LOB - NYSE

Good morning, ladies and gentlemen, and welcome to the Q3 2024 Live Oak Bancshares Earnings Conference Call. At this time, all lines are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. [Operator Instructions] This call is being recorded on Thursday, October 24, 2024. I would now like to turn the conference over to Greg Seward, General Counsel and Chief Risk Officer. Please go ahead.

Thank you and good morning, everyone. Welcome to Live Oak's third quarter 2024 earnings conference call. We're 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 and 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. 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.

Good morning, everyone. As we did last time, BJ is going to kick things off. He will then turn things over to Walt who will dig into the details on the quarter. I'll make a comment or two before we go to Q&A and we'll dig in on your questions at the end. BJ?

Thanks, Chip. Good morning, everyone. Let's get started on our slide deck, on slides four and five. This was a big quarter for Live Oak. Really pleased that our strategy is working. Our momentum is excellent. Our continued ability to acquire new small business relationships and control what we can control are on full display. We again delivered strong PPNR growth on both the reported and adjusted basis, excellent loan and deposit growth, and record loan production. On the lending front, our teams delivered exceptional production and balance sheet growth results at healthy spreads in the quarter and yet pipelines are still near all-time highs, both of which bode well for continued growth. We did see elevated provision with about 35% of it driven by, what I call, good provision due to the record loan growth and about 40% of it from three specific impairments. On the conventional lending side of our business, the overall portfolio across both small business and commercial banking remains healthy and my confidence in our credit quality processes and people remains high. With the improving prospects of a soft landing and lower rates, which will benefit customer and revenue growth along with credit performance, we believe that our momentum is accelerating at a very opportune time. As you can see on slide six, our focus on the profit basics growing revenues faster than expenses while still investing in good costs such as new lenders, products, technology, and risk management has resulted in accelerating PPNR growth of 18% on an adjusted basis versus last quarter and 22% since this time last year. In fact, if you -- as you look on slide seven, our PPNR over the last 12 months versus the prior 12 months is up 29%, driven by 10% revenue growth and only 1% expense growth. Particularly encouraging is the activity we are seeing on the lending front with loan production this quarter topping our previous high water mark by 50% and should continue with pipelines still near all-time highs. A big shout-out to our lenders and our vertical heads along with our underwriters, closers, loan operations people, construction, and our credit officers to get this capital into the hands of our customers. On slide eight, while we again saw low levels of charge-offs, as mentioned earlier, we did build the reserve due to the record loan growth in the quarter along with the impairment of those three relationships with our disciplined credit box, our deep understanding of government-guaranteed lending requirements and an unmatched, in-depth servicing and watch-list activity process. We have the system to get ahead of borrower stress and we're doing that. As we discussed previously, we're proactive with provisioning for growth, changes in our portfolio performance, and impairments of specific loans when warranted, so we are well-reserved when charge-offs occur. Our reserve levels remain very healthy. Turning to slide nine. While I'm pleased with this quarter's results, as a growth company, I'm much more excited about where we're headed. There's a lot of gas remaining in the loan pipeline tank. Our new small dollar SBA lending efforts ramping up quickly and will be a meaningful contributor to our results over time. Checking balances, which were immaterial a year ago continue to build as do full relationships with our customers. Our brand and our reputation continue to attract and retain the highest quality talent and customers, and we continue to heavily invest in our future. So with a big thank you to all Live Oakers and our customers, Walt, how about running through some of the financial highlights?

