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Live Oak Bancshares (NYSE: LOB)
Q3 2024 Earnings Call
Oct 24, 2024, 9:00 a.m. ET
Key Highlights from the Prepared Remarks
- Prepared Remarks
- Questions and Answers
- Call Participants
Overview of the Call
Operator
Good morning, ladies and gentlemen, and welcome to the Q3 2024 Live Oak Bancshares earnings conference call. This call is being recorded on Thursday, October 24th, 2024. I would now like to turn the conference over to Greg Seward, general counsel and chief risk officer. Please go ahead.
Gregory Seward — Chief Risk Officer and General Counsel
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 mentioned during our discussion, please visit our website at investor.liveoakbank.com and go to the Events and Presentations tab for supporting documents.
Our third-quarter earnings release is also available on our website. Before we begin, I want 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 these forward-looking statements to reflect circumstances or events that may occur after today’s call.
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Details regarding any non-GAAP financial measures mentioned, including reconciliations to GAAP measures, can 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.
James S. Mahan — Chairman and Chief Executive Officer
Good morning, everyone. BJ will start things off before we hear from Walt on the quarter’s specifics. I’ll add a few comments before we move to Q&A.
BJ?
BJ Losch — President, Live Oak Bank
Thanks, Chip. Good morning, everyone. On Slides 4 and 5, you’ll see this was a significant quarter for Live Oak. We are delighted that our strategy is effective, showing excellent momentum as we continue to acquire new small business relationships. We delivered strong PPNR growth on both reported and adjusted bases along with solid loan and deposit growth, setting new records in loan production.
Our lending teams achieved outstanding results for production and balance sheet growth with healthy spreads this quarter. Pipeline activity remains at near record highs, suggesting continued success ahead. We recorded an elevated provision for loan losses, of which about 35% was due to what I call good provision, stemming from our record loan growth. The remaining 40% was linked to three specific impairments.
Despite these challenges, the overall portfolio quality across small business and commercial banking is robust. I have confidence in our credit quality processes and team. As we navigate lower rates and the potential for a soft landing, we anticipate benefiting both customers and revenue growth.
Looking at Slide 6, our focus on profitability by ensuring revenues grow faster than expenses remains key. We’ve experienced PPNR growth of 18% on an adjusted basis since last quarter and 22% compared to one year ago. Our PPNR over the last 12 months has increased by 29%, thanks to a 10% rise in revenue while keeping expenses to just 1%. Notably, loan production this quarter exceeded our previous high by 50% and is poised to continue growing with strong pipelines.
On Slide 8, while we reported low charge-offs this quarter, we proactively increased our reserves in response to record loan growth and specific impairments. Our disciplined credit practices ensure we stay ahead of potential borrower stress, and our reserve levels are strong for when charge-offs do occur.
Aiming for Slide 9, I’m pleased with our current results but even more excited about our future potential. There remains significant opportunity within our loan pipelines. Our new small dollar SBA lending initiatives are gaining traction and should contribute meaningfully to our performance over time.
Our customer checking balances, previously minimal, are Building as we develop deeper relationships. Our brand continues to appeal to top talent and customers alike. With ongoing investments in our capability, a big thank you to all Live Oakers and our customers. Walt, please walk us through some key financial highlights.
Walt Phifer — Chief Financial Officer
Thanks, BJ. Good morning, everyone. Let’s review our summarized Q3 2024 metrics…
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Quarterly Financial Review: Strong Loan Growth and Increased Profitability Highlights
On Slide 11, several highlights warrant attention on the right-hand side of the page.
- We experienced modest annualized net charge-offs of 8 basis points in relation to our average loans and leases held for investment.
- There was a notable 9% growth in linked quarter Pre-Provision Net Revenue (PPNR) and a 5 basis point expansion in net interest margin.
- Loan originations surged by 50% and loan balances grew by 7% compared to the previous quarter, net of loan sales.
Furthermore, as highlighted at the bottom of the charts, our total loan and lease portfolio surpassed the $10 billion mark in the third quarter. Our deposit portfolio is growing at a similar pace. Let’s take the next few pages to explore the leading factors driving this quarter’s impressive PPNR performance and growth.
