(EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following presents management's discussion and analysis of the financial condition and results of operations of Live Oak Bancshares, Inc. (the "Company" or "LOB"). This discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes included elsewhere in this quarterly report on Form 10-Q and with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2020 (the "2020 Form 10-K"). Results of operations for the periods included in this quarterly report on Form 10-Q are not necessarily indicative of results to be obtained during any future period.
Important Note Regarding Forward-Looking Statements
This quarterly report on Form 10-Q contains statements that management believes are forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995.
These statements generally relate to the financial condition, results of operations, plans, objectives, future performance or business of Live Oak Bancshares, Inc. (the "Company"). They usually can be identified by the use of forward-looking terminology, such as "believes," "expects," or "are expected to," "plans," "projects," "goals," "estimates," "will," "may," "should," "could," "would," "continues," "intends to," "outlook" or "anticipates," or variations of these and similar words, or by discussions of strategies that involve risks and uncertainties. You should not place undue reliance on these statements, as they are subject to risks and uncertainties, including but not limited to, those described in this Report. When considering these forward-looking statements, you should keep in mind these risks and uncertainties, as well as any cautionary statements management may make. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information actually known to the Company at the time. Management undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements contained in this Report are based on current expectations, estimates and projections about the Company's business, management's beliefs and assumptions made by management. These statements are not guarantees of the Company's future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in the forward-looking statements. These risks, uncertainties and assumptions include, without limitation:
deterioration in the financial condition of borrowers resulting in significant increases in the Company's loan and lease losses and provisions for those losses and other adverse impacts to results of operations and financial condition;
changes in Small Business Administration ("SBA") rules, regulations and loan products, including specifically the Section 7(a) program, changes in SBA standard operating procedures or changes to the status of Live Oak Banking Company (the "Bank") as an SBA Preferred Lender;
changes in rules, regulations or procedures for other government loan programs, including those of the United States Department of Agriculture ("USDA");
changes in interest rates that affect the level and composition of deposits, loan demand and the values of loan collateral, securities, and interest sensitive assets and liabilities;
the failure of assumptions underlying the establishment of reserves for possible loan and lease losses;
changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments;
the potential impacts of the Coronavirus Disease 2019 ("COVID-19") pandemic on trade (including supply chains and export levels), travel, employee productivity and other economic activities that may have a destabilizing and negative effect on financial markets, economic activity and customer behavior;
a reduction in or the termination of the Company's ability to use the technology-based platform that is critical to the success of the Company's business model or to develop a next-generation banking platform, including a failure in or a breach of the Company's operational or security systems or those of its third party service providers;
changes in financial market conditions, either internationally, nationally or locally in areas in which the Company conducts operations, including reductions in rates of business formation and growth, demand for the Company's products and services, commercial and residential real estate development and prices, premiums paid in the secondary market for the sale of loans, and valuation of servicing rights;
changes in accounting principles, policies, and guidelines applicable to bank holding companies and banking;
fluctuations in markets for equity, fixed-income, commercial paper and other securities, which could affect availability, market liquidity levels, and pricing;
the effects of competition from other commercial banks, non-bank lenders, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and mutual funds, and other financial institutions operating in the Company's market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone and the Internet;
the Company's ability to attract and retain key personnel;
changes in governmental monetary and fiscal policies as well as other legislative and regulatory changes, including with respect to SBA or USDA lending programs and investment tax credits;
changes in political and economic conditions, including as a result of the 2020 federal elections;
the impact of heightened regulatory scrutiny of financial products and services, primarily led by the Consumer Financial Protection Bureau and various state agencies;
the Company's ability to comply with any requirements imposed on it by regulators, and the potential negative consequences that may result;
operational, compliance and other factors, including conditions in local areas in which the Company conducts business such as inclement weather or a reduction in the availability of services or products for which loan proceeds will be used, that could prevent or delay closing and funding loans before they can be sold in the secondary market;
the effect of any mergers, acquisitions or other transactions, to which the Company or the Bank may from time to time be a party, including management's ability to successfully integrate any businesses acquired;
adverse results, including related fees and expenses, from pending or future lawsuits, government investigations or private actions;
other risk factors listed from time to time in reports that the Company files with the SEC, including those described under "Risk Factors" in this Report; and
the Company's success at managing the risks involved in the foregoing.