Thanks, BJ. Good morning, everyone. Let's start with our summarized Q3 2024 metrics shown on slide 11. There are a few highlights that I would like to specifically call out on the right-hand side of the page. Modest 8 basis points of annualized net charge-offs relative to our average loans and leases held for investment. The strong linked quarter reported PPNR growth of 9% and net interest margin expansion of 5 basis points and the 50% increased linked quarter in loan originations and 7% increase linked quarter in loan balances net of loan sales. On the bottom of the charts, on the left, you will also see that our total loan and leases portfolio across the $10 billion mark in the third quarter, and our deposit portfolio continues to grow at a similar pace. Now let's spend the next few pages on the leading drivers of this quarter's strong PPNR performance and growth. Slide 12 highlights our loan originations by vertical and business unit. As BJ mentioned, loan production crested all-time highs in Q3 with approximately $1.8 billion of loans closed. This was driven by a strong pipeline entering the quarter, an outstanding effort by our lending, funding and operational teams to get the loans closed and approximately $320 million of project finance loan production driven primarily by solar energy and hotel deals. Our project finance team had a slow start in the first-half of the year, but rallied in Q3 to reach its highest single quarter of loan production in its history of the banks. $811 million of 46% of Q3 loan production came via our small business banking team, primarily in the form of SBA 7(a) loans, a 26% increase linked quarter, and a 35% increase year-over-year. The remaining $947 million, or 54% of Q3's loan production came via our commercial lending team, a 79% increase linked quarter and double the commercial production compared to the prior year. You can see the year-over-year momentum across our verticals on the left-hand side of the page, with approximately 60% of our verticals originating more production through the first nine months of 2024, than they did in 2023. Slide 13 illustrates the quarter-over-quarter loan and deposit balance growth, highlighting strong growth trends through the first three quarters of 2024. While many banks across the industry continue to be minimal, if any, loan growth, our loan balances are up 7% linked quarter and 16% compared to the prior year. This elevated growth rate in Q3 was primarily driven by the aforementioned strong loan production. Also, let's not forget, before loan sales and participation, our loan balance growth was actually 11% linked quarter. Deposit growth of 7% linked quarter, 14% compared to prior year, continues to be driven by our customer deposit platform as well as our utilization of broker deposits to help fund short-term liquidity needs, in addition to providing flexibility in our customer deposit repricing strategy in an uncertain rate environment. Lastly, on this slide, our business deposits have grown 6% linked quarter and 22% compared to prior year and continue to be a focal point of our funding strategy. As BJ mentioned, we are extremely excited about the momentum that we are seeing in building fuller relationships with both our loan and business deposit customers as shown on slide 14. You may recall that we fully launched our first true operating account offering to customers in Q1 of this year. Since then, the percentage of customers with both a loan and a deposit account tripled to approximately 12%. Our business checking balances have increased to $145 million and the savings and CD balances related to businesses with a checking account at Live Oak have increased approximately two times to $232 million. The result of expanding our business relationship with our customers' stickier deposits with an average blended cost of funds in Q3 2024 of 2.45%, approximately 40% less than our total bank blended cost of funds. We continue to build upon these trends and our deposit efforts will provide substantial tailwinds to our net interest income and net interest margin over time. Speaking of net interest income and NIM, their trends are highlighted on slide 15. Starting with the graph, at the top of the page, our net interest income increased 6% linked quarter and is up 9% compared to Q3 2023. Net interest margin increased 5 basis points quarter-over-quarter to 3.33%. Improvement in both our net interest income and NIM were primarily driven by our loan growth, as highlighted on the bottom right-hand side of the page. Now moving to the table below the graph, our net spread increased 2 basis points linked quarter to 3.68%, driven by our loan portfolio yield which expanded 4 basis points to 7.83% from the previous quarter while our cost of funds only increased 2 basis points to 4.15%. I continue to feel really good about the things that we can control, such as our loan growth