Record Loan Originations Propel Growth
Slide 12 showcases our loan originations categorized by vertical and business unit. As BJ mentioned, Q3 loan production reached an all-time high of approximately $1.8 billion. This outstanding performance stemmed from a strong loan pipeline entering the quarter, along with the dedicated efforts of our lending, funding, and operational teams. Notably, we achieved about $320 million in project finance loan production, primarily from solar energy and hotel projects. After a slow start in the first half of the year, our project finance team rallied in Q3 for their highest quarterly loan production in the bank’s history.
From the total amount, $811 million, or 46% of Q3 loan production, originated from our small business banking team, predominantly through SBA 7(a) loans. This marked a 26% increase from the prior quarter and a 35% rise year-over-year. In contrast, our commercial lending team generated $947 million, representing 54% of Q3’s loan production, which was a remarkable 79% increase linked quarter and double the commercial production of the previous year. Year-over-year trends reveal that approximately 60% of our verticals have outperformed their 2023 production levels through the first three quarters of 2024. Slide 13 illustrates continued loan and deposit balance growth, emphasizing strong trends in the first three quarters of 2024.
Loan and Deposit Balances on the Rise
In contrast with many banks in the industry that are experiencing minimal loan growth, our loan balances increased by 7% linked quarter and 16% year-over-year. This elevated growth in Q3 was mainly driven by robust loan production. Before accounting for loan sales and participation, our loan balance growth was actually 11% linked quarter. Additionally, deposit growth of 7% linked quarter and 14% year-over-year is supported by our customer deposit platform alongside broker deposits that address short-term liquidity needs and add flexibility to our deposit repricing strategy, especially in a fluctuating rate environment.
Our business deposits also reflect a positive trend, growing 6% linked quarter and 22% year-over-year as part of our funding strategy. As BJ noted, we are thrilled about the momentum we are building with our loan and business deposit customers, showcased on Slide 14. Following the launch of our operating account offering in Q1, the percentage of customers with both a loan and a deposit account has tripled to approximately 12%.
Business checking balances have risen to $145 million, and corresponding savings and CD balances for businesses with a checking account at Live Oak have doubled to $232 million. This expansion of customer relationships results in “stickier” deposits, with an average blended cost of funds in Q3 2024 lower than the total bank blended cost. Our ongoing efforts in this area will provide significant support to our net interest income and net interest margin over time. On that note, net interest income and NIM trends are detailed on Slide 15.
Net Interest Income on an Upward Path
The graph at the top of the page demonstrates that our net interest income increased by 6% linked quarter and is up 9% compared to Q3 2023. There was a 5 basis point quarter-over-quarter rise in net interest margin, now at 3.33%. Improvement in both metrics was largely due to loan growth, as highlighted in the lower right corner of the slide. Our net spread increased 2 basis points linked quarter to 3.68%, attributed to a 4 basis point rise in loan portfolio yield to 7.83%, while the cost of funds only rose by 2 basis points to 4.15%.
Looking ahead, we remain confident about our control over factors that impact growth. The momentum in loan pipelines appears solid, critical for our net interest income and NIM expansion moving forward. We continue to maintain strong pricing discipline on new loan originations, resulting in new loans being issued at roughly 100 basis points above our average portfolio yield, which has proven beneficial. Increases in cost of funds since early 2023 have largely resulted from maturing CDs renewing at higher rates.
As depicted in the middle of the page, significant headwinds from previous quarters are converting into tailwinds. Approximately one-third of our customer deposits and one-fifth of total deposits are tied to maturing CDs. As noted in our last call, current CD offering rates are now below maturing rates, indicating a favorable spread expected to widen over the next year as the Fed continues down its easing path. While we anticipate Fed cuts to support growth, net interest income, and margins over time, their timing and magnitude will impact our financials quarter-over-quarter.
More than half of our loans are variable and primarily adjusted quarterly, meaning they will reprice the first business day after the quarter ends. A 50 basis point Fed cut at the end of the quarter may create a timing difference, as it won’t allow sufficient time for the deposit market, particularly consumer and business savings, to adjust before our loans reconnect. Compounding this, we have a negative one-year repricing gap of around 19%, signifying $2 billion more in liabilities will reprice at lower rates compared to assets over the next 12 months. This indicates an imminent margin compression, although we are optimistic about future recovery as market conditions shift and deposit pricing adjusts.
