of Investor support at those levels notwithstanding current market conditions.

Moving on to the next slide.

Just as we did last quarter, we would like to reiterate just how good we are at lending to small businesses.

The average charge off ratio for other SBA lenders is over 13 times ours, while 66% of the $20 billion in loans, we have originated since inception.

And within the SBA 708 program.

If we have proven that we can grow the business organically in a unique way are there other arrows in our quiver if economic challenges arrive.

Let's move to the capital slide.

The conservative nature of this slide goes beyond the tier one capital ratio of 13, 2%.

Our adjusted capital ratio, which equals tier one capital plus allowance for credit losses, plus the fair value Mark divided by our <unk> loan exposure equals an unprecedented 22, 9%.

The addition of implied pre tax value of Fintech investments Mark to market adds another $158 million to the frenzy.

While SBA premiums have declined our mark to market profit on our guaranteed portfolio has historically been an excess of $100 million.

Excess capital is freedom.

And flexibility.

Let's move to the continuum cycle next slide.

So what does all this mean.

First of all there is no evidence of a recession, yet we are ordering in the first column.

If the downturn occurs and credit losses began bank credit officers, typically react and underwriting guidelines changed dramatically.

This is always created an enormous opportunity for us to not only stand by our existing customers, but it allows us to actively seek new opportunities as the competition pulls back.

Again, if any of this occurs there will be a flight to quality and we will be in the thick of it.

Let's talk results.

Excellent. Thanks chip good morning, everybody.

We'll start with the quarter highlights on slide 13.

And as you can see our earnings per share were <unk> 96.

Driven by strong net interest income and loan growth, which we'll talk about a little bit more and of course, the previously announced <unk> gain.

Net interest margin of 384 held up very well again in the quarter declining just five basis points from the second quarter. Despite a 150 basis points of rate hikes. During the third quarter. Our net interest income growth Youll see us up 26% year over year on 23%.

Loan growth loan production.

Again, <unk> $1 billion and pipelines are still near all time highs and credit quality remains quite strong despite the uncertainty of the economic outlook.

Our core business performance, along with continued success with our ventures investing.

Chip highlighted continues to add significant tangible book value per share at 15% year over year.

Turning to slide 14, you'll see our adjusted results and the notable items that make up those adjustments the biggest which of course is the paver else gain another one I'll quickly highlight is the renewable energy tax credit impairment as we've had a few of these over the last several quarters. These investments are a good thing.

And a net positive when we make these investments the accounting treatment is to impair a substantial portion of it immediately which flows through the expense line. This is more than offset by a larger reduction to our tax expense and effective tax rate over the course of the same year that is why we are.

Just out the expense when looking at adjusted PPE NR or pre tax earnings and also why our effective tax rate is lower than statutory rates. We will continue to have more of these investments from time to time, including one in the fourth quarter that we currently estimate to be about $12 million.

As I said earlier credit remains quite healthy while our allowance for credit loss reserve coverage stayed steady overall at 123 basis points net charge offs were actually lower in the quarter. Its only a $1 7 million provision was up quarter to quarter due to strong loan growth along with portfolio on macro.

Economic changes as we proactively look ahead to a potentially less benign credit environment.

As we discussed on last quarter's call, we've seen secondary market dynamics for guaranteed loans sales shifting rapidly due to the current aggressive fed rate tightening cycle. As you know we moderated sales in the second quarter and this quarter, we saw modestly better opportunities in SBA variable rate sales.

But the market for fixed rate sales remains unattractive again, it's important to understand that this income is not permanently lost we simply earn it over time in the form of spread income as evidenced by our strong loan in net interest income growth.

Because of the flexibility, we have with strong capital and liquidity levels, we are more than happy to hold more high quality assets and we will remain patient with secondary market sales until further normalization turning to slide 16, you'll see our loan originations remained diverse across our multiple verticals.

With particular strength in both some of our most established small business verticals, such as vets investment advisors in agriculture.

And in some newer verticals such as our SBA lending group and our middle market sponsor Finance group.