momentum and pipelines remain robust. Growth is the essential component of our net interest income and NIM expansion going forward. We continue to demonstrate good pricing discipline on new loan origination, with new loans coming on at approximately 100 basis points above our average portfolio yield and thus remaining accretive. And our increase in cost of funds since early 2023 has largely been driven by maturing CDs renewing into a higher price offering. You can see in the middle of the page that these substantial headwinds, this has generated in prior quarters as that portfolio is approximately one-third of our customer deposits and one-fifth of our total deposits. As noted on our last call, with current CD offering rates now below maturing rates, these headwinds have converted to tailwinds and we expect this favorable spread between our maturing rates compared to our current rates to increase over the next year as the Fed continues the long and decent cycle. And while we expect the Fed easing will be a tailwind for our growth, net interest income and margin over time, the timing and magnitude of the Fed cut can be impactful to our net interest income and margin from a quarter-over-quarter perspective. As we discussed in our last call, more than 50% of our loans are variable and primarily quarterly adjusted, meaning that they re-priced the first business day following the quarter. The Fed cutting 50 basis points at the end of the quarter creates a timing difference in the very near term as it does not provide time for the deposit market, specifically the consumer and business savings markets to reprice down before our loans reprice. This timing difference is further supported by our negative one-year repricing gap of approximately 19%. Or said another way, we have approximately $2 billion more of liabilities that will reprice or mature and be replaced at lower rate offerings compared to assets that will reprice over the next 12-months. We will see margin compression in the very near term and then we are confident it will expand as the Fed continues to ease in the online deposit market along with our deposit pricing adjusted to a lower rate environment, while at the same time, we still remain well positioned on the net interest income front as our strong quarter-over-quarter loan origination and subsequent loan growth will help maintain our net interest income on its up and to the right trajectory. Moving on to quarter-over-quarter fee income on slide 16. The demand for government-guaranteed SBA and USDA loans on the secondary market continues to be strong and our gain-on-sale volumes reflect that. We sold $267 million in Q3 2024 for an average premium of 7%, largely in line with the last three quarters. Expense trends are detailed on slide 17. Our Q3 2024 expenses of $78 million have been flat for the first three quarters of the year, thus aiding in driving our efficiency ratio down to approximately 60%. Our teams continued to show great expense discipline over the last year, even while adding 43 FTEs, primarily within growth-oriented sectors focused on revenue generation and funding growth, as well as investing in our risk and technology divisions within the bank. Key credit trends are shown on slide 18. Shown on the top right are unguaranteed classified loans as a percent of unguaranteed held-for-investment loans. Unguaranteed classified loans increased to 240 basis points as of Q3 2024 was about 40% of the increase, driven by the same three relationships, BJ mentioned earlier. $73 million or 109 basis points of over 30-day past dues as of Q3 2024 are noted on the bottom left graph. I'll note that this has been reduced to $56 million or 84 basis points of our unguaranteed balances as of this morning. The main theme driving the increase over the last two quarters was largely borrowers still working through the elevated rate environment, and we do think lower rates will be an aid to our borrowers. Non-accrual trends on the bottom right are largely in line with the historical eight-quarter trend and net charge-off levels remain modest at approximately $2 million in Q3 or 3 basis points of our held-for-investment unguaranteed loans. Broadly speaking, movements in our credit performance continue to be driven by either the highest rate environment in decades or by isolated non-thematic circumstances surrounding a few relationships. Lastly, slide 19 highlights our capital profile which remains healthy. We like our current position and will continue to ensure that capital levels remain appropriate for our robust growth trajectory. Overall, we are happy with our strong PPNR performance and growth trends. We remain comfortable and confident in our credit quality and processes, and we are excited about our continued momentum as we head into the end of the year and into 2025. I will now turn it over to Chip to add any final comments before Q&A.