Sound Fee Income Despite Competition
Shifting to quarter-over-quarter fee income on Slide 16, demand for government-guaranteed SBA and USDA loans remains robust in the secondary market. Our gain-on-sale volumes reflect this strength as we sold $267 million in Q3 2024 for an average premium of 7%, consistent with trends over the past three quarters.
Expense Management Continues
Details about our expenses can be found on Slide 17. Our Q3 2024 expenses totaled $78 million, remaining stable through the first three quarters of the year. This consistency has contributed to a reduction in our efficiency ratio to approximately 60%. Our teams have shown remarkable discipline in managing expenses over the past year while adding 43 full-time equivalents, mainly in growth-oriented roles.
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Positive Outlook for Live Oak Bank Amid Challenging Credit Conditions
Live Oak Bank remains focused on revenue growth and investments in technology, signaling resilience in the current financial landscape. As highlighted in Slide 18, the bank’s credit trends are showing signs of stability despite recent challenges.
Rising Unguaranteed Classified Loans
As of Q3 2024, unguaranteed classified loans rose to 240 basis points, accounting for approximately 40% of the increase. This surge was largely influenced by three specific borrower relationships, as mentioned by BJ earlier. Over 30-day past dues reached $73 million or 109 basis points, though this figure has improved to $56 million, or 84 basis points, just this morning. The increase in past dues has primarily stemmed from borrowers adjusting to a higher interest rate environment, with expectations that lowering rates will assist many in managing their repayments.
Non-Accrual Trends Remain Stable
Non-accrual trends continue to align with the historical eight-quarter averages, and the net charge-off levels remain modest at around $2 million in Q3, equating to 3 basis points of held-for-investment unguaranteed loans. Movements in credit performance are primarily driven by either the highest interest rates seen in decades or specific non-systemic circumstances affecting isolated borrowers.
Strong Capital Foundation
Slide 19 indicates that the bank’s capital profile remains robust, with the current adjusted capital ratio exceeding 18%. This positions the bank favorably for ongoing growth and stability. Leadership expresses satisfaction with the bank’s performance and is optimistic as they anticipate the end of 2024 and the beginning of 2025.
James S. Mahan — Chairman and Chief Executive Officer
Before we open the floor to questions, I’d like to emphasize a foundational principle: banking should prioritize soundness, profitability, and growth. Our thorough approach to customer engagement—where we assess their financial health before extending loans—distinguishes us from other SBA lenders. Our team of 72 young analysts diligently reviews financial statements, ensuring that we’re well-informed about our 7,412 loan customers.
Due to BJ’s strong management, I spend time on the road engaging with prospects and clients. The recent provision increase is an anomaly and does not reflect systemic issues. Ultimately, we believe that maintaining solid capital levels is essential.
Our adjusted capital ratio surpasses 18%, and our loan loss reserve is twice the industry average. I have never felt more optimistic about the bank’s growth prospects.
Questions & Answers:
Operator
Thank you. [Operator instructions] Your first question comes from Crispin Love at Piper Sandler. Please go ahead.
Crispin Love — Piper Sandler — Analyst
Thank you, and good morning. Could you provide further insight into this quarter’s originations and future outlook? You’ve indicated impressive numbers around the $1 billion mark historically. Are there specific industries contributing to this surge? Do you anticipate originations to normalize closer to $1.5 billion in future quarters, given the current pipeline? Thank you.
BJ Losch — President, Live Oak Bank
Good morning, Crispin. This was indeed a fantastic quarter. Reviewing some of the slides Walt presented, the strength was widespread across various sectors. Notably, small business and commercial banking saw significant increases, particularly as solar projects that had been delayed earlier in the year finally came to fruition. Additionally, we experienced notable growth in project finance and seniors’ housing.
While I don’t anticipate consistently high production levels like our recent peak of $1.8 billion, I do believe we are poised to maintain elevated loan production in the range of $1.2 billion or more. The current activity levels are encouraging, especially as interest rates have begun to decline.
James S. Mahan — Chairman and Chief Executive Officer
To add to BJ’s points, we’re also nurturing a robust pipeline of new lenders joining us, especially as other banks are modifying their compensation plans. Therefore, both our existing loan origination pipeline and our lender recruitment efforts are in excellent shape.