Energy and infrastructure solar remains quite strong and why bio energy lending is down from last year. Both of these should benefit significantly going forward due to the clean energy incentives in the recently passed inflation reduction Act.

Balance sheet trends look great as discussed on slide 17 and 18.

And as you can see on slide 19.

Production post pandemic and in addition, as we have discussed we accelerated our technology hiring this year. Thanks to the Fintech gain that is also largely can freely going forward. We will continue to be opportunistic on hiring particularly for revenue producers, but we expect to see our expense growth.

Iterate into 2023.

Credit trends as I discussed on slide 21, the great having 43% of your total loan portfolio government guaranteed as both a great comfort and great responsibility that we take very seriously non accruals and past dues remain at historic lows as to net charge offs, but we know there's clouds.

On the horizon. So we will continue to be proactive with our outreach to existing customers. We have strict well established concentration limits for higher risk portfolios and verticals and we're doing stress testing on those portfolios with various recession scenarios do you anticipate impacts so to recap production topped a one.

I'll turn it over to 100 east Huntley for some additional color on the business.

Thanks, P J I'm going to wrap up today by focusing on three questions. The first is our small business is doing overall the second is what's the opportunity for us at live oak to serve them and then third what are we doing to address that and we get a lot of questions about the overall health of small business, given where we sit.

And three years ago, we started a quarterly survey of small businesses along with Barlow Associates is one of the preeminent research firms serving small businesses and we wanted to share a bit of information from their most recent survey to give you a sense of how small businesses are feeling but also would indicate some of the opportunity that we have to serve them.

May have bottomed out recently, although they still remains decidedly negative expectations of the financial performance of companies have also deteriorated, but remain more positive than views of the overall economy, it's clear that the.

Majority of small business is expect to slowdown and are positioning themselves for a weakening economy.

And Thats still in contrast, as chip and Vijay referenced with our current credit performance, which remains outstanding.

So the opportunity for us to serve small businesses with working capital product in deposits and dramatically expand our addressable market.

You've likely heard the term silver tsunami to referenced the generational shift among small business owners occurring in the U S. On the bottom right you can see that almost a third of small business owners expect to transition ownership of their company in the next five years. These change of control transaction Theyre right in our wheelhouse, both for lending, but also an opportunity to change primary banking.

Our relationships and while the uncertainty of the economy and volatility in the markets has put some of these transactions on hold we believe the overall macro trend of small business acquisitions will continue to provide a significant opportunities.

Anecdotally across our portfolio, we hear a consistent set of concerns labor market inflation supply chain is being at the top of the list and while we see overall sentiment more cautiously. We also witness everyday the resilience, let's see and entrepreneurial spirit of our small business owners as they navigate this cycle.

So what's the opportunity for us turning to page 24. The SBA data says there are 32 million small businesses in the U S. But we know the majority of these are very small solo print all of our businesses. We look at our primary market is the roughly 6 million small businesses in the U S that have between two and 500 employees.

Which generate on average a $110 million of revenue each.

Currently across our small business lending, our savings and our and our new checking businesses. We serve about 17000 small business customers. So you can see our market share is pretty tiny.

If you add to that very few of our customers do we actually have multiple products with our repeat customers and you can see that despite being pretty good at what we do we still have a lot of runway to better serve small businesses and deepen these relationships. So.

So what are we doing to address this on slide 25.

First and foremost we continue to invest in our lending franchise over 15 years, we've built a small business lending platform that effectively marries great people and great technology, and we continue to work to improve that every day you have seen over the last year expense growth related to hiring not only in new lenders, but also in folks needed to support the process and while we still.

We'll be opportunistic on new hires were in a really good place overall and you can see the production numbers and our pipelines reflect that.

Yes.

You'll also see the head count expense growth as BJ mentioned theyre going to slow down into next year.

We're also in the process of finalizing the migration to a new loan origination platform still leveraging salesforce and <unk>, but with some pretty high powered enhancements that we built in house. The new platform is designed to further reduce application to funding cycle time improve efficiency and deliver a best in class portal for our customers and partners, we're already observing some enhancements.

In key areas and we're excited about what we can accomplish on modern architecture.