Thanks, Walt. On most of our previous quarterly calls, I kick things off and discuss credit quality. Just a word on that before we go to Q&A. We have always believed that the key to operating a bank was to focus on soundness, profitability, and growth, in that order. Just as a reminder, we go see all of our customers before we make a loan. Our lenders sit around the kitchen table, go over budgets, and understand our customers' plan for success. Other SBA lenders do not. Another reminder, we have 72 22-year-olds reviewing quarterly financial statements on all 7,412 loan customers. Because BJ does such a great job of operating this bank, I'm on the road a couple of days a week calling on prospects and customers, usually with a plane full of young folks. This provision is a blip. It is not systemic. Lastly, we have always thought capital is king. Our adjusted capital ratio, as Walt just pointed out, is over 18% and our loan loss reserve is twice industry averages. I have never been more excited about our prospects for growth in this bank in the future and now, we're happy to take your questions.

Thank you, ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] Your first question comes from Crispin Love at Piper Sandler. Please go ahead.

Thank you and good morning, everyone. I hope you're well. First, just can you dig a little bit deeper into the originations for the quarter and the outlook there? Very strong quarter for originations. For many quarters, you've been around that $1 billion mark. But -- so first, are there any specific industries where the originations were concentrated? And then, how do you think about originations in coming quarters compared to the third? Could $1.5 billion or so be a more normalized level forward -- level going forward just given on pipeline? Just curious on how you're thinking about that after a record quarter. Thank you.

Thanks, Crispin. It's BJ. Good morning. Fantastic quarter. And if you look at what some of the slides that Walt showed, it was really pretty broad-based. We had really strong performance in our small business verticals and in our commercial banking, we saw a pretty significant increase. What we saw earlier in the year from our solar business, in particular, was projects moving to the right and, third quarter, we really saw a lot of that pinup origination hit in the third quarter. So that was kind of a significant step-up on the solar side. We also saw some strength in project finance, particularly around seniors' housing as well. So they were pretty big, meaningful step-ups from second quarter to third quarter. So, I don't think we're going to continue to see a $1.8 billion. Do I think that we're now at elevated levels of loan production in the $1.2 billion range or more? Yes, I do. And I'm very encouraged about, again, how broad-based it is and that the pipelines, as we showed, continue to remain very healthy. So I really think there's a lot of good customer activity out there as rates have crested and started to come down. So I think we've got kind of our production engine rolling at just the right time.

One thing to add to that, BJ, we have another pipeline, and that's a pipeline of lenders that we're talking to. And our SBA lender pipeline is at an all-time high as we see some other banks changing comp plans and things like that. So our existing pipeline of originations is robust, as you mentioned before, but so is the lender pipeline.

Thanks, BJ and Chip. Appreciate all the color there. And then just on the three relationships that drove $14 million of the provision, just a little bit more color there would be great. What industries are those companies in and how large are the individual loans? And then just views on credit broadly in the portfolio. It seems that you're pretty confident here, given that uptick might just be a blip, but curious on your views. Thank you.

Sure. Yes, let me start and then I'll kick it to Michael, who looks at our portfolios each and every day in detail with his credit officers. But really they are isolated incidents across our portfolio. One was just a poor management transition and oversight by equity sponsors. One is litigation overhang, hindering a customer's ability to get new business. And the third was one that didn't work. And as a bank, we're in the business of taking risk, and we get it right. 99% -- 99.5% of the time. And sometimes we don't. But we still, like we said, feel really comfortable about our overall portfolio. Michael, what would you add?

Yes, good morning. What I would add to that is that for my seat, I have a lot of confidence in our lending strategy and our loan portfolio and our credit team and our servicing team, our lenders or analysts. We're all meeting quarterly to go through all of the loans in our commercial portfolio. We're talking about them and looking at trends on an individual loan basis and in the markets that we serve. And when I look at these three credits, I don't see an underlying theme that is woven into the rest of our portfolio. I see them as truly one-off isolated events.

Great, thank you. And then are you able to share how large the individual credits are?

I think we'll kind of pass on that. But, you know, if it's $15 million, there's three credits. You know, you can kind of guess.

Okay, thank you. I appreciate it.

Thank you. Next question comes from David Feaster at Raymond James. Please go ahead.

Hey, good morning, everybody.

Hey, David.

I want to touch on. You touched on a bit, BJ, but I wanted to get a sense of the small dollar SBA originations, kind of where we are in the build-out there. You talked about it being a material growth driver over time, but where are we there? And when would you start to expect more significant growth revenues from that?

