The nearly $8.1 billion asset Live Oak Bancshares (LOB 3.24%) recently turned in its strongest quarterly earnings in the company's history, generating a profit of $33.8 million in the third quarter. That's up roughly 766% from the same period of 2019 and up a similar amount from this year's second quarter. It also more than tripled analysts' earnings estimates for the quarter. The stock is trading at 226% above book value and is up about 75% year to date. "We're hitting on all cylinders," said Live Oak's CEO, James Mahan III, on the earnings call. Here are four reasons why.
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1. Strong net interest income and revenue
Live Oak's net interest income climbed to more than $51 million in the quarter, while its total revenue exceeded $98 million. Both of those numbers surpassed any previous quarter in the bank's history, at a time when most of the banking industry was experiencing pressure on loan margins due to the low-rate environment.
Now, part of that net interest income surge is due to $13.6 million in fees the bank collected from the Paycheck Protection Program (PPP). Live Oak is the leading Small Business Administration (SBA) lender in the country, and the PPP program was built off SBA lending. The bank originated nearly $1.7 billion in PPP loans. As the loans are forgiven, Live Oak collects fees from the SBA that are added to interest income.
However, even without the $13.6 million in PPP fees, Live Oak still would have had quarterly net interest income fairly similar to levels in 2019, which is good when you consider that in March, the Federal Reserve dropped its benchmark lending rate -- which greatly impacts net interest income -- from 2% to near zero. Live Oak originated more than $960 million in loans in the third quarter, way above normal levels. Much of this jump in originations can be attributed to the fact that the SBA agreed to pay six months of principal, interest, and fees for new SBA loans made between March 27 and Sept. 27 of this year.
But even without the subsidy, there are still a lot of promising signs. For one, Mahan said he felt confident the bank had the right pieces in place to originate $2.5 billion to $3 billion in loan volume on an annual basis, which equates to 25% more than normal on an annual basis. Mahan also said the bank's current loan pipeline is at an all-time high, and that the bank is seeing new opportunities in other loan segments. The bank also still has close to $43 million in deferred fees from the PPP program that will flow through to interest income as PPP loans are forgiven, most of which is likely to occur in 2021.
2. Strong credit quality and transparency
Live Oak saw its net charge-off rate tick up a decent amount to 1.03% in the third quarter, up from 0.21% in the linked quarter. The bulk of that came from a markdown on hotel loans that were either sold or reclassified. Hotel loans do make up about 5.4% of total loans at the bank that are not guaranteed by the SBA. But if you look at what's left in the hotel loan book, the top 10 largest loans have really strong loan-to-value ratios, meaning there is already lots of cash flow because the borrower has paid a good chunk of the loan already.
Additionally, Live Oak takes away a lot of its credit risk just by being in the business of SBA lending because the SBA guarantees a big portion of each loan, sometimes as much as 90%. More than half of Live Oak's loan book is made up of cash, securities, and SBA loans, and if you add all of the PPP loans to that equation the number rises to more than 65%.
There also haven't been any new past due loans, largely because of the SBA subsidy on principal, interest, and fees. Non-performing assets in Live Oak's unguaranteed loan portfolio, those that haven't received an interest or principal payment in more than 90 days, make up 0.29% of total loans at the end of the third quarter.
The bank has plenty of regulatory capital available to absorb unexpected loan losses, and management was incredibly transparent when it came to showing credit data. Not only did it give the normal credit ratios, but it provided extra detail on its hotel portfolio; credit and fair value metrics; loan servicing status; credit reserves data; and lots of information on at-risk segments. This, in my opinion, shows how confident management is in the strength of the bank's loan portfolio.
3. Technology
Live Oak has been making years' worth of technology investments that are beginning to pay off. After five years of work, the bank has a new direct deposit platform that allows it to easily open business banking accounts online. According to Live Oak President Huntley Garriott, the platform went live in September and has already added more than 200 new customers and over $10 million in deposits with very little marketing.
In addition, Live Oak launched a venture banking business last year, making investments in several fintech companies. Since that time, the bank has invested more than $18 million in a number of companies that now have a carrying value of more than $90 million. In the third quarter, Live Oak saw a $13.7 million gain on one of its portfolio companies, which is reflected on its income statement under the equity securities line item that ultimately benefits non-interest income. As Live Oak Bancshares President Neil Underwood said, the venture investments are great for Live Oak for two main reasons: They provide capital to the bank without having to give away equity, while also providing the latest fintech technology that the bank can use to innovate.
4. Better expense discipline
The bank managed expenses better in the third quarter than it did all of the last year, with non-interest expenses slightly down from the third quarter of 2019, but significantly lower than the first two quarters of the year. And the bank managed to do this while pumping out record earnings, nearly $1 billion in loan originations, and a huge jump in total revenue. As a result, its efficiency ratio, a measure of expenses expressed as a percentage of total revenue (lower is better), was below 44%. Not only is that incredibly strong for the industry, but it's nearly half the company's level from the third quarter of 2019. Management acknowledged that this is likely not sustainable going forward, but to see the company pump out this level of profits and revenue while keeping expenses essentially flat year over year is really encouraging.