Except as otherwise disclosed, forward-looking statements do not reflect:
Amounts in all tables in Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") have been presented in thousands, except percentage, time period, stock option, share and per share data or where otherwise indicated.
Nature of Operations
LOB is a financial holding company and a bank holding company headquartered in Wilmington, North Carolina incorporated under the laws of the state of North Carolina in December 2008. The Company conducts business operations primarily through its commercial bank subsidiary, Live Oak Banking Company (the "Bank"). The Bank was incorporated in February 2008 as a North Carolina-chartered commercial bank. The Bank specializes in providing lending and deposit related services to small businesses nationwide. The Bank identifies and extends lending to credit-worthy borrowers within both specified industries, also called verticals, through expertise within those industries, and more broadly to select borrowers outside of those industries. A significant portion of the loans originated by the Bank are guaranteed by the SBA under the 7(a) Loan Program and the U.S. Department of Agriculture's ("USDA") Rural Energy for America Program ("REAP"), Water and Environmental Program ("WEP") and Business & Industry ("B&I") loan programs.
The Company's wholly owned subsidiaries are the Bank, Government Loan Solutions ("GLS"), Live Oak Grove, LLC ("Grove"), Live Oak Ventures, Inc. ("Live Oak Ventures"), and Canapi Advisors, LLC ("Canapi Advisors").
The Bank's wholly owned subsidiaries are Live Oak Number One, Inc., Live Oak Clean Energy Financing LLC ("LOCEF"), and Live Oak Private Wealth, LLC. Live Oak Number One, Inc. holds properties foreclosed on by the Bank. LOCEF provides financing to entities for renewable energy applications and became a wholly owned subsidiary of the Bank during the first quarter of 2019. Live Oak Private Wealth, LLC and its wholly owned subsidiary, Jolley Asset Management, LLC ("JAM"), provide high-net-worth individuals and families with strategic wealth and investment management services.
GLS is a management and technology consulting firm that advises and offers solutions and services to participants in the government guaranteed lending sector. GLS primarily provides services in connection with the settlement, accounting, and securitization processes for government guaranteed loans, including loans originated under the SBA 7(a) loan programs and USDA guaranteed loans. The Grove provides Company employees and business visitors an on-site restaurant location. Live Oak Ventures' purpose is investing in businesses that align with the Company's strategic initiative to be a leader in financial technology. Canapi Advisors provides investment advisory services to a series of funds (the "Canapi Funds") focused on providing venture capital to new and emerging financial technology companies.
The Company generates revenue primarily from net interest income and secondarily through origination and sale of government guaranteed loans. Income from the retention of loans is comprised principally of interest income. The Company had historically elected to account for certain loans under the fair value option with interest reported in interest income and changes in fair value reported in the net (loss) gain on loans accounted for under the fair value option line item of the consolidated statements of income. Beginning in the first quarter of 2021, the Company chose not to elect fair value for all retained participating interests arising from new government guaranteed loan sales. Income from the sale of loans is comprised of loan servicing revenue and revaluation of related servicing assets along with net gains on sales of loans. Offsetting these revenues are the cost of funding sources, provision for loan and lease credit losses, any costs related to foreclosed assets and other operating costs such as salaries and employee benefits, travel, professional services, advertising and marketing and tax expense. The Company also has generated gains and losses arising from its financial technology investments in its fintech segment, as discussed more fully later in this section entitled "Results of Segment Operations."
Indications of recovery from the COVID-19 pandemic are continuing to appear in the United States; however, the fallout continues to have a complex and significant adverse impact on certain areas of the economy, the banking industry and the Company, all of which are subject to a high degree of uncertainty. This uncertainty is magnified with the risk of a resurgence of the virus or new variants. While it is not possible to know the full universe or extent of these impacts as of the date of this filing, we are disclosing potentially material items of which we are currently aware.