Sure, I'll start. Anybody else can kind of jump in. But a couple weeks ago, we crested $100 million of production in our -- like what we call, Live Oak Express or small dollar 7(a) program which is primarily loans $500,000 and below. And as you recall, David, we really just didn't focus on that lower end of the market. We were focused on the higher end. But we redoubled our efforts on that starting at the beginning of the year. And really -- what's really exciting about it is we stood up, essentially a new business to -- for small dollar SBA and done $100 million. We'll probably do $125 million or $130 million by the end of the year with a modest amount of technology and a heck of a lot of work from people. I think what you're going to see next year is a heck of a lot of work from our people, enabled by a significant improvement in our technology for our people and customers. It's going to be a lot easier to do business with us. We are approving loans by and large between four business days and 12 business days, or getting to approval that quickly, which is a huge benefit to those borrowers. And I think our processes and our technology advancements going into the next year is going to make that even better. So, $125 million in a year without technology is just the start. I think this is a $0.5 billion to a $1 billion a year production business over the next couple of years.

That's great. And then maybe just kind of staying on the investment and expansion side, I wanted to touch on two things. First, just embedded banking, something we've talked about in the past. I know it's still in its infancy, but curious what you're seeing there, how the pipeline is. And then, we saw the announcement was simply -- and, you guys have been exploring syndications for a while. I'm just kind of curious where you are in the build-out of that platform and your plans for that.

Sure, I'll start again. David. On embedded banking, we still remain really excited about the opportunities there. We've spent really the last couple of years building out what I would call our technology chassis, building out a broad array of APIs in a very professional, world-class developer portal to be able to eventually take on embedded banking clients across any type of vertical and allow them to integrate with our APIs seamlessly. We launched our first partnership with Anatomy Financial, which is a startup in the healthcare industry. We're very pleased with how that's going. We've essentially been co-developing our embedded banking efforts with each side learning from each other. I expect that we'll add a second partnership this year to accelerate our efforts going forward. So this to me is kind of a moonshot effort where we're combining all the innovation that is part of the fabric of Live Oak and bringing it to bear with our customers, and figuring out the right partnerships over time to be able to drive deposit growth, loan opportunities, and payments growth over the next several years. So more to come on that, but still very excited about it. On the simply side, this is kind of the essence of the Live Oak culture. We had one of our developers in-house that was doing work for us and came to us with something he was already building and said, hey, I think there's an opportunity here to help the bank, but then also maybe commercialize something that other banks could use. And so we internally incubated that for about a year with some funding and some resources, and then, as you saw, just went to the external market to get some more seed capital to allow them to grow and commercialize further. So, just another point of evidence about the innovative nature of what we're doing here at Live Oak. We're very willing to try new things and be able to innovate on behalf of our company first, but then the industry as well.

The only thing I would add to that, certainly word moonshot is appropriate, BJ, in embedded banking and our nascent effort with anatomy and soon-to-be others, that business cannot occur on a traditional core. Our proprietary advantage of putting that business on a fintech core provides an enormous barrier to entry when we get it right over the next several years.

That's good color. And last one for me. You touched on the improvement in the secondary market, and as rates come down, gain on-sale margins likely continue to improve, I'm just curious, how do you think about -- what's your appetite for additional loan sales into the secondary market just kind of given where gain-on-sale margins are in the growth? I mean, you talked about $1.2 billion in originations and then the acceleration in the small dollar SBA. Kind of just curious how you think about the pace of loan sales going forward versus retaining on the balance sheet?

Hey, David, this is Walt. Thanks for the question. I think if you think about secondary market sales and the trajectory year-over-year, they kind of fall a similar pattern, kind of up and to the right through the year with Q1 being the lowest and then kind of bridges up as it gets Q4 with each quarter being higher than it was the prior year. So that kind of gives you a feel for, in terms of trajectory. I think $1.2 billion, $1.3 billion origination, with the demand in the secondary market and where premiums are right now and where our pricing is, we'll continue to basically sell as much as we can for the SBA loans. And then, obviously, with the small loans at that production ramps, that'll just be accretive and give us some flexibility for any of those larger loans that we may want to hold.