The timing of this couldn't be better as it allows us to better react to potential changes in the SBA programs that are being contemplated.

<unk>.

As we introduce more products and services, we have a growing base of customers to better serve.

So the wait is finally over we officially have a checking account in the market. This product offers balanced protection improved account funding Nextgen Bill pay and Quickbooks integration among other features in.

And our marketing efforts are really just started but were seeing on average 40% to 50, new accounts a day and we currently sit at over 300 accounts and about $10 million imbalances. So we're off to a good start.

And checking balances and we're actually close to a $100 million already as we move into the fourth quarter. It's still a couple of big wins on the technology front, but we're certainly not slowing down bringing our entire platform together on modern architecture anchored by our modern things at core remains our top priority.

We believe that'll open up incredible opportunities for us in areas like embedded banking customer insights and payments.

In the short term, we will continue to deliver treasury management capabilities working capital solutions and our initial embedded banking partnerships.

So where does that leave us on page 26, and I think BJ sum this up well our lending platform solid credit quality is excellent. Although we remain vigilant and theyre certainly not declaring victory secondary markets are strong enough to support our balance sheet.

We remain a premier destination to work in both banking and financial technology.

Yes.

As a reminder to ask a question you will need to press star one one on your telephone again Thats Star one wanted to ask a question. Please standby, while we compile the Q&A roster.

Yes.

Our first question comes from the line of Steven Alexopoulos of JP Morgan. Your line is open Steven.

Hey, good morning, everyone.

Hey, good morning, Steve.

I'd like to start so first on the cost of deposits. If we look the cost of interest bearing deposits is around one 5% in the quarter. If we look at your online rates. It looks like it's between $2 75 to $3 75. So first how quick does the overall cost of interest bearing deposits move into that range.

And do you expect more incremental funding has come from the online savings rate, which is a lower end are born from Cds, which is the upper end.

Hey, Steve Good morning, its BJ.

Yes.

Our team has really really done a great job managing.

Deposit rates up through.

Both last quarter and this quarter is that a lot of the big moves in rates.

The fed happened towards the latter part of the quarter, which meant that there was not nearly as big of an impact on the overall portfolio in the quarter as.

As you would've expected I think now with the fed moving earlier in the quarter going into the fourth.

As well as what they did in the third youre going to start to see our portfolio cost.

Move more towards where our spot rates are today.

In terms of the mix.

We still believe that savings is really where we're seeing most of the volume.

We certainly expect deposit cost to continue to rise but on the.

Left side of the balance sheet loan yields we are very very pleased with what our lending officers have been able to do to adjust quickly. We're seeing loan yields really start to move October four.

Is it was a big deal for us because that's when our quarterly adjusting loans of which we have a quite a bit adjust up 150 basis points.

So our loan yields are keeping up with our deposit costs growing and Thats why.

We've been able to do such a good job on holding the net interest margin and we expect that to continue.

So P J, if we stay with that.

Previously we talked about on these calls $3 $53 75, NIM for the fourth quarter. How are you trending in that range could you frame for us what.

23 could look like.

NIM bottom.

Yes, so as we said last quarter.

Expected more to be at the higher end of the range.

Still feel very good about that.

Based on again, what I would just.

Talked about a little bit as rates.

As the fed stops its tightening cycle or at least slows it down significantly.

We think that our net interest margin starts to stabilize as well.

And again, because we're cycling through and readjusting, our loan yields in particular to the market and funding costs. We think the margin stabilizes it into 2023, depending on when the fed stops raising rates, we could start to see it modestly moving up again.

Got you okay.

And then finally for me on the expenses just following up on that slide indicating that spending requirements are moderating a bit I mean the.

Growth rates been very elevated on expenses could you help us think about what's a reasonable growth rate of expenses from here.

Yes, if you look at adjusted expenses up 30% year over year because of our.

Bob will I think that that that should come down by.

At least 25% if not more in terms of the rate of growth.

And so yes.

We still see very healthy revenue growth both from net interest income as we just talked about but then.

Into 2023, starting to see further normalization on the gain on sale.

So strong revenues far outpacing the expense, but the expense will moderate.