Financial position and results of operations
Relating to our September 30, 2021 financial condition and results of operations, improving conditions around COVID-19 continued to have a positive impact on the allowance for credit losses ("ACL") on loans and leases and net interest income while these same improving conditions were mitigated by current market fluctuations influencing loans carried at fair value, loan servicing asset revaluation and net gains on sales of loans, as discussed below in MD&A. With improving conditions, the ACL and resulting provision for loan and lease credit losses continue to slowly return to pre-pandemic levels relative to credit exposure. The Company continues to monitor pandemic-at-risk verticals, and is seeing a substantial number of borrowers showing signs of recovery by making regular payments in the absence of payment deferrals and payment subsidies provided by the SBA. Accordingly, total credit related reserves were also positively impacted by this continued improvement during the third quarter. Refer to the discussion of the ACL and loans at fair value in Notes 5 and 9, respectively, of the Unaudited Condensed Consolidated Financial Statements as well as further discussion below in MD&A. The net interest margin continued to be positively impacted by the continued recognition of Paycheck Protection Program ("PPP") income as discussed more fully below in MD&A. Should economic conditions worsen, the Company could experience significant levels of provision in the ACL and negative fair value marks and record additional credit or market related loss expense. It is also possible that the Company's asset quality measures could worsen at future measurement periods if there is a continued resurgence of COVID-19 cases or variants.
The income from gain on sale of loans in future periods could also be reduced due to COVID-19, the termination of pandemic response programs or other economic factors. At this time, the Company is unable to project the materiality of such impacts but anticipates that the breadth of the economic impact could impact gains in future periods.
Interest income could be further reduced due to COVID-19. In accordance with guidance from banking regulators, the Company has worked and continues to work with COVID-19 affected borrowers to help defer their payments, interest, and fees. In addition to regulatory relief on deferrals from banking regulators, payment relief was available from the SBA for certain loans guaranteed by that agency pursuant to the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") and subsequently by the below discussed Economic Aid Act. While interest will still accrue to interest income through GAAP accounting, should eventual credit losses on these loans with deferred payments emerge, interest income accrued would need to be reversed. In such a scenario, interest income in future periods could be negatively impacted. As of September 30, 2021, the Company carried $302 thousand in accrued interest on outstanding loans with deferrals made to COVID-19 affected borrowers. At this time, the Company is unable to project the materiality of such an impact on future deferrals to COVID-19 borrowers, but recognizes the breadth of the economic impact may affect our borrowers' ability to repay in future periods.
Capital and liquidity
As of September 30, 2021, all of the Company's capital ratios, and the Bank's capital ratios, were in excess of all minimum regulatory requirements. While the Company believes that capital is sufficient to withstand a double-dip economic recession if brought about by a resurgence in COVID-19, reported and regulatory capital ratios could be adversely impacted by further credit losses. The Company relies on cash on hand as well as dividends from the Bank to service any debt at the Company. If our capital deteriorates such that the Bank is unable to pay dividends to the Company for an extended period of time, the Company may not be able to service its debt.
The Company maintains access to multiple sources of liquidity. Wholesale funding markets have remained open to the Company, but rates for short-term funding can be volatile and the secondary market for guaranteed loans has shown reactionary and varying responses to the changing economic environment. If funding costs are elevated for an extended period of time, it could have an adverse effect on the Company's net interest margin. If an extended recession causes large numbers of the Company's deposit customers to withdraw their funds, the Company might become more reliant on volatile or more expensive sources of funding.