Crispin Love — Piper Sandler — Analyst
Thank you for those insights. Regarding the three relationships that contributed to the $14 million provision, could you provide more details on the industries involved and the size of the loans? Additionally, what is your general view on credit quality across the portfolio?
James S. Mahan — Chairman and Chief Executive Officer
Certainly, Crispin. Let me start, and then I’ll pass it over to Michael, who monitors our portfolios closely. These three situations are isolated incidents without a broader trend affecting our overall credit quality. One case involved a management transition issue, another was tied to litigation that impeded business opportunities, and the last was simply a miscalculation. While we take on risks as a bank, we typically succeed in 99% of our ventures.
Michael J. Cairns — Chief Credit Officer
Good morning. I have full confidence in our lending strategy and the oversight of our credit team. We analyze all loans within our commercial portfolio quarterly, ensuring we remain vigilant about trends. Regarding the three credits in question, I can confirm they are completely isolated events without significant implications for the rest of our loan portfolio.
Crispin Love — Piper Sandler — Analyst
Thank you. Can you disclose the size of these individual credits?
James S. Mahan — Chairman and Chief Executive Officer
We would prefer not to disclose specific amounts, but for context, they are likely around $15 million each.
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Live Oak Bank Reports Strong Growth in Small Dollar SBA Loans
Crispin Love — Piper Sandler — Analyst
OK. Thank you. I appreciate it.
Operator
Thank you. Next question comes from David Feaster at Raymond James. Please go ahead.
David Feaster — Raymond James — Analyst
Hey. Good morning, everybody.
James S. Mahan — Chairman and Chief Executive Officer
Hey, David.
David Feaster — Raymond James — Analyst
I want to touch on the small dollar SBA originations, particularly where we are in the build-out. You mentioned it being a material growth driver over time, but what is the current update, and when can we expect more revenue growth from that?
BJ Losch — President, Live Oak Bank
Sure, I’ll start. A couple of weeks ago, we surpassed $100 million in production for our small dollar 7(a) program, which focuses on loans of $500,000 or less. Initially, we did not concentrate on this lower end of the market, but we made a concerted effort to shift our focus at the beginning of the year. This new business has shown exciting potential. We anticipate hitting $125 million to $130 million by year-end. While we accomplished this without advanced technology, we expect significant operational improvements going forward.
Currently, approvals take between four and twelve business days, making it easier for borrowers. As we enhance our technology in the coming year, I believe we have the potential to reach $0.5 billion to $1 billion in annual production in this sector within a few years.
David Feaster — Raymond James — Analyst
That sounds promising. I’d also like to discuss your investment and expansion strategies, particularly regarding embedded banking. What’s the current landscape for you there?
BJ Losch — President, Live Oak Bank
Absolutely. We are very optimistic about embedded banking opportunities. Over the past couple of years, we’ve developed a strong technological foundation, including APIs that allow for easy integration with clients across various industries. We initiated our first partnership with Anatomy Financial, a healthcare start-up, and are pleased with our collaborative efforts. By year-end, I expect to form a second partnership to enhance our impact going forward.
This project represents a significant innovation opportunity for Live Oak, as we combine our strengths to create new deposit and loan opportunities. It’s an exciting venture that reflects our culture of exploration and innovation.
James S. Mahan — Chairman and Chief Executive Officer
I’d add that the term “moonshot” is fitting for our embedded banking initiative. Our proprietary technology platform distinguishes us from traditional banks, establishing a competitive barrier that we believe will yield substantial benefits in the future.
David Feaster — Raymond James — Analyst
Thanks for that insight. Lastly, you mentioned improvements in the secondary market. As rates decrease and gain-on-sale margins improve, what’s your strategy regarding further loan sales into the secondary market?
Walt Phifer — Chief Financial Officer
Hi David, thanks for your question. Secondary market sales have shown a consistent upward trend over the past year, especially towards Q4. We’re looking at maintaining a trajectory of around $1.2 billion to $1.3 billion in origins. Given current demand and premiums in the secondary market for SBA loans, we plan to maximize our sales while ensuring we have the flexibility to manage larger loans on our balance sheet.
David Feaster — Raymond James — Analyst
OK, that sounds great. Thank you, everyone.
Walt Phifer — Chief Financial Officer
Thanks, David.
BJ Losch — President, Live Oak Bank
Thanks, David.