Okay. Terrific. Thanks, everybody.

Thanks, David.

Thanks, David.

Thank you. Next question comes from Tim Switzer at KBW. Please go ahead.

Hey, good morning. Thank you for taking my question.

Hey, Tim.

Hey, Tim.

My first question is a follow-up on some of the credit discussions and the outlook there. Can you discuss some of the challenges your borrowers are experiencing right now and how do you expect that to change over the next year or so, and how lower rates might be to help? And some of the credit migration you've seen this quarter, was that primarily due to struggles with the higher rates and inflation or more idiosyncratic issues?

Yes, I'll take that. It's Michael. So when I look at the portfolio as a whole, I don't see an area of particular stress. Our team's real focused on credit quality and portfolio [Indiscernible], as I mentioned earlier, I kind of look back at where we have been, our small business borrowers have been over the last couple of years, and they've had to navigate some challenges, and the interest rate environment obviously, is a big part of that. And we've seen loans that were underwritten two years ago that were at much lower rates than where they are today. So to your point, I agree that the rate environment that we're in today that's declining should provide some breathing room for our borrowers. So, yes, I would say that's probably the biggest impact on our small business owners today.

Okay, thank you. And the other question I have is more on kind of like the deposit beta trajectory. How do you expect that to change over the course of the cycle? And, you know, like, what has kind of been the initial customer reaction to lower deposit costs and I guess the competitive dynamics you've seen recently as well.

Hey, Tim, this is Walt. I think, to kind of get a feel for that beta trajectory, I have to go back to pre-COVID, I think, July 2019 where the Fed cut, I think it was July, August, September of that year. And what you essentially saw was early in the cycle banks were cautious in their repricing, assessing their liquidity and their growth needs and really what the whole deposit market, how the deposit market will behave, especially on the savings front. And then, with time, as banks started to reprice downward, it was kind of this ratcheting effect, right, where a couple major banks come down and then others would follow and then, it was kind of back and forth for a while. It took about five to six months to get back to what we would say would be our -- kind of equivalent to our assumed cumulative betas, which is in that 50% to 70% range for savings. CDs on the other hand, they've repriced pretty quickly back then and they're doing the same again in this cycle. We've been able to reprice our 12-month term, which is our most productive CD offering down 40 basis points already. Most of that was leading up to the Fed. That's an 80% beta. That's right in line with our historical. This cycle, I would say, so far on business and consumer savings, we repriced 10 bps, so 20%. We have this great problem that's just strong as you see in Q3, the strong quarterly loan growth. So we can't be aggressive or overly aggressive to reprice down quickly. But what we do is we essentially evaluate our market position, see what other banks do and then we kind of slot ourselves in at the right level to support our growth with the thought of being as efficient as we possibly can. Customer reaction has been pretty much a non-reaction which I think is a good thing, where I think they've largely expected rates are going to come down. I think it's widely publicized that the Fed's going to cut rates, banks are going to drop the rates as well. We haven't really seen any reaction or negative flows to our early changes. We don't expect to. The market itself is basically balancing their rate reductions with other promotions, whether it's cash bonuses. We're no different. We've seen some competitors do what we think, what we call, bait and switch, where they sunset an old product and they launch a new product that's not the Live Oak way. I don't think that's kind of in our DNA. And we've seen others do kind of promotional rates where it's -- you're locked in for three to six months and then it drops you down to 25 basis points or 50 basis points again. I think that's a bait and switch. It's not a long-term play. It's not -- it's not doing the right thing by the customer. So largely in line of what we're seeing now is what we expected early on in the cycle. We do think it's going to ramp up. I'm encouraged, especially over the last few weeks of seeing some major digital competitors come down, which is allowing some of these smaller competitors at the very top of the market to reprice, essentially resetting the entire product down.

That was great. Appreciate all the detail. Thank you.

Sure.

Thank you. We have no further questions. I will turn the call back over to Chip Mahan for final remarks.

Thanks to everyone for attending today, and we shall see you in January.