The Federal Reserve created the Paycheck Protection Program Liquidity Facility ("PPPLF") to help provide financing for the origination of PPP loans. The PPPLF extends loans to banks that have loaned money to small businesses under the PPP, discussed in more detail below. Amounts borrowed are non-recourse and have a 100% advance rate equal to the principal amount of PPP loans pledged as security. In addition, loans financed under the PPPLF have a neutral impact on regulatory leverage capital ratios. The maturity date of a borrowing under the PPPLF is equal to the maturity date of the PPP loan pledged to secure the borrowing and would be accelerated (i) if the underlying PPP loan goes into default and is transferred to the SBA to realize on the SBA guarantee or (ii) to the extent that any loan forgiveness reimbursement is received from the SBA. Borrowings under the PPPLF bear interest at a rate of 0.35%, and there are no fees paid by the Company. As of September 30, 2021, the Company had outstanding borrowings of $526.0 million from the PPPLF.
Lending operations and accommodations to borrowers
With the establishment of the PPP administered by the SBA, the Company implemented new loan programs and systems using its technology platform while participating in assisting its customers and other small businesses in need of resources through the program. PPP loans earn interest at 1% and currently have a two-year or five-year contractual term depending on the origination date. For the earlier loans with a two-year term there is an option to extend to five years if agreed upon by the borrower and lender. The Company continues to receive substantial levels of forgiveness for these loans. As of September 30, 2021, the Company carried 3,211 PPP loans on its balance sheet representing a book balance of $489.8 million, which includes $13.2 million in net deferred fees, expected to be amortized and recognized in interest income over the remaining lives of the loans. In comparison, the Company carried 6,580 PPP loans on its balance sheet with a book balance of $927.3 million at June 30, 2021. The Company recognized $10.9 million and $39.3 million of interest income in the third quarter and first nine months of 2021, respectively, related to amortization of net PPP fees. Loans funded through the PPP are fully guaranteed by the SBA, subject to the terms and conditions of the program. Should those circumstances change, the Company could be required to record additional credit loss expense through earnings.
With the passage of the CARES Act on March 27, 2020, the SBA was making six months of principal and interest payments on all fully disbursed SBA 7(a) and SBA Express loans in regular servicing status that closed by September 25, 2020. In addition, with regulatory guidance to work with borrowers during this unprecedented situation, the Company has also mobilized to provide a payment deferral program when needed by customers that are adversely affected by the pandemic. Depending on the demonstrated need of the client, the Company was deferring either the full loan payment or the principal component of the loan payment for 60 or 90 days. In accordance with interagency guidance issued in March 2020, these short-term deferrals were not considered troubled debt restructurings. After 60 or 90 days, borrowers may apply for an additional deferral. In the absence of other intervening factors, such short-term modifications made on a good faith basis are not categorized as a troubled debt restructuring, nor are loans granted payment deferrals related to COVID-19 placed on non-accrual (provided the loans were not past due or on non-accrual status prior to the deferral). At September 30, 2021, and December 30, 2020, the Company estimated that as a percentage of total loans and leases at amortized cost, excluding PPP loans, 8% and 20%, respectively, of its loans were receiving the six months of payments from the SBA and that 0.5% and 11%, respectively, of its loans had a payment deferral in place. The decrease in loans on payment deferral was largely a product of the Economic Aid Act introduced late in 2020, as discussed below. The Company estimated that 8% of its loans and leases at amortized cost, excluding PPP loans, were receiving payments from the SBA and that 0.5% had a payment deferral in place as of October 31, 2021. On October 2, 2020, the SBA began approving PPP forgiveness applications and remitting forgiveness payments to PPP lenders for PPP borrowers. As of October 31, 2021, the Company has received approximately $1.90 billion in PPP loan forgiveness from approximately 12,600, or 85% of total PPP loans originated by count.
On December 27, 2020 the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the "Economic Aid Act") was enacted which allows the SBA to make payments of up to $9,000 per month for up to six months of principal and interest payments on certain fully disbursed SBA 7(a) and SBA 504 loans in regular servicing status based upon the origination date. In addition, this legislation increased the 75% guarantee on many SBA 7(a) loans to 90%, among other things.