Operator
Thank you. Next question comes from Tim Switzer at KBW. Please go ahead.
Tim Switzer — Keefe, Bruyette and Woods — Analyst
Hey. Good morning. Thank you for taking my question.
James S. Mahan — Chairman and Chief Executive Officer
Hey, Tim.
BJ Losch — President, Live Oak Bank
Hey, Tim.
Tim Switzer — Keefe, Bruyette and Woods — Analyst
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…
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Live Oak Bank’s Financial Outlook: Adjustments and Strategies Amid Changing Interest Rates
Understanding Current Credit Conditions
Michael J. Cairns — Chief Credit Officer
I’ll address that. Looking at our overall portfolio, I don’t identify any significant stress points. Our team prioritizes credit quality and portfolio oversight. Reflecting on the past few years, our small business borrowers have faced various challenges, notably due to the interest rate environment.
Several loans were issued two years ago at substantially lower rates than what we see today. Therefore, I concur that the current declining rate environment should afford our borrowers some relief. Hence, this change is likely the greatest influence on our small business owners now.
Deposit Beta Trajectory and Competitive Responses
Tim Switzer — Keefe, Bruyette and Woods — Analyst
Thank you. My next question concerns the deposit beta trajectory. How do you foresee this evolving throughout the current cycle? What initial reactions have you seen from customers regarding lower deposit costs and the competitive landscape?
Walt Phifer — Chief Financial Officer
This is Walt. To evaluate that beta trajectory, I have to reference pre-COVID times, specifically July 2019, when the Fed made rate cuts. In the initial phase, banks were cautious about repricing, considering their liquidity and growth needs while assessing market behavior.
As time passed and banks began to lower rates, a sort of chain reaction occurred. Major banks would reduce rates, followed by smaller banks adjusting their rates accordingly. This cycle took about five to six months to reach our expected cumulative betas, generally in the 50% to 70% range for savings. In contrast, CDs reproached quickly during this phase as well as in the current cycle. For example, we have successfully lowered our 12-month term CD, our most sought-after offering, by 40 basis points.
Leading up to the Fed’s actions, that represented an 80% beta, aligned with our historical patterns. So far this cycle, we’ve adjusted business and consumer savings by 10 basis points or 20%.
Our recent strong loan growth has restricted us from being overly aggressive in repricing quickly. Instead, we assess market position and observe competitor actions, positioning ourselves accordingly to facilitate growth while aiming for efficiency. Customer feedback has been largely positive or neutral, indicating expectations for lower rates, which seems to reflect in their reactions.
Widespread announcements of anticipated Fed rate cuts have set the expectation that banks will follow suit. We have not encountered any negative customer flows in response to our early adjustments, and we anticipate that trend to continue. The overall market appears to be balancing rate decreases with various promotions like cash bonuses.
We’ve observed competitors deploying what we view as “bait and switch” tactics—shuttering old products for new ones not aligned with our principles. Other competitors tend to offer promotional rates that drastically drop after short periods. We believe this is not sustainable and does not serve customers’ long-term interests. Our current market behavior aligns with our initial expectations.
Encouragingly, we’ve noticed major digital competitors lowering their rates recently, granting smaller competitors at the highest tier the opportunity to adjust rates accordingly, essentially resetting the overall market.
Final Remarks
Tim Switzer — Keefe, Bruyette and Woods — Analyst
That was insightful. Thank you for the details.
Walt Phifer — Chief Financial Officer
Sure.
Operator
Thank you. There are no further questions. I’ll hand the call back to Chip Mahan for closing comments.
James S. Mahan — Chairman and Chief Executive Officer
Thank you all for joining us today. We look forward to seeing you in January.
Operator
[Operator signoff]
Duration: 0 minutes
Call participants:
Gregory Seward — Chief Risk Officer and General Counsel
James S. Mahan — Chairman and Chief Executive Officer
BJ Losch — President, Live Oak Bank
Walt Phifer — Chief Financial Officer
Chip Mahan — Chairman and Chief Executive Officer
Crispin Love — Piper Sandler — Analyst
Michael J. Cairns — Chief Credit Officer
David Feaster — Raymond James — Analyst
Tim Switzer — Keefe, Bruyette and Woods — Analyst
Michael Cairns — Chief Credit Officer
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