Okay.

Okay. Thanks for taking my questions.

Okay.

Thank you our next question.

Comes from the line of Crispin Love with Piper Sandler Your line is open Crispin love.

Thanks, and good morning, everyone.

On the venture portfolio, you've had some nice exits from M&A year to date, but I'm just curious how you're looking at the at our full portfolio Chip you made some comments earlier in the call that make it seem like you're confident in the current valuations. There. So I'm just curious what the key reasons for that is that VC backed companies broadly are seeing.

Lower valuations and less activity there.

So Neil Underwood has joined US on the call and Neal just got back from money 2024 days' worth of what is the current state of the Fintech business.

I think my comments Neil to turn this over to you more about.

How will we know these companies how will we know the other investors on those boards and how they seem to be at least from my perspective recently very supportive of the current valuation in some of these valuations are as much as a year old. So why don't you take that and maybe say a word about the future.

Sure first of all the reason we were out there.

As you guys know canopy in live Oak ventures are two of our investments.

Vehicles, and fueling top of funnel for live Oak ventures is equally as important to us looking at expanding canopy and so when you look at live Oak ventures, I think chip nail that it's really the quality of the investors around the table.

And the timing for which we got into these investments many of these investments we've gotten we've gotten into many many years ago.

<unk>.

The last valuations are.

Yes, if you can actually can actually stand up.

Clearly there has been.

A discount across the board on most of what we see are mostly the BDC either heavy heavy discounts. If you recall our strategy is around b to b.

Selling to banks bank infrastructure payments Tech and so forth, which has held up pretty strong from a from a revenue perspective and a growth perspective.

Thanks, <unk> I appreciate the color there and then just one more on the interest bearing deposits.

Vijay you're able to give any color on what spot rates currently are for deposits.

You mean, just what savings.

Savings rates are in those types of things.

Yeah, Hey, guys, so im kind of like what Youre seeing right now.

We are.

So really where we're at in terms of online deposit rates for savings is more.

More in the two and a quarter range is what we're seeing for the more established online banks.

Moving up pretty quickly I think where we're today.

Actually its higher after our recent move so it's $2 75.

De <unk> and Thats kind of where some of the largest online players are and one year CD rates more in the $3 75.

Range.

Alright. Thank you I appreciate you taking my questions.

Sure.

Thank you.

Our next question comes from Michael Perito of K VW. Your line is open Mike Perito.

Hey, good morning, Thanks for taking my questions.

Good morning, Mike.

I wanted to start on the business checking launch so.

The customers are already up to 1300, it sounds like from the 70 75 at the end of the quarter. I mean, do you guys have a sense of like what the average balances on these deposits that are coming over as we tried to type of frame our growth opportunity here over a realistic time periods.

Yes, Mike sure. So we've got about $10 million and balance across 1300 accounts. So they are in the five to $10000. The majority of them are in the five to $10000 range. So like we said the smaller end of small business right now.

And that's what we're seeing I think as we as we go to market.

Ideally start to push off a bit with that but like we said on the call.

Its product doesn't have the treasury management capability and some of the largest small businesses need and will be coming at that end of the market in the first quarter, which we think is where we will get to some of the more significant balances in the market.

This is the marketing like kind of an <unk>.

And sales effort need to change at all as you try to make that transition or or is it pretty.

Okay.

Consistent across both customer basis, it's more just the product capability that needs to evolve as you target the bigger presence.

Yes, I mean look the marketing itself is pretty is pretty.

Consistent across our brand and who we serve.

While we have now is a more call it a mass market small business product and we're kind of marketing that accordingly.

Okay and then.

10, 31 exchange balances the $60 million or are there any other.

Verticals.

Become a size that are on your radar that you can share with us at this point and then just secondly kind of as a backup to that just on the embedded finance side any.

Timing updates on when do you think those numbers could start to really maybe impacted the financials a bit more of the growth opportunity there Robert.

Sure. So on the specialty deposit side, we are looking at a handful of the HOA space is one that we spend a fair amount of time on and I think it's obviously, a reasonably competitive marketplace, but trying to figure out exactly where our niche could be and where we can differentiate ourselves and have some ideas. There we've been spending some time on so.