While some industries have experienced and continue to experience impacts as a result of COVID-19, the Company has $472.5 million in total unguaranteed exposure in six verticals considered by management to be "at-risk" of significant impact: hotels, educational services, wine and craft beverage, entertainment centers, fitness centers, and quick service restaurants, each comprising $127.5 million or 4.1%, $117.9 million or 3.8%, $97.8 million or 3.1%, $49.0 million or 1.6%, $41.3 million or 1.3%, and $39.0 million or 1.3% of total unguaranteed loans and leases (all at amortized cost, inclusive of loans carried at fair value) as of September 30, 2021, respectively. A substantial number of borrowers continue to show signs of recovery by making regular payments in the absence of payment deferrals and payment subsidies provided by the SBA. As of September 30, 2021 there are only 17 loans with an aggregate balance of $20.8 million in at-risk verticals still on payment deferral and 30 that continue to receive SBA payment subsidies with an aggregate balance of $53.8 million. While the third quarter reflected positive signs of emerging from at-risk status, management continues to closely monitor these vulnerable verticals for signs of weakness.
The Company continues to work with customers directly affected by COVID-19 and is prepared to offer short-term assistance in accordance with regulatory guidelines. As a result of the uncertain economic environment caused by COVID-19, the Company continues to engage in more frequent communication with borrowers in an effort to better understand their situation and the challenges faced as circumstances evolve, which the Company anticipates will enable it to respond proactively as needs and issues arise.
Results of Operations
Three months ended September 30, 2021 compared with three months ended September 30, 2020
For the three months ended September 30, 2021, the Company reported net income of $33.8 million, or $0.76 per diluted share, compared to net income of $33.8 million, or $0.81 per diluted share, for the third quarter of 2020. While net income was relatively the same for both periods, the primary changes are described in the following items:
Increasing net income:
Increase in net interest income of $26.4 million, or 51.3%, predominately driven by significant growth in total loan and lease portfolios combined with lower costs of interest bearing deposits;
A decrease in the provision for loan and lease credit losses of $6.0 million, or 58.0%;
Increased net gains on sales of loans of $6.2 million, or 48.6%; and
Decreased income tax expense of $2.3 million primarily due to renewable energy tax credit investment activities.
Decreasing net income:
A net loss on the loan servicing asset revaluation of $5.9 million, increasing by $7.9 million, or 385.2%, compared to a net gain of $2.1 million for the third quarter of 2020;
A net loss on loans accounted for under the fair value option of $1.0 million, increasing by $4.4 million, or 130.3%, compared to a net gain of $3.4 million for the third quarter of 2020;
Decrease in equity security gains of $14.5 million. Gains in the third quarter of 2020 were principally comprised of $13.7 million associated with the Company's investment in Greenlight Financial Technologies, Inc. ("Greenlight"); and
An increase in total noninterest expense of $12.8 million, or 30.0%, comprised principally of increased salaries and employee benefits of $4.0 million, travel expense of $1.6 million, professional services of $2.9 million and data processing of $1.9 million.
Nine months ended September 30, 2021 compared with nine months ended September 30, 2020
For the nine months ended September 30, 2021, the Company reported a net income of $136.8 million, or $3.05 per diluted share, as compared to $30.0 million, or $0.73 per diluted share, for the nine months ended September 30, 2020. This increase in net income was largely due to the following items:
Increase in net interest income of $86.7 million, or 65.5%, also predominately driven by significant growth in total loan and lease portfolios combined with lower costs of interest bearing deposits;
A decrease in the provision for loan and lease credit losses of $20.7 million, or 64.7%;
Increased net gains on sales of loans of $12.5 million, or 36.3%;
A net gain on loans accounted for under the fair value option of $4.3 million, increasing by $12.6 million, or 151.9%, compared to a net loss of $8.3 million for the first nine months of 2020;
Increase in equity security gains of $29.7 million. This increase is principally the result of a second quarter 2021 gain of $44.1 million associated with the Company's investment in Greenlight.
Key factors partially offsetting the increase in net income for the first nine months of 2021 were:
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Nov 03, 2021
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