That's probably the one that the next closest behind $2 31.

And it's that actually dovetails into some of the work we're doing in embedded banking, we're looking at areas where software providers.

In a space may lead us to deposit opportunities and some specific industries that maybe we're not in so far and I think.

And it can be a nice example of that for an example.

We should have pilots. We're in pilots now we've got a couple of small ones that are that are up and running but we.

So we think it's going to be into next year before we really start to see embedded banking numbers that move the needle on our.

On our balance sheet.

And not to put you guys on the spot maybe asking <unk> question, a different way here I mean, what do you guys see.

Obviously, youre noninterest bearing mixes below where you'd like it to be right.

Are you guys thinking at all about where you think that mix can move next year or is there any kind of framework or guardrails around that you think that's reasonable that we should be thinking about.

As you kind of like take everything you just said together Huntley you can think about all the growth opportunities.

Yes, so I think we sit today, maybe 3% of our deposit mix and noninterest bearing which is negligible.

Next year, it moves up modestly, but not meaningfully maybe a couple of percentage points, but I think if we're sitting here five years from now.

Probably 10 times.

Size.

In terms of mix that we're at today so.

I think what Huntley, just talked about with our title.

Mass market small business type product rolling out early next quarter are larger.

Treasury management offering and then embedded.

Sure.

Great. Thanks, guys for spending some time on that and then just lastly for me maybe a question for chip, but just from a high level right. I mean, if you think about the second third quarter hopefully we're in the last quarter, who knows what 2023 Hasnt store, but the last quarter of the 75 basis point fed hikes.

As we move towards the end of the year here.

And kind of where the margin environment is hopefully a stabilization in the SBA secondary market. Once we are through these massive fed hikes.

Any updated thoughts on the balance between selling and holding loans as we look to next year, because it's been a little choppy or on a percentage basis recently.

Because of the environment just curious if there's any updated thoughts there that we should be mindful of.

Okay.

So I'll start that and you guys can add to that I mean.

Thank you.

We talked to our lending officers about and remember our lending officer basis.

<unk> daily I mean, we've added.

12, or 15 lending officers just this year, primarily in the SBA area.

And certainly the secondary market for fixed rate SBA paper has been a.

Bloodbath SaaS operation.

And so our lending officers are now.

And then the prices for those loans in the SBA secondary market has held up in her coming back quite nicely. So I think we're seeing more lending officers being more aggressive on a bit lower right needle not two or two and a half over prime but something slightly less than that and I think we will see that continue over the next several <unk>.

<unk> you guys may want to add to that yes, as a matter of fact.

Chip to your point over the last three quarters, we've seen.

Our percentage of variable rate production.

Double double over the last three quarters. So I think yes, there was a lot of demand for fixed and fixed suggesting production, but to your point customers are starting to maybe see the crest. Our lenders are doing an excellent job providing customers options and many times the customer wants to be.

<unk> rate option because near term the rate is lower and they also think that it could float down over the course of <unk>.

Or the term of the loan so all of that I think is pretty good on.

Broadly just thinking about our gain on sale income and mix, though we didn't necessarily want.

The tightening cycle to happen like it did we've gone from maybe 15 to as much as 20% of our income in any given quarter being gain on sale.

Two down to about six six to eight.

We've been intentionally moving that down as we've originated to hold more.

This has given us a step down opportunity if you will to kind of reset the base.

And then be a lot more.

Full about what we keep in what we sell and quite frankly gives us a lot more flexibility going forward too.

<unk>.

Maximize our gain on sale across our different portfolio. So.

I think thats going to help us in terms of more consistent earnings going forward.

Awesome. Thank you guys for taking my questions I appreciate it.

Thank you Mike.

Thank you at this time I would like to turn the call back over to CEO chip Mahan for closing remarks, Sir.

Okay.

Thanks to everyone for joining this morning's call and as always we will see you in 90 days.

This concludes today's conference call. Thank you for participating you may now disconnect.

Q3 2022 Live Oak Bancshares Inc Earnings Call

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